Financing Social Projects in a Time of Instability: Pay for Success and Social Impact Bonds

by Hyungjin Choi, BA ‘16 (3/12/13)

Hyungjin Choi, BA ‘16

Creating a new method for financing social welfare programs with private investment.

Rick Edwards, MBA ’77, Partner at Third Sector Capital Partners, believes a combination of private investment and public intervention could significantly change the way the government has been addressing some of the most pressing social issues such as recidivism and juvenile justice.

Rick Edwards is no beginner when it comes to the marriage of public and private sectors. With more than three decades of experience in capital markets, Edwards has developed a keen eye for public and private partnerships and the potential impact this partnership could make. At the Finance and Sustainability Colloquium on February 4th, Edwards lectured on the basic mechanism of Pay for Success, an innovative way of financing non-profit, social welfare programs with private investment.

In his lecture, “Critical Response on Pay for Success and Social Innovation Financing,” Edwards started with a gloomy reality check on the current financial status of non-profits and governments. The turmoil in the markets for the past few years has left philanthropic organizations with little to no budget to fund projects while the collective budget gap for the fifty states now exceeds $500 billion. In its latest Giving USA report, the Center of Philanthropy at Indiana University estimated that in 2011 philanthropic organizations nationwide received around $298.4 billion in charitable donations, an 11% drop from 2007. Without these funds, non-profits will struggle to complement the efforts of states in addressing society’s many social problems.

As a potential solution to this dilemma, Edwards introduced an innovative way to finance much needed social projects by linking the public, private, and nonprofit sectors: Pay for Success (PFS). This is a system in which private investors provide funding for specific welfare projects which non-profit organizations execute. If the desired outcome is achieved, the government would provide a payout to the investors. This ideal situation would be a “win-win” for all parties involved. The government enjoys substantial cost savings by not spending tax money on failed projects while paying only for successful ones. Private investors make both a social and financial return while non-profits receive funding for projects. Edward’s organization, Third Sector Capital Partners, serves as an intermediary between these actors and facilitates the design and implementation of PFS contracts.

Edwards also commented on the potential risks involved.  First and foremost, the non-profit implementer must be able to demonstrate a strong track record. If not vetted carefully, the non-profit organization may fail to deliver the desired outcomes. A rigorous screening process must be set in place. Another significant concern is the evaluation of outcomes. It is absolutely necessary to set a way of collecting accurate and relevant data to successfully evaluate the results of a project. Finally, there is a political risk as governments may not be able to provide the payout to investors due to budget deficits or other restrictions. One way to maneuver around this risk is to create a sinking fund trust that would guarantee repayments of the PFS contracts.

Edwards recognized that more challenges are ahead as the PFS method is still in its infancy. Questions like how to attract investors who are willing to overlook purely financial gains for social benefits and how to gain mainstream acceptance among governments still need creative answers.

Several states including Massachusetts, New York, California, and Ohio are considering employing this innovative method. Massachusetts, the leader in the implementation of PFS, is already piloting two PFS contracts to solve problems in juvenile justice and chronic homelessness. There have been several success stories, one of which is Break Recidivism, a program in the United Kingdom that works to reduce the number of youth offenders returning to prison. As a result of PFS, the British government saved close to 13 million USD while decreasing recidivism by 22%.

Edwards observes that if just 1% of $50 trillion globally managed assets were allocated for social impact investments it would represent a more than doubling of capital available to help finance the social sector. Although certain challenges lie ahead, the implementation of PFS, according to Edwards, could significantly change society for the better. Continued research and experimentations with PFS will provide means to create solutions to the most urgent problems in society.

Written by Hyungjin Choi, BA ‘16; based on write-ups provided by Zoe Wang, BA’13 and Carlos Yoneda, MBA’13.