A social innovation gaining prominence, Social Impact Bonds (SIBs) are being termed as a vehicle to fund social-purpose organizations in an operationally efficient manner by tying returns to predefined social indicators. The return on investment would effectively be contingent upon the ability to generate cost savings by deploying capital in an effective manner. In theory it is a reasonable proposition, which involves the private sector, makes the sovereign accountable, and inculcates a sense of societal ownership in the private sector. However, the attractiveness of these bonds in actually making a difference would be contingent upon their relative attractiveness to investors and the control that the private sector can exercise over the service providers (in which they have deployed their capital).

Although it makes sense to link improvements in social indicators⁽¹⁾ to returns, it is unclear how an investor would recoup the initial investment in the service providers. Since the providers would not have significant revenue generation ability⁽²⁾, the investor would ideally rely on the government or the respective agency to guarantee capital preservation. If the government is guaranteeing payback of principal, then it is the government’s liability – in such a case it does not make sense for the government to involve the private sector as capital outlay has to take place sooner or later. Sooner, if the government injects capital directly in the social cause⁽³⁾; later, if the government guarantees to pay back the principal to the investor at some later stage. For example, if ABC Foundation makes an investment of $100m in XYZ Nonprofit Services, then at some point in time (depending upon its investment horizon) it will want to liquidate its investment. A lack of clarity regarding its ability to recoup can be a hindrance in making SIBs a potential alternative investment avenue.

As explained earlier, the returns would be contingent upon improvement in predefined social indicators, which in theory lead to cost savings for government. The underlying premise seems to be that government-run programs are inefficient and are unable to deploy capital efficiently, whereas the private sector with its gung-ho spirit can weed out inefficiencies and extract incremental value from the capital deployed. Investors in SIBs would want a higher return and would want control over the social program so that the characteristics of that program can be tweaked to improve social indicators and maximize return. It is pertinent to note that, private investors would have a short- to medium-term horizon whereas a government has multi-generational horizon. So the decisions taken by the private sector may not necessarily be beneficial in the long run. They may demonstrate improvement in social indicators over the short run (higher returns), but their viability in the long run may be questionable. For example, after making an investment in a high school with a target of reducing dropout rate, the investors (through their control of service providers) can try to amend the curricula, change teachers, or simply make the grading system less rigorous. In this way, the dropout rate can be reduced, and returns can be increased – but is that really the sort of social change that was supposed to be attained? A classic case of moral hazard is at play here.

A better alternative might be to raise funding from private sector by providing tax benefits. The tax benefits provided by an investment in SIBs could be used to set-off tax alpha generated by the investor’s portfolio. In such a scheme, the investor would have a genuine interest in allocating a portion of the portfolio to SIBs since that would lead to a more tax-efficient portfolio. An improvement in social indicators can then be used to provide incremental tax benefits (as an incentive) rather than an outright return. In absence of an active return from SIB, the investor can treat SIB as a passive investment (which accrues tax benefits) – and can focus attention on managing other investments.

In the rough back-of-hand model explained above, the government can raise necessary funding (with a lock-in period), avoid conflict of interest and generate investor interest via tax benefits. A detailed valuation methodology after considering expected cash flows, probability of realization and estimated discount rate needs to be developed. The availability of an empirically driven valuation method would enable investors to compare returns to other alternative investments and plan portfolio allocations accordingly. As social impact bonds are still an emerging financial instrument, tweaks to the model may be considered in order to fit different contexts and to reduce some of the issues identified above.

Notes:

⁽¹⁾ SIBs rely on more than just indicators, and are aimed at producing social outcomes - measurable changes that have a profound effect on the issue.
⁽²⁾ This is one of the benefits of Social Impact Bonds, in fact - they provide a way to finance social-purpose organizations.
⁽³⁾ The question regarding why governments do not simply invest in social causes directly has been addressed in Social Innovation Generation’s December 2010 report, Social Impact Bonds: Addressing Key Stakeholder Issues.

SocialFinance.ca has a dedicated resource page for Social Impact Bonds, with links to research as well as opinions being posted around the globe.

Photo credit: http://www.flickr.com/photos/jurvetson/4685661036/in/photostream/

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