By V. Kasturi Rangan & Lisa A. Chase
As government funding for social welfare services
diminishes, considerable attention has been
focused on a new funding approach—social
impact bonds and pay-for-success contracts—that holds out the promise of attracting private
investment capital to serve society’s critical social
needs. Instead of government paying nonprofit organizations to
deliver services like job training, private investors provide the funding
and are repaid later by the government (along with a potential
profit) if the service meets agreed-on performance benchmarks.
To understand how pay-for-success (PFS) and social impact bonds
(SIBs) work, consider the example of recidivism. In 2014 the state of
Massachusetts, the nonprofit Roca, the financial intermediary Third
Sector Capital Partners, and a group of investors entered into a contract
under which Roca was paid by investors to operate a program
to keep formerly incarcerated young people from ending up back in
jail. If Roca meets or exceeds the contract goals, the state will repay
the investors their principal and potentially even a profit. (If the program
fails, investors could lose some or all of their money because
the government would not have to pay.) Massachusetts is willing to
repay the loan with interest to investors because it saves even more
money by keeping young people out of prison. Investors are willing
to put their capital at risk because they believe that Roca’s program
works, and because philanthropic funding is mitigating that risk. And
Roca is eager to be a part of this complex scheme because it is a way
to scale up its work with at-risk youths and young adults.
The idea of using private “return-seeking” capital to rescue at-risk
youth, provide housing for the homeless, and educate pre-K children
has wide appeal, with PFS proponents asserting that attracting private
capital in the service of society may be the perfect innovation to plug
the funding gaps in the government and nonprofit sectors. Some have
suggested that directing even a small percentage of the $43 trillion
of assets under management in the United States would unleash a
huge flow of return-seeking capital in the service of public good.1,2,3
Although PFS and SIBs are generating attention, especially in the
United States, after studying the initial contracts we believe that for
now the model is appropriate only for a narrow cohort of nonprofits
that meet two related criteria: they must be able to effectively deliver
and measure their social impact; and they must be able to translate that
impact into financial benefits or cost savings that are traceable to the
budgets of one or more institutions or government departments. (The
Massachusetts recidivism program is a good example of one that is well
suited to this model.) The application of the PFS model for programs
that fall outside of this set of criteria will be challenging and their success
will require significant adaptations in financing and measurement.
This is not to minimize the potential social benefits of PFS programs:
they will undoubtedly make an important contribution. By
attempting to attract investments in the service of impact-driven
models, government agencies will learn to quantify the costs of social
issues and nonprofits will learn to quantify the benefit of their interventions,
leading to a more effective partnership in serving society’s
needs. Moreover, the more recent PFS programs, both in the United
States and abroad, have targeted a broader array of social issues and
attempted to craft innovative funding and measurement models.
Nevertheless, we believe that despite all the hype, PFS’s ability to
attract pure return-seeking capital to social programs will be muted.
If anything, given the prominent role philanthropy has played in recently
launched PFS deals, PFS’s potential contribution will actually
be to unlock philanthropic and foundation assets in buffering the
risk for return-seeking capital or, in some cases, to entirely finance
certain PFS projects. Ultimately, impact-seeking rather than return-seeking
capital will spur the growth of PFS.
Although the potential social benefits of PFS appear to be real, one
cannot ignore the likelihood of unintended negative consequences. A few high-performing nonprofit organizations thus far have received
the bulk of the PFS funding, and rather than motivating the rest of the
pack to “lift” their game and demonstrate effectiveness, the inability
of these other organizations to raise PFS funding could hamper their
ability to deliver social services. Moreover, we fear that after the initial
round of savings have been effectively delivered in the first contract
period, political pressure may force the lowering of the success payments
for subsequent PFS contracts, in line with the new efficiency
benchmarks. With little room for upside returns, we suspect private
capital will be tempted to flee existing PFS markets. Most important,
in the rush to quantify costs and benefits, we fear that there could be
a retraction from those social issues where the outcomes are hard to
pin down and successful interventions hard to identify, but which are
the very issues demanding society’s attention and resources.4,5,6,7,8
Pay-for-Success in the United States
The first PFS contract in the United States was launched by New York
City in 2012 to reduce juvenile recidivism, and six contracts have been
launched since then. The first contracts addressing recidivism fell
within the parameters of the type of programs that we believe can be
successful—ones that are measurable and result in clear and significant
cost savings. Subsequent contracts addressing other issues like K-12
education and homelessness have narrowed the scope of their service
delivery and their target populations in order to fit the PFS parameters.
