Analysis: “Counterparty risk” seen as key as Peterborough prison bond peters out

Policy shift just one headwind for innovative social impact bonds

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There were two milestone events in the world of social investment recently.

First up was the announcement of the winners of contracts to deliver probation services across the UK. Catering and outsourcing firm Sodexo, in partnership with crime reduction charity Nacro, was named as preferred bidder to supervise tens of thousands of low- to medium-risk offenders across England.

It is part of a £450m-a-year privatisation of 70% of the work of the probation service – and is probably the final nail in the coffin of the pioneering Peterborough social impact bond, which is being scrapped by government earlier than planned despite a steady reduction in reconviction rates and expected returns for investors.

The following day saw the launch of the Choosing Social Impact Bonds: A Practitioner’s Guide report by Bank of America Merrill Lynch and social investment firm Bridges Ventures.

The timing was coincidental, but the report could not ignore the Peterborough experiment, talking about the “counterparty risk” inherent in such SIBs.

Discussing the Peterborough project specifically, the report stresses: “For SIBs to flourish, investors will seek reassurance that commissioners [those who commission projects] are committed over a sufficiently long-term time horizon,” the report states.

It even quotes an unnamed investor as saying the “government does have a tendency to change the rules. Their tinkering with the system is a big risk”. Investors hate the goalposts being moved, but that is just what it seems happened with the Peterborough scheme.

But it all started so brightly. The Peterborough SIB (the “One Service”) was due to support three cohorts of 1,000 short-term ex-offenders. But, then the government out of the blue announced that it was to be cut short, and only deliver support to two cohorts of short-term ex-offenders.

Instead there will be a new nationwide scheme into which the Peterborough SIB won’t fit.

A spokesman for the Ministry of Justice (MoJ), the government department which sponsored the Peterborough SIB, told Responsible Investor that the pilot will continue in its current form until June 2015, when rehabilitation support to the second cohort of ex-prisoners is due to finish.At the time of the announcement, David Hutchinson, chief executive of Social Finance, the not-for-profit organisation which structured the SIB, said it was disappointing that investors in the pilot no longer have the opportunity to earn a return for working with the third cohort.

He also feared that further SIBs would not be used in rehabilitation support: “We have real concerns that the structure of the incentives in the proposed probation contracts is not sufficiently strong in the early years to stimulate investment in the sort of rehabilitation support which the One Service at Peterborough has provided.”

The MoJ did not respond to enquiries from Responsible Investor on whether it planned to support any further SIBs. Back in August, it told Responsible Investor that other SIBs were being led by a different government department, though few details have been forthcoming.

But while the Ministry of Justice appears to have cooled on SIBs, other parts of the UK government are firmly behind then. At the recent Social Impact Investment Taskforce conference in Rome, former leader of the Conservative Party and current Secretary of State for Work and Pensions Iain Duncan Smith extolled their virtues. Duncan Smith’s department has a £4.5m social impact bond fund aimed at improving employment outcomes for vulnerable young people. He said: “Social impact bonds shore up government finances through investors bearing the risk. They pay upfront to deliver services, taking the burden off the taxpayer.”

But, Big Society Capital, the UK’s social investment bank, has very publicly commented on the MoJ’s behaviour.

While it does not mention SIBs explicitly, Big Society Capital went into print, criticizing the Ministry of Justice in the London Evening Standard for creating a structure around probation service delivery which locks out charities and social enterprises – the very organisations which were involved in the Peterborough SIB.

Big Society Capital revealed that it offered a form of guarantee to socially led bids, but was not successful.

So, all in all, a pretty lacklustre end for the world’s first SIB. The first government department to sponsor one does not want to talk about them, or seemingly sponsor them further.

It’s also worth noting that counterparty risk is not the only headwind facing social impact bonds, though.
As SIBs take off, so does the scrutiny. Not for the first time in the US, a social impact bond has met with opposition from unions.

Chicago Mayor Rahm Emanuel – the former White House Chief of Staff – plans to use the SIB model to give 2,618 children access to early childhood education. His plan is being backed by $17m from the Goldman Sachs Social Impact Fund and Northern Trust as senior lenders. Subordinate lenders are the J.B. and M.K. Pritzker Family Foundation.

But, the Chicago Teachers Union (CTU), SEIU Healthcare Illinois and their City Council allies have condemned the arrangement because it could see investors more than double their investment over 18 years.Chicago’s Chief Financial Officer Lois Scott has said that borrowing through social impact bonds could provide a rate of return of about 6.3% to investors. That translates to $34.5m over the next 18 years.

Kurt Hilgendorf, a policy researcher for the CTU, said: “This is one of the worst ways to fund a program like this.” He notes that 10% of the $17m investment will go toward overhead costs to compensate “four levels of intermediaries.”

He says: “These complex financing schemes result often in less efficient delivery of public services.”

So watch this space to see if SIBs prove to be a false dawn, hampered by policy change, cost and complexity.