Pay For Success Bonds

Summary

A Pay for Success Bond, also known as a Social Impact Bond, is a contract between government and one or more non-government entities that shifts responsibility for a social service program from government to the private entity(ies) in hopes of achieving better results and reduced taxpayer expense.

Under the contract, private investors, working with the non-government entity, finance, manage and ensure delivery of a government service. If the program achieves an agreed-upon goal (such as increasing high school graduation rates in a low-income school district), the goverment is obligated to reimburse investors as well as compensate them for the risk they assumed. If the program fails to meet the target outcome, the government doesn't have to pay anything.

This type of bond is not like a traditional debt security bond. A key difference is that Pay for Success Bonds reach "maturity" (i.e., pay investors) only if a predetermined outcome is achieved.

The idea for Pay for Success Bonds originated in the United Kingdom as a means for government to encourage community service and tap into new funding sources. The first pilot program was launched in September 2010 by Social Finance.


How Pay for Success Bonds Work

Below are five steps that describe, in general terms, how Pay for Success works:

  1. The government creates, or oversees the creation of, a bond-issuing intermediary. The bond-issuing intermediary is a private or quasi-governmental organization created specifically to manage the Pay for Success program and raise capital.
  2. The government negotiates a contract with the bond-issuing intermediary. The government and the bond-issuing intermediary negotiate a contract that specifies the population to be served, the definition of success, the means for measuring results, financing, interest rates, the schedule of payments, etc.
  3. The bond-issuing intermediary raises capital from private investors. Private investors at an institutional level, such as hedge funds and foundations, provide financing up-front for the program. Investors assume all or most of the financial risks involved.
  4. The bond-issuing intermediary hires service providers to implement the programs. The bond-issuing intermediary hires the organizations that will deliver the services to the target population. These service providers can be for-profit or nonprofit.
  5. The government pays the bond-issuing intermediary and investors. If the program is successful the governmet is obligated to pay the bond-issuing intermediary and investors the predetermined sum. If the program falls short of the agreed-upon targets, the government pays nothing.

Benefits of Pay for Success Bonds

Pay for Success Bonds offer many potential benefits to various groups. Below are key benefits to government, investors and beneficiaries.

Benefits to Government

  1. Taxpayer money is spent intelligently. Financial risks for government services are transferred to the private sector. Government only pays for successful outcomes, meaning that taxpayers won't lose money on programs that don't work.
  2. New funding sources are created. By inviting the private sector to participate in funding government services, an additional source of financing becomes available.
  3. Improved transparency. With a contract in place that contains, among other things, a specific definition of success, taxpayers will be better informed and know what programs are working and not working.
  4. Barriers are lowered to innovation. Pay for Success creates an incentive to try new solutions. Since taxpayers aren't on the hook, government can move forward with testing programs that are new or unproven. Traditional government funding tends to support the status quo, as new approaches are deemed too risky to pursue.
  5. Less government spending. Under Pay for Success, programs that don't work will not be paid for. Equally important, programs that don't work will not receive goverment funding year after year, like the traditional government funding method. Ideally, the savings achieved by a successful Pay for Success program would be used to pay investors.
  6. Better service to constituents. A key purpose of Pay for Success is improved services for beneficiaries. Successful outcomes mean government is operating at a higher level of performance.
  7. Improve government performance across agencies. Other government agencies, having noted the Pay for Success program, may be motivated to improve their own performance.

Benefits to Private Investors

  1. Opportunity to earn a profit. In terms of making money, Pay for Success Bonds are an investment just like any other.
  2. Opportunity to help people and improve society. Pay for Success offers investors an opportunity to help underprivileged people and improve their communities.

Benefits to Program Beneficiaries

The main benefit to beneficiaries is improved quality of service. Below are three reasons for beneficiaries to expect a higher level of service:

  1. Private sector management and discipline. Pay for Success introduces private sector management and discipline to public sector services. An underlying premise of Pay for Success is that private sector management is more effective and efficient than public sector management.
  2. Stakeholders have a financial incentive to make the program work. The bond-issuing intermediary and private investors have a strong incentive to see a successful outcome because otherwise they lose their money. This downside risk is likely to lead to tight oversight of program operations and quick adjustments to approaches that aren't working. Stakeholders will be trying to minimize any risk that could damage performance.
  3. Delivery of services by good companies. The organizations that want to deliver the services will have to compete to convince the bond-issuer and investors that they are the best team for the job. The bond-issuer and investors will be looking for the company that is most likely to achieve a successful outcome.

Drawbacks of Pay for Success Bonds

Most potential problems with Pay for Success stem from poorly written contracts. The people tasked with drafting the contract, both on the public and private sides, must be very clear and specific. Any ambiguity can lead to paralyzing disagreements down the line.

A contract that is not perfectly clear and specific can result in the following problems:

  • disagreement among the parties over the interpretation of results (e.g., they may disagree over the definition of a key term);
  • disagreement among the parties over the method of measuring results (e.g., they may disagree over which groups of beneficiaries count toward a successful outcome);
  • uncertainty over which government agency is responsible for payment after a successful outcome; and,
  • the beneficiary population may be harmed if investors pull the plug on the program because they no longer believe it will succeed and they won't be reimbursed.

Other potential drawbacks include:

  • Pay for Success funding may not be available for large government programs, as raising billions of dollars for a social service program from investors may not be possible; and,
  • Investors, wanting to minimize risk, may only be interested in funding programs with a high likelihood of success, thus neglecting programs with lower odds that may serve populations needing the most help.

Pilot Programs Funded by Pay for Success Bonds

In the United Kingdom, the Ministry of Justice along with private investors established a social impact bond intended to reduce the recidivism rate among a prisoner population. According to the deal, investors will be paid if reoffending rates fall by at least 7.5%.

In the United States, the 2012 Federal Budget allocated $100 million to fund Pay for Success programs across several areas, including job training, education, juvenile justice, and care for children with disabilities.

The New York-based investment firm, Goldman Sachs, has also been on the vanguard of Pay for Success investing in the United States. Listed below are two videos from the company describing their initiatives.


Videos

Introduction to Social Impact Bonds. Source: McKinsey & Company via YouTube
Social Impact Bond for Early Childhood Education. Source: Goldman Sachs via YouTube
Social Impact Bond Project on Rikers Island, NYC Source: Bloomberg TV

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