Many of the 20 or more PFS contracts that are now under
development in the United States have stretched beyond the narrow
domains of the initial PFS contracts. These new contracts that attempt
to address social issues such as homelessness, mental health,
and child welfare, across broad populations, may find it challenging
to construct a robust PFS model correlating social impact and
monetary savings. To attract private investment capital, they will
have to devise new and innovative financing and measurement.9,10
To better understand how PFS works, we will look closely at several
of the contracts and examine how they promise to deliver social
impact and generate aggregated cost savings.
Delivering social impact | PFS contracts
in New York State, Massachusetts, and
Cuyahoga County, Ohio, demonstrate the
need to realize financial savings by delivering
social impact.11 In December 2013,
New York announced a PFS contract to
improve employment and public safety.
Historic data revealed that of the roughly
24,000 people released from prison in 2013,
nearly 41 percent were likely to return to
prison within five years to serve an average
sentence of 460 days. The PFS contract
engaged the Center for Employment Opportunities
(CEO), which ran a successful
employment re-entry program for former
prisoners. CEO had demonstrated the effectiveness
of its programs through rigorous
and continuous program assessment
and reporting.12,13
An in-depth study by the nonprofit
education and social policy research
organization MDRC and the US Department of Health and Human
Services estimated that CEO reduced return-to-prison rates by 9 to
12 percent through its job training and employment opportunity programs,
saving taxpayers $20,440 annually per person, in addition to an
imputed benefit of $10,585 per person on behalf of those who avoided
being victims of crime. For every day a person stayed out of prison,
the state’s savings plus society’s benefits were estimated to be $85.
The PFS contract charged CEO with reducing recidivism through job
training and placement by a minimum of 8 percent for 2,000 people,
the level at which outcome payments would begin.
In January 2014, Massachusetts finalized a contract with the
nonprofit service provider Roca to reduce young adult recidivism.
Historic data revealed that of the nearly 800 young men released
from prison in the state annually, nearly 65 percent would return to
jail within five years of their release and serve an average sentence
of 2.4 years. A significant proportion of the 3,000 young men on
probation each year were also likely to violate their terms and enter
prison. The estimated incremental cost of housing each prisoner is
$12,500 annually (for food, uniforms, and prison programming), with
a fully loaded cost (including housing, prison administration, and
other overheads) of $47,500 annually, so the state would realize significant
savings from reducing recidivism. That task was entrusted
to Roca, a community-based nonprofit headquartered in Chelsea,
Mass. Roca focuses on helping very high-risk young men stay out of
prison, secure jobs, and stabilize their lives. Its intervention model
is highly data driven, built on nearly seven years of evaluating and
aligning its work with evidence-based practices and programs. Roca
had demonstrated that its intervention was capable of reducing recidivism
rates by 25 to 60 percent.14,15
Similarly, in late October 2014, the Cuyahoga County government
finalized a contract with FrontLine to reduce time spent in foster care
for children of homeless mothers. FrontLine had devoted 26 years to
providing comprehensive services to mentally ill homeless people, with
the goal of transitioning its clients to permanent supportive housing.
FrontLine had also demonstrated that moving homeless mothers to
stable housing increased their chances of
recovering and regaining custody of their
children from foster care. The county’s
data revealed that children of homeless
mothers spent considerably more time in
foster care than other children (724 days
compared to 440 days) at a daily cost of $75
per child. Keeping mothers in stable housing
with their children therefore represented
significant savings for the county.16
CEO, Roca, and FrontLine are unusual.
Unlike many social service nonprofits, they
continuously assess their interventions,
rigorously collecting data and tracking
outcomes for each client. These attributes,
along with the continuous adjustment of
their service delivery models, make all
three of these nonprofits ideally suited to
the PFS model.
