Profits Meets Philanthropy in ‘Pay-For-Success’ Investments — Horizons (WSJ)

By MICHAEL J. CASEY

Do you care about reducing the prison population? Want to create work opportunities for homeless people? Re-employ veterans? Well, a new model of investing allows you to fund such projects — and even take home a profit.

It’s called Pay for Success, a radical form of civic-minded financial engineering that effectively reverses a problematic paradigm that prevailed during the financial crisis. Unlike the dysfunctional situation of 2008, when giant bank bailouts amounted to “privatized profits and socialized losses,” this model leaves private investors bearing the risk that a social program might fail but sharing the spoils with taxpayers if they work, explains Tracy Palandjian, chief executive officer of Boston-based nonprofit and pay-for-success pioneer Social Finance.

Often described as “social impact bonds” – somewhat erroneously, as they perform more like equity than fixed-income securities – pay-for-success securities steer investors’ money into civic improvement programs and deliver them a return, in the form of payouts from the sponsoring government agency. Their profitability is based on how well a predefined and independently measured positive social outcome is achieved.

The movement began in 2010 with a pilot program at Petersborough prison, north of London. With Social Finance’s help, the British government tapped £5 million from 17 investing foundations, handed the money to a coalition of nonprofits whose programs aim to keep ex-convicts out of trouble, and promised to pay the investors a profit if reconvictions fell below certain thresholds over six years. The thinking was that government w0uld reap big savings from reducing the number of prisoners and could share some of that with similarly incentivized investors.

Since then, more than 45 projects worth $185 million have been launched across nine countries, according to Social Finance. Although that’s a tiny drop in the roughly $50 trillion ocean of government bonds worldwide, the idea is gaining traction, driven by a rainbow alliance of charitable organizations, tech-minded service providers, governments and asset managers.

In the U.S., there are now seven projects in five states targeting recidivism, education, housing and homelessness, and child and family welfare, as well as various others coming online for asthma management, maternal and child health, workforce development, and mental illness. Institutions engaged in organizing, funding and promoting these projects include Goldman Sachs, Bank of America Merrill Lynch, the Rockefeller Foundation, the Federal Reserve Bank of San Francisco and agencies from all levels of government.

Twenty states have either enacted or are considering pay-for-success legislation and bipartisan bills are currently in both houses of Congress to create a $300 million federal pay-for-success incentive fund. The White House has also provided grants to more than 40 nonprofits and local and state governments to explore the feasibility of such projects.

One reason for the enthusiasm: the post-2008 fiscal crisis. Governments were eager to find anyone but taxpayers to foot their mounting bills. Just as important, in an era of legislative gridlock, the idea finds rare bipartisan accord.

“The left is pleased to see capital flowing to community projects that they care deeply about and the right likes the market-based mechanism that directs capital and allows increasing rigor around the measurement of outcomes,” said Andy Sieg, head of Global Wealth and Retirement Solutions for Bank of America Merrill Lynch. Working with Social Finance, Mr. Sieg’s team raised $13.5 million to provide reentry employment services to 2,000 formerly incarcerated people in New York City and Rochester, N.Y.

By shifting the burden to investors, this model gets around the problem of politicians’ reluctance to make large up-front investments in preventative programs even though they’d save taxpayers’ money over the long term.

“A lot of public funds are tied up in programs that remediate problems that could have been avoided if we’d just invested in the right upstream program,” says Ian Galloway, senior research associate at the San Francisco Fed’s community development department.

The model exploits a new “impact investing” mindset that’s melding investment and philanthropy “like nothing we have seen in previous generations,” says Kippy Joseph, who heads the Rockefeller Foundation’s social impact bond program.

Surveys of high-net-worth investors show that the World War II generation saw no place for social impact considerations in their investment decisions, that a larger number Baby Boomers believe they are important, and that an “off the charts” 80% of Millennials believe “impact” is an integral part of the investment outcome, according to Bank of America Merrill Lynch’s Mr Sieg.

It’s a shift from the “modern portfolio theory that…involved a two-dimensional trade-off between risk and return,” he says. “The impact investing dimension is really adding a third element of return, a Z axis.”

Until now, however, impact investment solutions still required a trade-off between the social objective and returns – a higher micro-lending interest rate would attract investors but hurt borrowers, for example. Under pay-for-success, by contrast, the social outcome and investors’ profits are deliberately aligned.

That’s not say there aren’t challenges – like coming up with the right metric. The closely watched Petersborough project failed to achieve a first payment goal because its 8.4% recidivism reduction over the first four years missed an overly ambitious initial 10% target – although that put it on target for profitability in 2016, when a 7.5% average reduction gauge will be used.

The “Z axis” concept also means returns are inevitably below comparable private-equity investments. Some inventive financiers are seeking to divide tranches with differing profitability and seniority between contributors with varied philanthropic and return-on-investment needs. Even so, performance-obsessed traditional investors might eschew deals that price poorly against higher-paying traditional benchmarks.

And yet if we take the example of the five-and-half-year New York/Rochester anti-recidivism project, its 12% maximum and 6% average expected return can look attractive compared with the sub-1.7% yield on a five-year Treasury note. One could argue that the added benefit of making society safer and more productive is a better use of your money than simply refinancing Uncle Sam’s debt.

– Follow Michael J. Casey on Twitter: @mikejcasey.