Children play on a newly constructed playground by the community nutrition site in the village of Soavina in Madagascar. Photo: World Bank / Sarah Farhat
Talk to any public sector official and you hear a common refrain.
Large amounts of private sector financing is needed to bridge the development gap. Financial innovations such as green and sustainable bonds have been successful in tapping capital from large institutional investors, but they don’t promote risk sharing.
Social Impact Bonds (SIBs) can help bridge this divide but they haven’t lived up to their true potential. Here I outline five possible ways to overcome some of the structural issues that have been holding SIBs back.
What is a social impact bond?
A SIB is a pay-for-performance instrument that incentivizes investors to take the risk of a certain project achieving specified social outcomes in exchange for a potential financial reward.
The basic structure of a SIB is like any other bond. An issuer borrows funds from an investor for a certain period. Instead of offering a fixed return, SIBs are structured to pay coupons (and the principal itself) linked to successful performance of pre-identified metrics against baseline levels.
These performance payments are usually financed by a donor, or “outcome funder”. Investors can lose some or all their money if outcomes are not achieved.
What’s the value proposition?
SIBs offer several benefits. Issuers, typically non-profit or public sector organizations, or their Special Purpose Vehicles (SPVs), can tap into private sector funds at a time when public resources are scarce and face competing demands.
Many investors today are committed to socially responsible investing, and SIBs offer them the opportunity to make an impact. The use of independent evaluators to monitor project performance encourages transparency and accountability through objective data collection, measurement, and reporting. SIBs can also create efficiencies and reduce costs by shifting the focus from inputs to outcomes.
Track record
So why is it, then, that in the almost 10 years since the first SIB was issued, SIBs have mobilized only $424 million in total financing? To put this in perspective, over the same period, issuances of green bonds, an instrument pioneered by the World Bank, exceed $500 billion. Impact investments, meanwhile, exceed $228 billion.
One reason for these sobering volumes is that so far SIBs have only been structured to appeal to philanthropies, not mainstream investors. In fact, one can argue that far from raising additional amounts of funding, SIBs have merely transformed traditional grant making into an investment opportunity.
Bring back the bond
SIBs can be successful if they are structured like bonds, and not just customized contracts negotiated on a bilateral basis. The following changes have the potential to help SIBs mobilize meaningful amounts of private capital:
1. Market-based pricing
Reinsurers, asset managers, and pension funds use statistical models to price the risk in their alternative investments such as cat bonds.
They want to enhance yield by buying assets that offer uncorrelated exposure to traditional asset classes. SIBs could fit that risk profile, depending on the availability of historical data and the robustness of the quantitative modelling that could support the probability of expected outcomes.
2. Issuer risk retention
Investors putting their investment at risk want to be sure that the issuer’s interests are aligned with theirs.
If risk is entirely borne by the investor and the outcome funder, then the issuer’s commitment to the success of the project can come into question. The International Committee of the Red Cross (ICRC) solved this problem in their SIB by retaining some of the risk on their books.
3. Scale and transaction costs
Increasing the size of SIB offerings beyond the typical $10-20 million can attract investors who need liquidity and reduce transaction costs related to project monitoring and evaluation.
SIBs have traditionally focused on smaller projects. Scaling these projects at the city or state level can lead to more efficient interventions. Sponsors can also take advantage of the existing issuance infrastructure and market franchise of entities such as the World Bank to decrease costs and increase speed to market.
4. Tradability
Philanthropies who have traditionally bought SIBs tend to be buy-and-hold investors. Issuing and servicing SIBs through clearing systems and getting a credit rating can enable secondary market trading in these instruments, bringing in institutional and even retail investors interested in supporting the cause.
5. Principal protection
Structuring SIBs so that investors are guaranteed some or all of their principal back at maturity, with only the interest or a portion of the principal at risk, can also attract institutional investors who have mandates to protect the value of their original investments.
SIBs for the future
The last decade has seen a surge in investor interest for impact investing.
Investors still don’t want to compromise on their financial returns, but they are focused on impact. SIBs push that a step further with investors fully vested in the outcome of the project, and that is a good thing.
This blog post was originally published on Apolitical. Read the original here.
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