U.S. local governments are under continual pressure from their constituents to show measurable results from the taxes and fees that their community members pay. One solution governments have come up with is social impact bonds (SIBs), which are designed to directly reward the outcomes of social policy programs.

In a SIB agreement, the government sets a specific, measurable outcome that it wants achieved in a population, such as lower incarceration rates or increasing educational outcomes for underserved children, and promises to pay an external organization (sometimes called an intermediary) if and only if that organization accomplishes the outcome.

Typically the financing team in a SIB consists of the local government supporting the issue, the organization managing the program, an investor in the program, and an intermediary. The team agrees on the goals and milestones of the government program, and the rewards investors will earn if the agreed-upon milestones are met.

Investors provide the working capital for the external organization to hire and manage service providers, and a third-party evaluator determines whether the outcome has been achieved. If the agreement succeeds, the government releases an agreed-upon sum of money to the external organization, which repays its investors with returns for taking on the upfront risk. If the agreement fails, the government is not on the hook, and the investors do not get repaid with public funds.

The UK issued the first social impact in 2010 and has been the most active in this field, issuing 24 social impact bonds through 2014. Three of these issues have met their targeted goals so far and recently returned their principal plus interest to the investors.The United States has been the second most active, with social impact bonds supporting seven projects between 2012 and 2014. Australia, The Netherlands, Germany, Belgium, Canada and Portugal have also issued these bonds.

Often, the outcomes are benchmarked against a control group to determine success. For example, in early 2014, the Commonwealth of Massachusetts issued a social impact bond aiming to reduce incarceration, improve job readiness, and increase employment for a group of at-risk young men aged 17-23. To be considered successful, the participants’ incarceration rate must decrease by 70% compared to the control group. The success-based payments will reach up to $27 million, with estimated savings to the Commonwealth of $45 million, according to one of the deal investors, Third Sector Capital Partners.

Not all SIBs have been successful in the traditional sense, though. In September 2012, New York City was the first to issue a social impact bond in the United States, to try to reduce recidivism among young men at Rikers Island prison. However, according to the Vera Institute of Justice, which was the evaluator for this program, the targeted outcome of reducing recidivism for the targeted group of 16-18 year olds had failed to be met, and the program ended in August 2015. (Vera Institute of Justice, July 2, 2015). Because the program did not reach its outcome goals, the city does not owe anything to Goldman Sachs or Bloomberg Philanthropies, the investors in this issue.

Future of Social Impact Bonds

Although SIBs have the potential to create new incentives for impactful governance, they are still not very well understood, and opinions on their use are mixed. The contract period for these already-issued bonds in the United States has been seven years or less (relatively short term in the bond market), since the bonds need to align with program milestones.

Since there is a limited history of these types of transactions, to date, the time and effort of the involved parties to reach the final terms of the transactions may still be significant, which may undermine the overall cost savings for the government. Determining what is a successful outcome of these targeted social areas may significantly slow down or potentially stop a social impact bond transaction from going forward. The Brookings Institute analyzed 38 SIBs and found that transactions took between six months and three years to develop.

What Can the Municipal Market learn?

As SIBs and other pay-for-success programs continue to be a topic of discussion but they are unlikely to displace conventional municipal bond issuances any time soon. The municipal bond market, had over $330 billion in par issuance in each year between 2012-2015, and the funds raised in a large number of bond issuances are used towards addressing some of the same social issues that SIBs hope to help tackle. Meanwhile, many local governments are also getting better at using big data and advanced analytics to measure analytics. Nevertheless, governments could benefit from more focused attention on the outcomes of bond issuance programs and the extent to which these issuances are producing the value taxpayers and investors expect.

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