Private Finance, Public Good: The Future for Children Bond

[You can download a PDF of this post here.]

At a time when we’re still suffering from the predations and gluttony of many on Wall Street, it can be hard to remember there was a time when financiers actually did something socially useful.  But we would not have the bounty most of us take for granted in technology, health care and energy without the foresight and courage of those who discovered those embryonic opportunities and raised the money to sustain and grow them.  The economic vitality of the United States since World War II would not have been possible without our singularly robust capital markets.

Still, much of the financial sector clearly lost its way, and the rest of us are still paying the price.  Nor have we really learned from our mistakes.  So while “financial engineering” isn’t intrinsically evil, it’s clearly capable of being grievously misused.

Many reasonable people fear that “social investment” (also called impact investment) will take us down the same road.  For example, after the Alberta College of Social Workers passed a motion on January 18th to oppose the use of social impact bonds in Alberta, Canada, spokeswoman Lori Sigurdson told the Edmonton Journal, “We don’t want some people to profit from the misery of others.”

This isn’t an illegitimate or trivial concern.  I happen to agree with Ms. Sigurdson that “[t]he primary responsibility of government is to be supporting vulnerable and marginalized people.”  Of course, the problem today is that government doesn’t fulfill that responsibility, and (as I write about in my book) hasn’t really done so for the last several decades.  The once-gloried social compact has become something of a bad news/bad news tale:  the safety net doesn’t work, and we can’t afford it.

The emergence of impact investing does not herald the selling out of the social sector.  I won’t say there aren’t risks we have to guard against.  The evolution of the microfinance industry, for example, provides a cautionary tale.  But this is truly a case where we don’t want to become so intransigent that we preemptively deny social entrepreneurs the means to grow that only private capital might be able to provide.

A case in point is the Future for Children Bond, announced today by Allia, an English charitable organization that describes itself as “The Social Profit Society.”  The Future for Children Bond is “the first public offering of a Social Impact Bond to retail investors.”  What does that mean and why is it a very big deal?

As Allia explains, social investment is simply “the provision of finance with the objective of achieving specific social outcomes and the expectation of receiving back at least the original amount invested.”  The words “objective” and “expectation” signal that uncertainty is involved, while “at least” suggests the prospect of a positive reward beyond merely breaking even.

Readers of this blog know what a Social Impact Bond (SIB) is, and newcomers can find a great New York Times article here.  Inherent in most formulations of the SIB concept is the possibility that investors could lose some or all of their initial investment, an unwelcome prospect known as “loss of principal.”

Like all social investors, SIB investors hope that won’t happen, and that the worst outcome would be that they “only” get their money back.  In the basic SIB model, investors break even if the project they support hits the agreed social outcome target (say, a 10% reduction if prisoner recidivism), and they earn a profit (“a return”) if they exceed the target.  If they fall short, they stand to lose some or all of their principal depending on how the SIB contract is written and how close they get to the agreed results.  The idea is to encourage social investors to support innovative programs that might produce superior results, and to accept a certain amount of risk that they might not.

Of course, most impact investors are also philanthropists.  They give money away with no expectation of getting any of it back.  But the supply of philanthropy isn’t unlimited.  If we want civic-minded affluent people to make a lot more money available for social purposes, they need to know they’ll eventually get it back.  Philanthropy is disposable, social investment is recyclable.

Finance is socially useful when it supercharges economic output, which is why it’s entirely reasonable for conservatives to say that “the best social program is a job.”  While the nonprofit sector does produce millions of jobs and generates billions of dollars of economic value, philanthropy is designed, in large measure, to address market failure.  Finance is designed to amplify market success.

The Future for Children Bond exemplifies financial innovation for social good at its best.  If offers some inspired improvements over the simple SIB model that should make it much more attractive to investors and, therefore, a potentially much more powerful way to expand social programs that clearly work and that children and families desperately need.

I’m going to explain in some detail what makes them more attractive and why they have greater growth potential.  You might want to get yourself a nice cup of hot chocolate and a comfy chair.  This will take a while.

Why Future for Children Bonds Are Attractive Social Investments, Part I:  “Security Trumps Returns”

No one’s going to get rich investing in SIBs.  At this point, we don’t even know if they work, and, if they do, the returns are likely to be modest.  (Another lame SIB joke:  “The risks are high, but at least the returns are lousy.”)  SIBs won’t get your blood racing unless you’re an investor who’s motivated by the possibility of producing much better social outcomes.  As Cathy Clark, Jed Emerson and Ben Thornley recently wrote, social investors might well consider “low single-digit financial returns with clear social outcomes” to be “[e]xceptional returns.”  We’re lucky to have such civic-minded investors.

The really challenging part of getting SIBs right is managing the risks, or, in financial lingo, “reducing the downside.”  Social investors aren’t looking for huge profits, they’re looking for modest profits they think they will actually see.  As Steve Godeke and Lyel Resner recently observed, “security trumps returns.”  Katie Hill, an advisor to the City of London Corporation agrees:  “protection of the downside is more important than potentially high upside.”

SIBs have downside risk because investors get their principal back only if they invest in charities that achieve results established in the SIB contract with government.  In the world’s first SIB, recidivism rates for Peterborough prison must be at least 7.5% lower than rates for comparable ex-offenders released from ten other English prisons.  In the first US SIB, juvenile recidivism at Rikers Island jail must be reduced by at least 10%.  If Peterborough rates are only 7.4% lower, the investors lose their entire principal.  If Rikers Island recidivism falls by at least 8.5%, investors lose half of their principal; if not, they lose everything.

That’s a lot of downside risk.  As I explained in the latest issue of the Social Impact Bond Tribune, SIB developers are exploring a variety of ways to try to reduce that risk.  In the case of the Future for Children Bond, Allia has come up with a particularly clever approach.

How The Future for Children Bond Works

When you buy a Future for Children Bond, you’re actually making two social investments at once, with very different levels of risk.  The first one is an honest-to-goodness bond, a fixed-rate loan to Places for People Homes, “a Moody’s Aa rated housing provider that builds, sells and rents homes and provides services and support to those who live in them.”  Moody’s Investors Service says “[o]bligations rated Aa are judged to be of high quality and are subject to very low credit risk.”

