Building a Healthy & Sustainable Social Impact Bond Market: The Investor Landscape

Transcription

1 Building a Healthy & Sustainable Social Impact Bond Market: The Investor Landscape

2 Foreword Delivering improved social and environmental conditions at scale will require more money than public dollars, philanthropy and civil society contributions can provide. In the current economy, as most major American cities and states are facing staggering budget deficits, taxpayers and politicians are not willing to risk their dollars for testing programs that are not a guaranteed success. In addition, publicly funded attempts to help poor or vulnerable populations are often remedial, ineffective and expensive. In the meantime, there are prevention-focused interventions with proven efficacy that are not being identified, taken up and scaled by government or that require more capital than governments can provide upfront. As a result, poor or vulnerable populations in the US are not receiving the critical services they need. The Rockefeller Foundation believes that social impact bonds (SIBs) or pay-for-success financings could represent a new and potentially disruptive way to improve and pay for social service delivery while linking the government and the private sector in an unprecedented partnership to save taxpayer dollars. Social impact bonds were first piloted in 2010 in the UK with support from the Foundation and are now being launched in the US with our support. Over the past two years, we have been committed to galvanizing the energy others have for specific social impact bond deals into a larger social impact bond ecosystem, and thus ensuring that the innovation can be tested appropriately. In particular, we believe it is crucial to ensure the catalytic use of philanthropic funds and concessionary capital to develop high quality investment opportunities. By building a successful track record of transactions, we can engage the broader capital markets in capitalizing a scaled and sustainable social impact bond market. As part of this aim, we were pleased to partner with Godeke Consulting to conduct investor outreach and research to surface distinct concerns, preferences and insights critical to building a healthy and sustainable market for SIBs that can leverage capital from a diverse set of investors to deliver better social outcomes. This publication represents an important contribution to better understanding the investment landscape for SIBs. Over the next several months, we hope to continue to drive the field forward by catalyzing investor collaboration that brings together private foundations and commercially-oriented capital, leveraged into these deals initially by subordinated philanthropic investment. Our commitment to testing SIBs stems from the belief that this structure could represent the most tangible example of innovative financing we are likely to see for the next five to ten years. We hope you will join us in building this market to scale solutions to social problems facing poor or vulnerable communities in the US. We look forward to sharing our lessons learned and findings along the way from the Foundation s exploration into social impact bond and other innovative financing models. Kippy Joseph and Justina Lai, The Rockefeller Foundation Disclaimer The social impact bond opportunity sits at the nexus of the Rockefeller Foundation s work to support innovation and to harness the power of impact investing. The Foundation has funded this research report as a publicly-available resource for all stakeholders interested in supporting the development of a vibrant social impact bond ecosystem. Readers should be aware that the Rockefeller Foundation has had and will continue to have relationships with many of the organizations identified in this report, including through the provision of grant funding and program-related investments. The Rockefeller Foundation expressly disclaims any responsibility in the use of this report, including its potential distribution with any other materials, for investment purposes or otherwise.

3 Contents Acknowledgements 2 Executive Summary 3 Promise and Potential of Social Impact Bonds 5 Roadmap to Terminology Focus on Prevention Current State of the Pay-for-Success Financing Market Pay-for-Success Financing in the US Massachusetts Planned SIBs for Chronic Homelessness and Juvenile Justice Embracing Complexity Value Creation in PFS Financings: Is There a Free Lunch? 9 Who s at the Table and Why Potential Roles of Intermediaries The Investor Landscape 10 Research Methodology Philanthropy and Program-Related Investment Grantmaking and PFS Financings Program Alignment is Key Foundations as Infrastructure Builders Perspectives on Evaluation of Outcomes Role of Program-Related Investments The PFS Financing Capital Structure New York City Acquisition Fund Donor-Advised Funds as SIB Funding Vehicles The Other 95% of Foundation Capital Insights, Concerns and Preferences Community Development Financial Institutions and CRA Banks Challenge of Underwriting Social Services CRA Credit Matters Safety and Soundness Standards Structuring Considerations Government as Payor and Credit Enhancer? Insights, Concerns and Preferences Commercial Investors Commercial View of PFS Financing Risks Outcome Performance Risk Commercial Players Government Counterparty Risk Insights, Concerns and Preferences New York City s SIB for Incarcerated Youth Recommendations to Each Player at the Table 23 Government Philanthropy Service Providers Investors Conclusion 24 Attachments 25 Research Participants & Institutions Human Capital Performance Bond How Does a Social Impact Bond Work? Peterborough Social Impact Bond Operating Structure Resources About the Authors

