Since our article on Social Impact Bonds (SIB), Clarmondial has had numerous discussions with clients and potential clients about impact bonds. Given that a financial structure needs to ultimately meet the specific program conditions, and local conditions were not suited to a ‘standard’ impact bond, we created and will help local organisations implement a conditional donation instrument. We hope to provide more information on this as a concrete case study in due course.
One issue that has been raised repeatedly by ODA (Official Development Assistance) providers and private donors is that of risk: When we use a Results-Based Funding (RBF) structure such as a SIB or a DIB (Development Impact Bond), who is actually exposed to financial risk? How are the risks assessed and allocated? We wish that investors would focus more on this same issue with respect to “mainstream” structured products, but we will keep this discussion to the sphere of ‘impact finance’ in this article.
About risk
Risk is a vast subject, combining psychology, mathematics, statistics, history, economics, etc. It has been around since mankind (or at least part of it) adopted “the notion that the future is more than a whim of the gods and that men and women are not passive before nature”, as Peter L. Bernstein describes it in his book Against the gods: the remarkable story of risk. Risk management has obviously evolved over time, and is defined as the process of identifying, assessing, analysing, mitigating, allocating and monitoring risks.
Risks can be managed by contracts, such as financial securities, whereby different parties take responsibility for different risk components. An optimal risk allocation should distribute different risk components among stakeholders in order to (i) minimise the total cost of risk (by allocating each risk component to the party best able to manage it) and (ii) align all parties with the common goals.
In discussions with clients and potential clients, their main concern is financial risk, which we loosely define as the direct monetary cost of a negative program outcome. In other words: who loses cash if things go wrong?
About bonds
Please refer to our previous article on SIBs for an introduction to these instruments.
Risk allocation: SIBs
In the case of a SIB, governments (SIB issuer) and investors (SIB buyer) engage in a financial transaction to fund the development of a social program. Under a typical construction, the government has the obligation to repay investors only if the program succeeds – otherwise investors lose their monies. This means that investors take full execution risk. As a compensation for assuming this risk, investors receive a small interest payment and a share of the non-financial benefits linked to promoting social goods. Therefore investors require transparency and a strong say in the process to mitigate this risk (e.g. the ability to replace the program manager).
Under typical circumstances, if the program succeeds, the:
- Government has improved social outcomes, in exchange for part of the resulting savings (e.g. reduced cost of prison services due to fewer prisoner re-offences).
- Investors profit from a small interest payment, and the non-financial benefits of promoting a social good.
- Target population benefits as a result of the increased social good.
- Investors and the target population may benefit from a lower tax burden in the future (we hope!) as a result of improved social goods.
However, if the program fails, the:
- Government may lose political capital (i.e. the trust, goodwill and influence with the public) and credibility.
- Investors lose their money.
- Target population does not benefit from the expected improvement.
- Investors and the population may face a higher tax burden in the future to address the social issue.
Risk allocation: DIBs
Development Impact Bonds (DIBs) are an adaptation of SIBs for emerging economies. DIBs and SIBs have very similar structures. The main difference is due to the perceived additional counterpart risk associated with an emerging economy: investors usually request a more credit-worthy counterpart, and therefore they usually require that international donors (such as ODA providers or private foundations) take on payment responsibility in the case of program success – or at least that international donors share this obligation with the local government. Investors may also request a partial refund if the program fails as a way to reduce their financial exposure.
Under typical circumstances, if the program succeeds, the:
- Government has improved social / public good outcomes.
- International donors repay the investors.
- Investors profit from a small interest payment, as well as the non-financial benefits of promoting a public good in an emerging economy.
- Target population benefits from improved provision of the improved provision of public goods.
Since DIBs tend to have foreign investors, and the emerging economy government is not likely to experience a budget surplus as a result of the program, a lower future tax burden if the program is a success should not be expected.
If the program fails, the:
- Government may lose political capital towards the local and international community.
- Investors lose their money (or part of it, if a partial refund had been agreed).
- International donors waste time and resources in arranging this.
- Target population does not benefit from the expected improvement.
The reaction
Despite the excitement of dealing with a trendy financial innovation, investors and donors share a significant concern about engaging with SIBs and DIBs. They question how fairly risks and rewards are allocated in such instruments, especially in DIBs. Although they appreciate a governments’ lack of resources to implement public good programs, many are not convinced that international donors (DIBs) and investors (SIBs) are best suited to bear such program risks, especially given the natural information asymmetries between stakeholders. This concern, and the small interest rate offered compared to the risk, seem to be the main barriers preventing SIBs and DIBs from evolving to an attractive investment class rather than niche philanthropic activities.
Alternative solution
In reaction to the concerns about SIBs and DIBs, Clarmondial was invited to create and implement a conditional donation instrument, which we have labelled the “Guaranteed Philanthropy Structure” (GPS). Suitable for many scenarios, it can be summarised as follows:
- Governments, ODA providers and private donors divide themselves into two groups (Collateral Donors and Conditional Donors) depending on their risk appetite and role in the program.
- Conditional Donors transfer the funding required to the program, while Collateral Donors match such amount by depositing monies (or guarantees) in an “escrow account”.
If the program succeeds, then the:
- Conditional Donors are happy to donate to a successful initiative.
- Collateral Donors can reuse the same monies to support the following phase / program, therefore increasing their budget.
- Target population benefits from such improvements.
If the program fails, then the:
- Conditional donors receive a full refund.
- Collateral donors lose their monies.
- Target population does not benefit from the expected improvement.
The GPS can be used in any program / intervention / project that (i) has a measurable & auditable outcome (ii) within a period of three to five years, (iii) has a budget of at least USD 2 million and (iv) is attractive enough to raise donor (philanthropic) funding.
ODA providers and private donors are currently negotiating the implementation of this instrument in a specific location. They are happy to take this risk because they believe the underlying program will deliver the expected results, so they had already agreed to finance the intervention – which has an existing set of tested assessment metrics which will be independently audited by a credible third party. The ODA providers and private donors see GPS as a way to significantly increase their budget by using it as a collateral to raise additional philanthropic funding.
Please feel free to contact us if you would like to hear more about the instruments and approaches discussed in this paper.
