Social Impact “Bonds”: The Wrong Name

Careful readers of my posts about the Pay For Success program have noted that I never used the phrase “Social Impact Bonds”. Social Impact Bond is the phrase used to describe the program in the UK that inspired the Pay For Success program. It is also frequently used in the US as a catch-all phrase for Pay For Success-like programs.

I think the phrase is misleading and could limit the potential for private investors to finance Pay For Success-like programs.

As I described in my column about Pay For Success, the primary innovation in the model is a contractually agreement between the government and an intermediary (which would then contract with nonprofit service providers) for the delivery of specific results. Instead of paying for program execution, the government instead would pay for results (such as higher test scores, a lower rate of ex-felons return to jail or a higher rate of welfare recipients reentering the work force).

Since government payments would only be triggered when certain results-based benchmarks were achieved, the intermediary would need to finance the program execution prior to receiving payment. In addition, the intermediary might never receive payment since successful results are not guaranteed. This means that the intermediary would need to raise capital (unless the intermediary was an endowed foundation, which I’ll discuss in another post) and this is where the “social impact bond” concept comes in.

In the case of the UK model, private financing was provided to the intermediary. If no successful results are achieved, the private investors will lose all of their money. If success is achieved, government payments will be triggered that will result in a return of capital plus an additional rate of return to compensate the investors for the risk they took. The rate of return will increase as the level of success increases.

This framework is not a bond. A bond is a loan that the borrower promises to repay along with interest payments. The mechanism used in the UK program is a performance based contract. This might sound like semantics, but if the Pay For Success program ever hopes to attract private financing at scale, it will need to look to Wall Street. When Wall Street looks at this framework, they will immediately recognize it as a high risk investment that has a significant potential of total loss of principal and bears no resemblance to a bond. Frankly, calling it a bond would be false and misleading advertising. A Wall Street firm marketing these instruments as “bonds” would be inviting an SEC investigation.

Now, I don’t believe at all that the UK program used the phrase Social Impact Bond in an attempt to be misleading. I’m certain that the private investors fully understood the type of investment they are making. But as these sorts of programs attract national interest in government and Wall Street, it is imperative that the financing aspects of the program be described correctly.

The Pay For Success program doesn’t only create a format for performance based contracts. It also specifically allows for outside financing to be obtained by the intermediary. But these two aspects should be understood as separate and distinct aspects of the program.

If the Gates Foundation acted as a intermediary, they could participate in Pay For Success and self-finance the deal. Enterprising intermediary may, over time, create a multitude of financing approaches to pre-fund their program costs. Some of these approaches may very well come in the form of loans or bonds. Theoretically, a for-profit intermediary entity could emerge and seek to raise equity financing (selling shares in itself to outside investors) to create the capital it would need.

Some day we might see true social impact bonds that are used to finance Pay For Success programs. But the phrase is incorrect and misleading when it is used a catch-all phrase to describe Pay For Success-like programs.


  1. Arthur Wood says:

    Sean – it is a long time since we last spoke in Dubai but as the person who is acknowleged by the UK Social Investment Bank as having given them the original idea of what has become known as a “social impact bond” , and presenting the idea to UBS Global Philanthropy forums and the Canadians since 2006 – you will allow me these few comments. I do this as there are some real misunderstandings of what this structure is and is trying and indeed what it could do. My comments are qualified in my old bankers hat as head of a Product development Unit of a major bank.

    First off you are quite correct it is not a Bond as such – it is what bankers know as Structured Product and as such is certainly very common in Europe Private Banking circles and with many instiutional investors. Thats is the reason when I first spoke about it publicaly in 2006 onwards I referrred to it as a Enhanced Social Investment Note or Contingent return model. SIB in the UK subsequently dubbed it an SIB. As an aside my hat off to them for there brilliance in getting the UK Tresury to accept the concept

    I however see no problems with Regulators as was implied by one post and no problem of any banker in London or NY understanding what it is.

    In terms of the framework for those of you with children you will recognise the nursey rhyme – This way – That Way – backwards and forwards over the Irish Sea – A bottle of rum to warm my tum – thats the life for me.

    In essence when you take all the mystique and buzz words out of financial product development much of it is in essence is just moving cash flows backwards and forwards.

    What this structure does is define a cash flow as a function of a social intervention – that cash flow does not just need to be the opportunity cost / benefit to Government as is currently proposed – it could also be applied to the opportunity cost to a company – legitimsed by the use of an L3C in the US or SELLP in the UK (which I have also been involved in). As an aside but I slightly digress an L3C or SELLP should also provide a mechanism to replicate these structures cost effectively to Social Entrepreurs and an easy compliance framework for Govt.

    In essence this flips the traditional model on its head – as opposed to a traditional grant and for profit model with social impact almost taggged on — this then creates a clear cash flow as a function of social impact.

    As any banker will tell you once you have cash flow you can create a whole range of fiancail products for social purpose. For example under this model if the cash flows were to be securitised (conceptually not that hard) – you would create instruments that would then trade as a function of the achievement of the social purpose. These could be traded on a social stock excahnge to ensure adherence to core values – and as a very positive aside create an entry and exit opportunity for the social capital market – the lack of a secondary market is a major detrient to investment in this market.

    A comment was also made that these are very risky – that is not a compliance issue as long as the risks are clearly laid out and would have to be – however it is worth noting that the standard position is that the Investor gets a negative 100% return – its called a grant. This offers them a return and if they help / pressure the outcome quicker a higher return

    The structure was designed so that this process drives creative destruction into the system – this will not be welcomed by all. But as a sector we should ask for the most part why do we have the same players as existed thirty years ago.

    The role of the corporate sector / investor in this structure is to incentvise and drive the quickest achievement of the social metric. It rewards results and incentivises innovation. For the Social entrepreneur it gives long stream income flows in support of there core compettnce – not as oppse to spending 50 cents on the dollar raising unleveraged unannuitised income – this surely should be welcomed.

    To the Metrics point – as in business – what ges measured gets done – so the definetion of the metric is the hardest bit – but logically will be applied where the highest social impact can be identified.

    If we get this right this structure also moves us towards outcome models – not Input how much money do we raise, nor Output – ie how many hospitals / services do we provide – but an Outcome asks a far more blunt question – How many children die in this area or How polluted is this river ? This will force intra and inter sectoral collaboration – what we all surely want and what we all intuitively realise is necessary to the major issues.

    This should NOT be seen as a bi lateral process for the social sector as it flounders to get money in an increasingly hostile fiscal environmement – the Minnesota Performance Bond proposal is classic in this regard – with no clear indication as to who will provide cash flow or take the risk – a mysterious “intermediary who has not been identifed yet” Perhaps Santa Claus and his eleves – see you at the North Pole….Best Arthur

    • Hi Arthur,
      Thanks for leaving the comment. As you saw in my first post on this topic, I’m very much in favor of the Pay for Success (or Social Impact Bond) programs. I just think that the term bond is the wrong one for this program. The semantics are important because we’re bringing together finance and philanthropy and the philanthropy side isn’t very familiar with finance (nor finance with social impact).

      A few years ago there was a spate of “charitable IPOs” in the US, one even counted Warren Buffett as an “investor”. But these transactions were really just normal donations dressed up to look and feel like Wall Street. I’d like to see the Pay For Performance program get billed correctly.

      Your comments about cash flows allowing for various structures is spot on. The cash flows are want makes something a viable investment. By identifying and claiming the cash flows that accrue to government due to social programs, the Pay For Success program creates the potential for a whole range of financial investments.