The second part of the Future for Children Bond is a SIB offered by the Essex County Council to provide services to troubled families whose children are considered to be “at risk” of being placed “in care,” that is, removed from their homes to protect them from potential child abuse and neglect.  (In the US, we call these “child welfare” services.)

Essex County is a study in contrasts, with some of England’s wealthiest and poorest communities.  All but one of its 18 Members of Parliament belong to the Conservative Party.  When it comes to children in care, Essex faces some formidable challenges:

• “High numbers of children in care;
• Predominance of high cost residential placements;
• Higher proportion of older adolescents with behavioural issues;
• Poor parenting support in particular around managing behaviour;
• Under developed early intervention and family support services;
• Lack of higher level intensive interventions and limited resources to establish them; and
• Vicious circle, wrong service offer, young people in care unnecessarily, pressure on budgets, reducing available investment.”

Roger Bullen, the Head of Joint Working at Essex County Council, has a simple goal for changing the system for children on the edge of care: “Fix it, and fix it forever.”

The Future for Children Bond funds two social investments in order to separate the risk and return features of the bond:  the loan to Places for People Homes protects the principal amount and the Essex County SIB provides the potential return.  For every £1,000 invested in the Future for Children Bond, £780 goes to Places for People Homes, £200 goes to the Essex County SIB, and £20 (2%) goes to Allia to cover its costs.

At the end of the eight-year term of the Bond, Places for People Homes will repay £1,000 for the £780 loan, an interest rate of 3.2%.  As this is a very safe loan, the likelihood that investors will get back their entire principal is extremely high.  So the worst expected financial outcome for the Future for Children Bond is that the investors break even (leaving aside inflation and the time value of money).  Allia’s statement that the “[m]inimum return to investors will be 100% of funds invested” is not one that most SIBs can make.

A “not-for-dividend” organization, Places for People,  is “one of the largest property management, development and regeneration companies in the UK.”  It manages more than 83,000 homes and has “a long track record of successful development, from large-scale regeneration projects to the creation of whole new communities and manage[s] these projects so they remain sustainable into the future.”  In 2012, Places for People earned a Platinum award in the Corporate Responsibility Index, recognizing it as one of the most ethical businesses in the UK.

That’s the first part of what makes Future for Children Bonds so attractive.  The odds of losing any of the principal are negligible, and the loan proceeds are put to very good use for eight years.  For social investors who just need to make sure they get their original investment back and do some good along the way, the Bond should be a no-brainer.

Why Future for Children Bonds Are Attractive Social Investments, Part II:  Getting More Than Just Your Money Back

But there are two more features that make the Bond an attractive social investment.  The first is the possibility of making a modest profit on the investment.  The second is the possibility of making really effective social services much more widely available to kids who really need them.  Let’s get the profit part out of the way first.

Like most SIBs, the underlying concept is that “an ounce of prevention is worth a pound of cure.”  As Allia explains, “[t]he Essex SIB will fund a programme of ... intensive support to approximately 380 children and their families. The target is to divert around 100 young people from entering care by providing support to them in their home. The success of the SIB will be measured by the reduction in days spent in care by these children, as well as improved school outcomes, wellbeing and reduced reoffending.  If the programme is successful in reducing the amount of time children need to spend in care, it will result in cost savings for Essex County Council, which can be used to provide a return to the investors in the SIB.”

This might be a good time to replenish your cocoa, as I’m going to take a rather deep look at this simple explanation.  The parties behind the Future for Children Bond have tapped into something truly significant.

Taking children at risk of abuse and neglect away from their families is an emergency measure that, unfortunately, produces its own adverse consequences.  “When it is clearly unsafe for a child to remain in his or her home, foster care provides a temporary safe haven. However, for too many children, foster care becomes long-term and unstable. Research demonstrates that children who have been in foster care for lengthy periods of time do not fare as well as their peers, especially in the areas of education, employment, mental health and teen pregnancy. Factors such as the number of changes in foster families, changes in schools and separation from siblings often harm a child’s behavioral and social functioning.”  Casey Family Programs, “Ensuring Safe, Nurturing and Permanent Families for Children” (May 2010).

In the US, about one-quarter of the 424,000 children currently in foster care have been there for more than three years.  That’s far too long.  In the UK, there are currently more than 67,000 children in care, with around 1,500 children in Essex County.  The SIB targets one particular group:

“The largest group being looked after is adolescents. They often enter care because of multiple and complex behaviour problems which lead to aggression, antisocial behaviour, parental loss of control, family breakdown, and ultimately an inability or lack of desire to continue living with their birth family.  Young people who enter care in their teenage years are likely to spend more than 80% of their remaining childhood in care.  The life chances of these children are typically bleak:  half of looked after children obtain fewer than five GCSEs [a UK academic qualification] or equivalent compared to the national figure of 10%; one in three previously looked after children is not in education, employment or training at age 19; one in four of all prisoners has been in care, compared with 2% of the population overall.”

Beyond the traumatic social impacts of children languishing in foster care or residential placements, “[s]tate care is also expensive, costing up to £180,000 [about $283,000] a year for a child in residential care.”  Total projected spending in the UK for foster care alone is about £2.4 billion  (about $3.8 billion) per year, and the US spends about $29.4 billion (about £18.7 billion) per year for child welfare programs.

That’s a lot of money.

But child abuse and neglect is also a problem we know how to prevent to a much greater extent than we currently do.  The funds raised by the Essex SIB will be used to provide Multi-Systemic Therapy (MST), a comprehensive approach that “blends the best clinical treatments—cognitive behavioral therapy, behavior management training, family therapies and community psychology.”  For anyone worried that SIBs will favor investors by avoiding hard cases, MST works with “the toughest offenders ages 12 through 17 who have a very long history of arrests.”

