One of the most interesting trends in public-private partnerships (PPPs) is performance-based contracting-also known as payment-by-results-in which part of the contracting service provider’s remuneration is tied to the achievement of particular performance targets specified in the contract.
One relatively new-and increasingly popular-type of performance-based PPP is the “social impact bond,” a construct that brings together government, which decides on a problem to be tackled, an intermediary, which finds investors to provide funds and hires service providers to deliver a targeted intervention, and an evaluator, who determines how successful that intervention has been.
Put simply, the private and third sectors finance and implement new social service delivery models on behalf of government under a pay-for-success model. If the interventions improve outcomes and save public funds, investors receive success payments from government that generate a return on their investment. If outcomes do not improve, government pays nothing and investors lose money.
In the U.S., social impact bonds are already moving forward in Massachusetts, New York City and Fresno, California, and are on the horizon in several other states, counties and municipalities. More information can be found in Reason Foundation’s Annual Privatization Report 2013.
The nonprofit organization Social Finance UK pioneered the social impact bond concept in the United Kingdom. In 2010 it raised $7.8 million from 17 investors to fund the first social impact bond pilot project, which aimed to reduce recidivism amongst prisoners in one British prison: HMP Peterborough. In June 2013, Reason Foundation Managing Editor Tom Clougherty sat down with Jane Newman, International Director at Social Finance UK, to learn more.
Tom Clougherty, Reason Foundation: Can you describe for our readers what a social impact bond is? What is the role of private capital in financing social interventions? And why the private and third sectors, not just government?
Jane Newman, International Director, Social Finance UK: We think of social impact bonds as a partnership between (a) government, which is the principal purchaser of services to address social issues, (b) service providers, who are the normal contracting party, and (c) a new set of interests, which are investors and private sector individuals who are interested in driving change in the way government contracts and also addressing social issues. From our perspective, I would say a social impact bond is really a partnership between social providers, the government and investors-brought together by an intermediary that focuses very specifically on a social issue. Very often, the social issue is a disconnect or gap in an existing service provision, or it’s an opportunity to invest in prevention and show that can generate savings down the line.
Clougherty: So you’re doing things that government wouldn’t do, because these activities are more speculative or more innovative?
Newman: Government can find it difficult to invest in prevention. Let’s take criminal justice. Government has the responsibility to deal with offenders, put them in prison. And it has to bear the costs of that responsibility.
At the same time, there are programs where-if you tackle some of the issues associated with offenders-you might be able to improve the possibility of those offenders not re-offending in the future. But it’s quite difficult for government to both carry the cost of the consequences and at the same time invest in prevention.
So what we’re talking about is an opportunity to try untested interventions-exploring whether something is capable of working, or, where it does work well small scale, if it’s capable of being scaled up. It’s an opportunity for government to innovate and explore and share the risk inherent in doing so with the private sector.
Clougherty: In the kind of archetypal social impact bond you just described, what is Social Finance UK’s role? Are you the intermediary in that scenario?
Newman: Yes. So, the first social impact bond in the Peterborough prison is focused on reducing reoffending. That was the first one. And in a sense, because it was the first one, we had more roles than we necessarily need to have. What we did is bring it together. We approached the Ministry of Justice and asked them, “how much is it worth to reduce reoffending, say by 5%? How much is it worth to reduce it by 10 percent?” and then we looked at whether or not there are programs that have the capacity to do that. Then we brought in the investors and co-developed the concept.
Having launched the program, the entity that actually holds the social impact bond-which means it holds the contract from the government, then employs service providers and raises money from investors-it’s a special purpose vehicle, an independent entity. And we have an advisory relationship with that entity. Having raised the capital from investors, we were concerned that it’s not the capital structure that drives change, it’s the program management which drives change, so we felt it was important to put in a layer of performance management in the program, so we have that role as well. But this is because the market is at a very early stage. As it matures, we expect other organisations will become involved in some of the roles.