4 Acknowledgements The Authors would like to thank all of the research participants from the fields of investment, philanthropy, government and non-profits whose expertise and insight have been the foundation of this project. We especially extend our gratitude to our Advisory Committee a dedicated team who shared their diverse perspectives on social impact bonds and served as our sounding board throughout the project. Their input and guidance has been invaluable: Jim Baek, Deutsche Bank; Laura Callanan & Jonathan Law, McKinsey & Company; government officials and non-profits as they partner with these investors in future transactions around the country. Finally, please let us know what you think. Please send any comments or feedback to info@godekeconsulting.com. We hope you find this report meaningful and helpful as we all work to move capital to more effectively address the critical social challenges we face today. Steven Godeke and Lyel Resner John Goldstein, Imprint Capital; Kippy Joseph & Justina Lai, The Rockefeller Foundation; and Lisa Kleissner, KL Felicitas Foundation. We would like to extend special thanks to Kippy Joseph and Justina Lai from the Rockefeller Foundation. Without their enthusiasm and support, this report would not have been possible. Our goal was to explore the landscape of potential social impact bond investors and determine the structures and institutions needed to create a healthy and sustainable SIB market. Since we began our research in early 2012, the US social impact bond market has transformed from simply being another good policy idea into a reality. We are pleased to be part of this dramatic change and hope that this report will not only whet the interest of investors for SIBs but also inform the strategies of philanthropists, 2 BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

5 Executive Summary Pay-for-Success (PFS) financings, sometimes known as Social Impact Bonds (SIBs) or Social Innovation Financings, have attracted much attention because they offer the promise of governments paying only for successful programs while also increasing funding for prevention programs by accessing the capital markets. PFS financings will need to reach beyond philanthropic funding and balance the sometimes conflicting priorities of investors and government if they are to meet their full promise. These PFS financings can create value by re-engineering the way in which social services are financed, but it is essential to understand the distinct priorities which will bring government, service providers, philanthropy and investors to the table. We spoke with more than ninety investors and other stakeholders over an eight-month period to understand the PFS investment landscape and determine the structures and investors that were most likely to attract incremental capital to the US PFS financing market. Our aim was to highlight distinct investor concerns, preferences and insights that inform the systems, structures and sequence critical to building a healthy and sustainable market for PFS financing. In these conversations and meetings, our goals were to: Put PFS financings on the radar of various investor types; Learn how those building the PFS financing market are thinking about how to attract investors; and Discover and share best practice for those currently sourcing, structuring and managing deals. Across this investor landscape, three distinct groups of potential PFS financing investors emerged with specific preferences and concerns: Philanthropy/Program-Related Investment (PRI) Makers; Community Development Financial Institutions (CDFIs) and Community Reinvestment Act (CRA) Banks; and Commercial Investors. For philanthropy, PFS financings can build on effective grantmaking strategies, and PRIs can provide cornerstone capital for the early transactions. CRA and CDFI capital can be a bridge between philanthropy and mainstream commercial investors. However, underwriting social service provision is new for these financial institutions and will require credit support until PFS financings establish performance records. Commercial investors stressed that outcome performance goals need to be clear, objective, measurable, and non-debatable; and that government counterparty risk needs to be addressed early in the negotiation. Credit enhancement will also play a major role in bringing commercial investors to the table by providing external collateral or supporting senior positions in capital structures. Creative risk sharing not risk transfer will be necessary to continued BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 3

6 Executive Summary address investor concerns about performance risk, illiquidity and deal flow. Finally, we recommended next steps to each of the players at the table to accelerate the growth of the PFS financing market: Government should be open to structures and public policies that will accelerate commercial investor participation. It should also share outcome performance risk with other stakeholders and incentivize investors to develop skills to eventually underwrite transactions without credit enhancement. Philanthropy should leverage existing program evaluation methodologies to construct better PFS financing evaluation tools for other investors. In addition to providing credit enhancement to PFS financing structures, philanthropy can also build constituencies for preventative services and the expansion of evidence-based projects. Service Providers should continue to develop clear evidence-based intervention models that are appropriate candidates for SIBs. The following report presents more detailed recommendations and insight into investor preferences and concerns, as well as the systems, structure and sequence needed to build a healthy and sustainable market for Pay-for-Success financings. For CDFIs and CRA Banks, PFS financings can be an opportunity to expand the reach of community and economic development. Investors will benefit from viewing PFS financings as a market opportunity to build expertise in the evaluation of social service performance risk. First-mover competitive advantage will come to those who invest resources and time in early transactions. 4 BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

