States want to do good: Here's how Wall St. is helping (CNBC)

By Ali Montag

Goldman Sachs could be coming to a pre-K program near you. Or, at least, that may be the case in Pennsylvania.

The state is proposing to implement social impact bonds, where private investors, like Goldman Sachs, can provide the upfront cash for legislators to address problems, like early education.

"The governor wants to break down the silos that exist between the public and private sectors," said Jeff Sheridan, press secretary for Pennsylvania Gov. Tom Wolf, who used his record as a businessman to get elected last fall. "This way, the taxpayer doesn't foot the bill. This is a way to effectively allocate taxpayers dollars while increasing funding for services."

The state is nearing the end of a 30-day review period to get perspective from citizens. Wolf identified five areas of focus that the funding could go toward: Early childhood care, education, recidivism and public safety, health services, and long-term living.

Pennsylvania is only part of a trend that is gaining momentum, and along with it, controversy.

Since 2014, 14 states began considering or passed legislation toward initiating social impact bonds, according to Social Finance, a nonprofit that designs public-private-nonprofit partnerships. Currently, 17 state and local governments are using social impact bonds to target problems, according to the Rockefeller Foundation, which invested in the first social impact bond in Peterborough, England.

Social impact bonds, also known as "pay-for-success" programs, allow governments to use money raised from private investors to hire specialized organizations to tackle a problem. The banks and private investors are only paid back if the initiative is successful.

For example, Goldman Sachs and other investors raised $17 million in private capital last fall in Chicago to create a program that plans to fund pre-kindergarten education for public school children. According to the fact sheet for the program, they will only be repaid if enough kids improve academically.

States supposedly benefit from social impact bonds by having an established, money-saving program, and the investors get a return.

Goldman Sachs has provided a part of the funding for four social impact projects, including the largest social impact bond ever in 2014, which totaled $27 million.

Goldman Sachs said it was not able to comment by press time in response to a request from CNBC.

Bank of America Merrill Lynch partnered with Social Finance to raise capital for a $13.5 million program in New York state to reduce recidivism in 2013.

Liam O'Neil, head of the markets group at Merrill Lynch, said money for the New York project came from groups like the Robin Hood Foundation, the Rockefeller Foundation and philanthropies associated with some big names: Larry SummersBill Ackman, Jim Sorenson and more.

Within the year, Bank of America Merrill Lynch is hoping to fund two new social impact bonds dealing with veterans and health care, he said.

"What we're trying to do is bridge the gap between investing and philanthropy to create a vehicle for investors to fund important social causes," O'Neil said.

Federally, the 2016 budget established a Pay for Success Incentive Fund endowed with $300 million over the next 10 years. Presidential hopeful Hillary Clinton endorsed social impact bonds in 2013.

But despite all those shows of support, some argue there are reasons to be critical of the new financial tool.

The American Federation of State, County and Municipal Employees, the largest national union for public service providers, with 1.6 millionnurses, corrections officers and sanitation workers among others as members, passed a resolution in 2014 against social impact bonds.

According to the resolution, "Tying high stakes to outcome-based performance measures may motivate investors to game the system to avoid losing money, including not serving the neediest populations, focusing on selected outcomes at the expense of other aspects of a program, or rigging the rules."

In 2013, a study by the Department of Legislative Services in Maryland looked at the state's social impact bond program for reducing recidivism, and concluded that the complexity of arranging all of the moving parts was more costly to the state than what it saved.

"The additional costs of a SIB program cannot be justified by offsetting savings. Other potential benefits do not justify the cost or complexity of a SIB program either," the study's summary said.

Emily Gustafsson-Wright, a fellow at the Brookings Institution, who has researched social impact bonds extensively, said the benefits are more long term.

In the case of pre-kindergarten education, she said the savings for the government are probably much bigger than what they're calculating now.

"It not only reduces remedial education, it reduces crime, it reduces unemployment down the road," she said.

Social impact bonds have significant potential in the right circumstances, Gustafsson-Wright said.

"What this really is about is getting governments and service providers to focus on outcomes, and getting governments to focus on preventative services," she said. "It's a lot less risky than business as usual for governments. Billions are spent on social services that we don't know what the outcomes are."

Pennsylvania state Rep. Mike Schlossberg, who worked closely on the state proposal, said he is hoping to fund early education through social impact bonds in his home district.

He said he sees it as a chance to improve future outcomes for kids and save money.

"They're going to wind up being much more productive citizens over the course of their career," he said. "We invest a little now, save a ton of money down the line."

Schlossberg said there are challenges in the coordination, but that he supports pay-for-success contracts.

"It is a highly complex process," he said, adding that "a pay-for-success program works when you have enough data to unquestionably prove that throwing money at a problem will improve that problem."

Schlossberg, a Democrat, said both parties can get behind using social impact bonds to fund projects.

"Democrats sometimes have a tendency to talk about spending, and Republicans have a tendency talk about cutting, but this is a way."