Social Impact Bonds Bring Social Innovation to the Bay State

SIBs represent the dawn of a new era, one that will accelerate the evolution of the Impact Economy.
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It does not have the presidential allure of CGI or the whiz-bang feel of TED, but the Milken Global Conference, which wrapped up last week, deserves a spot in the canon of conferences. Under the canopy of the Southern California sun, it convenes the greatest minds from global finance for a three-day smorgasbord of substance. The sessions start at 6am and run until late at night -- a pounding schedule of panels, break outs and late night sessions on topics like risk capital, bond markets, commodity prices and black swans.

This year, however, the most compelling innovation in capital markets was not found at the Beverly Hilton but instead, on the opposite side of the country.

Late last week, Governor Deval Patrick and the Commonwealth of Massachusetts quietly released a Request-for-Information (RFI) on an esoteric new public financing concept. The state cautiously issued its RFI without much fanfare. No trumpets or flags, just an understated press release announcing its interest in the issuance of a Social Impact Bond.

Observers might look back on this measure as an important milestone for a new era of government. This RFI is among the first shots of a modern revolution, a transformative process that could alter the public conversation about how government interacts with the private sector and public citizenry, paving the way for an Impact Economy. In an age of looming public deficits and diminishing social services, Social Impact Bonds (SIB) hold powerful promise as a valuable addition to our toolkit of financing models for public good.

SIBs were not invented here in the US, but imported from the UK. Among others, famed investors Sir Ronald Cohen and David Blood are given credit for bringing this new instrument to market. Despite their esteemed careers in asset management, it might be seen as their most significant contribution to the field of modern finance, as it forged a more sustainable form of capitalism.

SIBs are designed to address the intrinsic tension in the policy-politics dynamic. The current debate about entitlements reform reminds us that our short-term election cycle discourages long-term systems change. In brief, politicians are rewarded at the voting booth for cutting ribbons today, rather than cutting recidivism rates tomorrow.

As a result, a range of preventive services historically are underfunded. Offenses mount and costs increase. This in turn places a higher burden on taxpayers which then further constrains our policymakers who resort to crisis management. It's a vicious cycle that is difficult to break.

SIBs reverse the process with an ingenious model that leverages the core competencies of all the parties. For starters, government must identify an area where prevention creates a measurable impact , such as reducing adult incarceration rates. In a country where we spend $70 billion on our penal system a year and incarcerate more than 3 million people, the recidivism rate exceeds a staggering 60 percent. Yet, relatively small measures can yield tremendous benefit.

Studies show that early counseling of juvenile offenders can reduce recidivism dramatically, saving quantifiable dollars by diverting would-be offenders from a life of crime. Despite the clear cost savings, government still cannot pay for such programs when its discretionary budgets have been slashed. SIBs flip the model on its head, allowing government to engage private capital to fund such preventive programs and incur public benefit.

Through a SIB, government attracts private capital to fund the upfront costs for critical services in exchange for a capped return to be paid out down the road based on the savings as a result of prevention. There is some risk, however. If the program does not achieve the predefined metrics, the SIB will not achieve a return for the investors. Nonetheless, when nonprofits suddenly benefit from the capacity enabled by predictable cash flows, theoretically they should be able to focus on their highest value activities -- delivering effective services rather than perfecting their fundraising pitch. It's a win-win for all parties: government achieves savings, investors earn a return, nonprofits focus on their competencies, and the public good is preserved.

In this scheme, we shift from top-down, big government thinking, to more lateral interactions between equal partners. As such, SIBs exemplify the new era of social capital markets, the wave of financial innovation shifting our society from a conventional economy, where individuals often seek to maximize individual gain at all costs, to an Impact Economy, wherein market forces are leveraged to enable private gain but also to drive public benefit. In an Impact Economy, cross-sector collaboration is not the exception but the rule, a new mode of serving the national interest.

Let's be clear: SIBs are not a silver bullet. The very nature of a capped return probably means that SIBs will need to be kick-started by philanthropists and other "impact-first" investors with PRIs before they gain mainstream acceptance. Unlike conventional fiduciaries, philanthropists more easily can square SIBs with their investment priorities. Nonetheless, if this model is proven to work, such experimental philanthropy might be viewed as the venture capital of an era of social innovation.

Indeed, an argument has ensued as to whether such "Impact Investments" represent a new asset class. SIBs offer a provocative response: these are investments that promise to deliver predictable returns uncorrelated from the rest of the market. Its not hard to believe that these attributes might make them attractive to investors seeking a strategic asset allocation. Indeed, if SIBs bear fruit, such low-risk instruments could emerge as an essential element in the balanced portfolios of sophisticated financial managers.

Beyond reducing recidivism rates, there are many issue areas where SIBs might drive meaningful impact: resolving chronic homelessness, reducing childhood obesity, improving personal health. The list goes on. The Rockefeller Foundation has funded some initial explorations to consider the possibilities. Even the White House has recognized this wide-reaching potential. President Obama staked out $100mm in his proposed FY2012 budget for the instrument, described by the administration as "pay-for-success" bonds, potentially to be used by five different federal agencies.

As the field evolves, we should expect to see a flurry of new groups seeking to design such public-private partnerships. Today the field is sparse. Social Finance, a US group launched by Sir Ronald and Mr. Blood, presently appears to be the only significant player in the field. But, many more will come as impact investors, social entrepreneurs and new intermediaries spring up to scale SIBs and launch new innovations.

Elected officials and civil servants should take note. They will need to prepare to engage with these new players and rethink old models. More than ever, its imperative to pursue public policies that leverage innovation to maximize the common good.

It should be interesting to watch the outcome of the Massachusetts' RFI. However, SIBs clearly are gathering steam They are contributing to an amplifying conversation around private financing for public benefit. SIBs indicate that the Impact Economy is starting to accelerate. Buckle up -- it should be quite a ride.

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