7 Promise and Potential of Social Impact Bonds Social Impact Bonds (SIBs) and other Pay-for-Success (PFS) financings have attracted much attention from the public sector, philanthropy, social service providers and investors as a new tool to address complex social problems through a multi-stakeholder approach. Pay-for-Success financings have the following basic characteristics: A government entity enters into a contract to pay for social outcomes, e.g. declines in prison recidivism rates not just outputs; Investors fund the cost of running the program which creates the social outcomes; The government pays investors for the costs of these services plus a return on their investment if the social outcomes are created; and The outcome performance risk may be transferred to the investors or shared among the stakeholders (investors, philanthropy, service providers and the public sector). PFS financings hold the promise of increasing needed funding for prevention-focused services and ultimately unlocking more capital beyond philanthropy to address social issues. Roadmap to Terminology Due to the newness of this approach, the language describing Pay-for-Success (PFS) financings, Social Impact Bonds (SIBs) and Social Innovation Financings remains unclear. While governments have long used Pay-for- Performance contracts to provide public services, the payments have been contingent upon outputs, not outcomes. Pay-for-Performance contracts are typically executed between government and service providers and do not involve investors. In PFS financings, the government pays only for outcomes. The term Social Impact Bond was first used in the UK to describe a Pay-for-Success model in which the outcome performance risk was entirely transferred from government to investors. Social Innovation Financing has been used to describe the SIBs being developed in Massachusetts. While earlier discussions have emphasized the full risk transfer of the outcome performance risk from government to investors as essential to the structure, future transactions, especially in the US context, are expected to encompass risk sharing. A SIB is not a bond and does not have a set repayment schedule or interest rate. A SIB is a multi-stakeholder partnership based on contracts that define the targeted outcomes, risk sharing and payment mechanisms among the partners. The government s obligation to pay SIB investors is a contractual obligation; it is distinct from a general obligation, moral obligation or revenue bond. Other types of Pay-for-Success financing include Human Capital Performance Bonds (HUCAPs) also known as Minnesota Bonds. 1 In HUCAPs, investors purchase bonds and the proceeds fund a performance payment pool which is disbursed to service providers upon the achievement of preestablished performance targets. Service providers must access working capital from other sources and assume the outcome performance risk. 2 In this report, Pay-For-Success financing will be used except when describing specific SIBs such as the Peterborough transaction in the UK. Focus on Prevention The public sector has traditionally funded social services by focusing on remedial interventions such as prisons and emergency medical care rather than more cost-effective preventative measures like alternatives 1 For a range PFS/SIB resources, see the Nonprofit Finance Fund s PFS/SIB Learning Hub: 2 See Attachment 2 for graphic of the Human Capital Performance Bond in Minnesota. BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 5

8 to incarceration programs or wellness programs. The reasons for this misallocation include legislative mandates to provide public services, the shortage of public operating funds to scale evidencebased preventative demonstration projects, and the lack of clear constituencies to advocate for prevention. These inefficiencies provide an opportunity for investors to fund these interventions and deliver sufficient cost savings to the public sector to repay the cost of the intervention, providing a return to investors while still saving taxpayer money. In other words, governments are good at providing ambulance P services at the bottom of cliffs for those who fall, but tend not to invest in building fences at the top of cliffs to prevent the falls in the first place. This leads to fewer resources for preventative programs, which in turn creates more demand for higher cost safety-net services. PFS financings monetize the economic value of positive social impact from prevention and early intervention programs while providing a net cost savings to the public sector. The following hypothetical PFS financing describes the basic economics and mechanics, from both the investor and government perspectives, of how these structures can monetize the value of prevention compared with the cost of operating remedial programs. 3 Pay-for-Success Financing Prison Recidivism 3 For a detailed description of the structure and stakeholders of a SIB, see Attachment 3 How Does A SIB Work from Callanan, Laura, Jonathan Law and Lenny Mendonca, From Potential to Action: Bringing Social Impact Bonds to the US, McKinsey & Company, May 2012, pp BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

