The Stew BLOG

Considering a Social Impact Bond? Tread Carefully.

Lindsey Alexander, Project Director | 02/17/2017

I would imagine there aren’t many people who remember the hype the Segway generated when it was introduced in the early 2000s. Touted as “the future of walking,” Steve Jobs reportedly saw it in development and said it was going to be “as big a deal as the PC.” John Doerr, an American venture capitalist who invested in Amazon and Netscape, saw it and said it “may be bigger than the internet.” Fifteen years later the Segway is largely forgotten–relegated to mall cops and city tours (if cities even allow them on sidewalks; many don’t).

In our work with community multi-sector partnerships around the country, we’ve heard a lot of interest in social impact bonds, or SIBs for short–and for understandable reasons. Deemed an “audacious idea for solving the world’s problems” by Harvard Business Review, they are relatively new and innovative and dangle the possibility of infusing cash-strapped social service programs with private sector investment. But there’s reason for pause. Some of the early U.S. experiments, at places like Rikers Island State Prison and Salt Lake City, have raised important questions about their utility.

So we’re wondering: are SIBs the Segway of financing mechanisms, passing through on their way to relative obscurity? Or are they a useful way for communities to fund important work with limited budgets? Perhaps they fall somewhere in between?

While only time will answer this question, your (friendly!) ReThink Health Sustainable Financing Team has spent some time talking with about a dozen leaders in the field in order to gain an understanding of what it really takes to get one of these deals done. One of those leaders is Ian Galloway, a senior research associate at the San Francisco Federal Reserve Bank, who has researched and written extensively on pay-for-success (PFS) measures like SIBs. I’ll share some of Galloway’s take on SIBs, but first a bit of background:

Many times, the terms SIBs and PFS are used interchangeably, but SIBs are actually a part of the PFS family. PFS is generally thought of “outcomes based” financing in which payment is contingent upon reaching pre-established performance measures. SIBs are one type of PFS agreement. With SIBs, the private capital is provided up front to finance service delivery. The savings generated from the success of an intervention, determined through an independent evaluation upon completion, should cover the principal, interest and transaction costs.

So what advice did Galloway have for those considering these arrangements?

(1) Know your motivations. Galloway’s comments on PFS in general can be summed up in two words: tread carefully. It’s not that SIBs are inherently good or bad. You just have to go into the process with your eyes wide open and know your motivations.

Galloway said there are two contexts in which PFS is currently being used: (1) when there are upstream investments that have been proven to produce downstream benefits and cost savings, but there isn’t the money on hand to make those investments and (2) when there isn’t certainty that a given upstream investment will ultimately translate into downstream benefits and cost reductions. Galloway said there is a debate in the field about which of these two contexts PFS is most appropriate, so understanding which of these motivates your interest is important.

“It may be in some cases we use it to scale programs that work, and in other cases, we use it to encourage innovation in social policy. I think the financial terms of the one versus the other are going to be very different. If I’m investing in a program that has a long track record of success and I consider it to be a low-risk investment, then I’m going to expect a lower rate of return, for example,” Galloway said. The reverse would be true of unproven, innovative pilot programs: investors would expect a higher rate of return to compensate them for a riskier investment.

Galloway’s point is critically important. An article in the New York Times reported that at the conclusion of an SIB deal in Salt Lake City, Goldman Sachs, the private investor involved, was reported to have said that they had learned that PFS is best suited to financing existing interventions with successful track records.

Which leads me to wonder: if SIBs are best suited to financing proven initiatives, then the purpose is to raise cash. But that’s an expensive way of doing things. The transaction costs are high (more on that next), and SIB deals — being transactional in nature — have to occur repeatedly. This means that savings that could be reinvested in the initiative, are instead used to pay transaction costs (interest, yes, but also lawyers, bankers, and evaluators). Not an efficient long-term strategy. Community or public sector organizations might consider whether they could finance their work on their own– at a much lower cost– and reinvest the savings rather than share them with private investors.

