Giving Compass’ Take:
• Mary Margaret Frank and Stefano Rumi discuss the Pay for Success funding gap and what can be done to fill it.
• Is Pay for Success the model that makes sense for the issues you want to tackle?
• Learn about impact investors funding pay for success programs.
The adoption of Pay for Success contracts (PFS), also known as social impact bonds, has spread across the world. PFS is a public- private partnership in which the government contracts with a service provider to furnish an intervention to address a societal issue, and private investors provide financing for a performance-based financial return. As of April 2019, $431 million have been raised for 139 projects launched, and by the end of 2018, more than 69 more projects were in development.
However, PFS represents only 0.001 percent of the $79.2 trillion in global assets under management. So long as PFS fails to attract more interest from traditional investors, its ability to scale will remain unfulfilled. And there is good reason to think that PFS will continue to face a funding gap from traditional investors.
If PFS is going to scale using capital from private investors, the government must get a better handle on the risks and costs of such contracts. This is not an easy problem. Typically, the government employs a simple direct contracting model that uses tax revenues to pay a fixed fee for the services provided. Performance risk and innovation risk from new interventions still exist and are borne by the government, but their price is unknown.
One way the government can assess the price demanded by investors to bear the performance risk is by implementing performance-based payouts in its direct contracts with service providers and requiring the same method of evaluation demanded for PFS. Many proponents of PFS demand the costly gold standard of randomized controlled trials (RCT) to ensure that the investors, not the government, bear the risk of the provider’s underperformance. The investors then demand a higher return for assuming the performance risk. By not following the same performance-based payments and high standards for evaluation in its direct contracts, the government accepts the risk of nonperformance, which society bears. PFS simply places an explicit price on performance risk and forces the government to decide if it is willing to pay to mitigate the risk in its contract for services.
Thanks to philanthropic capital, which pays for due diligence, monitoring, and evaluation, and absorbs some of the investors’ financial loss by acting as a guarantor, the government currently pays a discounted price to transfer the risk to the investor. Repetition will create learning, data, and measurement infrastructure, reducing the costs of risk bearing. Unfortunately, this reduction is limited, because scale will likely be achieved by engaging new governments, introducing new interventions, and expanding to new providers—generating new performance and innovation risk. Thus, the government’s willingness to bear risk or pay the price to transfer it to investors will influence the need for philanthropic capital.
Despite such challenges, PFS will undoubtedly tap some of the almost $80 trillion of assets under management. The question is how much it can tap given investors’ other opportunities. Private equity investors, who take on more financial risk and have extensive due diligence, evaluation, and monitoring costs, expect financial returns of 20-25 percent. Investors in public securities demand market returns because they can diversify away security-specific risk. Given the investment opportunities available to these investors, future PFS contracts will likely support interventions with less risky social outcomes or continue to need significant capital from philanthropies and the growing impact investor community.
For our purposes, impact investors are willing to take lower financial returns or wait longer for their return because they also seek social impact. While some impact investors are committed to the success of PFS, many seek the greatest social impact irrespective of the funding vehicle. Because impact investors also seek financial returns, PFS must compete to deliver the financial and social returns that justify the risks vis-à-vis alternative social-investment vehicles. Even if PFS could compete on both fronts, impact investing assets are small compared with the trillions in global assets.
Read the full article about the Pay for Success funding gap by Mary Margaret Frank and Stefano Rumi at Stanford Social Innovation Review.
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