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The Hidden Reality Behind Social Impact Bonds

| Tuesday February 22nd, 2011 | 23 Comments
Hidden within President Obama’s proposed budget is a line item that attempts to start a new model for financing government controlled projects: Social Impact Bonds. So, what exactly are Social Impact Bonds? How much of the budget is allocated to this?  Will it actually work, or is it too good to be true?

First off, the Social Impact Bond is truly hidden within the budget proposal. The term “Social Impact Bond” does not even show up in the 200+ page budget proposal. The closet line item to have the word ‘social’ in it (besides Social Security) is the Social Innovation Fund. But, this is a program created in prior budgets of the Obama administration.

Social Impact Bonds are an idea copied from the United Kingdom.  The term used for Social Impact Bonds in the Obama proposed budget is “pay for success” bonds.  This phrasing hints at how Social Impact Bond attempts to work.

According to social investment firm Social Finance, “through a Social Impact Bond, private investment is used to pay for interventions, which are delivered by service providers with a proven track record. Financial returns to investors are made by the public sector on the basis of improved social outcomes. If outcomes do not improve, then investors do not recover their investment.”

In other words, private money is invested in a given social project.  If the project fails, the investor gets no money back.  If the project succeeds (by the predefined measures of social outcomes) the government pays the private investor a return. Companies similar to UK based Social Finance, such as US-based Nonprofit Finance Fund, would act as the middlemen offering such bonds.

Out of the $3.7 trillion budget, Obama’s proposed budget is calling for $100 milliion to be used for Social Impact Bonds.  That’s only 0.003% of the entire budget.  Sounds like a good deal?  Not quite.

What is the hidden realty behind the Social Impact Bond?

Let’s take a systems approach to understanding the biggest flaw of the Social Impact Bond program. We have to ask the question, where does the money funding the Social Impact Bond come from?  Obviously, it comes from the budget of the federal government.  Now, where does the federal government get the money for its budget?  It comes from taxpayer dollars.

This is where a Social Impact Bond starts to make no sense at all.  Here is a more concrete example.  Assume that a given program is successful in meeting its predefined measures.  The program was funded by a private investor.  The government now has to pay the private investor its profit, using taxpayer dollars.  Taxpayer dollars are explicitly going into private hands through the use of the Social Impact Bond.

On a side note, assume that a given program is bound for failure.  What investor would invest in something with no return?  One might as well donate money instead.

Don’t get me wrong.  The core idea of funding a program from a voluntary private individual is fine. In fact, all things being equal, that is the best way to go through the trial and error process of an enterprise.

The problem is when you or I are forced to pay a profit to that private individual via a tax. It is no longer a voluntary exchange.  Private profit provided by taxpayer dollars, is in itself not sustainable.

While the intentions of the Social Impact Bond may be for the benefit of the social side of sustainability, ironically, in the long run, it may not provide financial or economic sustainability.


▼▼▼      23 Comments     ▼▼▼

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  • http://changecharity.blogspot.com Jeff Raderstrong

    I think the idea with these bonds is that the taxpayers will actually be saving money through this public/private partnership. In the pilot case in the UK, the government won’t pay the bonds unless prison recidivism reduces to a certain target due to the program. I’m assuming they’ve determined this target based on a cost-benefit analysis, with the tax payers ultimately saving money through the bond payments.

    The overall goal of social impact bonds is cost savings to the tax payers. It remains to be seen if it will work, I think you are taking a very limited view of this program.

    • Jonathan Mariano

      @Jeff Raderstrong: Thanks for the comment. If there has been a cost-benefit analysis, I would like to take a look at it to understand their logic and thought process of creating an SIB. Not that I would agree with it, but it would be good to know how they arrived at their conclusions. If you do run into any, please do share.

  • http://www.sffx.net Promise Contracts

    We find the idea of the “Social Impact Bond” very exciting and in fact our founder has dedicated the last five years to promote this concept all over the world. We, together with Social Entrepreneur organization Ashoka, brought the idea to the UK Government and advised on a pro-bono basis for their pilot (the same one that is being used as model for the US). We called (and still do) it “Promise Contracts”. We truly believe this is a simple concept that will help better the world. Our motto is “Anything a society truly wants can be financed and achieved”. We are completely turning upside down, in a good way, the way we use capital markets to unleash a constant flow of large scale capital and the best talent in the world to focus exclusively in improving quality of life for all, and at the same time a profitable enterprise for investors, there is plenty of room for both.
    Today, for example, financial markets allow billions of our own dollars to be spent on incentivizing our kids to demand a particular consumer product such as a video game that they may or may not “need”. That is, billions of dollars spent on creating new demand for products. Why can’t similar talent and resources be channeled to improve people’s lives without them having to consume something? Can this talent only be applied to such goals during their weekends or after hours? Are social goals really a second class objective? That is one riddle that markets and appropriate financial structuring can help solve by eliminating the importance of the legal definition, or at least subjugating it to the more important aspect of the role that it plays. We are a for-profit start company that given our limited resources is working on the “proof of concept” in Peru but looking forward to bring it forward to all over the world. Our “corporate” site is http://www.sffx.net and the Peru pilot site is http://www.contratospromesa.com

    • Jonathan Mariano

      @Promise Contracts: Thank you for sharing you thoughts. Don’t get me wrong, I think there is something to be said for spending money via investing, financing, or donating towards “social needs.” I am not contesting that. What I am contesting is this particular incarnation of moving taxpayer dollars into private profits. To me, that doesn’t make any sense.

