With big investors come big issues
Up-front financing plays a key role in the implementation of Social Impact Bonds (SIB). In Anglo-Saxon countries, particularly in the United States, institutional investors such as banks are increasingly stepping up as financial backers, which is often seen as an ideal solution for German-speaking countries as well. Is this the right assumption?
Tyler Moazed, who in recent years worked as a project director in the United States evaluating two federally commissioned Social Impact Bonds and has in-depth insight into overall developments in the United States, addresses this question in his guest article and presents the major challenges that can come along with involving private investors in a SIB. For an introduction to the topic of SIBs, please see our blog posts: What is a Social Impact Bond? and 10 ways to describe Social Impact Bonds.
With big investors come big issues – Why having for-profit investors in SIBs can sometimes be more trouble than it is worth.
by Tyler Moazed
The growth of the SIB model is a worldwide phenomenon. But while the core concept of an impact-oriented financial instrument that reduces taxpayer risk for social services remains consistent, there is a lot of variation in implementation both within and across countries. A notable point of difference between how the United States is approaching SIBs compared to Germany and Austria is the involvement of for-profit financial institutions. In all but one of the eight active SIBs in the United States, the majority of up-front financing has come from for-profit investors (especially banks). In contrast, both the Juvat-led SIBs in Germany and Austria received up-front financing exclusively from philanthropic organizations that do not seek a significant return on investment (ROI).
One of the key reasons for the divergence in the source of up-front financing is a clear distinction in how SIBs are viewed. Since its initial development in the United States in 2012, the SIB model has been perceived by many in the field as a new type of socially responsible investment. The “investment mentality” has led to large for-profit investors playing a central role in the financing of nearly every active SIB. As discussed in one of the previous Juvat blog posts previous Juvat blog post, one of the central ideas around involving for-profit investors and (re)framing SIBs as a type of investment is to bring new capital into the social services world. And while that blog post lays out why this train of thought is potentially flawed, experiences from the United States also provide examples of some unforeseen consequences.
- Increased complexity of SIB contracts – The involvement of for-profit investors like banks within SIBs necessitates complex legal contracts that are typically cumbersome (some hundreds of pages in length) and require extensive, expensive consulting from lawyers for all involved parties. The legal and administrative costs associated with these contracts can create a large, upfront financial burden for local governments and social service providers.
- Influence over KPIs – When a SIB has a large (often the largest) investment from for-profit financial institutions, they carry a significant amount of influence over the project’s structure. Since these institutions see SIBs as a type of investment, their goal, as with all their investments, is to optimize their ROI while reducing their risks. Although this mentality is expected for traditional investments, it can shift a SIB’s KPIs and repayment amounts to levels that best suit the for-profit investor (low performance benchmarks with small gains resulting in large-scale returns), but are out of step with the sponsoring government agency and community at large. This can lead to repayment tiers that are below the projected savings goals of the local area.
- Exit strategies – Due to the investment nature of SIBs in the United States, for-profit financial institutions do their best to protect their investments. One common strategy for reducing the possibility of a total loss is the inclusion of “exit options” within SIB contracts. These exit clauses typically involve various interim benchmarks and/or requirements by the partner agencies to perform certain tasks or meet certain deadlines. If any of these requirements are not met, the for-profit investors are free to pull their investment and ostensibly kill the project. If capital is removed before the project is complete, it can introduce significant dangers to participants and the service provider.
As Germany and other European countries continue to explore the SIB model and its many forms, the level of involvement of for-profit investors will be an important consideration. In the end, governments will need to weigh the benefits that greater capital brings against the potential consequences to find a solution that is right for them.