Pay-for-success: The latest thinking on social impact bonds

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2018 has seen a tremendous amount of activity around impact investment policy in the US, says Fran Seegull, director of the US Impact Investing Alliance.
In the first few weeks of the year, the Tax Cuts and Jobs Act passed with new tax incentives for investments into US low-income communities; there has been a bipartisan bill introduced in the Senate to create what Seegull describes as a “true development finance institution” in the US; and most significantly, the US Congress passed a bipartisan bill to create a $92m fund for social impact bonds.
The Social Impact Partnerships to Pay for Success (SIPPRA) Act has been five years in the making, supported by politicians of both political colours, most prominently Republican Senator Todd Young and Democrat congressman John Delaney (the latter is running to be a 2020 presidential candidate). Following the creation of the new fund, US House Speaker Paul Ryan reportedly described social impact bonds as “the law of the land now” at the Milken Institute Global Conference.  
Broadly, the initiative creates a fund, housed at the Department for Treasury, which targets pay-for-success projects such as social impact bonds, where private investors fund social interventions and are repaid, with interest on measured social outcomes. The ‘outcome payer’ is typically a government department who uses the savings gained from effectively tackling a social issue to pay investors a return.
Seegull explains: “States and localities can apply to the US Treasury to create local impact partnership projects that need to produce measurable outcomes and federal, state or local savings.”
Importantly, the fund seeks to address one of the key barriers to social impact bonds – governments not wanting to pay for measured social outcomes if some of the cost savings benefit other government departments.
“Some call it a ‘wrong pocket problem’ and SIPPRA was designed in part to obviate this by creating some mechanism for federal outcome payments when specific outcomes are achieved,” says Seegull.
States can also apply for funding to do feasibility studies on pay-for-success projects.
Tracy Palandjian, CEO of Social Finance US, whose UK arm was the progenitor of social impact bonds, says: “It’s incredibly validating and gratifying that the bill went through.
 “We are incredibly excited and it comes at a very important time for the field because there have now been 20 pay-for-success projects launched in America mobilising over $200m across a wide range of issue areas from workforce development, homelessness to criminal justice advocation. I just think the field is really poised to take lessons from the last five years and really understand the various dimensions of the various prototypes that we and others have put in the marketplace.
“We really feel we are at the point to really take the tool to scale.”
Scale has been an issue for the social impact bond space. While the US has seen some of the largest social impact bond deal sizes, in the tens-of-millions it is still too small for most large institutional investors.
But there are efforts by mainstream investors to engage. Goldman Sachs backed the US’ first social impact bond tackling recidivism, and BNP Paribas started investing in US social impact bonds in 2016. It is part of a drive to expand the bank’s corporate responsibility efforts in the US and further financial innovation, says Hervé Duteil, Chief Sustainability Officer, Americas at BNP, who says that due diligence in the space is a “lengthy, methodical process”.
“It was almost a two-year process from the start to the end. So, the first motivation as a financial institution is to innovate and expand the application of finance. The greatest sin is to think we have invented it all in finance. For the last 50 years we’ve devised lots of fascinating and sophisticated funding mechanisms for people who take risks to make money like venture capital and private equity.
“I would say that the next 50 years will be devoted to creating new funding mechanisms for people who take risks to do good.”
Duteil says that social impact bonds are one of the earliest instruments in this process, but also one of the most extreme. “Virtually 100% of the return and 100% of the capital will be returned solely based on social performance and not credit worthiness.”He says that BNP Paribas views it like a laboratory experiment, providing learnings and ideas that can be applied to traditional and mainstream financing. A recent example of this is BNP Paribas giving multinational Danone a €2bn revolver loan where a small part of the coupon is tied to social and environmental outcomes. It offers a discount when outperforming on agreed sustainability goals, or a premium when underperforming. 
BNP Paribas is working on two more social impact bond products in the US and is also very involved in the French version of social impact bonds, contrats à impact social.
In the UK, large pension funds have been able to invest into UK social impact bonds through a pooled fund from Bridges Fund Management and there are efforts to create a similar product in the US. Andi Phillips, co-founder of Maycomb Capital, who previously managed the Goldman Sachs Social Impact Fund and led its first social impact bond deal, says: “Pooled funding vehicles are being formed that will help crowd in new investors who may not have the capacity to invest directly, but are excited about the impact potential of bringing these projects to scale.”
And Steve Goldberg, the first managing director of Social Finance US, which brought social impact bonds to the US, is promoting a new and ambitious approach to create ‘institutional investment grade social impact bonds’.
He says that the current social impact bond market is categorically not designed for commercial or institutional capital. “The programmes are too uncertain, the savings are speculative and there are major limits on transaction sizes because governments are usually originating the projects, and they tend to think of the constraint on deal sizes as the amount of money they will have to pay back if the transaction is successful. Government says they are only willing to pay $10m – $20m over five years, for example, so everything is driven by that parameter.”
Goldberg says a better approach would be for a market-based transaction designed by investors. He expands on the idea in a report published by the Federal Reserve Bank of San Francisco.
“What I’ve proposed is a focus on a very select group of social programmes that have the strongest irrefutable evidence of effectiveness, but also of producing savings that exceed the cost of service delivery. If you have rock solid evidence, then a commercial investor can satisfy itself that these are manageable risks. The savings are very well-documented and reliable, so if these programmes are implemented with fidelity, which costs money – these are not low-cost, we know how big the savings will be, where they will materialise and where they will come from.”
Goldberg says the US Congressional Budget Office has already scored savings for one such social programme, the Nurse-Family Partnership that arranges nurse visits to low-income first-time mothers.
He also says that if investors originate social impact bond deals themselves, it would help meet their fiduciary duty obligations. “Even with large deal sizes, a fiduciary investor could never invest in a pay-for-success project they didn’t help develop from day one. If they get handed an RFP from a government for a social impact bond programme, they would have to do the due diligence all over again.”
Goldberg says commercial investor would also bring benefits in the way they look at investment opportunities such as assessing the size of the problem, how much it would cost to address, what is the maximum feasible growth rate to invest in and what is the deal flow, long-term from solving this problem.
“They look at it as a business opportunity and would figure out how to finance the long-term expansion of a programme commensurate with unmet population needs other than incremental growth that we do now.”
Goldberg admits the idea is unorthodox for mainstream investors, but says it presents a multi-billion dollar investment opportunity. “They should think of these evidence-based programmes as a potential line of business that would absorb billions of dollars of capital for years to come and evaluate it on that basis. But commercial investors mainly don’t know anything about [social impact bonds]. They need to be convinced on the economic merits, how it will work, will government go along, how to manage risk. It’s a very different, challenging, unfamiliar conversation with a whole new group of market players that is just starting to begin.”