9 Current State of the PFS Financing Market The social impact bond concept emerged from work by the Young Foundation 4 in the UK that focused on new investment approaches to social problems and the potential for cost savings from prevention. This effort drew upon a range of existing methods which link investment return with the creation of social outcomes such as pay-for-performance contracts, advanced market commitments to incentivize R&D in drugs for developing countries, and tax increment financings which fund public infrastructure in anticipation of future increases in tax revenues. The first SIB was launched in September 2010 to fund a program to reduce the expected 60% prison recidivism rate among 3,000 male, short-sentence prisoners leaving Peterborough prison near London. In the structure, Social Finance, Ltd., an NGO, raised 5 million from 17 investors. Social Finance, Ltd. is working with four experienced social service providers to assist the prisoners and their families. The UK Department of Justice has agreed to repay the investors their principal investment plus 7.5% if the recidivism rate is 7.5% lower than a comparable control group of former prisoners who are not in the program. If the program creates better results through lower re-conviction rates, the return to the investors can increase up to 13.5%. The investors bear all outcome performance risk and will lose their entire investment if they do not meet the 7.5% minimum reduction. 5 Other countries, including Australia, Ireland, Scotland, Israel, Germany and Canada are also exploring the structure and are expected to launch transactions. Social Finance, Ltd. is leading a project to explore how to apply the SIB model in emerging markets. 6 Pay-for-Success Financing in the US Several factors are driving the creation of the PFS financing market in the US. Unlike the more centralized government structure of the UK, many of the functions and funding for social programs in the US that are candidates for PFS financings are shared across multiple levels of government. Therefore, PFS financing will require significant coordination across federal, state and local governments and agencies. While the complexity of PFS financings in the US may be greater than their UK counterparts, this has also created a more grassroots approach and openness to adapting the basic structure to local conditions and stakeholders. This bottom up phenomenon is expected to create local differences among the early transactions. The social issues addressed, depth and nature of the political support, investor risk appetite and availability, and capacities of service providers are all expected to vary significantly across communities. 7 To date, state and local governments have been the primary source of activity for SIBs with New York City and Massachusetts leading the way; 4 Geoff Mulgan, Neil Reeder, Mhairi Aylott & Luke Bo sher, Social Impact Investment: the challenge and opportunity of Social Impact Bonds, The Young Foundation, November 2010, Revised March See Attachment 4 for the Peterborough SIB operating structure See Nonprofit Finance Fund, Risk Trade-off Continuum for Different Structural Approaches to Pay-for-Success Financing, April BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 7

10 however, in some states, such as Connecticut, citizen groups have been the catalysts to begin the conversation with government. In August 2012, New York City, Bloomberg Philanthropies and Goldman Sachs announced a fiveyear $9.6 million SIB to reduce the recidivism rate of incarcerated youth. 8 There is also significant preliminary work occurring in jurisdictions around the US including New York State, Minnesota, Detroit, Los Angeles County and Cuyahoga County Ohio. At the federal level, the White House has supported Pay-for-Success demonstration projects as part of an effort to fund more evidence-based programs. President Obama directed $100 million of existing funding in the 2012 budget toward Pay-for-Success programs. As part of this effort, the Department of Labor and the Justice Department are currently soliciting grant proposals from state and local governments for PFS financing pilots in criminal justice and workforce development. Embracing Complexity As multi-stakeholder public private partnerships, PFS financings need to navigate the complexity of working with and delivering results across sectors as well as monetizing savings from a variety of sources. Although this Massachusetts Planned SIBs for Chronic Homelessness and Juvenile Justice In 2011, Massachusetts, with strong political leadership from Governor Deval Patrick, began a formal process of gathering ideas for SIBs through a request for information. The state then issued a request for response in January 2012 for SIBs in two issue areas: chronic homelessness and juvenile justice. The legislature passed a bill to establish a mechanism for the state to fund this $50 million initiative, which Governor Patrick signed into law. In August 2012, Massachusetts selected the service providers and the intermediaries which will operate the programs. These SIBs are expected to be funded by the intermediaries borrowing from foundations, individuals and other investors. Initial investors in the Massachusetts program are expected to be philanthropists who seek to achieve concrete social outcomes and in some cases seek financial returns. State-level administrators in Finance, Health and Human Services and the Department of Housing and Community Development have commenced negotiations with the intermediaries and service providers and are expected to finalize the underlying contracts and performance benchmarks in the fall of The juvenile justice contract will be designed with the specific goal of reducing recidivism and improving education and employment outcomes over several years for a significant segment of the more than 750 youth who exit the juvenile justice system, and the several thousand who exit the probation system, annually. The chronic homelessness contract will provide stable housing for several hundred chronically homeless individuals and raise the number of housing units in Massachusetts from 220 to approximately 600. The goal of the initiative will be to improve the well-being of the individuals while simultaneously reducing emergency shelter and Medicaid costs. 9 8 See Commercial Investor Section for more details about this transaction and its implications for the SIB market. 9 Commonwealth of Massachusetts Press Release August 1, BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