Dr. Scott Henggeler developed MST in the mid-1970s when he was getting his Ph.D. at the University of Virginia.  After working with some of the state’s most antisocial teenagers and making little progress, he decided to visit the adolescents in their homes. “It took me 15 to 20 seconds to realize how incredibly stupid my brilliant treatment plans were.”

MST is “an intensive family- and community-based treatment program that focuses on addressing all environmental systems that impact chronic and violent juvenile offenders – their homes and families, schools and teachers, neighborhoods and friends. MST recognizes that each system plays a critical role in a youth’s world and each system requires attention when effective change is needed to improve the quality of life for youth and their families.”

Now, MST is not your average social program.  It’s used in 34 states and 14 countries to treat more than 23,000 youth and their families every year.  Rigorous research involving more than 5,200 families, including 20 randomized control trials, shows that MST reduces out-of-home placements by 47-64%.  A 14-year follow-up study by the Missouri Delinquency Project showed youths who received MST had up to 54% fewer re-arrests, 57% fewer days of incarceration, 68% fewer drug-related arrests, and 43% fewer days on adult probation.

In fact, MST has consistently demonstrated positive outcomes with chronic juvenile offenders for more than 30 years.  It has been endorsed by Blueprints for Violence Prevention, the Office of the Surgeon General, the Coalition for Evidence-Based Policy, SAMHSA's National Registry of Evidence-based Programs and Practices (NREPP), and the Washington State Institute for Public Policy, among others.

In order to achieve these results, MST Services, Inc. was founded to disseminate the intervention in compliance with a long list of specific practices that are critical to its success.  In 1996, the Medical University of South Carolina licensed MST Services to train therapists and provide them and their supervisors with support, resources and ongoing coaching, including budgeting and business planning, hiring, record-keeping, reducing staff attrition, quality assurance, and marketing and public relations.  You can’t provide “MST®” – and that’s the only kind of MST there is – without signing up for the complete package.

This is why the Essex County Council knows that MST will work.  And the Council knows it will save money because MST has also been the subject of exceptionally thorough cost-benefit analysis. The Washington State Institute for Public Policy estimates the net direct cost of MST to be about $4,743 (a little more than £3,000) per participant, and found that “taxpayers gain approximately $31,661 [just over £20,000] in subsequent criminal justice cost savings for each program participant.”  Every dollar spent on MST saves $6.68, and every pound saves £4.25.

In short:  the current governmental response to reports of child abuse and neglect is ineffectual and prohibitively expensive.  With MST, we have a highly-effective, low-cost way to prevent an array of devastating social problems afflicting one of our most vulnerable populations, older teenagers at risk of being placed in long-term foster care or residential facilities.  

At about this point, you’re probably wondering why government doesn’t just pay for MST directly.  There are a number of messy and confusing explanations, but the short answer is there’s little or nothing left for MST after government pays for emergency care and residential placements.  Even though government could provide better care at lower cost using MST, it can’t take money away from acute care to pay for prevention because prevention takes time to work and, in any event, it won’t completely eliminate the need for emergency services and out-of-home placements.

As the US Department of Health and Human Services said in 2011, “there is often a struggle encountered with successfully scaling up selected evidence based interventions while converting the old services array to new evidence-supported services.”  Government can’t pay for both at the same time, so it needs to use someone else’s money to bridge the gap.  That’s where private investors come into the picture.  Let’s turn next to what gives the Future for Children Bond much greater power to expand MST.

Why Private Investment in Future for Children Bonds Can Expand MST in Ways That Government Spending and Philanthropy Can’t

Allia calls the Future for Children Bond a “capital plus” bond which “combines a low-risk ethical investment into affordable housing (Places for People Homes) to provide the funds to repay capital to investors, with a high-risk investment into the social impact bond with the aim of delivering a high social impact and providing an additional variable return.”  Allia is starting out rather modestly, seeking to raise just £3.1 million, but once this gets rolling, I think the demand will outstrip the supply.

Would this be an opportune time for me to mention that I don’t make any money from Future for Children Bonds?

I have to begin with some tedious terminology that will sound crass and cynical to many ears.  Please bear with me while I try to convince you that they have the potential to accomplish things that nicer-sounding words like “grant” and “social compact” can’t.  

“Monetization” means extracting a financial benefit from a nonfinancial activity.  When preventing a problem saves money, the savings become available for other uses.  So SIBs monetize future government savings (we hope) by reducing the demand for more expensive government programs.

“Financialization” means, at least in this case, making the opportunity to monetize an activity into something that others can invest in.  So a SIB isn’t just a way to pay for prevention programs, it’s a financial instrument that investors can buy so they can share in any returns that result from monetizing future government savings.

So the first step in raising more money for MST (or, indeed, for any SIB), monetization, is making something that doesn’t have financial value into something that does, and the second step, financialization (or securitization), involves creating an investment vehicle that can raise capital from lots of investors who want to fund the monetizing activity.

It’s common for reasonable and dedicated people involved in charity to think that this turns an activity that shouldn’t be about money – helping children at risk – into something that’s just about money – investing.  But SIBs and other social investments don’t make money more important than helping people.  Instead, the only way they make any money for investors at all is if they do help people.  If they don’t, the investors won’t get paid and that’ll be the end of this grand experiment.

Social investing will definitely be a major change in how we fund social programs, and there’s no question it rubs some people the wrong way.  All I can say is that the way we used to address these kinds of problems no longer works, and the problems are only getting bigger and uglier.  Impact investment might work a lot better.

Future for Children Bonds provide a small financial incentive for investors to pay for more MST, which could reduce the number of children taken from their homes and save government a lot of money.  Monetization creates an entirely new source of funding that doesn’t compete with limited government budgets or donations.

The 380 kids who will benefit from the initial £3.1M bond sale represents a good start on the 1,500 children-in-care in Essex County, but it barely scratches the surface of the 67,000 in the UK.  If the Essex County SIB works, there’s no reason why other bonds couldn’t be offered in other counties.  By financializing the investment opportunity, MST can be expanded, and there’s an enormous untapped supply of capital available for low-risk investments that produce reliable social benefits.