In Chicago and Salt Lake County,
PFS projects are targeting early childhood education. Although the structure of these contracts, and
the social issues they address, differ from those in New York,
Massachusetts, and Ohio, all of these examples demonstrate targeted
interventions for which an implementing organization has devised a
highly structured and proven program. Independent studies of the
Child-Parent Center, the service provider for the Chicago contract,
reported that program recipients had a 29 percent higher graduation
rate from high school, a 41 percent reduction in special-education
enrollment, and significantly lower rates of juvenile arrest. Similarly,
United Way, which oversees the Utah High Quality Preschool Education
program in the Salt Lake contract, has reported that recipients
are half as likely to need special-education services as children without
preschool education.17,18,19
Aggregating cost savings | In order to fit the PFS framework and
attract private capital, the service intervention needs to demonstrate
not just impact but also aggregated cost savings that can be
measured and traced to the budgets of clearly identified government
departments. In New York State, a 10 percent reduction in recidivism
by CEO is the break-even target, at which the federal, state, and local
government savings will total $13.172 million, and be paid to investors.
The state’s payments to investors are calculated according to
prison savings, increased tax revenue from employment, and public
benefits from lower crime. CEO’s success will be evaluated through
a randomized control trial (RCT) to assess the number of reduced
“bed days” in jail for the target population and the days of increased
employment. With the performance payments capped at $21.544 million,
public-sector savings and benefits will exceed the payouts by $8
million at a 30 percent recidivism reduction, and $16 million at a 40
percent reduction.
With the Massachusetts juvenile justice PFS, the state will achieve
savings from reduced court costs and policing, as well as direct savings
to the state Department of Corrections and the county Houses
of Correction. The break-even rate for the Massachusetts PFS is a
40 percent recidivism reduction, the level at which the program
savings and payouts will both equal $22 million. If Roca achieves
a 70 percent reduction in recidivism, the payout will be capped at
$27 million and the state will save an additional $18 million over
the contract period. At that level of impact, Roca will receive additional
payments up to $1 million, Goldman Sachs will be paid up
to an additional $1 million, and the Kresge Foundation and Living
Cities will each receive up to an additional $300,000.
In Cuyahoga County, while numerous government agencies will
likely realize savings from keeping children with their parents and
out of the foster care system, the PFS contract specifically benefits
the Department of Children and Family Services. If FrontLine reduces
by 25 percent the number of days that children of homeless
mothers spend in foster care, the Cuyahoga County government will
return investors the entire savings in the form of success payments
of $4 million, plus a nominal interest payment. At a 50 percent reduction,
success payments will be capped at $5.5 million with the
county saving an additional $3.5 million. Although the Cuyahoga
County contract addresses a very different social issue from the
Massachusetts and New York state projects, the RCT evaluation
model and framework for tying government payments to those
outcome measurements (and associated government savings) are
virtually analogous.20,21
For social challenges that cannot easily identify and aggregate
societal benefits and correlate them to cost savings, the PFS model’s
effectiveness is more difficult to demonstrate and has to be structured
differently. The Chicago and Salt Lake County pre-K education
programs base the cost savings on each child who avoids the
need for special-education services as a result of the intervention
($9,100 a year for Chicago and $2,470 a year for Salt Lake County).
The Chicago contract’s payout structure also rewards the benefits delivered,
paying $2,900 for each student who is “kindergarten ready”
after attending the program. Both programs lack rigorous RCTs to
assess success and correlate social welfare interventions to Department
of Education savings, instead relying on standardized testing to
measure educational achievement and special-education placement.