11 will be a challenge, this complexity may be one of the reasons that the public sector has not, to date, been able to successfully scale some interventions. Services delivered through traditional siloed systems can be poorly equipped to provide the necessary coordination and flexibility. For example, a formerly homeless person not only needs a home, but also the full range of social and medical services provided by supportive housing to stabilize and ultimately succeed. Value Creation in PFS Financings: Is There a Free Lunch? PFS investors can play a critical role by providing the risk capital to scale preventative programs in exchange for a return on their investment. This risk and return tradeoff will only be achieved with interventions in which there are sufficient savings to compensate the investors as well as provide cost savings to the taxpayers. In most cases, the investor is bridge-financing the cost of scaling evidence-based social interventions that were developed with philanthropic grants but have not been funded by the public sector. By providing this bridge financing, the investor capital can create a disruptive change that shifts funding from outputs (prisoners incarcerated) to outcomes (successfully reintegrating former prisoners into communities) while increasing the capital available for prevention. PFS financings are not privatization of the provision of social services in fact, most US state and local governments already deliver social services through contracts with nonprofit and for-profit service providers. PFS financings shift the terms of those contracts from buying outputs to a contingent payment based on the creation of social outcomes. Not all outcomes that are beneficial to society can be readily converted into direct cash savings by government. For example, in a pro-forma analysis of a juvenile justice SIB by McKinsey & Company 10, approximately 25% of the total benefits accrued to taxpayers while the balance went to the participants in the program and to other members of society. This distinction between monetizable and non-monetizable social benefits may influence the selection of the interventions. Who s at the Table and Why By linking the distinct interests of the public sector, service providers, philanthropy and investors to the creation of social outcomes, a PFS financing can generate value for all parties. The execution of a PFS financing requires tight coordination of several systems: sound research on evidence-based interventions, economic valuation of the social outcomes and the development of a series of contracts to codify these agreements. A PFS financing can create value by re-engineering the way in which social services are funded, but it is essential to understand the distinct value propositions which will bring government, service providers, philanthropy and investors to the table. 10 op. cit., McKinsey & Company, 2012, pg. 49. BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 9

12 Pay-For-Success Financing Value Proposition by Stakeholder Shift outcome performance risk and upfront cost to investors Creation of outcomes not just outputs Improve lives of beneficiaries Expansion of preventative services Monetize cost savings of prevention Uncorrelated return and diversification Risk-adjusted return on investment Government Service Providers Philanthropy Investors surfacing ideas in the public sector, coordinating service providers, raising capital from investors, working with evaluators and managing the transaction during its multi-year life. These intermediaries can operate as non-profits or for-profits with expertise in particular interventions or regions. Ultimately, intermediaries could aggregate investor capital, brokering deals and acting as fund managers operating on a fee basis and possibly assuming a share of the outcome performance risk. However, given the early stage of this market, intermediaries are expected to require upfront philanthropic funding to support their capacity building work. s the government, The priorities and value propositions of PFS financings (positive, neutral or negative) for the stakeholders tend to fall into two clusters: the government, service providers and philanthropy have similar priorities, but the investors priorities are quite distinct and in a few cases at odds with the goals of the other stakeholders. As outlined above, direct conflicts arise between the government s priority to transfer the risk of generating outcomes to the investors and the investors priority to receive a risk-adjusted return on their investments from the government. Successful, scalable PFS financings will require a balancing of these sometimes conflicting priorities. Potential Roles of Intermediaries While community leaders or advocates for a specific issue can coalesce around the creation of a PFS financing, intermediaries are expected to play an important role in catalyzing these complex public-private partnerships by The Investor Landscape Adiverse investor base will play a critical role for PFS financings to meet their full promise. While most early proof-of-concept transactions are expected to largely rely on philanthropic capital, there is clear value in including commercial investors at the table even if their participation requires significant financial support. While most early transactions are expected to rely on philanthropic capital, PFS financings will eventually need to tap into the capital markets to access larger pools of capital and ensure philanthropic funds are not cannibalized. Assessing the current investor demand for PFS financings is a classic chicken or the egg problem. Surfacing preferences for a product that has virtually no track record is a significant challenge. On the other hand, in order to establish a track record that satisfies the needs and preferences of investors, they 10 BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