When Paying Retail is a Good Thing

Allia’s bond has one more trick up its sleeve, and it’s a beaut.  

As we’ve learned the hard way, securities can be dangerous, so they need to be regulated.  Different kinds of securities need different levels of regulations, which have the general purpose of informing investors of the risks inherent in any particular instrument, known as “disclosure.”  Different kinds of investors need different kinds and amounts of disclosure, often based on how sophisticated the prospective investors are likely to be.  Professional investors need less disclosure because they have other sources of information; the general public needs more disclosure because they can’t understand and don’t even read fine print.  Some investments are simply too complicated to explain to amateurs, so they can’t be sold to the public.

SIBs are an untested and unconventional financial instrument with uncertainty and risk at every link in the value chain:  private investment => prevention => government savings => repayment of principal plus return.  At this point, they’re essentially unregulated, so only professional investors can buy them, which limits their growth potential.  If and when we understand the risks better, SIBs should be able to be sold with adequate disclosures so they can raise more money to expand more programs like MST, which will take billions of dollars to serve every family that needs it.

But Allia took this dilemma head on.  First, recall that 78% of the proceeds from the Future for Children Bond is invested in a very safe and very ordinary bond, which is used to repay investors 100% of their principal.  Second, the SIB only gets 20% of the proceeds (Allia gets 2%), which goes toward profit if and only if the MST services save Essex County an agreed amount of money.  Allia tells investors up front they might get absolutely no return from the SIB portion of the bond.

Voilà:  investors now understand their risks.

Allia adds one more feature:  Future for Children Bonds can only be purchased through financial advisors licensed by the British Financial Services Authority, the counterpart of the US Securities and Exchange Commission.  These registered advisors now have a financial incentive to tell their clients about these Bonds.  Taken together, these three features make the Future for Children Bond the first SIB that can be sold to “retail,” i.e., nonprofessional investors like you and me.

Well, not me, because the minimum investment size is £15,000, or $23,578.50, which I don’t happen to have on me at the moment.  (Would you take a post-dated, third-party check?  Doesn’t matter.  I don’t have one of those either.)

But £15,000 is way below the minimum “subscription” amount for securities that can only be purchased by “accredited” investors, which run into the hundreds of thousands or even millions of dollars.  The SEC defines an accredited investor as an individual with an income of more than $200,000 per year, or a couple with joint income of $300,000, in each of the last two years, or anyone with a net worth exceeding $1 million.

By designing the Future for Children Bond as a retail investment product, Allia is opening a completely new frontier for social investment.  If things go as planned, someday investments like this will become something that virtually anyone can invest in as part of your regular portfolio or your retirement account at work.  Mutual funds, pension funds and even foundation endowments could include SIBs.  That’s why impact investment has the potential to raise tens or hundreds of billions of new money for effective social innovations like MST.

Okay, we’re almost done.  I’ve tried here to explain the Future for Children Bond and its significance in terms that anyone can understand.  If I’ve been successful in simplifying something pretty arcane, I hope that no one draws the conclusion that there’s no rocket science in this particular innovation.  I have a Master’s degree in economics and a law degree, I’ve worked in government, business and nonprofits, and I could never have invented this thing.

With apologies in advance to everyone I’m leaving out, many of the brilliant people who did come up with this hale from the very same financial services industry and related corporate enterprises that brought the world to its knees beginning in late 2008:

• Tim Jones, CEO, Allia:  “Tim’s 35-year career spans financial services, SME start-up and social entrepreneurship. He has worked in North America, the Gulf and Europe – posts included Head of Marketing at FTSE Top 30 company Royal Insurance, and Managing Director, Europe, at Direct Marketing Corporation of America. He subsequently spent 12 years building, and successfully exiting, two enterprise start-ups – Fraser-Milne and STD Belgrade – before taking on Allia in 2002.”
• David Hutchison, CEO, Social Finance, Ltd. (UK):  “This follows a 25 year career at Dresdner Kleinwort where he was most recently Head of UK Investment Banking and a member of the Global Banking Operating Committee, coordinating the bank’s activities in the UK across the full range of investment banking products, M&A, debt and equity raising and derivatives marketing.”
• David Cowans, Group Chief Executive, Places for People:  “David has led the transformation of Places for People from a traditional Housing Association into a diverse business [with assets in excess of £3.1 billion] which provides a range of products and services to build and manage communities that can prosper and be sustainable in the long term. This includes regeneration services, financial services, affordable childcare, care and support services and a range of options to enable people to access a home whether through outright sale, affordable rent or sale or market rent.”

Of course, not everyone involved is a former banker or business executive:

• Children’s Support Services Limited (CSSL) is a newly-formed company set up by Social Finance to manage the outcomes contract with Essex County Council.   One of CSSL’s Directors, Lisa Barclay, is a Director at Social Finance who started her career as a public policy advisor focusing on Treasury, Transport and Employment policy areas and was a Special Advisor at the Department for Education and Employment.
• Tom Jefford, another CSSL Director, is the Head of Youth Support Services at Cambridgeshire County Council and has worked with MST Services for the last 10 years and is in the third year of a 4-year trial of MST for child abuse and neglect.
• The primary service provider is Action for Children, a charity that dates back to 1869 and is the largest single voluntary sector provider of services for looked-after children in the UK.  Clare Tickell, chief executive of Action for Children, whom Third Sector voted the “Most Admired Chief Executive” in 2008, “joined the charity in January 2005 after 16 years leading voluntary sector organisations.”

Not exactly Gordon Gekko.

I’ll close (finally!) with a personal observation.  On May 14, 2012, the Administration on Children, Youth and Families of the U.S. Department of Health and Human Services issued an “information memorandum” on “Child Welfare Waiver Demonstration Projects.”  The objective was essentially the same as the Future for Children Bond:  “there is a growing body of evidence suggesting that there are promising and effective approaches to improve outcomes for children and families in which abuse and/or neglect has taken place or is likely to take place. However, such approaches are utilized too rarely by many child welfare agencies. Our goal in facilitating innovation and experimentation in child welfare programs through waiver demonstrations is to improve outcomes for children and, thus, we encourage States to consider whether funding flexibility and improvements in the service strategies for children both at risk of foster care placement and those already placed outside the home could lead to better outcomes for children.”