(2) Measurement and monetization are where the rubber meets the road. It sounds relatively straightforward – measure what your program produces and how much money it saves. But in reality, not only can it be difficult to specify outcomes that can actually be measured (outcomes, not outputs[1]), but assigning those outcomes a dollar value is a sophisticated process. Even something as seemingly straightforward as monetizing the cost of reduced recidivism, for example, can quickly become complicated.

Many times, there is a portion of an outcome that cannot be monetized. What happens when an intervention saves only a portion of its cost, but there are other benefits – like increased health, or higher future wages or less crime– that you can’t easily monetize? Galloway hopes this is one area that PFS evolves, making ROI less about the dollar value saved, and more about the value to society.

In other instances, proving success in SIB deals can be extremely onerous, requiring costly and robust evaluations. This seems somewhat arbitrary given that we make public investments all the time that don’t call for a high degree of evidence. Take public infrastructure, for example. How many bridges and highways are built each year, without any thought to actually monetizing the return on investment? It’s assumed that the returns will materialize.

Galloway, however, thinks the burden of proof isn’t all bad. “One of the things I like about PFS is that it brings a clarity and an intention to the measurement, the importance of measuring what it is that we’re getting for our public sector investments.” As my colleague, Stacy Becker, suggests in her recent blog, perhaps we need to create new norms and standards around what level of proof is most appropriate for different kinds of situations.

Another issue regarding measurement concerns the timeframe for returns. Let’s not forget that SIBs are an investment vehicle – which means there are investors who want a return on their money, typically sooner rather than later. Officials involved in the Salt Lake City transaction said that investors were primarily looking for SIBs that delivered a return within 3-5 years. How do you balance the long-term nature of complex social problems with an investor’s need for a short-term return? While interim measurements and benchmarks are one way, Galloway cautions that those measurements can take an initiative off-course if not well-aligned with the longer-term, end goals.

(3) Transaction costs are significant. SIB contracts are very complicated. They include several key players – nonprofits, public entities, the investors, and independent evaluators, to name a few. Getting an SIB deal off the ground can take years. The Chief Strategy Officer for Roca, a Boston youth organization that recently entered into an SIB contract, said in an  interview, “I teach financial management to graduate students and I’m a lawyer, and I still needed help understanding the financing.” Roca took two years to complete the deal, along the way tapping into $250,000 worth of free legal aid to help with the transaction.

It’s still unclear to what extent there is potential for standardization of deals, and therefore reduction of transaction costs. “We don’t know yet. Each deal has been different,” Galloway said.

Within the umbrella of “tread carefully,” Galloway gave two more pieces of advice to organizations interested in SIBs:

  • prepare yourself for a level of scrutiny that you’re likely not accustomed to (Salt Lake City was on the front page of the New York Times business section), and
  • be mindful of the potential consequences of failing to produce the outcomes that you’re contracted to deliver. If you find yourself in that position, it may be difficult to raise future funding either through another PFS contract or more traditional sources.

While Galloway is prominently featured here, I’ve spoken with numerous individuals who have worked on SIB deals around the United States. I would echo Galloway’s advice, and I’d add that SIBs are not for “beginners.” I know that there are a lot of communities struggling with how to finance community health transformation. And hearing of a “new” and “innovative” mechanism that could infuse some much needed cash might offer up some hope.

But SIB deals in this country have had mixed results. Some have fared well–Salt Lake City, for example–while others have not, such as Rikers Island. (Not to mention the communities that invested significant resources only to find they couldn’t get an SIB deal off the ground.) And structuring SIBs around health-focused initiatives is particularly tricky given investors’ desire for such quick ROI.

Lastly, with SIBs, you simply trade one risk for another. Sure you might have an investor who’s on the hook if your initiative doesn’t produce the desired outcomes. But your partnership is taking on the risk that you’ll be able to get an SIB deal done, and they are sophisticated deals that require significant resources to put together.

What’s YOUR take on SIBs? What questions, concerns or advice would you add to this list?

Please comment below or reach out to us with your thoughts – we’d love to hear them! You can find me via email at [email protected] or on Twitter @lkalexandermn.


[1] There’s a difference between outcomes and outputs. Outputs are what your organization produces, the units or activities (i.e., workshops or programs, etc.) Outcomes are the impact of those outputs; the increase in knowledge or behavior that is changed as a result.