At GrantStation we've discussed many of the changes taking place in or adjacent to the nonprofit realm—from contactless donations to cryptocurrencies to donor-advised funds. An innovation that has gained traction in recent years is the use of social impact bonds (SIBs).
They're yet another invention that has flowed from the realm of finance and economics, but what are they, how do they relate to the third sector, how do they work, and do they perform as advertised?
Today we're going to have a look at this innovation that may shake up not only financing for social services, but everything we think we know about how society is supposed to work.
What are social impact bonds?
A social impact bond is a government backed investment that has its value linked to an outcome or set of outcomes. The bond is redeemable only after the outcome is achieved. In essence, it's a way to use private capital to fund social interventions via a type of pay for success (PFS) financing. Traditionally, governments spend money on issues such as homelessness and drug abuse prevention without knowing whether the programs will accomplish their stated goals. These investments in improving society are part of government's presumed function, part of its purpose for existing. By using social impact bonds, the same types of programs can be funded, but private investors take on the cost and are able to cash in only if the desired social outcome is actually achieved.
If it’s the first you've heard of this, it doubtless sounds strange, but you'll soon know plenty because nonprofits are conceived of as indispensable service providers in this realm. For an example of how a bond might work, let's say a major avenue is occupied by numerous homeless people. Homelessness on the avenue persists at high levels despite the city's annual spending on the issue. Instead of directly using public funds, the city decides to enter into a service contract with a nonprofit, but with the requirement that the number of homeless on the avenue drop by 50% within a year. In order to raise initial capital to pay for the program the city issues social impact bonds, promises a potential 10% profit on investment, and sells them to speculators. After homelessness is reduced by the agreed upon amount within the agreed upon time frame, the city pays the investors. The investors make money, the nonprofit has performed its mission, and the city has gotten a longer lasting solution for homelessness.
Social impact bonds are used to fund interventions in areas such as educational achievement, teen pregnancy, immigrant support, refugee job training, and more. Basically any social area in which government spends money can be suitable for a social impact bond scheme. Needless to say, these bonds are inherently risky investments. It's fair to say one thing they're designed to do is transfer risk from the public to private sector. While they can be structured to give investors escape hatches in case of mismanagement of programs and for other reasons, generally investor money is lost if the agreed upon benchmarks are not met.
Despite their potential risk, usage of these bonds has expanded since the first were created in Britain in 2010. The U.S. quickly adopted the strategy, largely due to the fact that the bonds had ideological advocates across the political spectrum. Most Republicans, as well as some Democrats, like them because they give the private sector access to public services and potentially billions of dollars in profit. Some Democrats like them for a second reason, which is that they increase investment in public services. In addition to the U.S. and Britain, social impact bonds are now in use in Australia, Argentina, Russia, India, South Africa, Spain, Japan, and approximately thirty other nations.
Most articles and papers on social impact bonds hail their innovation, and they're undoubtedly that—a radical new way of thinking about social services. But it's worth noting that innovation in the digital age tends to follow a pattern. The innovation is first praised by stakeholders, with those messages amplified by media, followed by growing knowledge serving to build up the market, with objective assessment of pros and cons occurring only well after the disruption is complete and the innovation is entrenched. Examples range from collateralized debt obligations (CDOs) to Airbnb. Social impact bonds are not yet widely known outside government and nonprofit circles, which makes a closer look at them at this median stage important.
Social impact bonds in the real world
The first social impact bond ever created makes for a good case study. In 2010, the British government wanted to reduce the recidivism rate among parolees of Peterborough Prison in Cambridgeshire. At the time, 60% of short-sentence prisoners were re-arrested within one year of release. Four social sector organizations, including the YMCA and Ormiston Children and Families Trust, were commissioned to reduce re-arrests among 3,000 recent male parolees. Seventeen foundations committed £5 million to buy bonds, and the project was evaluated by a neutral arbiter in yearly phases, with drops in recidivism within different phases triggering different bond payouts, to a maximum of 13% per year over eight years.
The program didn't initially produce a large enough drop in recidivism for the investors to be repaid at all, but the funders did ultimately receive a 3% return on their capital thanks to secondary benchmarks being met in later phases of the project. The details are less important than the larger picture: the Peterborough project improved upon previous government results with an 8.4% reduction in recidivism, and, though it wasn't funded by financial speculators, it showed observers from that sector that profit was possible. Since the costs of crime, justice, and incarceration surpass those of early prevention, it also demonstrated how upstream spending can prevent higher downstream costs.
The bonds can be structured in an assortment of ways. In this case, as a pilot program, the funders were foundations. But the goal is for all types of private investors to see the bonds as worthwhile ventures. A glance around the Internet shows scores of pages boosting their viability, with lists of pros: innovation, specificity, budget savings; risk transfer away from government; and a chance for investors to intervene directly in their own communities. But while on paper all these advantages may exist, in the real world some SIB schemes have had problems.
Between 2012 and 2015, a program called the London Homelessness Social Impact Bond resulted in St. Mungo’s, one of the largest providers of homelessness services in Great Britain, divulging to immigration officials the locations of “entrenched rough sleepers,” resulting in deportations that helped benchmarks to be met in the bond contract. The contract had five metrics for success, including, “reconnection to settled accommodation abroad for non-UK nationals.” That metric offered the second highest outcome payment. In effect, bond investors not only profited from deportations, but those deportations were incentivized.