With commendable prodding and support from the Office of Management and Budget, HHS included SIBs as one of the flexible funding mechanisms it wanted to promote:  “The proposed arrangements could take many forms and utilizing funding from non-Federal sources, including the philanthropic community and social impact bonds, is encouraged. For example, a state could condition provider payments, or bonuses paid from a foundation partner, on measurable improvement in child well-being outcomes or increased numbers of successful adoptions among the longest waiting children in foster care.”

As far as I know (and for reasons that I won’t go into here), no states applied to HHS for a spending waiver to use SIBs to keep at-risk kids from being taken away from their families.  Now that the UK has once again led the way by developing this brilliant social investment strategy as a promising approach for expanding proven prevention programs like MST, it’s time for government, foundations, social service agencies, and advocates in the US to take a close look.  This is one kind of financial engineering that can do an awful lot of public good.

Worried About Change

These are tough days to be in the public sector and it’s not going to get much better any time soon.  This isn’t a time for sugar-coating the situation in which we find ourselves.  Sir Ronald Cohen, Chairman of Big Society Capital in London, pretty much captures it when he says, “Government is out of money and out of breath.”  Social needs are rising and government can’t keep up.  Civil society is coarsening, poverty has become intergenerational and the tools of social mobility are calcifying.

As someone who has spent nearly 40 years working in and around government, and believes deeply in the social compact, I talk to a lot of public officials and employees who are frustrated and discouraged, but soldier on nonetheless.  These front-line troops know things have to change.

I’ve been working full-time on Social Impact Bonds for two years now because I think they have real potential to transform anti-poverty programs like nothing we’ve seen since Lyndon Johnson’s Great Society (which I’m old enough to remember first-hand).  But I’ll be the first to admit that raising money from private investors is an extremely unorthodox way to pay for innovative social programs.

James Clancy, the President of the National Union of Public and General Employees (NUPGE), has expressed his indignation about SIBs in a commentary entitled, “Top 10 reasons to be worried about Social Impact Bonds.”  Here’s his main argument:

“Like other privatization schemes, they are intended to help governments shift costs off their balance sheets. They try to do that by allowing the private sector to run services to make profits for investors.”

First off, SIBs don’t privatize anything.  They fund nonprofit prevention programs that the government doesn’t provide because their budgets are exhausted by safety-net, emergency response, acute care, and other remediation programs. 

But Mr. Clancy is not the first and won’t be the last detractor to weigh in against SIBs.  I’ll give him this:  his long list does a pretty good job of collecting virtually all criticisms of SIBs in one convenient place.  Having been involved in a many controversial government programs in my time, I’ve known all along that those of us promoting SIBs would have to address these concerns at some point.  Every one of his “reasons” are fair subjects for debate, so let me respond briefly to each.  This is a discussion we’ll be having for a long time to come.

“10.  There’s no proof they even work.”

Quite true, although that’s hardly a reason not to try.  But there’s considerable irony in the fact that SIB investors don’t get paid unless they can prove that they do work.  I don’t need to unfairly condemn government programs to say that one thing we don’t have much of is evidence of their effectiveness. 

Much of the impetus behind SIBs comes from the fact that we either know many government-funded programs don’t work or we have no idea whether they work.  Worse, some nonprofit programs that have been proven to work reach only a tiny fraction of the people who need them, in large part due to a lack of sustainable funding.  Those of us working on SIBs are fully prepared to be judged by our performance.

“9. They allow governments to hide debt and pass costs onto future generations.”

SIBs are not government debt.  Private intermediaries issue SIBs to raise capital from private investors.  The government agrees to pay the investors back, with interest, only if and when they achieve contractually-agreed results that save government money by reducing the need for expensive safety net programs like uncompensated emergency care, prison cells and homeless shelters.  If they don’t, the government has no financial obligations.  In fact, the whole point of SIBs is to transfer the financial risk of expanding nonprofit prevention programs from taxpayers to private investors.  That’s the bet investors make:  if the programs they invest in don’t work, they lose their money.

“8. Setting up Social Impact Bonds is complex and costly.”

It is, but the current system of responding after the fact to preventable social problems is much more so.  For example, it costs well over $40,000 a year to send someone back to prison after they’ve been released because they couldn’t find a job, a decent place to live and a drug treatment program, all of which cost less than half as much.  States pay upwards of $33,000 per person per year to provide emergency shelter, acute medical and mental health care, and countless other safety-net services to hundreds of thousands of chronically-homeless adults, many of whom can be so much safer and healthier in permanent supportive housing that costs about $24,000.

What’s complex and costly about SIBs isn’t so much the programs they fund, but the difficulty of shifting from an ineffective emergency response system funded by taxpayers to a privately-funded system that focuses on prevention.  The status quo isn’t based on contingent contracts that obligate states to repay investors if specific outcomes are achieved, investors aren’t familiar with how effective nonprofit programs work, and data about current costs and potential savings often isn’t available or reliable.  We’re in the process of trying to fill those gaps, and it is too soon to say whether we’ll pull it off. 

With the help of some innovative foundations and intrepid government leaders, we’re working hard to expand proven prevention programs using someone else’s money.  We have to convince investors that these programs work, we have to convince nonprofits to consider a whole new way of doing business, and we have to convince government to commit public funds based on avoiding unnecessary government expenditures.  Stay tuned.

“7.  Governments end up paying no matter what.”

This is just flat wrong.  All of the SIB contracts under development are being written as “pay-for-success” agreements, which means exactly what it says.  In fact, SIBs set the bar especially high because success has to be verified by an independent assessor before investors can be paid.  Investors know full well this is what they’re signing up for, and most won’t have any interest in SIBs because the financial returns are likely to be much lower than conventional investments that are much safer. 

