The Guru Is In

The three right answers in Social Impact Bonds

By David A. Smith
March 1, 2018 5 min read

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For more than half a decade now, we’ve heard unicorn tales of Social Impact Bonds (SIBs), and despite a compelling common-sense soundbite case, SIB sightings are rare, volume is minimal and replicable scalability at best theoretical…because we are having trouble putting together the right ingredients, the right government counterparties and the right sponsors.

A. The right ingredients. A SIB is a financial instrument that raises money to do the front-end work needed to make a paradigm shift in tackling a critical social-economic problem by using a pay-for-success (P4S) approach that rewards outcomes rather than processes or inputs. Any potentially sensible SIB will be made from the right mix of these ingredients:

1. A vulnerable population of people who deserve assistance both socially (because we want to help them) and economically (because if they are not helped, it costs government and taxpayers money) – such as elderly in affordable housing aging in place toward frailty.
2. A governmental agency that currently pays out when the vulnerable population ‘fails.’ Medicaid and Medicare work this way, and as everyone knows, their costs are rising fast.
3. Foreseeable possible events, either bad or good, that determine what the government pays. Some events are bad ones that the vulnerable population doesn’t want and that yet will cost the government money if they happen – for instance, aging elderly moving from affordable housing into a nursing home. Some events are good ones that the vulnerable population wants and that will reduce the government’s future exposure – moving chronically homeless from shelters into permanent supportive housing.
4. A service provider with an impactful program that it believes will change the future, either by (a) reducing, delaying or entirely averting future bad events, or (b) producing good events that deflect expected future government costs.
5. A long-term pay-for-success (P4S) contract under which the agency will pay contractually agreed payments for quantifiable observable P4S metrics that are proxies for either (a) avoidance of adverse events (e.g. averting nursing home admission), or (b) occurrence of current good events (e.g. getting a permanent job) or trail markers for future good events (e.g. lower blood pressure, reduced asthma that extend healthspan).
6. Capital investment up front. Money to create or modify the vulnerable population’s living situation, because we know that for vulnerable populations, everything begins with housing.
7. A SIB sponsor that investment-banks the transaction, issues the SIB and intermediates all the performance and counterparty risks.

Tempting though it may be to skimp on the ingredients, folks who omit any of them are surprised when their SIB doesn’t bake.

B. The right government counterparty. Anyone who’s ever billed a government agency knows that while invoicing is easy, inducing timely (or even untimely) collection is hard verging on impossible. So when a SIB sponsor is pursuing a contract with a government agency that will make the P4S payments, it encounters these several varieties of government counterparty risk:

1. Jousting levels of government. Though federal agencies may work with state and local ones, ask one level to fund another level’s program and watch the fur fly.
2. Free-rider government agencies. When it comes to budgets, government departments and agencies think zero-sum and zealously guard their current funding priorities. Help HHS cut Medicaid expenses and it will say thanks; send it a P4S bill and it will say HUD should pay this because we certainly won’t.
3. Risks of future appropriations. No appropriated-budget department or agency that will sign a contract without crossing its fingers by including ‘subject to appropriations’, and no matter what a current legislature promises, a future legislature can rescind or sequester that promise.
4. Risks of collection and enforcement. If your bill goes unpaid, you can dun the government, and government lawyers are adept at making that as unfun, unfair, unfree and unfast as possible.

Categorically eliminating all government counterparty risks is impossible. Instead, they can be minimized only by reaching and securing commitment from the apex executive – and the right level of government to target is the state, because a governor (and his or her budget secretary) can coordinate and hold accountable multiple governmental arms – if the economic case to the state is compelling.

C. The right sponsor. Even with the right ingredients and the right government counterparty, SIBs need a sponsor, who does all of the following things:

1. Obtain and mix together the right ingredients for the vulnerable population.
2. Design the P4S metrics and payments.
3. Negotiate bilateral agreements with
   (a) the service (provider for the impactful program and (b) the government for the long-term P4S contract.
4. Price the SIB, including assessing what yield expectation the market will need.
5. Spend the out-of-pocket money to write the SIB’s legal offering documents.
6. Issue the SIB and sell it in the capital markets.
7. Hold the service provider operationally accountable, including changing service providers if necessary.
8. Hold the government counter party accountable, and enforce the contract even if this is politically awkward at the time.
9. Intermediate all risks, including both the known and unknown risks.
10.  Credit-enhance its own risk intermediation by making the commitments or guarantees that will coax capital providers into investing in the SIB.

This is old-school investment banking, where the firm and its senior partners simply judge, based on the totality of their experience, that they can do the deal on these terms at that price to these investors.

To be a SIB sponsor requires domain knowledge, mission purpose and business/financial courage. Hardheaded visionary heroes are needed.