Clougherty: Was it Social Finance who really developed this concept of the social impact bond from the beginning or were there other influences involved there?
Newman: There were other influences. The history can be found in materials on our website. Part of the idea was if you were to invest in prevention in an area that is capable of generating savings in the future, could you use those future savings for the initial investment in the program and drive change? So that theoretical concept was around in discussions. Arthur Wood, a former investment banker, was exploring the area, as were others, such as Peter Wheeler and David Robinson (both now on our Board). The Young Foundation had also done some research. What we did at Social Finance is that we developed the theoretical concept and turned it into a transaction, and that makes, I think, all the difference.
Clougherty: Could we talk a little bit more about the pilot program in the Peterborough prison? Now, obviously this is focused on reducing recidivism rates among male offenders in Peterborough. What prompted this particular program, and are there specific aspects about the way it works that you would like to share with us-people involved, various responsibilities and so on?
Newman: So, what prompted it: we were set up as an organization to bring together experience from the financial sector and explore how they could address social issues. We were exploring a range of different social finance/social investment options, and this was one of the most interesting ways to finance projects around a social issue.
There were a number of social issues we were interested in exploring. We quite quickly came to concentrate on the recidivism area, probably for a number of reasons. Criminal justice experts recognized there was a gap in the system-and that’s short sentence prisoners, who are not clients of the probation service. [Editor’s note: In the UK, adult offenders given prison sentences of fewer than 12 months do not currently receive support from the probation service upon their release from prison.] They also recognized that there were particularly high rates of reoffending amongst this particular group of people. So there was, on the government side, an interest and open-mindedness to explore innovative solutions that might be able to address that problem.
From an investor perspective, the investors in the Peterborough social impact bond are foundations and high net worth individuals. But the lead investors were some foundations that had been grant-making in the area for a long time and well understood the challenges. I think they were really excited about the idea of doing something at scale, over time. Bringing these influences together was, I think, important to the design of the bond.
Clougherty: I know there’s no full assessment of the Peterborough social impact bond due until 2014, but there are some interim findings. Can you tell us about how it’s going and what signs of success or otherwise you’re seeing so far?
Newman: To start with-just to say why there are no findings until 2014-that’s associated with the design of the intervention: the program is designed to work with 3,000 prisoners in groups of 1,000, so it takes time. It takes about 18 months for 1,000 prisoners to leave Peterborough prison – that’s just the volume going through the prison. And then after the last of those have left, we measure reoffending rates for a year afterward. So it takes about two and a half years, plus a bit of time to go through the courts to actually have a group of people you can measure-that’s why it’s 2014.
What we have on the ground is a sort of total experience of the way the program has changed, the way the prison is engaged in change, and the way it’s embedded into the system. There are some recent interim results announced by the Ministry of Justice, but it’s important to differentiate those as they don’t measure the reoffending behavior over the same period, and they don’t measure it against the same thing as the social impact bond is measured. But with that caveat, the recent interim results are encouraging because they suggest that measured against a historic baseline there’s a reduction of offending when the national average is going up. So we’re pleased to see that, but we’re very conscious that it’s not comparing like with like.
Clougherty: You talked about the possibility of scaling up the kind of interventions that you’ve tried in social impact bonds. And as you say, it’s obviously early days in Peterborough at the moment. But it does seem that the Ministry of Justice is keen on this payment-by-results idea throughout criminal justice, sentencing, probation and so on. There has been talk about massively expanding private contracting in probation using the payment-by-results model. Do you see this as a natural way for the sort of thing you’re doing in Peterborough to be scaled up? And do you think that there are dangers in adopting a more universal approach rather than specific targeted interventions?
Newman: I think it’s a very interesting question. It’s one we debate a lot internally because scaling up produces challenges. In principle scaling should be possible, but we’re also conscious that many of the organizations we might want to use as service providers are relatively small, under-capitalized or thinly capitalized voluntary sector organizations. To scale up, you would have to have the national/regional coverage that many of these organizations don’t really have.
