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Annual Privatization Report 2013

The Emergence of Social Impact Bonds: Paying for Success in Social Service Innovation

Subsection of Annual Privatization Report 2013: State Government Privatization

Leonard Gilroy
April 22, 2013

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Public-private partnerships (PPPs) that leverage private funds to construct public assets like highways and schools have become an increasingly popular tool used to build and modernize public infrastructure worldwide in recent decades. But only recently has the concept been extended in a robust way beyond brick-and-mortar infrastructure and into the realm of social programs. That changed in 2010 with the introduction of the "social impact bond" concept—also known as "pay for success," "social finance," or "social innovation finance" programs—in the United Kingdom.

A social impact bond is a PPP in which private philanthropic organizations, financiers, nonprofits or other nongovernmental organizations finance and implement new social service delivery models on behalf of governments under a pay-for-success contract model. If the privately financed interventions improve social outcomes and save public funds, investors receive success payments from government that generate a commensurate return on investment. If outcomes do not improve, government doesn’t pay, placing the focus squarely on implementing evidence-based practices that deliver results, lest investors risk their investments.

The term "social impact bond" can be somewhat misleading, as they are usually not structured as government-issued bonds at all, but rather as performance-based contractual arrangements in which private investors provide upfront capital to launch the programs, with costs recouped later via a government success payment only if pre-determined outcome targets are met.

According to a 2013 report by Social Finance—the U.K.-based nonprofit that originally developed the social impact bond concept—the primary goals of social impact bonds are to:

In the first social impact bond pilot project launched in 2010, Social Finance raised $7.8 million from 17 social investors to fund a pilot project in one U.K. prison. In this project, nonprofit organizations provide intensive support to prepare approximately 3,000 short-term male prisoners for release, working with them both before and after release to prevent re-offending. If recidivism drops by more than 7.5 percent within six years, investors will receive a payment representing a share of the long-term savings from avoided recidivism, with up to a 13 percent return if they exceed the target. Conversely, investors will receive no return if they fail to meet that target.

A 2012 report by the management consultant McKinsey & Company identified seven stakeholder groups involved in social impact bonds:

  1. Governments: Public entities establish policy on social impact bonds and commit to making future payments to private partners if specific outcome goals are achieved and public sector costs lowered.
  2. Investors: Philanthropic and other social innovation investors finance social impact bond projects, providing the upfront capital to service providers to cover the costs of service delivery.
  3. Nonprofit service providers: These organizations directly deliver social interventions to affected populations.
  4. Intermediaries: Intermediaries are typically nonprofit organizations that manage social impact bond projects on behalf of governments and create a separation between service providers and public agencies to minimize the potential for government micromanagement that could limit providers’ flexibility to achieve targeted outcomes. They are responsible for raising funds from investors, selecting the service providers to deliver interventions, receiving success payments from governments, and repaying investors if program goals are reached.
  5. Independent assessors: Assessors perform the critical task of measuring program performance to determine whether outcome targets are met.
  6. Evaluation advisers: Evaluation advisers work with intermediaries to provide ongoing monitoring and refinement of social impact bond programs.
  7. Constituents: Program beneficiaries receive the social services delivered.2

Since the U.K. pilot launched in 2010, the concept has spread quickly to the United States, where several state and local governments have announced new social finance projects and policy proposals across a range of social services. The Obama administration has even embraced the concept, with the U.S. Department of Labor and U.S. Department of Justice instituting grant programs to help communities and organizations launch pay-for-success programs. Noteworthy U.S. social finance efforts announced to date include:

Massachusetts: In 2012, Massachusetts became the first state to move forward on a social finance program when Governor Duval Patrick’s administration announced successful bidders in a procurement for two pay-for-success contracts—termed “Social Innovation Financing” initiatives in Massachusetts—targeting juvenile justice and chronic homelessness, respectively.

