What is a Social Impact Bond?
With increasing demand on limited public resources, national and local governments are recognizing the need for a new approach to social services that emphasizes the identification of effective, innovative ideas. However, a lack of available funding and the unwillingness to risk that a promising, but untested, idea might fail have created obstacles to this new approach. The social impact bond model is designed to eliminate these obstacles.
Social Impact Bonds (“SIB”) are not bonds in the traditional sense, but rather pay-for-performance contracts, through which private capital finances innovative social programs otherwise funded by governments and charities. Investors receive a return on their investment if the program saves public funds by addressing the social condition it seeks to improve.
Unlike traditional bonds that generally provide a guaranteed rate of return, the return to investors in a SIB transaction is entirely contingent upon the achievement of a specified social outcome. In terms of investment risk, SIBs are similar to equity investments. However, a SIB is not a financial instrument that can be bought and sold, but rather a contractual relationship between the government and an external organization to arrange and manage social intervention programs in pursuit of a defined outcome. If the external organization achieves that outcome, the government pays out an agreed upon return. If the desired outcome is not achieved, the government makes no payment.
The concept of SIBs originated in the United Kingdom, where the first SIB was launched in 2010 to reduce recidivism among the population of short term, nonviolent men incarcerated at Peterborough Prison. Efforts to implement SIBs within the United States are gaining momentum. In August 2012, the City of New York announced the implementation of the first SIB in the United States (the “NYC SIB”) aimed at reducing recidivism among 16 to 18-year-old adolescents imprisoned in the Rikers Island complex. In 2013, the State of Utah implemented a SIB (the “Utah SIB”) to expand the availability of high-quality early childhood education. Goldman Sachs has served as the lead investor in both financing efforts, contributing $9.6 million and $4.6 million to the City of New York and the State of Utah respectively. Most recently, the State of New York announced the development of another SIB (the “New York State SIB”) aimed at reducing recidivism rates among New York state prisoners. Bank of America Merrill Lynch will contribute $13.5 million, raised from more than 40 private and institutional clients, to fund this endeavor.
The Structure of Social Impact Bonds
Although the structure of SIB transactions can vary significantly, they are likely to include the following entities: (1) a government or governmental agency; (2) an external organization or intermediary; (3) investors; (4) service providers; and (5) an independent evaluator.
The government or governmental agency typically initiates the SIB transaction. The government or governmental agency defines the targeted outcome, population and duration of the transaction and will provide payment if the defined outcome is achieved.
The external organization or intermediary operates as the counterparty to the SIB contract with the government or governmental agency. The external organization or intermediary can be a nonprofit or a for-profit entity and may be tasked with hiring and administering service providers, raising working capital from investors, and managing overall progress.
The investors provide the working capital necessary to fund the social programs or interventions implemented to achieve the outcome. If the program is successful and the predetermined outcome is achieved, the external organization or intermediary repays investors with a rate of return negotiated by the parties.
The service providers are hired and managed by the external organization or intermediary to implement the intervention program. Generally, service providers receive direct funds from the external organization or intermediary to provide the working capital contributed by the investors.
The independent evaluator certifies the achievement of the outcome using a methodology approved by the parties. The independent evaluator notifies the government or governmental agency if the predetermined outcome has been achieved. The government or governmental agency then releases performance based payments to the external organization or intermediary which then transfers these payments to the investors.
Application of the social impact bond structure
The NYC SIB serves as an example of the successful implementation of the structure delineated above. As stated, the City of New York launched the NYC SIB to reduce recidivism among the population of 16 to 18-year-old men incarcerated in the Rikers Island complex. The NYC SIB involves a series of interrelated contracts among the following parties:
The City of New York (government or governmental agency)
The Mayor’s Office initiated the NYC SIB, coordinating each of the city entities involved to structure the contracts and negotiate their terms.
The Department of Corrections (“DOC”) will repay the investors and provide an additional return on investment based on the reduction in recidivism and associated cost savings.
