In this article we provide a short description on Social Impact Bonds (SIBs), which are being explored as a new avenue for financing social goods. We first provide a short background to financial instruments and bonds, then describe SIBs and consider their role in promoting social goods. This is the first in a series: In the second post we will explore Green Bonds.
There is no established definition for Social Impact Bonds (SIBs). Also known as Pay-for-Success Bonds or Social Benefit Bonds, these are outcomes-based contracts whereby a public sector institution commits to paying for specific significant improvements in social outcomes for a defined population.
Through an SIB, private investors can provide upfront funding to pay for agreed interventions, which are delivered by service providers and procured by a public sector institution. Financial returns to investors are paid by the public sector based on measurable outcomes that can result in public sector savings. Typically, if outcomes do not improve, investors do not recover their investment – i.e. the public sector makes a payment only if the intervention is successful.
SIBs are gaining in popularity because they allow governments and development organisations to secure upfront funding for specific initiatives, while sharing risks. SIBs enable governments to execute projects without increasing short-term public expenditure and taking on new debt. A well-designed SIB should result in financial savings to public sector. For example, reducing prisoner re-offending rates reduces long-term spending on the prison service. Shifting government’s financial commitments from the short term to the longer-term also better fits government’s benefit-expenditure profiles. It also shifts risk of non-performance to the direct implementer, with the government acting as the administrator.
An increasing number of socially motivated investors are looking for new ways of meaningfully deploying their capital. SIBs are appealing because they can align interests of social-impact investors and governments, while adding transparency to public-good projects and reducing public funding requirements. They also encourage better coordination of social investments by the private, non-governmental sector.
A brief background on finance
In finance almost everything is possible – as long as it respects the law. Theoretically two parties can reach any type of agreement regarding an exchange of payments. Governments establish and enforce regulations to ensure the integrity of the system and set transaction frameworks.
An entrepreneur’s savings and support from family & friends typically finances a new business. Angel investors, venture capital funds and private equity funds act as potential investors to support the expansion of a company. Angel Investors refers to individuals who provide early stage capital for a business start-up, usually in exchange for equity or convertible debt[i]. Venture Capital and Private Equity funds, on the other hand, are pools of capital managed professionally by a regulated financial institution (e.g. asset management company)[ii].
It is rare for an entrepreneur to have the required funding to develop the company without third party capital. To reduce ownership dilution in the capital rounds (when equity is added to the company), entrepreneurs can have their efforts compensated in terms of additional shares – i.e. sweat equity, which may occur as shares or share options[iii]. Besides equity and debt, and other instruments in-between (e.g. convertible debt), there are other ways to finance a business start-up:
- Awards, repayable grants and donations are common, especially in the social and environmental impact space. Universities, philanthropists and Development Finance Institutions (DFIs) have created programs to support new business models and initiatives that address social needs.
- Crowd funding is a new way of attracting capital, where individuals pool funds, usually via the Internet, to support efforts initiated by individuals or organizations (e.g. www.kickstarter.com, www.indiegogo.com). This model of fundraising can now also be used to secure pre-sales of a product, or even equity investments (e.g. following the JOBS Act, in the USA).
Not-for-profit organisations and some other types of legal entities do not have “owners”, and therefore rely on funds from contributions, membership dues, program revenues, public and private grants for example. Since a not-for-profit organization has no equity, they are automatically excluded from the angel investor – venture capital – private equity route. It is still possible for them to raise debt in certain cases.
SIBs can be used to finance both for-profit and not-for-profit entities. Social projects can benefit from all the financing sources listed above if the project is developed as a for-profit entity (and based on a solid business model). However, in many cases the project is not commercially viable, and a not-for-profit entity is established – or the service is provided directly by the government.
Focus on bonds
Bonds are debt securities (loans), under which the issuer agrees to pay the holder back the money (principal) plus interest. The issuer is typically obliged to pay interest periodically. There are many types of bonds, and the total outstanding value reached USD 100 trillion in 2012 according to TheCityUK. The term “bond” has become a generic reference to a number of debt and debt-like instruments. Some alternative bonds may or may not fit the conventional definition of a bond, e.g. Green Bonds, Climate Bonds and SIBs.
A bond is created when an investor loans money to a company, government or other organization. In return for the loan (principal), the investor gains a right to a future repayment of a pre-agreed amount. In a typical bond, the entity issuing the bond must pay back the entire principal at a certain pre-agreed date, known as the “maturity date”. In many cases investors also have the right to regular interest payments (coupons). The more certain the repayment of the bond (i.e. the lower the perceived risk), the lower the rate of return.