In the first, the Administration will partner with social entrepreneurs to support youths transitioning out of the state’s juvenile justice and probation systems, with a goal of reducing recidivism and improving education and employment outcomes for the thousands of youths that leave these systems annually. The state selected the nonprofits Third Sector Capital Partners and New Profit Inc. to negotiate with the state as intermediaries for the contract, and it selected social service providers Roca, Youth Options Unlimited and the United Way of Massachusetts Bay and Merrimack Valley to participate in the initiative. A 2011 article by the Heartland Foundation noted that the recidivism rate for youth in Massachusetts tops 40 percent and the state spends approximately $45,000 per year per inmate; by contrast, less than 2 percent of participants in Roca’s programs were re-incarcerated after one year in 2010, and the nonprofit only spent roughly $5,000 per youth annually over three to four years, suggesting a large scope for potential cost savings in Massachusetts.3

In the second, the Administration will partner with organizations to provide stable housing for several hundred chronically homeless individuals to reduce emergency shelter and Medicaid costs. The state selected the nonprofit Massachusetts Housing and Shelter Alliance as the lead intermediary for the contract, with supporting partners that include the Corporation for Supportive Housing, Third Sector Capital Partners and the United Way of Massachusetts Bay and Merrimack Valley.

In January 2012, Massachusetts lawmakers passed a bill, signed by Patrick in July, to establish the state's Social Innovation Financing program and a trust fund to hold up to $50 million in aggregate state funds (with a portion appropriated annually over the next several years) to support future outcome payments for the contracts. The Massachusetts contracts are unique among similar social financing projects in that the state chose to separately procure both the intermediary to organize programs, as well as the service providers themselves, rather than leaving the selection of providers to the discretion of the intermediary, as in the “traditional” social impact bond model. A 2012 Center for American Progress report notes that this structure requires the state to be careful in how it delineates the boundaries of the relationships between itself, the intermediary and the service providers to ensure that the providers have enough latitude to adjust interventions and services during implementation in order to maximize their ability to achieve the desired results.4

New York City: In August 2012, New York City Mayor Michael Bloomberg announced that city’s award of the first local government social impact bond contract, which aims to reduce recidivism among young adults released from the Rikers Island correctional facility. According to the Bloomberg administration, nearly 50 percent of young adults leaving the Department of Correction system reoffend within one year. In order to reduce the likelihood of reoffending, the new program—known as the Adolescent Behavioral Learning Experience (ABLE) program—will provide evidence-based intervention involving education, training and counseling to improve personal responsibility skills among youth ex-offenders between 16 and 18 years old (approximately 3,000 per year).

The project involves a range of players in different roles. Goldman Sachs is financing the program’s operations for four years through a $9.6 million loan to the local nonprofit MDRC, which is contracting with the city to oversee implementation of the program. MDRC will manage the nonprofit service providers Osborne Association and Friends of Island, which will deliver the intervention. To mitigate some of the financial risks of the project, Bloomberg Philanthropies is providing a $7.2 million grant to MDRC to guarantee a portion of the Goldman Sachs loan. The Vera Institute of Justice, a national research organization focused on corrections and criminal justice issues, will serve as an independent evaluator for the project to monitor project outcomes and determine whether recidivism reduction targets are met.

The city's Department of Correction will make payments to MDRC based on outcomes and cost savings achieved in reducing recidivism levels. If the program reduces the recidivism rate of the target population by 10 percent, Goldman Sachs would break even on its original investment of $9.6 million (see Table 1). If the program reduces recidivism by more than 11 percent, the city will pay MDRC on a capped, sliding scale that rises as recidivism rates fall, and Goldman Sachs could earn a return on its investment up to a maximum of $2.1 million if recidivism rates fall more than 20 percent. At that maximum level, the city would net over $20 million in long-term savings, nearly ten times the return that would be paid to Goldman Sachs.

Table 1: New York City Social Impact Bond Payment and Savings Schedule

Reduction in Recidivism Rate City Payment to MDRC Projected Long-Term Net Savings to City*
≥20.0% $11,712,000 $20,500,000
≥16.0% $10,944,000 $11,700,000
≥13.0% $10,368,000 $7,200,000
≥12.5% $10,272,000 $6,400,000
≥12.0% $10,176,000 $5,600,000
≥11.0% $10,080,000 $1,700,000
≥10.0% (breakeven) $9,600,000 $1,000,000
≥8.5%  $4,800,000 $1,000,000
* Savings after repayment and continued funding for program delivery.

