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How the market can turbo charge social impact bonds
Even to hardened skeptics the opportunity to drive a focus on performance and efficiency into the social capital market and the provision of social services is particularly relevant in these times of austerity.
The ‘for profit’/’not for profit’ paradigm is failing to deliver, says Arthur Wood. But injecting some legal innovation into the embryonic social impact bond could trigger a significant growth spurt in the way capital and private sector solutions are driven towards solving social causes.
The Social Impact Bond (SIB) works in the same way as the International Finance Facility for Immunisation, originally proposed by the UK government in 2003. This structure captured future government cash flows from future aid budgets to change the incentive structure for scale. In the same way, the SIB captures the value of a future cash flow resulting from a social sector intervention and then uses this to change the incentive structure for collaboration and scale by the government, the civil society sector, NGOs and the private sector.
At its simplest, the SIB monetises the value of a social sector intervention, in essence flipping the traditional model on its head since a cash flow is now tied to the delivery of a social outcome.
But a highly sophisticated iteration of the SIB is about to enter the market. This will marry the SIB concept to new hybrid legal tools, currently in the legislative process in the US (in a form called the Low profit Limited Liability Corporation, or L3C) and under government review in the UK (under the name of the Social Enterprise LLP, or SELLP). Stephen Lloyd, senior partner of law firm Bates, Wells & Braithwaite introduced this new hybrid structure in a previous article on this website.
In the simple form the SIB provides the following benefits to stakeholders:
Government – Pays out of the savings it makes or the value (opportunity/cost saving) of a social intervention. Since it is a contingent return, the granting agency has greater control as to final delivery of money – potentially reducing corruption in international development and creating clearer accountability.
Private/commercialinvestors – A social investment now makes a return on money (as opposed to a negative 100% return on a grant) – indeed these players are incentivised to ensure that social return is delivered more quickly which would result in a higher financial return. The process therefore incentivises and rewards innovation and creative destruction as well as greater control and flexibility.
Social sector organisation– Acquires a commercial partner and skill sets, but critically receives long-term funding in support of their project. Allowing them to focus on their social mission and relevant collaborative partners rather than view a process normally driven by a process to fund raise unleveraged money annually. The creation of a clear transparent audit process around a simple metric is critical to all stakeholders as well as compliance of the vehicle with social objectives.
The forthcoming marriage of the SIB model with new legal hybrid structures provides opportunities to scale the social impact bond – and other impact investing tools – by making them accessible to a wider range of players at a much lower unit cost. This will help social entrepreneurs and civil society organisations use the SIB in a way that will ensure that, in their dealings with the commercial sector, the social mission is hard wired into the deal, and their social agenda is protected.
In addition, it will provide to government a simple, unitary, modular, transparent mechanism to allow regulation and fiscal monitoring should government be so minded to place a tax credit against the structure.
Domestically in the UK there are now four major SIB projects being pursued by government. There is also a move to implement the international applications of such vehicles from a number of international players. It is also worth noting that these newer vehicles are applicable to social causes both domestically and internationally, and there is a potential learning opportunity across government departments where traditionally they have been siloed.
Furthermore, the marrying of the two structures provides additional benefits to stakeholders and creates a framework for cross-sectoral outcome models. The benefits to those stakeholders are defined below:
- Clear defined mechanism and financial incentive to bring the corporate sector into the philanthropic market – now viewing it is a “bottom of the market” opportunity
- Access to new markets and new R&D
- Opportunity to apply new financing mechanisms to this market
- Potential to extend the concept of the Social Impact Bonds to the corporate sector where the commercial value of a social intervention can be identified
- Access to new resources/solutions and more sophisticated financing solutions – BUT with the social mission hard wired into the structure
- Empowers the community and social entrepreneurs to be a stakeholder in the product development cycle as opposed to the current system which disconnects them for the downstream economic benefits that are created
- Empowers civil society to implement new vehicles
- Civil society will no longer need to engage in highly inefficient funding structures – but access to long-term funding based on potential impact created
- Easy and cheap to replicate Social Impact Bonds across sectors and government
- Both the legal and financial vehicles should be cost neutral to positive to the Treasury – this is based on US congressional analysis of the Community Reinvestment Act structure in the US housing market.
- Government, as a major outsourcer of social services, benefits from the economies of scale driven into the sector and the focus on deliverable outcomes with agreed timelines
- Transparency - simple structures to audit and control if Governments were so minded to place tax credits against the structures
- If one considers social entrepreneurs as the R&D (research and development) of society – see also the Green debate on encouraging and scaling innovation – it gives countries the ability to leverage philanthropic resources as a source of long-term competitive advantage
- The opportunity to create not only cross-sectoral collaboration but the ability to create clearer focused collaboration between countries. This concept has been validated by lawyers including the leading US and UK lawyers in philanthropy (Marc Owens and Stephen Lloyd)
- It is also worth noting that the American Bar Association (Tax Committee) in the US has written to the IRS Commissioner and the Deputy Secretary of State to argue that as rule 501c3d legitimises the use of a grant as a charitable finance tool – in the same sense Rule 170d of the IRS code applicable to programme-related investment legitimises the full range of capital market tools (including international development and contingent return) for charitable purpose.