Green Bonds and Climate Bonds
These usually refer to fixed-income financial instruments (debt) linked to environmental solutions. Green Bonds are issued to raise the finance for an environmental project, while Climate Bonds are Green Bonds that focus on emission reduction or climate change adaptation projects.
HSBC published a report in June 2012 stating that there are ca. USD 174bn in over 1’000 climate-themed bonds outstanding from 207 issuers. Corporates, listed, state-owned and private companies, accounted for 82% of the total, followed by development banks and financial institutions (13%), project bonds (3%) and municipal bonds (2%).[iv] However, the estimated value varies depending on how the market is defined: In January 2012, Bloomberg published an article stating that Green Bonds were a USD 7bn market, dominated by Swedish and Japanese banks.[v]
IFC issued its first Green Bond in April of 2010. Proceeds of the 4-year USD 200m fixed bond were set-aside in a separate Green Account for investing exclusively in climate-friendly projects in developing countries. Proceeds from the IFC Uridashi Green Bonds (a type of Japanese bond) have supported 21 climate-related investments across 4 continents. The total value of green bonds issued by the IFC is USD 1bn.
Social impact bonds
The estimated size of the SIB market varies according to the information source, but it is not yet significant (probably less than USD 1 billion). To date, 14 projects have been financed in the UK via SIBs, at a combined value of GBP 26m (author’s estimate), and a SIB worth USD 9.6m SIB was issued in New York.
A brief history of SIBs
Results-based financing (RBF) instruments, such as SIBs, have been around for decades. RBF is an umbrella term that includes pay-for-performance contracts, performance-based financing, performance-based incentives, vouchers, output-based aid, and conditional cash transfers. RBF for public health improvements, for example, is a cash payment or non-monetary transfer that is made to a provider, manager, or consumer as an incentive to deliver or use priority health care services. Payment is made conditional on measureable actions being undertaken. One example is the GAVI Immunisation Services Support, which used reward payments of USD 20 per child vaccinated above a pre-established baseline.
SIBs differ from most other forms of RBFs, as payment for the SIB activity is usually disbursed upfront, while RBFs are typically paid mostly – or entirely- ex-post.
The first official SIB was announced in the UK in March 2010, to finance a prisoner rehabilitation program. It consisted of a GBP 5m investment by the private sector to fund a re-entry program (the One*Service) for short-sentenced prisoners leaving Peterborough prison, over a 6-year period. In the USA, SIBs are usually referred to as “Pay for Success Bonds”. In 2012, the city of New York raised a USD 9.6m social bond for prisoner rehabilitation. The Departments of Justice and Labor of the USA are also funding Pay for Success program pilots.[vi] In Australia, SIBs are called Social Benefit Bonds[vii]. The New South Wales Treasury launched the Newpin Social Benefit Bond in March 2013 to raise AUD 7m (USD 7.3m) in private capital to finance the expansion of a successful program targeted at restoring children to their families.
In emerging markets, SIBs are also called Development Impact Bonds (DIBs). The most advanced is probably the Performance Based Malaria Program, in Mozambique, led by Dalberg and a consortium of mining companies. Another example is a SIB to address Sleeping Sickness in Uganda[viii], led by Social Finance and the Center for Global Development.
How do SIBs work?
SIBs are usually a contract between the public sector and socially motivated investors. Parties first design and agree the SIB framework. Based on this, investors make an upfront payment to implement a project and the public sector commits to pay the investor if and when certain pre-agreed, verifiable outcomes are achieved. Repayments to the investor cover the initial investment plus a financial return, depending on the projects measurable outcomes.
Structuring a SIB is a lengthy process that comprises various steps, such as:
- Select the problem to be addressed and the target population
- Define type of intervention and basis for the project
- Set desired outcomes, metrics and measurement practices
- Assess potential savings and incentives for all stakeholders
- Design the project, from daily operations to incentive structures
- Establish baseline or control group
- List potential service suppliers
- Prepare material for potential investors and guarantors
- Negotiate terms with potential investors and guarantors
- Contracts, procurement and commissioning
- Implementation and project management
- Data collection (monitoring) and auditing
The process is unlikely to be linear, with steps taking place concurrently. It is imperative however that all parties understand the implications of the SIB, have their objectives aligned and are committed to the program success.