Source: City of New York, Office of the Mayor, "FACT SHEET: The NYC ABLE Project for Incarcerated Youth America's First Social Impact Bond," August 2, 2012, http://www.nyc.gov/html/om/pdf/2012/sib_fact_sheet.pdf (accessed January 16, 2013).

If the program does not meet its recidivism reduction targets, the city pays nothing, and Goldman Sachs would stand to lose $2.4 million of its initial investment (the difference between its upfront $9.6 million investment and the $7.2 million guarantee by Bloomberg Philanthropies).

Minnesota: In 2011, the Minnesota legislature enacted the Pay for Performance Act, establishing a new social finance pilot program targeting workforce development and supportive housing. The law approved $10 million in Human Capital Performance (HUCAP) bonds to finance the pilot, a variation on the social impact bond concept that involves the issuance of public debt through state appropriation bonds. The bond proceeds would pay service providers when they achieve outcomes that lower costs or increase revenues to the state in an amount greater than the debt service needed to repay the bonds, and ongoing savings or revenue increases from successful program implementation would be applied to debt service.

The law also established an oversight committee—led by the director of Minnesota Management & Budget (MMB), the governor’s budget agency—to guide implementation, determine eligible services and performance standards, and evaluate outcomes. In late 2012, MMB issued two requests for proposals seeking external partners to manage and evaluate the pilot projects in workforce development and supportive housing, respectively.

The HUCAP bond structure is intended to attract investors in high-quality public debt and spread risks differently than a social impact bond initiative, which relies on private sector financing (and private financial risks). Because they would only be paid for successful results and would have to fund their own operations until then, service providers bear the brunt of the risk in the HUCAP model, which may present a challenge for nonprofit providers with limited working capital.5 By contrast, the state and bond investors face comparably little downside risk, as the state will not spend the bond proceeds until program outcomes are achieved, and if none succeeds, the state could then simply pay off the bond early, only incurring the costs of short-term interest paid to bondholders.6

Separately, in late 2012 the Minnesota Department of Employment and Economic Development issued two requests for proposals seeking an intermediary and program evaluator, respectively, to help the agency develop a pay-for-success pilot program (using private financing, not HUCAP bonds) that could be submitted to the U.S. Department of Labor for possible pay-for-success grant funding.

Connecticut: After receiving legislative approval in the state’s 2013 budget, the administration of Connecticut Governor Dannel Malloy is moving forward with the development of a social impact bond program focused on reducing recidivism and increasing employment among ex-inmates. At press time, the Malloy administration was in talks with Social Finance U.S., the domestic branch of the organization that pioneered social financing in the United Kingdom, regarding a potential partnership to move the project forward.7

New York State: In the summer of 2012, the New York State Department of Labor issued a request for proposals seeking a social finance intermediary to work with the agency to prepare an application for the U.S. Department of Labor’s pay-for-success pilot grant program. The Department hopes to establish a program to reduce recidivism and improve employment for high-risk adult and juvenile ex-offenders re-entering society. The intermediary would not be paid for the grant application preparation, but would instead only be paid if the federal grant is awarded, any needed state appropriations are established, and the resulting pay-for-success program achieves validated, negotiated outcomes. At press time, the agency had not announced the results of the procurement.

New Jersey: In December 2012, the New Jersey Assembly Commerce and Economic Development Committee approved A-3289 (the “NJ Social Impact Bond Act”), which would establish a five-year social impact bond pilot program designed to attract private funding for state preventative and early intervention healthcare programs for low-income and uninsured residents in order to lower costs to the state. The New Jersey Economic Development Authority (NJEDA) would administer the program and would solicit private or philanthropic grants to fund its startup. NJEDA would also establish an internal study commission to help select a nonprofit partner to deliver program services, guide implementation and prepare annual progress reports.