The “social investors” who are eagerly exploring SIBs are primarily foundations and other philanthropists who will recycle their investments if they get paid back from successful programs.  No one’s going to get rich from investing in SIBs, but it could be an attractive alternative to just giving money away in the form of donations and grants.  The fact that investors hope to get their money back with a small profit means they’ll be more selective about which programs they back and keep a watchful eye on the intermediaries and nonprofits spending their funds.  If governments paid “no matter what,” there wouldn’t be any point.  None of us is interested in wasting our time.

“6.  They undermine community agencies and charities.”

To the contrary, SIBs provide local nonprofits with predictable, long-term funding without the strings and red tape that come with government contracts.  Can we have a show of hands for those who agree with Mr. Clancy that human services contracts provide “community agencies and charities ... some flexibility to innovate or deliver services that best meet the needs of vulnerable families and communities”?

The only way SIB investors get paid is by finding nonprofits that can produce the outcomes required under the government contract.  Why in the world would an investor, or an intermediary for that matter, want to tell an effective nonprofit with a strong track record working on difficult social problems like homelessness, recidivism or troubled families how to do their jobs?

SIBs have a good chance to produce better results precisely because the investors have strong incentives to find the best nonprofits with the most effective innovations, and the investors, nonprofits and intermediaries all have aligned interests to make sure that the pay-for-success contract won’t allow the government to micromanage decisions by nonprofit leaders who need the flexibility to adapt to real-world developments over a long period of time.  By focusing on results rather than the complicated and unpredictable steps involved in reaching those results, SIBs give nonprofits more control about how they work with clients.

“5.  They provide a smoke screen for cuts to public services.”

Actually, no.  Draconian cuts to public services are taking places whether or not SIBs gain traction due to overwhelming economic and political forces against which SIBs are, at this point, nothing.  SIBs don’t aid and abet budget cuts, but they offer a small glimmer of hope for ameliorating the worst effects of the fiscal crisis by providing independent funding to expand more effective programs.  Far from trying to “hide the fact that cuts to social services are leaving vulnerable people with nowhere to go for help,” we’re trying to light a candle rather than curse the darkness.

“4.  Investor profits and extra bureaucracy push up costs.”

It costs money to shift from ineffective safety-net programs to performance-based prevention programs.  We have to conduct detailed financial analysis to show potential savings, convince social investors to absorb financial risks that have virtually no track record, negotiate outcomes-based contracts that provide greater flexibility for innovative service delivery while maintaining government oversight, establish performance measurement and evaluation systems that will capture trustworthy data about program results, and implement prevention programs with fidelity to proven models under unconventional collaborative governance mechanisms. 

If SIBs can’t pay for all of this and still save government money, they just won’t happen.  We can justify incurring the additional costs only if we create demonstrably greater value by doing so.  Mr. Clancy’s right that “these are costs we don’t have to pay when services are publicly provided,” but we don’t get the results, either.  SIBs have to prove you get what you pay for.  If we don’t, no one will buy them.

“3. Services are no longer accountable or transparent to the public.”

SIBs shift public accountability from focusing on meaningless short-term inputs (e.g., how many people enrolled in training) to meaningful long-term results (e.g., how many people got a job).  The question of “how services are being run” is far less important than whether they’re working.  In exchange for telling investors they’ll only get paid back years down the road and only if they reduce the demand for emergency services, the government agrees to let smart nonprofits figure out the best ways to help their clients.  The contracts will preserve government oversight but eliminate micromanagement.

Intermediary organizations don’t “have a legal obligation to put investors’ interests first.”  The terms of the investment will clearly establish that both intermediaries and investees will focus first and foremost on accomplishing the results, and that investors’ rights are entirely contingent on success in doing so.  If that’s not acceptable, they won’t invest.

“2. Quality and continuity of services suffer.”

SIBs don’t depend on “kindly corporations,” but on social investors who act in their enlightened self interest, which is what smart investors do.  With SIBs, there isn’t a tradeoff between “helping those in need” and “making money.”  The latter won’t happen without the former.  That’s the point.

And, yes, SIBs are “usually a 5-year commitment,” which is 4 more years than most public spending, a crucial difference that is likely to enhance the quality and continuity of services.

If a SIB doesn’t work and investors lose their money, we’re no worse off than we started, with inadequate government funding of ineffective remedial services.  But if a SIB works and investors get their money back with interest, a new and larger group will be ready to sign up.  Rather than the downward spiral of budget cuts driven by unsustainable safety-net costs, we have an opportunity to create a virtuous cycle in which effective nonprofits will be rewarded by successful investors taking smart risks.

“1.  Investor profits are incompatible with universal programs that provide a safety net for all.”

SIBs can’t and won’t replace the social safety net.  They only have potential to work in the small percentage of cases where effective prevention programs can pay for themselves by generating offsetting savings.  But that small percentage of programs affects millions of vulnerable, poor, disabled, and discarded people, and costs taxpayers hundreds of billions of dollars for the safety-net treadmill.  The safety net ain’t what it used to be and it’s bankrupting us.  We need more effective and less expensive alternatives, and SIBs might just fit the bill.

Mr. Clancy repeats the canard that “people who are deemed too difficult and expensive to help (some of the most vulnerable people in our communities) will be excluded from Social Impact Bond projects and will get no help at all.”  In fact, the opposite is true.  The greatest potential savings from SIBs comes from preventing problems facing people with the most complex needs that cost society the most. 

SIBs fund innovative prevention programs that brilliant social entrepreneurs have tested and refined for decades and which have the best chance of avoiding a lot of wasteful public spending.  Examples include permanent supportive housing for chronically homeless people, transitional employment services for ex-offenders with high recidivism rates, family reunification services for kids stuck for years in foster care or out-of-home placements, and aging-in-place programs to keep low-income seniors from prematurely entering and languishing for years in expensive nursing homes.  We need these exceptional programs to grow exponentially, but there’s no – repeat, no – government funding to scale them.  Private investors just might.

