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

By Mark T. Fliegauf

In their insightful article, “The Payoff of Pay-For-Success,” Kasturi Rangan and Lisa Chase highlight the promise and potential pitfalls of an emerging trend in government procurement: pay-for-success contracts (PFS), and more specifically, social impact bonds (SIBs). While their analysis is confined to PFS and SIB contracts in the United States, their conclusions are applicable beyond North America.

Based on findings from Germany, I agree with Rangan and Chase’s assessment about the “critical and enabling” role of philanthropy and public funding in developing PFS contracts and SIBs in the next few years. The dearth of venture and primarily “return-seeking” capital in these contracts, however, has the positive effect of preventing unintended consequences that may accompany the infusion of such capital.

The authors are also correct when they say that PFS is helping create the dawn of a procurement revolution, but their focus on cost savings ultimately prevents them from recognizing the real “payoff” of SIBs: investing more public money rather than less in social programs.

Philanthropic capital and public incentive funding will indeed play a critical role in encouraging the use and further development of PFS contracts and SIBs in the next three to five years. The current instruments are neither established nor sophisticated enough to attract primarily return-seeking investors. It may take several years to modify, twist, and tweak SIB designs before individual and institutional investors will be willing to invest large amounts of venture capital (VC). Currently, such financiers shy away from the high risk and low liquidity that SIBs offer, as even annual returns in the double digits don’t provide enough payout.

What holds true for the Anglo-Saxon sphere is even more pronounced in Germany, where the country’s only SIB pilot, in the Bavarian city of Augsburg, offers its investors (three foundations and a social venture fund) an annual return of merely 1 percent.1

The persistent absence of social venture capital and the lack of private finance is not surprising. Although the proponents of social investment are fond of drawing analogies to VC’s role in the ICT revolution in the 1980s and 1990s, they frequently omit that venture capitalists tended to jump on the tech-train only after proofs of concept were established, frequently via public funding.2

True, having to forego large volumes of venture and return-seeking capital will limit the scope of PFS and SIB arrangements in the years to come. But it will also prevent problems that such investments could bring: investor activism, the creation of bubbles, and the development of a secondary social investment market where tranched and securitized debt, as well as credit default swaps, are traded without any form of rating system. Given that government foresight of such unintended consequences is woefully lacking, the current absence of social VC and private return-seeking capital may be a blessing in disguise.3

Philanthropic and public money will be essential to bridge the development period of more sophisticated instruments that in turn will attract return-seeking investors. Corporate funding could provide another bridge in this regard. Similar to philanthropic foundations, a vanguard of corporations may overhaul the way they finance CSR projects by relying on SIBs.4

Rangan and Chase maintain that by employing SIBs and other PFS contracts the United States, and in particular Great Britain, have started a likely revolution in public sector procurement. Their article, however, focuses too narrowly on the role of public cost savings and fails to adequately look at the wider impact that these contracts could have on government spending.

While SIBs are inherently tied to government cost savings, they are usually applied in instances where social service delivery is significantly underfunded (if it is funded at all). Any well-designed SIB allows social service providers, first and foremost, to deliver timely and effective interventions, even if program costs exceed those of alternative approaches. In a second step, the SIB ties increased efficacy to efficiency gains by proving that more intensive—and therefore more expensive—interventions today can generate significant savings tomorrow.5

It is this logic that holds promise for European states with extensive welfare systems such as Germany, because SIBs provide a mechanism to target spending more accurately and thus to allocate public funds more effectively. Take, for example, services for children and youths on the edge of care. As the head of a local youth services organization explains: “We all know what would help families with these children: more counseling and intensive family therapy over a prolonged period of time. I simply don’t have any allocated money for that.”

By relying on less intensive and less costly approaches, youth services cure the symptoms and manage to keep open conflict temporarily under the lid. But the subsequent deterioration of intra-family relationships frequently produces the need for more interventions and significant follow on costs.

The great promise and hence payoff of the PFS/SIB procurement revolution lies in the fact that it encourages government agencies to carefully reflect on the causal chains of potential interventions and their evidence base and to compare the aggregate long-term costs and benefits of alternative approaches. This quite often entails spending more money—more wisely—today to get better outcomes tomorrow. Not only for those affected but also for the public’s pocket.

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1 An assessment of the German SIB investment landscape can be found in Lucia De Carlo and Mark T. Fliegauf’s “Vorfinanzierung leicht(er) machen. Die Investorenseite des Sozialen Wirkungskredits,” stiftung neue verantwortung, Berlin, 2015.

2 For an illustrative example see Ronald Cohen and William A. Sahlman, “Social Impact Investing Will Be the New Venture Capital,” Harvard Business Review (blog posting), January 17, 2013. Marianna Mazzucato provides a detailed account of the role of public venture capital in getting the ICT revolution off the ground in The Entrepreneurial State: Debunking Public Vs. Private Sector Myths, Anthem Press, 2013. 

3 Jasper Kim, “Next-Generation Social Impact Bonds,” Stanford Social Innovation Review, (blog posting), December 29, 2014. 

4 Rosabeth Moss Kanter, Supercorp: How Vanguard Companies Create Innovation, Profits, Growth, and Social Good, Crown Business, 2009.

5 Mark T. Fliegauf et al. “Investition. Intervention. Impact. Der Soziale Wirkungskredit in Deutschland,” stiftung neue verantwortung, Berlin, 2015.

Mark T. Fliegauf is Fellow in Innovative Government at the Berlin-based think tank, stiftung neue verantwortung, where he leads teams of decision-makers from government, business, and the third sector in projects on social impact bonds and ways to reduce European youth unemployment.