Peterborough doesn’t provide probation services but works in partnership with all statutory providers in the area. It is true, though, that the government is trying to make the probation service more results-based, and also extend the probation service so that it deals with the group of people we work with-short sentence prisoners and people who fall through the system. What’s important about this is that the government is recognizing the social value which can be realized – not just cost saving. They want to wrap that all up together, package it into 21 units across the country, and invite private and voluntary sector organizations to bid for contracts to run each unit. I think the private sector will be the largest contractor for those, but the opportunity will hopefully be there for some social investment solutions as well.
It offers, I think, interesting opportunities, but challenges as well. One of the important things about the Peterborough model that we’re using at the moment is that it’s not compulsory-prisoners opt to participate in the program. In fact, we have very high levels of engagement. The interesting thing will be if you get the same levels of engagement if it becomes a compulsory system.
Clougherty: You’ve mentioned the investors and you’ve mentioned the service providers. I just wanted to get a little bit more detail on them. We’ll start with the investors. Now, you talked about the Peterborough social impact bond, and the money mostly coming from high net worth individuals and foundations. Are they doing it as a philanthropic venture or are they more concerned about the bottom line? Because it’s interesting that where this is being tried in the U.S., Goldman Sachs has been among the investors putting up money. You’d assume that the specifics of the contract and the profit margin at the end of it may figure more heavily in their calculations than it did for your investors. Is my characterization correct? And how do you see the investor space developing?
Newman: Yes, I think it’s very interesting. We would have been very interested to have more financial investors in the first round had there been that interest, but we recognize that the risk profile of Peterborough means that your maximum return is that 13 percent and there is the possibility that you would lose all your money. It’s a model program and the first of its kind, and that, to some extent, shapes the investors. Also, among the investors that we had-the lead investors-some were foundations that had been grant-making in this area. So their perception of risk would’ve been different because they had an understanding of the kind of things that work.. That shaped the first investment.
I think as we’ve moved on in the UK, we have a broader investor base. It’s still predominantly foundations and high net worth individuals, but there are also funds there. There’s Big Society Capital, which is there to make an investment, and there’s Bridges Ventures, which is also a social investment fund managing money. Internationally, the sector is broadening. The challenge is that to broaden the investor base, you need a track record-you need to have results and show that these things can work. There’s also the question of what the risk/reward balance is.
So we expect the investor base to broaden and we’re already seeing that. Certainly, if you look at the recent bond that’s been issued in Australia for the Newpin intervention, that has a different risk profile and will probably attract a different kind of investor.
Clougherty: Let’s talk about the service providers. You said they were undercapitalized and in some cases small non-profit service providers. Do you see that changing? Do you see bigger, more established social enterprises emerging, which are not charities on the traditional model, but are operating on a non-profit, philanthropic kind of ideal? Moreover, do you see the big for-profit players getting increasingly involved as well?
Newman: If you take the rehabilitation transformation in the UK and the large-scale contracts that will be bid there, I think it’s undoubtedly the case that the big, for-profit contracting organizations will be interested in those and are likely to be large participants in them. But we very much hope to see stronger social enterprises-not just charities, social enterprises-coming into the arena. Part of our philosophy is that this is an opportunity for the organizations that we work with, who are actually running these sorts of programs already, to participate in a program over 7-8 years, so that they have certainty of income, and know that if they continue to perform, they will have the opportunity to innovate and to grow. You use that stable funding base and grow around it. That’s very much a part of our core philosophy, to help that.
Clougherty: Social impact bonds have certainly captured the attention of policy makers, certainly in the UK, the US and Australia as you’ve mentioned. I’m curious to know-beyond recidivism reduction, what other areas are social impact bonds going to work in? Are there other areas which are already in play or already ongoing? And are there new areas that aren’t tested yet where you think social impact bonds may have a role to play?