SIBs are a “disruptive innovation” in both senses of the term.  They’re designed to significantly transform the way we respond to massive social problems.  Inevitably, transformation changes business as usual, which is an understandable source of concern to those habituated to the status quo.  We get why Mr. Clancy thinks people should be worried, but progress isn’t possible without trying new approaches that might or might not work.  I  like our chances, but we’ll have to keep on our toes to prove him wrong.

Priming the Pump for Impact Investing

The Omidyar Network makes a compelling case for a sector-based approach to impact investing.

Originally published in the Social Impact Bond Tribune.

Alongside leviathan public foundations like Rockefeller, Ford and Robert Wood Johnson, a crop of private upstarts has emerged much more recently founded by highly-engaged billionaire entrepreneurs like Bill and Melinda Gates, Jeff Skoll, Michael and Susan Dell, and Laura and John Arnold, many of whom bring the same market-based orientation to their philanthropy.  In 2004, eBay founder Pierre Omidyar and his wife Pam founded the Omidyar Network (a funder of Social Finance US, and affectionately referred to as “ON”), which describes itself as a “philanthropic investment firm dedicated to harnessing the power of markets to create opportunity for people to improve their lives.”

It’s fair to say that the jury is still out on whether this younger generation of philanthropists will prove more innovative or nimble than their elders that comprise the foundation establishment.  But this is an auspicious time for new models.  One momentous example is the announcement on April 12, 2012, by the redoubtable Clara Miller, who became President of the F.B. Heron Foundation on the very first day of that same month, that “we will invest the full spectrum of our capital (100 percent of our endowment) through a single capital deployment office, removing the traditional foundation's operating distinction between investments and grantmaking.”  

Another is the publication of “Priming the Pump:  The Case for a Sector-Based Approach to Impact Investing,” a six-part series by ON’s Matt Bannick and Paula Goldman (with assistance from Jayant Sinha and Amy Klement, an observer of Social Finance US’s board) in the September 25, 2012 issue of the Stanford Social Innovation Review.  The articles are important not only for the insights they provide about what it will take to realize the full potential of impact investing, but what they portend about ON as a new kind of foundation.

Herewith, a brief summary with editorial comments.

Part 1

Sectors, Not Just Firms

The authors begin by setting the audacious “goal of scaling entire industry sectors, in addition to individual firms,” asserting that “impact investors can massively increase the number of lives they touch by concentrating investments in specific industry sectors in specific geographies.” Recognizing that impact investing is not an incremental game, they point to a fundamental disconnection between the weapon and its target:  

“The paucity of financial and human capital available for high-risk, early-stage ventures (what we call ‘innovators’) and for sector-specific industry infrastructure poses a massive impediment to the healthy growth of the impact investing sector. Everyone loves to invest in the occasional impact investing ‘homerun’ that promises strong financial and social returns—and these homeruns have an important demonstration effect for the viability of the industry as a whole. Unfortunately, relatively few appear willing to step up to the hard and uncertain work of sparking and nurturing the innovations that ultimately generate a robust flow of investable, high-return impact investments.  It is as if impact investors are lined up around the proverbial water pump waiting for the flood of deals, while no one is actually priming the pump!”

Concerned about the lack of adequate deal flow, ON saw the need to think about the “gray space” between grants and investments that provide risk-adjusted returns.  The authors realized that insisting on the latter as the only alternative to grant-making would cause ON “to systematically under-invest in creating the conditions under which innovations, and entire new sectors, could be sparked and scaled.”

Part 2

Embracing the Full Investment Continuum

Bannick and Goldman drew three key insights from their analysis.  First, “social impact needs to be measured at the SECTOR as well as the firm level.”  Combining direct firm impact with sector-level impact yields a new measure of the value of impact investment, “total social impact of a firm.”  

Second, they identify three categories of actors “meant to apply to the development of for-profit markets for social impact,” rather than those served primarily by grant-making.  The “market innovators” believe in a product or service before its profit-making potential has become obvious.  Their job is “derisking the generic model of an innovation or product,” so it shouldn’t be surprising that these “high beta” firms have the greatest unmet need for patient impact investment.    

The “market scalers” follow the innovators “to refine and enhance the generic model.”  The disruptive tension between old and new approaches noticeably increases because “many market scalers DO earn risk-adjusted returns,” which “may threaten entrenched economic interests” and “raise concerns among politicians who ... may be uncomfortable with private sector approaches to social problems.”

The last group of players develop the “market infrastructure” without which a supportive ecosystem cannot take root (as our British visitors have realized).   As we know all too well, these essential contributors often face the toughest sledding in terms of viable business models, but the authors look reality in the eye when they observe that “LACK of infrastructure can disrupt an otherwise burgeoning sector ...”

Third, “investments in all these different vehicles and return profiles are necessary to move a sector.”

Part 3

Gaps in the Impact Investing Capital Curve

The sector faces “yawning gaps in the capital curve” for early-stage innovators and infrastructure developers, neither of which offer the kinds of risk-adjusted, market-rate returns that attract commercial capital.  The authors are not sanguine that traditional foundations will make a “dramatic mindset shift—from seeing philanthropy’s primary role as addressing market failures to also embracing its potential to catalyze markets.”

Instead, they “see the increased involvement of high net worth individuals in impact investing as potentially catalytic to the sector. Individuals such as Pierre Omidyar, Vinod Khosla, Steve Case, Jeff Skoll, Sir Ronald Cohen, and others have deep entrepreneurial backgrounds. They not only embrace innovation and have a high risk tolerance; they are also quite willing to experiment with market-based and for-profit approaches to achieving social impact. We believe that individuals with similar approaches could have a transformative effect on the impact investing industry by investing in early-stage, high-growth ventures, and by funding industry-specific infrastructure to support these.”

This analysis moves beyond the anecdotal experience of many in the impact investing space to a compelling argument for a fundamentally different rationale for the new generation of entrepreneurial foundations.  More than just a call to action by their peers, the “Priming the Pump” framework reveals why the emergence of a robust impact investing marketplace cannot be assumed, but instead won’t take off unless it is nurtured by a new cadre of funders who see capital market innovation itself as a strategic objective.