  • Jenna

    How long would the project have to be actually be successful? This seems like a tricky idea to mix the private and public.

    • Jonathan Mariano

      @Jenna: I concur, it is a tricky idea to be mixing the private and the “public”, or rather putting taxpayer dollars into private profits.

  • Dione Alexander

    The thesis behind social impact bonds is not without precedence. Freddie Mac, Fannie Mae, and Sallie Mae were all born from the need for the government and its quasi-public agencies to attract capital from private investors to support a social cause (i.e. affordable housing and education)and to pay the investors a reasonable return. In practice, every contract that the government enters into has an attached profit incentive that is financed by tax dollars. Private investors routinely fund high-margin defense, corrections, and healthcare contracts and the sucess metrics for their services are often unknown or unpublished.

    Social impact bonds appear to be a thoughtful mechanism to: 1) aggregate and deploy private capital, 2) provide a fair amount of transparency around perfomance metrics, 3)encourage best practice among service providers.

    • Jonathan Mariano

      I acknowledge that there has been other forms of taxpayer dollars going into private profits, as you have stated above, Freddie Mac, Fannie Mae, Sallie Mae, etc. But just because it such atrocities were created in the past, does that mean we must recreate or reincarnate them in another form? Take for example how Freddie and Fannie were one of the culprits of the housing bubble and recession.

  • Godwin

    The writer of this article is naive if he doesn’t already know that taxpayer money makes it into private hands for profit on a regular basis, any government contract compensates providers with profit. Unsustainable? You’re an MBA candidate? It’s funny that you introduce the fact that the federal budget is funded by taxpayers as a novel concept (revelation!).

    Secondly, taxpayers are only paying a premium (assuming costs are actually higher than a similarly run government program) if the program actually succeeds. As a taxpayer, I would gladly pay more to know that the programs I’m funding are meeting their objectives – or they are shut down. The same cannot be said for most publicly funded social interventions.

    • Jonathan Mariano

      @Godwin: Thank you for chiming in. Yes, I acknowledge that taxpayer money makes it into private hands year after year, both implicitly and explicitly. But does that mean we keep on doing it? Or attempt to put a stop to it?

      I claim no novelty with the fact that the federal budget is funded by taxpayer dollars. However, I do wish to point it out.

      I think that is great that you would want to pay for programs that are meeting their objectives. By the same token, I do not want to force others to pay for programs (via a tax or SIB) that they do not agree with nor wish to partake in.

      IMHO, a better way to run the “SIB” is to have folks voluntarily put their own money in, not coerced by the federal government.

  • Mitra Ardron

    One of the hardest things for a government to do is take risk, which means that govt programs tend to be boring, bland, predictable and never get any better. Govt staff are penalised for failure rather than rewarded for success, so they have every incentive NOT to take risks that might improve results but also might fail. I really like this idea, because the element of risk is removed from the govt, and pushed where it belongs, i.e. on investors. The analysis in the article is flawed – if the project succeeds, then the investor profits, if the project fails (which it might) the investor loses, either way the govt (i.e. taxpayers) only pay for results.

    I work in the area of looking for technical solutions to basic needs in developing countries, if we had something like this then I could source private money to take a risk on a new technology reducing the costs (for example of providing energy, or clean water, or medical refrigeration), these are risks that most governments, and most philanthropic money won’t touch, so several innovators I’m working with that have solutions that would half the cost of service delivery can’t get funding.

    I applaud the trial, lets hope it works out well (for the government (better outcome for less money) and the investors(profits while doing good) and is expanded.

    - Mitra Ardron
    http://www.naturalinnovation.org

    • Jonathan Mariano

      @Mitra: I appreciate you taking the time to digress on your thoughts, albiet we do disagree. If I may ask, what are some of the difficulties in obtaining private money now. Would something similar to an SIB work, if it were not funded by taxpayer dollars, but by voluntary “donations”.

      • Mitra Ardron

        Private money is hard to obtain for for-profit social ventures because the lack of significant profit scares off venture funders, the risk scares off banks. For non-profit social ventures, philanthropic money is also unwilling to take risks largely because they are staffed by people who are assessed on short-term metrics.

        Unlike you, I have no aversion to taxpayer money being used to fund social good, its the whole point of us paying taxes in the first place – to fairly distribute the cost of creating a society in which we can all live. The question is whether they are expended efficiently and achieve the best outcome per dollar spent. Governments are notoriously bad at achieving value, especially when innovation is required, which is why a social-impact bond is a good idea, it allows others to take the risk, while the government gets a known outcome per dollar spent.

