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Social Impact Bonds' Slippery Slope

Social Impact Bonds (SIBs) as a vehicle for funding social change are gaining renewed momentum right now as U.S. Senators Orrin Hatch (R-Utah) and Michael Bennet (D- Colorado) have crafted legislation to appropriate $300 million for state and local social-impact bonds over 10 years.
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Social Impact Bonds (SIBs) as a vehicle for funding social change are gaining renewed momentum right now as U.S. Senators Orrin Hatch (R-Utah) and Michael Bennet (D- Colorado) have crafted legislation to appropriate $300 million for state and local social-impact bonds over 10 years.

It's their second attempt and comes on the heels of even more social impact bonds unveiled over the last year in California, New York, Ohio, and elsewhere. In social impact circles the buzz ranged from praise along the lines of, "SIBs will revolutionize the way government provides social services, unleashing private capital for social good," to criticism that "they are, bottom line, making money on the backs of the poor."

Social impact bonds seem like a simple concept - donors and other investors provide money to a nonprofit that has a great way to solve a problem, like the number of criminals who land back in prison or the number of low-skills people who can get good jobs. If the project works and saves the government money by reducing the number of Americans behind bars or on welfare, then government pay the donors back for their investments. And if the project does better than expected, donors might get an extra payment beyond their initial investment.

As the leader of a foundation that has pushed to transform the way nonprofits are financed, I am happy to see real attempts to provide incentives to prevent social problems rather than pay for their cures, but I know how difficult these new efforts are to pull off.

While the Heron Foundation has made a commitment to an impact bond (it did not ultimately go forward) and is open to considering other such proposals, I am skeptical about this financial tool in the way that any investor should be skeptical about any financial technology. It can be used adeptly or ineptly. It's not the tool, it's what it does. Like loans, contracts and equity shares, social impact bonds are pretty much morally neutral. Is it the right tool for the job? Is it balanced - that is, a good deal not only for the investor, but for all parties to the transaction? (A particularly important question in the nonprofit world.) Is it affordable, given its life cycle? Are the parties competent? Who takes the risks? If it fails, who gets hurt?

Social impact bonds aren't new. One way to remove the rouge of innovation from the wizened face of this financial instrument is to refer to them as "performance contracts." Versions of pay for success have been used in many states for years. For example, there is some similarity to the shared energy savings contracts of the 70s and 80s, where a company fronted the capital cost of energy-saving equipment (i.e. florescent lighting, a new boiler or timer switches) in a building at no upfront cost to the owner, then split the subsequent "savings" (i.e. the monetized value of the reduction in energy costs) with the owner until the original investment, plus a return, was realized.

These energy performance contracts sounded straightforward to monitor but actually even the simplest was complicated. And even before the equipment was installed, complexity entered the picture. Is it the right equipment? What if it breaks down? What if the installer, or the company making it, goes bankrupt?

And monitoring "savings" made installation seem straightforward, with a variety of variables from energy costs to weather to operating schedules to demand charges and more. We learned that the best applications were the simplest and most reliably predictable.

As I see it now, this rule doubtless needs to be applied to social impact bonds as well. The Achilles's heel of the bonds are their complexity and transaction costs. People are infinitely more complex than boilers or valves, and on top of that, the bonds invite many more parties to a transaction than energy contractors (not only say, ex-prisoners or low-skilled workers, but as many as five more: the nonprofit that provides a service, a government agency, an intermediary, an evaluator and the investors).

If the market found shared energy savings complicated, imagine something as complicated as prison recidivism: What is reoffending: the same offense? A lesser one? Where? For how long? Who decides? Who adjudicates if there's a disagreement among the parties? What happens when something unanticipated happens? What if the main parties go out of business?

Savings are reductions in expenses which in the absence of positive cash flow, don't translate into payments to anyone. What is the threshold for real financial savings? With the brain power involved in SIBs, these questions are undoubtedly answerable, but does that largely technical exercise add net value?

I fear that even skilled nonprofits and intermediaries will have trouble translating great ideas into contracts that really provide the right incentives. When you look at how the parties do the accounting, how they measure "savings,: how they decide what the return should be to whom at various break points, it gets inelegant, to say the least.

Some deals that we have seen don't balance the interests of the parties well. In my opinion, nonprofits often take more risk than they should, and investors take less. What's more, nonprofits build their efforts around one transaction rather than focusing on how to strengthen their services overall. The government gets less in savings (i.e., return on investment) than it could, typically in an effort to court investors by offering, for example, guarantees. The group handling the transaction is often left with highly complex and difficult negotiating, monitoring and organizing tasks for very little money.

There is also potential for perverse incentives. After all, the burgeoning social impact bond "marketplace" depends on an ever-expanding supply of incarcerated people or other ripe social and financial opportunities. Nobody wants to end up in perpetual symbiosis with the Corrections Corporation of America to assure the market is scaling! That is not anyone's intention, of course. Given that a simpler version of these arrangements might be less expensive, perhaps governments will just do this work themselves (one of the best examples of an impact bond-like arrangement in the country, in Minnesota, has done just that, for years), using the expertise developed in this process. Then, rather than going to investors or transaction costs, more of the savings to government could go to serve other social needs.

In the "looking glass world" of nonprofit finance (where real adherence to mission demands that we look behind the mirror for ways to make ourselves superfluous, at least in health and social services), the big win will be that prison populations get so low that social impact bonds aren't needed at all, and the market dries up completely. That's victory for everyone involved in promoting the social good.

Perhaps another reason not to see social impact bonds as a panacea is this: They tend to focus financial resources on remedies where measurement of financial savings is the most reliable and short term. Thus they work most straightforwardly for problems that have become so bad that people are incarcerated, seriously ill, etc., so the cost is the highest, the remedy closest to the incurred costs, and the financial savings therefore high and relatively easy to measure. That's fine unless it means that we trade this low- hanging fruit for much more desirable but tough to measure long-term social investments.

That could well happen if the success of social impact bonds trains the capital markets and social investors to expect maximum, easily measureable financial return on efforts to solve all social problems, starving some of the best investments because they're longer-term in nature and have less circumscribed social return. The real bulls-eye is that youthful offenders never enter a prison, that they are born healthy and grow up in happy, stable families with a job in the house.

It's important that universal prenatal care, great pre-school, and school, college and trade-school scholarships, not to mention living-wage jobs for parents, get the lion's share of investment and attention, even though these investments may not "pay off" with high margins for investors, and may be prohibitively expensive to track, in any event. In the words of a major investor, we don't want social impact bonds --- or social investment in general to be "stuck in prison."

This article originally appeared in the April 2015 edition of Chronicle of Philanthropy.