Chicago chose to use a quasi-experimental comparison group of children
who did not attend a preschool program and Salt Lake County
relied solely on evidence-based secondary research documenting the
positive effects of a preschool program. It is little wonder that, given
the tenuous correlation between government savings and education
intervention, the Chicago and Salt Lake contracts have come under
criticism regarding the trigger points for paying back private capital.22
Unintended Consequences
While the PFS model’s focus on impact measurement is an important
step in improving program effectiveness, it also poses a challenge
for many nonprofits, few of which are as well equipped as
Roca, FrontLine, or CEO to rigorously measure impact. After all,
evaluating any nonprofit’s impact is both expensive and necessarily
complex, ranging from its outputs (How many high-risk young
men stayed out of jail?), to broader outcomes (Are those same young
men placed in stable jobs and are they better off financially?), to
long-term social impacts (Is the result greater economic and social
equality?). Correlating those impact measures to monetary returns
is even more difficult, and many social interventions simply defy
the kind of impact measurement and linkage to financial savings
the PFS structure demands. Such measurement will likely prove
difficult for nonprofits already struggling to fund services, let alone
finance the human and technical resources to support sophisticated
measurement and tracking systems.23
The Massachusetts contract to address homelessness illustrates
why the focus on linking impact measurement to cost savings poses
challenges for social issues where that alignment is difficult. The
state has a homeless population of nearly 16,000, with Boston alone
having on any given night 7,000 people living in shelters, hospitals,
and emergency medical facilities, or on the street. The contract’s
Home and Healthy for Good model, created by the Massachusetts
Housing Shelter Alliance, provides housing first, choosing to address
issues of medical and mental health and substance addiction,
after the move. To demonstrate rigorous cost savings, the PFS was
focused on a narrow segment of 800 chronically homeless people,
leaving open the question of how society could address the needs
of the remaining thousands of homeless people.
Given the PFS model’s focus on measurable societal impact
translating to financial savings, and the need to provide financial
returns to private-sector investors, the “best in class” and most well established
nonprofit organizations will likely get the bulk of PFS
funding. In Massachusetts, two nonprofits, Roca and Youth Options Unlimited, were originally selected by the state to bid on providing
services for the recidivism contract. By the time the PFS contract
was finalized, however, Roca had secured the entire agreement and
the resulting funding. Although the premise of the PFS model is to
motivate whole segments of nonprofits to “up their game,” it is also
possible that the “also-rans,” like Youth Options, could be further
handicapped in funding their operations, resulting in even poorer
social service delivery to populations that need them most.
In New York City, the government’s contract with the Osborne
Association to assist recently incarcerated young adults effectively
shut off government funding for similar nonprofits, including the
Center for Community Alternatives, increasing the pressure on these
organizations to focus on fundraising rather than on creating sophisticated
measurement systems and better programs. PFS projects in
Chicago and Salt Lake City were awarded to education providers
holding existing government contracts, without an open bidding
process. This creates little incentive for other providers to innovate
and operate more effectively in the hope of landing a contract.24,25
In a perverse twist, the very success of the initial PFS projects may
make it more difficult to do follow-on projects. After contracted nonprofits
deliver the first round of government savings, political pressure
will inevitably demand ratcheting down the success payments
for subsequent contracts in line with the recently achieved efficiency
benchmarks. Given the higher target and thus higher chances of
falling short, private capital may flee existing PFS markets, and potential
service providers may find it impossible to deliver critical services
at ever-higher efficiency without compromising the well-being
of the people they serve. Conversely, the model’s initial success may
undermine the very premise of PFS and encourage governments to
eliminate the PFS intermediary (and associated costs), and contract
directly with providers. For example, in the United Kingdom the Peterborough
Prison project was on track to achieve the target recidivism
reduction of 7.5 percent over two cohorts, but failed to reach the
average 10 percent reduction target for the first cohort to trigger
initial payments. Subsequently, the UK government announced an
early phase-out of the project and began constructing interventions
building on lessons from the Peterborough program using its own
direct funding without the need for intermediaries or investors.26
Another challenge is the seemingly high transaction cost of the
initial PFS contracts, much of which has been funded by philanthropic
contributions. In some cases the transaction costs can be as high as 7
to 10 percent (Chicago and New York State), but many of these costs,
such as auditing and legal fees, would have been incurred regardless
of the form of contracting. The one clearly additional cost, evaluation,
is at the heart of the PFS structure and does not exceed 2 percent of
the project costs in any case. The most contentious of the transaction
costs is “intermediary and fiscal agent services,” with some arguing
that the additional management oversight is superfluous.
The Role of Philanthropic Funding
Although PFS contracts are typically characterized as employing
private capital-market funding to solve social problems, a closer look
at all of the US PFS projects reveals the critical and enabling role
of philanthropic and mission-led capital. (See “US Pay-for-Success
Contracts” above.) To better understand the role of such capital in
the PFS funding structure we have divided funders into three categories:
senior lenders, junior lenders, and venture philanthropists.
Consider the first US PFS, the New York City Rikers Island contract.