Part 4

Do No Harm:  Subsidies and Impact Investing

Here, the authors address a surpassingly important question, “When, and in what circumstances, is subsidy appropriate?”  They thoughtfully compare the risks of firm subsidy—preventing a level-playing field for competition; subsidizing firms with limited scaling potential are an “inefficient use of capital”; and compromising the promise of the impact investing industry; with its positive uses—spurring market development; catalyzing other models of scale, and creating a pipeline for the impact investing industry.

This part of the article acknowledges that “in certain markets, there may be no chance of making impact investing a high returns business without first using subsidies to prime the innovation pump.”  They offer the example of microfinance, which “benefitted from more than a billion dollars of subsidy before reaching commercial viability.”

Eschewing sweeping generalizations, they conclude “there really is no simplistic ‘yes’ or ‘no’ answer, but rather a complicated and nuanced set of conditions under which different types of investments can play a complementary role in sparking sectors.”  The authors concede they are “reticent to invest in low returns businesses, lest that lead us down the path toward limited scale, sloppy investing, diminished expectations, and potential market distortion,” and simply acknowledge that “the biggest determinants of whether we will consider below market returns tends to be the income level and size of the market that the entrepreneur is trying to serve.” 

Part 5

Government Matters

If there is one place the authors fall a bit short, it would be the installment that considers the role of government.  While they appreciate the “urgent need ... to align interests between those who are trying to serve disadvantaged populations from a business perspective and those in government who feel they represent the disadvantaged,” they don’t quite achieve the same level of insight they displayed in analyzing the role of different types of foundations.

They start off on the right foot:  “Impact investors cannot afford to ignore critical political considerations. Enlightened politicians and policymakers have the potential to dramatically speed up the rate at which an industry can scale to responsibly serve hundreds of millions.”  And they are not wrong when they say that “the most important policy imperatives are: ensuring fair and robust competition; establishing appropriate regulation; and promoting entrepreneurship.”

What they fail to come grips with is the need to segment the government sector (just like the foundation sector) into those actors who have the capacity and inclination to foster impact investing and those who probably don’t.  Instead, they settle for the unhelpful observation that, “ultimately, success is best achieved when supportive politicians and policies are married with entrepreneurs and a diverse set of investors who are deeply committed to innovation and sector level change.”

Just as we need more enlightened foundations to make below-market-rate investments in innovators and infrastructure firms, we need to identify the factors that make government officials and their positions truly “supportive” of impact investing at scale.  In fact, there are attributes on both sides of the political aisle that lend themselves to fostering a more conducive environment for impact investing at the sectoral level, so there will be an opportunity to supplement Bannick’s and Goldman’s model.  

I’ll offer just one observation now.  The authors link to what is indeed “an excellent overview on the ways in which government can help drive a more entrepreneurial environment,” by Daniel J. Isenberg, a professor of management practice at Babson College and executive director of the Babson Entrepreneurship Ecosystem Project.  But Professor Isenberg’s worthy objective is to distill practices that “help build a vibrant business sector.”  Although business growth can certainly help reduce poverty, the advent of impact investing has been spurred by the need for more than just traditional enterprise.  

Part of the reason that much of social investment lives in the “gray space” between grants and market-rate investments is that we need to scale innovations, like prisoner reentry programs and permanent supportive housing, that span the public and private sectors.  Government needs to support impact investing not to help business or even nonprofits grow, but to improve the effectiveness of government itself.  We need to look for new structural models that are conducive to impact investing, perhaps along the lines set by Stephen Goldsmith and William D. Eggers in their seminal book, Governing by Network:  The New Shape of the Public Sector.

Part 6

Achieving Takeoff

Coming full circle, the authors reassert that “we must ask ourselves how we can create more innovations that achieve the kind of breadth and rapid expansion” needed to serve most customers, unlike, say, microfinance, which, after three decades, “still reaches a modest percentage of those in need.”  They settle on the idea that, in the developing world, using impact investment for the purpose of “accelerating the rate of adoption [of new innovation], even by a small amount, can yield extraordinary leverage in terms of the number of lives impacted.”  They propose focusing on “the emergence of sectors that have a strong chance of beating the typical ‘lazy S-curve’,” markets that aren’t unavoidably constrained by “limited scale and very slow adoption of a new product.”  

SOURCE:  Matt Bannick & Paula Goldman, “Priming the Pump for Impact Investing:  Part VI:  Achieving Takeoff,” Stanford Social Innovation Review (Oct. 2, 2012).

Now that’s a prescription I can endorse.  In fact, I offered a similar approach in my book for using performance-based philanthropy to scale growth-ready nonprofits.  In both cases, there are well understood models for exponentially increasing market adoption of disruptive innovations, of which the social sector and their funders are largely unaware. 

SOURCE:  Steven H. Goldberg, Billions of Drops in Millions of Buckets:  Why Philanthropy Doesn’t Social Progress, Exhibit 3.9, p. 108 (Wiley 2009).

I’ll confess to a certain amount of ambivalence when proponents of impact investing look to foundations as some kind of deus ex machina.  Bannick and Goldman don’t indulge in wishful thinking.  Instead, by identifying a special role for a specific class of foundations whose experienced teams should appreciate the insights and analysis of “Priming the Pump,” ON just might be leading the impact investing market exactly where it needs to go.

Observations on the World’s First RFP for Social Impact Bonds

BIG NEWS FROM DOWN UNDER

The Treasury Department of New South Wales (NSW), Australia, recently issued the world’s first Request For Proposals for a “Social Benefits Bonds Trial.”  “SBB” is the latest entry in the continuing search for a commonly-accepted name for Social Impact Bonds (SIB), otherwise referred to (primarily by the U.S. and some state governments) as Pay-for-Success (PFS) Bonds or Contracts.  (Thankfully, I won’t be wading into that debate and will use “SIB” here.)  As a former government lawyer who has litigated more than $2 billion in public procurement and contracting disputes, I’m happy to report that the NSW Treasury has drafted an excellent RFP that deserves wide consideration.