Response to "The Payoff of Pay-for-Success" (SSIR)

By George Overholser

In their article “The Payoff of Pay-for-Success,” V. Kasturi Rangan and Lisa Chase assert that the future of pay-for-success lies in philanthropy. Their main point is this: the crucial up-front risk capital needed for pay-for-success (PFS) deals to work in the long run will not come from profit-seeking investors; instead, it will be philanthropic dollars that will finance these deals. Philanthropy, according to Rangan and Chase, is the future of PFS. I do not share their view.

In the long run, it is not philanthropy that will keep the fires of PFS burning. Nor will it be return-seeking investors, who play such a vital role in today’s pioneering efforts. If PFS is to be widely embraced by the mainstream, then it must be government itself that will make it happen—with little or even potentially no private risk capital needed. Before I explain how this is possible, let’s start with a quick review of the PFS model.

The great promise of PFS is not to “unleash a huge flow of return-seeking capital” that will “plug the funding gaps.” This point of view perpetuates the notion that PFS is largely about the up-front funding mechanism, most notably social impact bonds (SIBs). Certainly, the funding mechanism is a critical component of PFS, but over time it represents mere catalytic pennies on the dollar when compared to the magnitude of government dollars that PFS can unleash.

As PFS evolves and as we learn more about how to forge successful PFS projects, a comparatively small amount of private capital will be needed to drive large redeployments of government funds toward the social innovations that work best for America’s most vulnerable communities. It’s a point that Rangan and Chase eventually make at the end of their article: “These [PFS] projects … 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.”

In the PFS approach, private financing is decidedly not intended to pay for social programs. Rather, its role is to provide temporary loans that are needed to bridge the timing delays that are a natural consequence of any measure-then-pay system. If and when the program hits its impact targets, then government (not private funders) pays for the program. This allows the private loan capital to be fully replenished and—this is critical—it becomes available to be recycled.

This recycling phenomenon is what makes it possible for a small amount of private loan capital to catalyze large amounts of government PFS payments. For example, our nonprofit firm, Third Sector Capital Partners, is currently working on PFS transactions that will require a total of approximately $92 million of up-front private SIB financing to mobilize about $176 million of success-contingent government payments. If and when the projects are repeated, the same $92 million could be redeployed to mobilize additional projects with $176 million of success-contingent government payments, and so on, over and over again.

But that is just for starters. Through the use of a “partial PFS” approach, the future recycling of the $92 million could be leveraged to affect far more than just $176 million per project. For example, we are already blueprinting projects where only 20 percent of government payments will be paid in the delayed PFS manner; the remaining 80 percent of government payments will be made under a traditional immediate reimbursement model. This partial PFS approach retains the vital performance-oriented outcome measurements that are essential to PFS contracting, while multiplying the amount of government resources mobilized by a factor of five. Thus, in principle, every time the $92 million of up-front private loan capital is recycled, another $880 million of government dollars will be placed into a PFS mode. Over, and over, and over again.

Indeed, in some cases, the need for up-front private financing can be removed altogether. For example, on one of our projects, we expect that the nonprofit social service provider will use its own financial resources to fund the up-front work and thus bridge the timing delays inherent in PFS. In this case, the power of reallocating government resources in an evidence-driven way will be fully retained, but there will be no need to tap into additional private capital markets.

Thus, although there are no doubt many limitations to PFS (it is not meant to be a panacea), we are more optimistic than Rangan and Chase that the growth of PFS will not be severely constrained by a lack of private loan capital. Loans will be recycled, partial PFS arrangements will multiply the power of loans to redirect government allocations, and ultimately, some providers will use their own balance sheets (not SIB loans) to finance their PFS contracts.

Rangan and Chase correctly assert that philanthropy has an essential role to play in the evolution of PFS. But I would suggest that philanthropy’s role is actually most crucial at this very moment, nurturing the development of PFS during its earliest manifestations in cities and states across the United States. Because PFS is new and unproven, it is currently a relatively scary place for mainstream lenders to make loans. Philanthropy can be used to test the waters so that projects can establish the track records needed to prove to commercial lenders that PFS projects are indeed debt-worthy (albeit not risk-free). Philanthropic subsidies are also needed to compensate for the reality that first-time projects are far more expensive to put together (because of the additional administrative and learning costs required) than replicated projects will be, and thus currently have less money left over to offer as financial compensation to mainstream SIB lenders.

Luckily, the current giving-pledge era augurs well for seekers of philanthropic loan capital. Moreover, the PFS philanthropic funding model offers a comparatively spectacular proposition to philanthropists. To understand why, imagine a funder who likes a certain program so much that she writes a $1 million check. Traditionally, her check might pay for 1,000 individuals to be served by the program, after which the money would be gone. Now consider the same funder under a typical PFS construct. She writes the $1 million check, but this time it is immediately doubled by private loans, which allows 2,000 individuals to be served by the program she likes. Then, as an extraordinary kicker, she is informed at the end of the project that because of the government’s success payments, her $1 million gift has been replenished and is now poised to be recycled, resulting in changed lives for many thousands of vulnerable people. (Of course, the PFS arrangement could also reveal that the project failed to work, in which case there would be no replenishment. But in this case the PFS model would fare no worse than the traditional write-the-check-and-it’s-gone giving model.)

With billions of dollars now flowing from the coffers of sophisticated giving-pledge philanthropists, we are bullish that the PFS model will attract the philanthropic capital it needs to catch on and become a mainstay of how government spends its money on programs and strategies that work best for our most vulnerable communities and families.

Read the rest of the responses.

George Overholser is cofounder and CEO of Third Sector Capital Partners, where he consults with governments, nonprofits, and funders to help create pay-for-success programs. Previously, Overholser founded NFF Capital Partners (a division of the Nonprofit Finance Fund), and earlier in his career was a member of Capital One’s founding management team.