Given that an SIB is an outcomes-based contract, the framework for defining success and assessing results is very important. Metrics should be significant, simple and measurable. While this might seem simple in principle, each stakeholder is likely to have their own views on the probability of achieving targets and the benefits associated with potential outcomes.
Another challenge is the natural information asymmetry among stakeholders. SIBs may be best suited for areas and interventions where credible baseline data is available. Incentives are also not necessarily aligned:
- Governments have conflicting interests: There is a political incentive to claim success, yet also an interest to set the bar as high as possible to maximise value for money;
- Investors have to balance their interests between setting a goal low enough to secure financial returns, but high enough to ensure the integrity of the SIB and the program.
It’s usually the role of the independent advisor to bridge this information gap and negotiate reasonable returns and success metrics (including timing) with both sides.
Pricing and structuring SIBs
From a public sector perspective, expected savings from the intervention must exceed the project cost plus the return to the investors. The chart below is a graphical representation of the benefit:
Source: Social Finance UK
From an investor perspective, there is no clear answer since most SIB investors are driven by both financial and non-financial motives. Based purely on financial return, the SIB can be priced using basic Real Options techniques: the opportunity cost of capital is compared to (i) the probability of success * the return in the case of success plus (ii) the probability of failure * the return (if any) in the case of failure. Non-financial benefits are harder to measure, but they are a key aspect to social investments and philanthropy. Both sides will come together once there is consensus on the project target (outcomes and beneficiaries), duration, and probability of success and possible benefits.
The figure below presents the typical stakeholders in a SIB:
Guarantors (e.g. Government body)
Board of Directors
Monitoring & Auditing
Who buys SIBs?
SIBs are still in their infancy, but many philanthropists and investors are interested in the topic. Investments have come from philanthropic sources (e.g. the Rockefeller Foundation) and social impact funds (e.g. Bridges Ventures). Goldman Sachs was the sole investor in the New York SIB. Either directly (e.g. through family offices) or indirectly, socially motivated investors remain the main source of funding due to low financial returns offered, relative conceptual newness, limited liquidity and small volumes offered[ix]. Similar to other social impact investments, project theme and targeted beneficiaries are key issues.
What can SIBs finance?
SIBs can be used to finance projects that will have quantifiable social outcomes in the near future. Since the repayment to investors is subject to project success, a critical aspect is the definition of success. The initiative must have a clear scope and clear goals. Those goals must be measurable and quantifiable, whether they’re based on incidence or prevalence, and must also be auditable by third parties. This characteristic adds transparency to public services under analysis.
It is usually difficult to attract investors willing to commit for longer than 5 years. Also, it may become more difficult to control the influence of other variables in a longer-term project. Consequentially, most SIBs are linked to 1-5 year programs.
SIBs are also likely to be appetising to investors in countries where perceived government and political risk is lower, or where development agencies such as the IFC are willing to act as the guarantor on behalf of a government.
Once these key aspects are addressed, there are many types of project that can benefit from SIBs. Potential issues under consideration range from education to HIV treatments to housing projects.
The outlook for SIBs
SIBs are still in their infancy, however, the concept is expected to develop rapidly, given the number of request for proposals (RFPs) published recently in various countries. Through SIBs, governments and donors can attract new sources of funding for public services, potentially releasing significant new funding for public services.
SIBs can allow governments to focus on defining priorities and acting as a central procurement agent, and leave the execution of the project to competent third parties, where reward is linked to success. If an initiative is successful, it is possible that such projects could occur on a rolling basis. In the long term, this could lead to a net decrease in government expenditure (public savings from the initiative minus payment for success). Social projects would then be funded directly by private investors, instead of indirectly through taxes.
[i] Convertible debt: a bond, note or other loan contract that can be converted into a predetermined amount of the company’s equity at certain times during its life
[ii] Venture Capital and Private Equity funds are collective investment schemes used for making investments in various equity (and to a lesser extent debt) securities
[iii] Sweat equity: a party’s contribution to a company in the form of effort – as opposed to a contribution in the form of capital
Options: a contract that gives the owner the right, but not the obligation, to buy (or sell) an underlying asset at a specified price on (or before) a specified date
[iv] Bonds and Climate Change: The state of the market in 2012, available at www.climatebonds.net
[ix] Relative newness of the initiative: SIBs have no track record, i.e. there is no historic evidence that such instrument works
Limited liquidity: no secondary market has been established yet, i.e. it might be difficult for an investor to sell an SIB prior to its maturity
Small volumes: professional investors typically target larger amounts to dilute transaction cost (e.g. due diligence, legal process)