Under the bill, NJEDA and the State Treasurer are authorized to enter into one or more social impact bond contracts, with the total amount of bonds issued capped at $3 million annually (or $15 million total over the five-year authorization period). Investors would not receive a return on investment for the bonds if the related social interventions fail to meet pre-defined performance levels and cost savings thresholds, as determined by NJEDA and the state’s Department of Human Services, which would assist NJEDA in developing and analyzing the effectiveness of the pilot program. “Opening the door to new resources while reducing government costs is crucial to building sustainable programs that improve quality of life while not burdening taxpayers,” said Assemblyman Angel Fuentes, the bill’s primary sponsor, in a press release. At press time, the bill was awaiting action in the Assembly Appropriations Committee.

Fresno, California: In October 2012, the city of Fresno, California announced the launch of a pay-for-success program aimed at reducing incidents of asthma caused by indoor air pollution in the nation’s first "health impact bond." Under the program, the nonprofit California Endowment will finance a $1.1 million program in which the nonprofits Collective Health and Clinica Sierra Vista will work with 1,100 low-income asthma patients over the course of a year to make behavioral and environmental changes designed to mitigate asthmatic triggers and lower costs to healthcare insurers by over $5,000 a year per patient.8 A portion of the savings to private insurers and the state’s Medicaid system would be used to repay investors at a 5 percent interest rate. Officials expect the project to move into operation in 2013.9

Cuyahoga County, Ohio: In November 2012, Cuyahoga County, Ohio became the first county government in the nation to launch a procurement for a pay-for-success pilot program, issuing solicitation seeking responses from intermediaries and service providers interested in developing programs targeting child welfare, youth mental and behavioral health, or other social interventions. The county seeks to demonstrate the feasibility and viability of social finance to support and deliver positive outcomes in preventative programs, and selected respondents will be asked to develop more detailed program proposals. Third Sector Capital Partners served as a technical advisor to the county in crafting the procurement. "Pay for Success will allow Cuyahoga County to direct its limited budget towards proven preventive interventions," Cuyahoga County Executive Ed FitzGerald said in a press release. "I am eager to work with our valued community partners to improve the lives of our most vulnerable residents while generating valuable fiscal savings."

Despite an as-yet-unproven track record—the first results from the pioneering U.K. social impact bond pilot program will not be available until 2014—social impact bonds have clearly captured the attention of policymakers across the United States who are seeking ways to experiment with new, less costly social service delivery models without incurring the associated upfront costs and performance risks. Even at this early stage, the variety of concepts and program structures in motion are likely to provide valuable case studies on what works and what doesn't as this new privatization tool matures.

» Return to Annual Privatization Report 2013: State Government Privatization
» Return to Annual Privatization Report 2013: Criminal Justice and Corrections
» Return to Annual Privatization Report 2013 homepage


Endnotes

1 Lisa Barclay and Tom Symons, A Technical Guide to Developing Social Impact Bonds, Social Finance, January 2013, p.4, http://goo.gl/b65bJ (accessed January 16, 2013).

2 Laura Callanan, Jonathan Law and Lenny Mendonca, From Potential to Action: Bringing Social Impact Bonds to the US, McKinsey & Company, May 2012, p. 7, http://goo.gl/8Kjy9 (accessed January 16, 2013).

3 Elizabeth Henderson, “Massachusetts Mulls Private Finance for Public Services,” The Heartlander, August 18, 2011.

4 Kristina Costa and Jitinder Kohli, “New York City and Massachusetts to Launch the First Social Impact Bond Programs in the United States,” Center for American Progress, November 5, 2012, http://goo.gl/BK5xq (accessed January 16, 2013).

5 Katie Gilbert, “The Human Capital Performance Bond,” Institutional Investor, June 13, 2011.

6 Invest in Outcomes, “About: Human Capital Performance Bond (HUCAP),” website, http://goo.gl/zjsFc (accessed January 16, 2013).

7 Dan Haar, “As Private Financing Emerges For Social Services, The State Is In Talks For A Deal,” The Hartford Courant, December 4, 2012.

8 Manuela Badawy, “California city seeks to cut asthma rate via bond issue,” Reuters, October 19, 2012.

9 Joe Moore, “Social Impact Bond May Fund Asthma Prevention in Fresno,” Valley Public Radio, November 2, 2012.


Leonard Gilroy is Director of Government Reform


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