The Manpower Demonstration Research Corporation (“MDRC”) (external organization or intermediary) identified the cognitive behavioral therapy intervention program and negotiated the terms of the transaction. Additionally, MDRC oversees the implementation of the intervention program.
The Urban Investment Group of Goldman Sachs Bank USA (“Goldman Sachs”) (investor) provided a $9.6 million loan to MDRC to implement the intervention program that provides cognitive behavioral therapy services for 16 to 18-year-old adolescents in the Rikers Island complex.
Bloomberg Philanthropies, a philanthropic investor, provided a $7.2 million grant that will partially guarantee the Goldman Sachs investment if the program fails. If the program is successful, the grant will be used to support future projects. Bloomberg Philanthropies also provided a separate grant to fund MDRC’s costs.
The Osborne Association and Friends of Island Academy (service providers), the nonprofit service providers, administer the cognitive behavioral therapy intervention services which are the centerpiece of the intervention program.
The Vera Institute of Justice (independent evaluator) will verify that the project has achieved the intended reductions in recidivism and determine if payment is warranted pursuant to the terms of the transaction.
The chart below demonstrates the interaction between the parties involved in the NYC SIB transaction and the flow of funds and services among these interrelated parties.
This chart and the information within this section have been reproduced from information contained in Timothy Rudd et al. Financing Promising Evidence-Based Programs Early Lessons from the New York City Social Impact Bond, MDRC (December 2013), available at http://www.mdrc.org/sites/default/files/Financing_ Promising_evidence-Based_Programs_FR.pdf.
The transaction between the parties to the NYC SIB is premised on the expectation that the investment will result in a minimum 10 percent decrease in the recidivism rate of the target population by 2016. A 10 percent reduction in recidivism will result in the full repayment of the principal investment made by Goldman Sachs by July 2017. If the recidivism rate of the target population is reduced in excess of 10 percent, further net projected taxpayer savings will be realized resulting in higher returns to Goldman Sachs.
The Development of Social Impact Bond Transactions Within the United States
Both the State of Utah and the State of New York have adopted the same basic structure employed in the NYC SIB, with some modification.
To fund the early childhood education program in Utah, Goldman Sachs provided an initial investment of $4.6 million. Although Goldman Sachs will not receive the added security of a guarantee in this transaction, J.B. Pritzker, an individual entrepreneur and philanthropist, has contributed an additional $2.4 million investment in the form of a subordinated loan, reducing the risk to Goldman Sachs in the event the program is deemed ineffective.
The New York State SIB, implemented to reduce recidivism among New York state prisoners, features investment in the form of a fund managed by Bank of America Merrill Lynch. Through this fund, Bank of America Merrill Lynch will contribute $13.5 million towards the New York State SIB, raised from more than 40 private and institutional clients. The Rockefeller Foundation will provide a $1.32 million guarantee, ensuring that investors will receive at least 10% of their principal investment in the event the program is deemed ineffective.
Using SIBs to Enhance Social Welfare
The entry of Goldman Sachs and Bank of America Merrill Lynch into the SIB market has prompted competitors to take notice of low risk investment opportunities that offer both a reasonable rate of return and a boost to public image. Increasingly, private investors are demanding double-bottom line returns which provide both financial returns on investments and quantifiable social impact. To address investor demand for social impact investments, Goldman Sachs has launched a $250 million social impact fund aimed at creating investment returns linked to the success of projects in early-childhood education, affordable housing, and reduced prisoner recidivism rates. Morgan Stanley has also announced the creation of the Morgan Stanley Institute for Sustainable Investing with the goal of attracting $10 billion of client funds in the next five years for projects aimed at achieving these double-bottom line returns. The participation of these leading investors will likely draw their competitors into the social impact investment market and will dramatically increase available funds from which governmental entities can seek financing for innovative social programs.
As municipalities face increased budgetary constraints, SIBs can provide the necessary financing to implement innovative social programs aimed at enhancing social welfare while transferring the risk of investment in ineffective programs to the private sector.