Newman: I think there’s a lot of exploration going on at the moment. In the UK, there are now four or five different issue areas. We are managing a project with Essex County Council which is targeted at young people on the verge of being taken into care by social services. That’s an intensive therapeutic intervention with the objective of keeping the family together, and avoiding the children going into care with all the consequences that come with having the state as your parent. There’s a very strong economic case for that as well.
There’s also some work around homelessness projects here, and programs which are focused on keeping young people in pathways to employment, improving their employability skills, stopping them from dropping out of school and things like that. Along with adoption-where another program was recently announced-these are areas that are already in operation in the UK.
Two of the Australian models are focused on different ways of tackling care issues. There’s also quite a lot of interest in early childhood development, focusing on the early years and seeing if a model could be built around that. A pilot, I think-not a social impact bond, but a demonstration project-was announced recently in the U.S., and we’re doing some work on that as well here in the UK.
There are a lot of areas being explored. The important thing though is that you need to have something which is quite focused. You need to have a target group that you’re going to work with, so you know who it is and who you’re going to measure. To get investors you need to have a defined cohort.
The other thing that’s important is that you really need to have a problem that is expensive for the state and have some well-structured programs that have an evidence base showing they they can tackle those problems. You need the cost of actually of providing the intervention to be modest compared to the actual cost to the state, so you can see that there’s that economic balance in your favor. This is why something like children in care is quite interesting, because the cost of care is very expensive. Any type of residential care is usually expensive. If it’s being spot-purchased or purchased on an incremental basis, and if by reducing the need for it you’re creating a saving, then there are quite strong economics around social impact bonds. Obviously, in this case not going into residential care also has to be the right thing for the individuals concerned.
Clougherty: One thing I see as a potential challenge in social impact bonds-and in fact, in performance-based contracting in general-is that governments often struggle with performance assessment. It’s not something that the public sector has traditionally tended to do. Given how central performance assessment is to the social impact bond concept, does this pose a challenge to their implementation? If so, how are you dealing with that? How are you making sure that governments, when they enter into these programs, assess performance correctly and do it in a way that is going to encourage future investment and participation?
Newman: Performance is fundamental to the structure. It’s fundamental because a social impact bond would be designed to measure improvement. So you need to have good data, and you need to have the data constructed and accessible in a way which is aligned with your objective.
I think the difference with social impact bonds compared to direct contracting with government is that in normal contracting it may well be that a lot of data is generated, but what happens to it? Could it be used better to drive performance? The interesting thing about a social impact bond is that it brings in a third party who is remunerated by reference to the results measured and captured by the data. That means there’s a third party with a stake in that performance assessment, so you have to design the social impact bond with it in mind. And this creates a robustness to that thinking because if you can’t actually get the robust data and a proper basis of measurement in the program design, then it’s not an investable prospect.
We actually get quite excited about this because we see it as a way of introducing third party interest and motivation to get government to think about data and performance in a really dynamic way. Some governments who have looked at this idea, one of the reasons they’re engaged with it is that they see it as an opportunity to look at performance in a new and refreshing way.
And when you have the data accessible, people can see better what works. That’s what we find in Peterborough. In the beginning you design a project in a certain way, and then you discover that some services aren’t being used, and you ask yourself why they’re not being used. Is it because they’re not needed or because we’re not engaging with the people in the right way? And we have changed the program to respond to what we’re seeing. The investors in that bond and in other ones get that information, and they’re really excited by it because they’re seeing feedback and reporting which is more granular than we’d normally see. And we’re getting a real sense of what’s effective on the ground.
Clougherty: And it’s fairly immediate as well, based on what you’re saying?
Newman: Yes. I think it’s quarterly in Peterborough, and some of our other programs have monthly board meetings.