Future potential developments of the social impact bond
Of course, the SIB is not a ‘bond’ as such but what bankers would call a structured product. The current return of the SIB operating at Peterborough Prison in the UK is structured to allow anything from negative 100% to plus 13%. Dependent on the social issue and level of opportunity cost that can be captured and/or subsidy employed, the new developments mean different risk-reward parameters could be achieved.
In addition, the cash flow of a SIB could be securitised. This would be easy to do in its current form as it is British Government cash flow. That would create an instrument that would trade as a function of the achievement of that individual social target. One could possibly see a number of these instruments traded on a Social Stock Exchange. This would then de facto create a secondary market, providing liquidity and exits for investors – a current clear deterrent to investment in scale in the current social capital market.
Furthermore, international applications may well require some form of guarantor structure to attract mainstream investors. This is well within the capability of current development agencies. An example might be OPIC, the Overseas Private Investment Corporation, in the US, or – by a revision of the rules – the Export Credits Guarantee Department (ECGD) in the UK.
The Social Impact Bond will work where there is a clear, definable social benefit which can be monetised to the financial benefit of another player – government or corporate.
There also needs to be a robust, independent metric process since in this structure “what gets measured will get done”, together with an independent auditor. In addition, the process should in some cases have an additional audit process, namely a further independent community feedback mechanism for validation of the social purpose and to ensure that the metric is not distorting the social endeavour.
As in all these impact investing structures, a minimum level that it does no harm should be adhered to. Developing technology also is beginning to give the ability to map a systemic outcome model on the ground of the interaction of a number of players.
With shortage of money there will be pressure for two-part relationships around Social Impact Bonds. This would be wrong, although it is clear the existing status quo may argue for it. It is critical that there are relationships involving several partners across government, civil society and corporate sectors, with the disciplines and flexibilities of the corporate sector and private capital market injected into the framework. This will also ensure that a premium is attached to innovation, disruptive technologies and the attainment of solutions.
Domestic initiatives – Since the launch of the UK prison bond in Peterborough, there are a further four projects in process with more being considered in the UK. One of them integrates the legal framework noted in this paper.
International initiatives– In the US the Obama administration has placed a line of $100m in the US budget for Social Impact Bonds. The Rockefeller Foundation has made a grant to the Nonprofit Finance Fund to further development of the structure in the US. There are a number of projects now in design or launch phase in Canada (Health), Mexico (Public Safety), Netherlands (Health in Africa) as well as around the issue of sanitation. This has a broad collaboration of players, including McKinsey, with metrics analysed by the WSP (Water Sanitation Programme) of the World Bank, indicating the annual cost to many developing markets is at between 2% and 7% of GDP – circa $500bn annually. It is worth noting that in many of these markets the benefits potentially to be monetised under a social impact bond are eight times or more the size of the current required investment.
In Europe, the EU is at the early stages of reviewing such vehicles. However, it is worth noting the proactive stance taken by Luxembourg in revising its investment law to create the legal framework for more sophisticated social investments. Of particular note is a layered microfinance structure supported by the Swiss and German development agencies. The structures are also being reviewed in a Pan Asian application and domestically in Hong Kong, Singapore, Canada, Italy and Holland. Indeed in the Dutch case, FMO, the development agency, has been working with the Scandinavians (Swedes and Tällberg Forum) and others (including my organisation TIA) looking at full value chain models where it has been noted that these models are two critical elements in a broader strategy to redefine the relationship between the public and private sectors. Following the Tällberg Forum, there has been a positive response to these innovations, including a speech by the Direcor General of the Swedish International Development Agency which can be viewed on this link.
Other than the US domestic agenda on these instruments (L3C and the US Social Impact Bond), internationally from the US there are initiatives applying these concepts in Water as well as an entity created in Geneva focusing on mechanisms to drive efficiency into the cost structures of multilaterals where the application of modern commercial or social entrepreneurial practices (with a legal enshrined social purpose) can be leveraged further through the innovative uses of social impact bonds which incentivise franchising structures to ensure quick and effective replication of such socially entrepreneurial ideas.
One does not want to over egg the pudding and we are still at the early stage in the development of these structures. However, the critical element is that SIBs, when linked to hybrid legal structures (guaranteeing social mission), move the delivery of social goods from within fragmented silos to a space where there are collaborative partnerships of “for profit” multilaterals and the broader citizens sector – who are then rewarded for real outcomes based on the delivery of tangible social impacts.
The application of these existing commercial and legal concepts to social purpose is of course a broader trend associated with impact investing and, as can be seen, there is limited downside risk from a policy perspective if properly structured.
It is fairly clear to most observers that the current “for profit”/“not for profit” paradigm fails to deliver sufficient capital to issues that could be argued threaten the very existence of our species.
Equally, even to hardened skeptics the opportunity to drive a focus on performance and efficiency into the social capital market and the provision of social services is particularly relevant in these times of austerity.
It is time to bring the skills and resources of the market to the most pressing issues of our time.
Arthur Wood is a Founder Partner of Total Impact Advisors. As the former Global Head of Ashoka Social Financial Services since 2005 based in DC, NY, London and Geneva he has been on the forefront of the development of Impact investing concepts. In relation to this memorandum he is acknowledged as the original thinker behind the social impact bond idea as well as the co-creator of the L3C in the US and SELLP in the UK. He is actively involved in many of the international projects noted in this article.
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