Announced today, a first-of-its-kind $10 million fund from Reinvestment Fund hopes to accelerate the pipeline of pay-for-success transactions (also known as social impact bonds) by changing the way investors get involved in financing projects designed for social good in the U.S.
Instead of bringing on investors one deal at a time, Reinvestment Fund is taking a portfolio approach and pooling money into a single fund that will only make pay-for-success investments. When Reinvestment Fund finds a deal that it likes, it won’t have to turn around and conduct a search for investors who are interested in a certain geographic area or issue.
“The PFS Fund offers an innovative organized capital source that will bring efficiency to these transactions by reducing costs and speeding deal execution,” said CEO Don Hinkle-Brown in a statement.
Even though they are relatively new (see Next City’s “Can Social-Justice Minded Investors Change How Cities Do Business?”), pay-for-success deals aren’t that much riskier than conventional public financing, in theory. They’re a shift in who holds the lion’s share of the risk. Normally, when investors buy municipal bonds, they get paid back no matter what the outcome — so that taxpayers ultimately bear most of the risk. They have to pay back investors whether or not the thing that the bond financed is delivering the social outcomes it was meant to deliver. Investors can be confident that it’s extremely rare for state or local governments to default or file for bankruptcy, although it does happen (like Puerto Rico did in May).
In a pay-for-success deal, if the new thing that investors finance doesn’t deliver the agreed-upon social outcomes in an agreed-upon timeframe, investors lose their money, and taxpayers don’t have to pay anything. The model has been used from Denver to South Carolina, on issues that include neonatal care for poor women and reducing homelessness. If everything works out, the idea is that savings elsewhere in the public sector (like fewer homeless people in city-supported shelters) ultimately result in a windfall for taxpayers as well, even after paying back investors with interest.
But everything doesn’t always work out. In the first U.S. pay-for-success deal, which targeted reduced recidivism for adolescents imprisoned on Rikers Island, the program failed to meet its social outcome goals. Goldman Sachs invested $7.2 million into the deal, and would have lost all of it if Bloomberg Philanthropies had not set aside $6 million as part of the deal to guarantee against investor losses. Goldman Sachs ended up losing the difference: $1.2 million.
As you might expect, investors aren’t exactly jumping at the chance to take on more of that kind of risk, which is partly why pay-for-success deals have been relatively few and far between. PayForSuccess.org, a project of the Nonprofit Finance Fund to document such deals across the U.S., lists one finished pay-for-success transaction (the Rikers Island deal), 12 pay-for-success deals currently financed and in progress, and another 59 currently in development.
Reinvestment Fund is ideally positioned to bring new investors into community development using the model. It is one of five S&P-rated CDFIs (community development financial institutions). With an S&P rating of AA, Reinvestment Fund has a higher rating than nine states.
The portfolio approach also helps reduce risk: If any one or more of the deals financed under the fund fails, as some are sure to, the returns from the others can hopefully cover for failures and ultimately the fund as a whole can provide the kind of financial and social return that can attract more investors into this fund or other funds like it in the future.
Reinvestment Fund is already learning from being part of two pay-for-success projects currently in progress. One in the Cleveland metro area seeks to reduce the amount of time that the children of homeless caregivers spend in out-of-home foster care. Another in Silicon Valley aims to reduce homelessness and the public cost of caring for chronically homeless individuals.
Who the investors are also matters. They need to have patience, even if they want competitive financial returns. With a pay-for-success transaction, it may take years for the investments to mature — which in these cases means the social impact has been delivered or not delivered in the specified timeframe. Reinvestment Fund’s Cleveland metro pay-for-success deal has a five-year term, with repayments timed for 2019 if everything works out.
Future pay-for-success deals may have even longer terms. For years, social scientists have known that investing in early childhood education provides the most bang for the buck. But who has the patience to invest in something now and not get paid back for well beyond a decade?
A hint may come from the largest investor in Reinvestment Fund’s new pay-for-success fund: QBE Global Insurance Group, one of the world’s 20 largest insurers, put in $7 million. Insurance companies have a lot of patience when it comes to their investments.
U.S. insurance companies take in $2 trillion a year in premiums, and they can forecast pretty accurately what they’ll need to pay out in claims every year for decades into the future. So every year, after paying claims, salaries and operating costs, they invest the rest, earning handsome returns. As of 2015, the most recent year of available data, insurers held around $5.8 trillion in investments, including $3.9 trillion in bonds. QBE alone holds $25 billion in investments, two-thirds of which are in corporate or municipal bonds.
What insurance companies generally look for are relatively large investments with high ratings and diversification across different geographies and sectors — something that CDFIs are starting to provide. Last month, Reinvestment Fund and LISC sold a cumulative $150 million in unsubsidized corporate bonds, the first sales of their kind from CDFIs. Insurance companies invested in both bond offerings.
Reinvestment Fund’s Pay-for-Success Fund could build off that momentum.
“We believe this financing mechanism has an important role to play in directing capital to what works, while aiming to make a financial return as well as a difference to communities,” said Gary Brader, Chief Investment Officer for QBE Insurance Group, in a statement announcing the new pay-for-success fund.
Oscar is Next City's senior economics correspondent. He previously served as Next City’s editor from 2018-2019, and was a Next City Equitable Cities Fellow from 2015-2016. Since 2011, Oscar has covered community development finance, community banking, impact investing, economic development, housing and more for media outlets such as Shelterforce, B Magazine, Impact Alpha, and Fast Company.