Clougherty: Many of our readers are policymakers and officials around the United States who are thinking of launching these kinds of programs, maybe their first social impact bond program. If you had to give them some advice on the things they absolutely must do, and the things they absolutely must not do in order to have a successful first program, what would you say?
Newman: One of the most important things is to keep it simple. There’s a temptation to design things with multiple metrics and multiple measurements, but that creates a level of complexity that is difficult to talk to investors about, and it creates a cost as well because you have to have the measurement structure and the data coming in for each of those.
Another important thing that we have found is that the debate and the interest in social impact bonds centers around programs which generate cost-savings, and are therefore self-funding. But one of the problems, very often, is that the part of government commissioning the bond and paying for the outcomes is not necessarily the recipient of all the cost-savings. It’s important to find an area where costs and savings are relatively well aligned, because if you try to group all the beneficiary public departments together you end up having an impossible conversation-who’s going to pay for what-that makes the whole program excessively complicated.
The other thing I think is that it’s important for the program to have economic value, but it’s also important to consider the wider benefit-the un-cashable savings-when you think through the value that you are generating. So for example, if we’re reducing reoffending, there’s obviously a benefit to the population in Peterborough-not having unsafe streets and low-level crime. We can’t cash that saving, but it has a value, so that’s important.
Finally-and we see this everywhere-you need to realize that when you’re starting out, it takes longer than you think to design social impact bonds. But it’s really important to go through a meticulous and thorough process because that’s what will make it investable. And that development process has value because you’ll learn more about the issue, and so you will move the dial in that process. But I think Peterborough shows the power of an exemplary transaction in getting something done. You learn a lot from doing it and it creates momentum for new opportunities. So get on and do it!
Clougherty: If I could just ask a couple of final questions about other aspects of Social Finance’s work. The first one is related. You established a social impact venture capital trust. Tell us a little bit about that.
Newman: Yes. The capital we were raising for the social impact bonds is targeted at non-retail investors, and that is a function of our regulatory environment in the UK. We were interested in expanding the capital available for investing in social issues and broadening it to a retail investor base so there was an opportunity for people to invest in their own communities. The way we chose to do that was through the venture capital trust. The venture capital trust is a fund, so it can be marketed to retail investors-they get a tax credit, so it’s attractive for them to invest-and then the money going to the fund would be invested in a range of different social or charitable organizations. For the moment though, we have closed the VCT early and before we reached the minimum subscription level-the government has started a consultation process for a social investment tax relief, which may in the end result in a more suitable retail investment vehicle for the sector.
Clougherty: One last question, which may be a slight diversion from our previous conversation. I saw on your website that you have some activity related to mutualization, a process in which groups of public sector workers “spin out” to form independent, employee-owned mutual organizations, which could then bid for contracts to deliver privatized services. Is that something you see happening a lot? Is it just getting started? What attracted Social Finance UK to working in that particular field?
Newman: I think one of the issues associated with the criminal justice reform around probation-and the whole rehabilitation revolution-is that it’s likely that some of the existing probation service organizations will spin out of the public sector as mutuals. So some of the interesting potential social enterprises for that area are likely to be mutuals, which means it’s part of our world now. It’s a small part of what we do, and I think there was probably an expectation or a desire from government for the mutual agenda to grow more quickly than it has done actually. But I think that if you take something quite as large as the rehabilitation work, then there’s a possibility for that to take a bit of a step change.
Jane Newman joined Social Finance in 2012 as International Director. She leads work on developing an international network of impact investment intermediaries to develop Social Impact Bonds. She joined from The Social Investment Business, the UK’s largest social investor, where she was Director of Governance and Company Secretary; prior to which she was a senior corporate partner at a leading international law firm, Simmons & Simmons, where she advised a wide range of clients across the commercial and financial sectors. She has broad international experience, leading transactions in a range of jurisdictions, and also held positions as managing partner of Simmons & Simmons’ German operations and as head of its Mainland China office.
Other articles in Reason Foundation’s Innovators in Action 2013 series are available online here.