In that deal, Goldman Sachs, the senior lender, provided a $9.6
million loan to fund the four-year program to reduce recidivism,
with Bloomberg Philanthropies granting MDRC a $7.2 million loan
guarantee to hold until 2016. A little more than two-thirds of Goldman
Sach’s investment was protected by philanthropy.
The senior lenders in the Massachusetts PFS have shown more
appetite for risk, but $6 million of the $18 million initial commitment
is still philanthropic. Goldman Sachs represents the profit-seeking
senior lender, while the Kresge Foundation and Living Cities represent
the junior lenders carrying a higher share of the risk. Goldman
Sachs, which is financing $9 million through its Social Impact Fund,
will be the first investor to receive its capital if Roca meets its targets,
plus a potential bonus. The Kresge Foundation and Living Cities,
which are providing program-related investment (PRI) loans, will be
the second-in-line investors to be paid back, along with a potential
upside. The role of these junior lenders cannot be minimized. The
primary motivations for their investments are the project’s alignment
with their mission and its potential for impact. Philanthropic
investors will be the last to see their principal repaid. The Laura and
John Arnold Foundation will use any returns it receives to support
future PFS initiatives, while New Profit and The Boston Foundation
will reinvest their returns back into Roca to scale up its work.27,28,29
The New York State contract is unique because of the private-placement
nature of the investment, where 44 entities (individuals
as well as foundations) have bought into an asset class with Bank
of America-Merrill Lynch. The Rockefeller Foundation provided a
first-loss guarantee to cushion the risk for the investors. While the
bulk of the financing has come from impact investors, philanthropic
funders are absorbing the initial risk, as in the Massachusetts deal.
In Cuyahoga County the contract is being financed entirely by
philanthropic dollars. The majority of the funding, $1.575 million,
comes from The Reinvestment Fund, a community development financial
institution (CDFI), another $325,000 of the junior lending
from Nonprofit Finance Fund is also a CDFI loan, and the remaining
$2.1 million is spread among the George Gund Foundation, the Cleveland
Foundation, and the Sisters of Charity Foundation of Cleveland.
The project is effectively the first instance of a PFS financing without
private investment capital, where the funders are overwhelmingly
focused on social impact rather than financial returns. The Massachusetts Home and Healthy for Good
PFS contracts are also heavily funded by mission-driven investors. The Chicago and Salt
Lake County PFS contracts are unusual in being
totally funded by return-seeking first-level
lenders.30
Even the United Kingdom’s so-called Social Impact Bond,
launched in 2010 and widely considered the first large-scale implementation
of social innovation financing, was funded largely
by philanthropy. In a public-private-nonprofit partnership, the
UK Ministry of Justice contracted with One Service to reduce recidivism
among prisoners released from Peterborough Prison and
engaged Social Finance to raise £5 million to finance the up-front
program delivery costs. The vast majority of the 17 “investors” were
charitable trusts and foundations, with the payback coming from
the UK Big Lottery Fund and the Ministry of Justice. Hailed as a
groundbreaking financial innovation to solve social problems, the
UK SIB was the first in a series of deals in which philanthropic and
private capital joined forces to fund socially innovative approaches
to society’s critical challenges, with philanthropists in most cases
buffering the risk for private investors.31
When one looks at the seven initial US PFS contracts it is clear that
of the three investment levels, only the first layer is structured to attract
potential market-return-seeking investors. Much of the project
risk is absorbed by the second and third layers, whose interests and
motivations differ from those of the profit-seeking investors. At best,
these funders may receive their principal with a lower than market
return or, in the case of philanthropic investors, their principal depreciated
by the amount of lost interest, to recycle into another social
investment. That is not the case for the profit-seeking PFS investors,
who have the first claim to the promised rewards. Without the risk reduction provided by impact investors and philanthropists,
we believe that market capital will
not rush to fund PFS deals.32,33
The Future of Pay-for-Success
All of the new PFS contracts being negotiated
from Connecticut to California will require service providers to
demonstrate rigorous data collection and impact reporting. These
projects targeting juvenile and adult incarceration, homelessness,
health care access, education, and other social challenges not only
will raise the bar for nonprofits to demonstrate robust indicators of
their outcomes but also, we believe, will fundamentally change the
way governments procure and deliver social services. (See “US Funding
for Pay-for-Success” below.)