        If you are arguing that the government should not spend money on social programs then that is a completely different (Libertarian) argument, and is really orthogonal to the issue of HOW the government addresses social issues at minimum cost.

        • Jonathan Mariano

          @Mitra: Thanks for sharing your thoughts. I have another piece about SIB’s but in the context of another form of government funding:

          http://goo.gl/qEbXt

          Would love to hear your take.

          I think we can agree upon that some folks have no aversion to taxpayer money being used for “social good”, yet other do not. By the same token, I’d also argue that there is a strong aversion by many to see taxpayer dollars go to the profit of corporations.

          My concern is for the folks who do have an aversion either way, going to “social good” or to the profit of corporations.

          On the last note on being “orthogonal”, I’d argue that the way government addresses social issues at minimum cost is not for the federal government to address it at all. That doesn’t mean that the social issues should not be addressed.

  • http://www.hipinvestor.com Nick Gower

    I am also very excited about social impact bonds, another great vehicle in impact investing. They are a innovative contracts that leverage both public and private funds to maximize human impact and profit (or minimalistic spending) on social ventures that benefit our society as a whole.

    Projects’ success can be measured with metrics involving keeping people from returning to prisons, preventative healthcare, or better education performance. These are issues the federal government already spends billions of dollars on, without concrete risk free results. Society benefits while investors and entrepreneurs earn a profit (financial and social)

    • Jonathan Mariano

      @Nick: Thank you for sharing your thoughts. Allow me to play devil’s advocate to the point on risk. I would argue that the “risk” with an SIB is not risk-free, just shifted. As with any entrepreneurial effort, there is always an element of risk.

  • John O

    Some major misunderstandings here:

    “Now, where does the federal government get the money for its budget? It comes from taxpayer dollars.”

    Of course it does. But these programs are already funded by taxpayer dollars via federal grants. SIBs are intended to replace some of this money with private money.

    The difference is that if a grant-funded project fails, the government currently pays the for the project no matter what. With SIBs, if it fails, the government pays nothing. If it succeeds, the government pays a profit to the investors. The overall result is a net decrease in government spending.

    “On a side note, assume that a given program is bound for failure. What investor would invest in something with no return?”

    If you can tell if a project is “bound for failure” before it gets funding, then you should become a securities trader, because you will get yourself filthy rich in no time.

    The point is that people don’t know. With SIBs, it’s up to the investors to determine a project’s risk of failure. Currently, the government does this, and furthermore, they spend taxpayer dollars even if it does fail.

    The point is to shift risk from the public to private investors. An additional goal is to shift money “naturally” to projects that have been successful. And given the high rate of “failure” of most of these projects, they should reduce government expenditures overall.

    • Jonathan Mariano

      Hi John O, Thanks for the comment. Here is a follow up piece along the logical fallacy of using both Social Investment Bonds and Government Funded Clean Tech Venture Funding.

  • Jonathan Mariano

    Hi John O,

    I concur, subsidizing industry is by no means new. I also concur, the dollar amount for each is not apples-to-apples, yet that does not deny the logical fallacy of implementing both schemes at the same time.

    My contention is:
    1) whether or not subsidizing industry should continue given no SIB’s
    2) whether or not subsidizing industry should continue given implementation of SIB’s.

    I fall on the side of not subsidizing industry in both cases, but you may fall on the side of supporting continuing subsidies.

  • John O

    The SIBs are pretty experimental, since they haven’t actually been tried anywhere except the UK, and they just started.

    I am generally against subsidizing industry, especially Big Oil, which receives billions in tax breaks and direct payments each year.

    I think the principle of putting taxpayer dollars to work to find new technologies that will benefit everyone is not inherently flawed. But there’s something not quite right, in principle, if taxpayers cover something like 50% of the costs but get 0% of the profits.

  • John O

    One other thing:

    “I think we can agree upon that some folks have no aversion to taxpayer money being used for “social good”, yet other do not.”

    I’d suggest getting familiar with the concept of “externalities,” and seeing if the latter people still feel that way. The vast majority of economists and policymakers do believe that government spending is the way to address many, if not most, externalities. Public education (positive externality) is a good example, as is regulation of pollution (negative externality).

  • jim hogg

    I’m with the author on this. It’s all about making profit in a new area with the taxpayer again as the source of the profit. It’s basically contracting out and paying later . . it means delaying public expenditure a little and that is the only benefit. The idea that the private sector does the work better is simply myth. What they will do is do it more cheaply, with cheaper labour, but the profit that has to be made means there would be no savings over a properly funded public sector solution. The sales pitch as per usual is sickening in its deceptiveness. It’s about making money, not about making the world a better place. And on the issue of failure and loss . . they will only take on winners. The idea can’t afford to be associated with failure. More gimmickry and bollocks for gullibles to salivate over. Government staff who fall for this kind of rubbish should be sacked.