Deeper questions about social impact bonds
From the street all the way up to the conceptual level there are issues to consider with social impact bonds. Do they value the most important metrics? Do they measure the right results? And crucially, how are the profits generated? Canadian researchers Cameron Graham, Christine Cooper, and Darlene Himick note in their joint paper, “Social Impact Bonds: The Securitization of the Homeless,” that because government social service expenditures in countries like the U.S. and the U.K. are subject to intensive oversight and budgets are slashed to the bone, the only possible savings to be found for investors is by cutting employee wages and benefits. Thus, social impact bonds, despite the good they do, may also funnel money up the financial ladder from workers to investors.
Tight public budgets are largely caused by lowered tax top end rates compared to the past, corporate tax avoidance, and increased subsidies for business and industry. Social impact bonds seek to ask the same people who are a primary cause of budget shortfalls to help solve them—at a profit. While the model may function in some cases, there's a strong element of moral hazard involved. With charitable cash increasingly coming from fewer and wealthier donors, introducing a regime of giving for profit risks shifting the charity landscape. Instead of social impact bonds being an alternative way to give, over time they might become the preferred way most corporations and wealthy give.
Another issue with the bonds is that their focused targeting may be a detriment rather than a benefit. Their global market was estimated to be worth $502 billion in 2019, but at that time more than half of the 151 SIBs that existed served fewer than 480 people, according to an article on the website Stanford Social Innovation Review. While being able to tailor programs for specific needs is a potential advantage, it's hard to imagine such a skewed ratio being the best expenditure of time or investment capital. Even if we assume these SIBs are so tightly targeted because they're new and conservatively designed, the data produced may not offer enough useful insight into how the bonds would work at larger scale.
Ronnie Horesh, an economist who was the first to suggest the idea of social impact bonds at the Australian Agricultural Economics Society in Blenheim, New Zealand more than thirty years ago, has said that at the moment they're inherently flawed. He contends that they, “favor existing institutions, are inherently narrow and short-term in scope, and impose relatively high monitoring costs.” Because investors want goals to be achieved quickly, he says, their influence diminishes the potential of the bonds. His solution is that they should be tradable—which is how he originally conceptualized them—but that presupposes a massive expansion of a social bond market that hasn't yet been shown to be a net social positive.
This is no minor point. Many advocates envision these bonds having world-shaping capabilities. Bonds that are tradable can be used to target issues on much longer timelines, even issues extending beyond the lifespans of bondholders. What this could mean is investor-driven interventions to stop global warming or end war. Because there would be overriding public interest in solving these problems, the bonds would rise in value and be increasingly saleable. At least, that's what some advocates say. If taken at face value these ideas are bracingly utopian, but since global warming and war are two offshoots of profit seeking at a civilizational magnitude, one has to question whether, in the face of such opposition, a social bond market could remain pure.
Radical change brings endless concerns
There are many examples of successful social impact bonds. At this stage, they're still being designed with the goal of showcasing their capacity to solve problems. For now, profit considerations tend to be secondary. But how long can such a state of affairs last? Investors gamble by definition, but that doesn't stop them from seeking any possible method to reduce their risk, which is why insider trading and securities fraud are problems. An ostensibly neutral assessor is a standard part of the social impact bond construct, but in the past some of the most respected assessors in the world have jettisoned neutrality—as the 2008 Wall Street collapse abetted by improperly rated investment instruments proved.
There's also the ethical question of bonds shifting social services away from considerations of inherent public good. As mentioned at top, improving society is one of government's presumed functions—at least the way the majority of people imagine government. Social impact bonds unavoidably involve wagering on the fortunes and misfortunes of others. “Will they make it into rehab?” “Will teen pregnancy go down?” And looking from the opposite end, are the beneficiaries of bond-funded programs informed, or are funding sources kept secret? If the beneficiaries know or find out, what do they think about being wagered upon? Filmmaker Nadine Pequenza, whose 2019 documentary The Invisible Heart delves into the world of SIBs, believes the bonds, “have the potential to undermine democracy and basic human rights.”
With their potential for paradigm shift, the questions raised by social impact bonds extend to the horizon. As governments increasingly rely upon investors to fund social services, and in response shift available money elsewhere, doesn't it follow that they will increasingly be unable to take on social responsibility again, even in dire need? Will certain policy areas be prioritized because they offer investors the easiest returns, while more intractable problems are neglected? Do the bonds represent a threat to public trust, a detrimental erosion of the widespread belief that society should do collective good because it's right? Will they encourage a form of disaster capitalism? Are they just backdoor privatization of the type that has enriched the few and harmed the many?
On the other hand, the biggest question of all may be this: What if they can work? Despite all the uncertainty around them, and the high levels of trust required to believe they will be used only as advertised, if these bonds can end war—let alone homelessness or hunger—doesn't anyone with a conscience have to support them? Whether such claims are real or mere salesmanship are of course yet another question, but here's what's crystal clear: all that's needed for social impact bonds to spread is belief, and there are plenty of believers in the places that matter most—the corridors of global government. More bonds will be issued. Hopefully this also means that more evidence will accumulate, and more discussion will result.