By using PFS contracts, and importantly philanthropic dollars,
to construct a new impact-driven model for meeting social needs,
governments and nonprofits will learn to operate more effectively.
PFS is an important step toward making governments and nonprofits
accountable and more effective in serving society’s neediest citizens,
and to the extent that PFS employs private capital to serve this end,
the money is well spent. The motivations of social impact investors
in PFS projects, and investors’ prioritization of social impact over financial
returns, could make the critical difference in how the sector
develops. Market capital will have a role to play, but return-seeking
investors will participate when the financing structure minimizes
their risk, as recent contracts have done. 34,35
Globally, active PFS contracts total roughly $200 million. The
United Kingdom is the epicenter of PFS and SIB activity, with almost
£55 million committed to 15 projects focusing on recidivism, youth employment,
and foster care avoidance. The European Commission has
expanded its Social Business Initiative to foster social entrepreneurship
and investments in social innovation
throughout Europe, where PFS projects to
address adult and youth unemployment
have been launched in the Netherlands,
Germany, and Belgium.
Farther afield, Australia (where the
model is known as a social benefit bond, or
SBB) and South Korea have embraced the
model to target foster care, family support,
and child welfare issues. Some of these
are characterized by innovative financing
structures. For example, in New South
Wales, Australia, the service provider (The
Benevolent Society) has combined with
two leading banks to offer a three-tiered
capital structure for a $10 million (Australian)
SBB. In the first level, the investor’s
capital is fully protected and a low interest
is paid over the life of the bond regardless
of the program’s performance, very much
like a conventional bond. Such an innovation
in the financial structure could open
the doors for pension funds and other institutional
investors seeking to diversify
their investment portfolios.
Similarly, in Rajasthan, India, Children’s Investment Fund Foundation
will pay out the initial $238,000 in funding for a development
impact bond, financed by UBS Optimus Foundation, to deliver education
programs to 10,000 underserved Indian girls through the
nonprofit Educate Girls. Philanthropy stepped in to fill a void where
a cash-strapped government did not have the budgetary savings to
backfill private investors (in this case, impact investors).
The pivotal role of philanthropy in these projects mirrors the evolution
of PFS that we see in the United States. The contract in process
in Santa Clara County, Calif., is the most recent indication of this approach,
where the government’s anticipated launch of a PFS project
to address homelessness is a direct indication of its commitment to
care for its neediest citizens. Although financing for this contract
has not been finalized, the prioritization of social welfare above cost
savings suggests a mature evolution of PFS contracting with philanthropy
and impact-seeking investments gaining center stage.36,37,38,39
The early termination of the New York City, Rikers Island, PFS in
July 2015, after failing to meet its recidivism goals, and Goldman Sachs
resulting $1.2 million loss in outcome payments, illustrate why return-seeking
investors are unlikely to invest in PFS projects without the
cushion of philanthropic risk absorption. Bloomberg Philanthropies
is taking the biggest loss, after all, paying out $6 million to Goldman
Sachs’ without receiving any success payments from the city. It also
provides valuable lessons for governments about how to vet service
providers for PFS contracting. Similar to the Peterborough project, the
New York City government too will hopefully apply the lessons learned
from its PFS “experiment” to structure its own recidivism programs.
Considering the fundamental role philanthropic and mission-led
investors are playing in PFS and SIB projects around the globe,
the future of PFS lies in aligning with impact-seeking investors, not
return-seeking investors. Despite early projections for PFS and SIB
instruments to enlist private capital to solve social ills, we are encouraged
by its potential to stimulate more foundation investments in the
sector, potentially sidelining profit-seeking investors. US foundations,
with assets of nearly $700 billion and average annual grantmaking
of $40 billion in the past 10 years, have long been criticized for their
relatively low levels of program-related investments, only about $500
million a year on average. Among the country’s largest private foundations,
impact-related investing constitutes only about 2 percent
of endowment spending and roughly one-half of 1 percent of grant
spending. The emergence of foundations as leading players in recently
launched contracts is indeed encouraging, and we see this—not the
engagement of private market capital—as the potential major funding
source for the PFS model. This development, along with improved
efficiency and effectiveness of both government and nonprofit social
welfare provisioning, will be the real and measurable benefit of the
PFS model for society’s neediest citizens.40,41