By Dave Hendrick
University of Virginia Darden School of Business Professor Mary Margaret Frank brought what she termed the “investor’s perspective” to the second annual Pay for Success and Social Impact Finance Conference, held at the Darden School 10 February.
The conference, designed to explore the current state and potential future of the pay for success model, also known as social impact bonds, brought together a leading group of academics, entrepreneurs and thought leaders to consider the innovative funding mechanism, in which a private investor pays upfront to work toward an end goal, while an end payer — often a government — agrees to repay the investors should certain outcomes be met or exceeded.
The arrangements represent a form of cross-sector collaboration, an academic initiative at the Institute for Business in Society that Frank champions.
Frank said all stakeholders collaborating on a pay for success model should carefully construct their contracts with partners and weigh the risk versus return of pursuing a still-novel funding structure, which she put into the category of “nothing ventured, nothing gained.”
“Investors want a return for the investment risk they are taking. Otherwise, it’s a donation,” Frank said, adding that everyone involved needs to be mindful of the different types of risk each partner faces.
The Darden professor said investors interested in pay for success models will consider the financial and social return to their investment. Both the cash flows to the investor and the social impact are affected by a variety of risks that potential investors are scrutinizing, such as:
- Completion risk
- Operating risk
- Structural risk
- Political risk
- Social risk
- Opportunity risk
The current “billion dollar question,” Frank said, is how to accurately account for these risks and price them into contracts.
“Right now, social impact bonds are new. That means they are risky because few people truly understand them,” Frank said. “However, the more people who are educated on these new funding models and gain experience with this financial innovation, the less risky it becomes.”
Frank brought up the pay for success case involving youth recidivism at Rikers Island in New York, in which Goldman Sachs agreed to invest $9.6 million over four years as part of an agreement that would return a maximum of $2.1 million if the recidivism rate dropped by 20 percent in five years.
The plan did not achieve the ultimate goal, with the recidivism rate falling to 8.3 percent after three years, a figure that wasn’t significantly different from the control group, and Goldman ended its investment via an option in the contract.
Was the plan a failure? The investor didn’t earn a return, as Goldman lost $1.2 million, Frank said, and incurred opportunity costs by not being able to invest in other projects.
However, Frank considers the project a success because innovation occurred, noting that Innovation doesn’t occur without risk, and the parties understood the risks.
Frank does worry about the implication of the outcome at Rikers on future pay for success projects, noting that the Rikers case may be considered a failure and deter other private-sector funders from investing in this novel approach in the future.
Regardless of the financial outcome, there is benefit to these early trials because they provide feedback about how the contracts in the space will need to evolve to incorporate the risk to all parties.
“When you structure these contracts you have to think about all the players,” Frank said. “What are the risks to all players? What are benefits to all players? How are we going to allocate those risks and benefits? How do we create optionality in our contracts, because optionality reduces risk.”
About the University of Virginia Darden School of Business
The University of Virginia Darden School of Business delivers the world's best business education experience to prepare entrepreneurial, global and responsible leaders through its MBA, Ph.D. and Executive Education programs. Darden's top-ranked faculty is renowned for teaching excellence and advances practical business knowledge through research. Darden was established in 1955 at the University of Virginia, a top public university founded by Thomas Jefferson in 1819 in Charlottesville, Virginia.
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