13 have to be engaged and given a seat at the table from the outset. Our investor outreach aimed to highlight distinct concerns, preferences and insights that inform the systems, structures and sequence critical to building a healthy and sustainable market that can draw from a diverse set of investors. More detailed investor preferences will emerge through the negotiation of specific transactions. Research Methodology A broad spectrum of over ninety investors and other stakeholders were engaged through interviews and meetings in order to understand this investment landscape and determine the structures and investors that are most likely to attract incremental capital to the US PFS financing market. These stakeholders included Academics, Banks, Community Development Financial Institutions (CDFIs), Family Offices, Foundations, Fund Managers, Insurance Companies, Non-Profit Intermediaries, High Net Worth Investors, Legal Experts, Pension Funds, Public Sector Representatives, Rating Agencies, Social Service Providers, Consultants and Wealth Advisors. 11 In these conversations and meetings, the goals were to: Put PFS financings on the radar of various investor types; Learn how those building the PFS financing market are thinking about how to attract commercial investors; and Discover and share best practice for those currently sourcing, structuring and managing deals. Through these conversations across the investor landscape, three distinct groups of potential PFS financing investors emerged: Philanthropy/Program-Related Investment (PRI) Makers; Community Development Financial Institutions (CDFIs) and Community Reinvestment Act (CRA) Banks; and Commercial Investors. In the following sections, we share how these investors would approach PFS financing risk and seek to mitigate it, as well as other concerns, insights, and preferences regarding their participation. We conclude with recommendations to government, philanthropy, service providers and investors about their distinct roles in building this market. Philanthropy and Program- Related Investment (PRI) Grantmaking and PFS Financings Pay-For-Success financing and effective grantmaking require similar skills and tactics. Effective grantmakers and PFS investors both need to assess the ability of service providers to operate programs and to deliver targeted outcomes. Many early PFS funders are expected to be philanthropic funders providing grants. Program Alignment is Key While some foundations will support a PFS financing as an innovation or public private partnership, most foundations will require clear program alignment between their mission and a proposed transaction. As a foundation officer said, start with the social issue you want to address and figure out who cares about the issue and the 11 See Attachment 1 for Research Participants and Institutions. BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 11

14 impact created. You can t start with the focus on the financial tool. For example, foundations that make grants in specific social service areas such as homelessness or juvenile justice would be well positioned to also fund PFS financings in those areas. The Annie E. Casey Foundation, a national foundation focused on disadvantaged children and youth in the US, looks to PFS financings as a grant strategy to increase the number of effective, evidence-based practices driving systems change and policy. Some foundations, which have focused on public sector budget policy using grants and advocacy, may see it as a new tool to improve the public sector s allocation of resources. PFS financings will appeal to foundations that are interested in creating more efficient and scalable programs and want to move funding from remedial programs to preventative programs. Foundations as Infrastructure Builders Foundations can also support PFS financings by funding field building research, bolstering intermediaries and supporting evaluation design. Foundations are using their roles as conveners in their communities to explore PFS partnerships with government investors and service providers. Community foundations are especially well suited to convene stakeholders to brainstorm specific sectors and interventions. Perspectives on Evaluation of Outcomes Given the direct connection between the generation of social outcomes and investment returns in the PFS structure, foundations with highly evolved evaluation systems are likely to participate in PFS financings. Several funders have been cataloging or supporting research to document proven social interventions which would be candidates for PFS financings. However, the level of evidence which funders use to assess their grantmaking varies widely. Some funders, such as Robin Hood, a New York City-based foundation focusing on poverty reduction, require evidence of a counterfactual in order to test the effect of a specific intervention. 12 Other foundations may choose to focus their support on organizations rather than specific interventions. Funders will also want to make sure that the target outcomes are truly incremental at the societal level and not just a transfer of costs from one system, e.g. the justice system, to another such as education, healthcare or housing. Although the negotiations between the public sector, investors and service providers should establish credible outcome targets, some funders voiced the concern that outcome targets will not be rigorous enough. Given that societal benefits which can be monetized and therefore used to structure a PFS financing are only a subset of the total benefits, the priorities of government, service providers, philanthropists and investors can easily diverge. Role of Program-Related Investments The PFS financial return combined with measurable social impact should attract significant capital from PRI makers. The US tax code defines PRIs as investments made by private foundations in support of their charitable purposes without an 12 Weinstein, Michael, Measuring Success: How Robin Hood Estimates the Impact of Grants, BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

15 expectation of a commercial return, adjusted for risk and mission. PRIs are often made by foundations to: Attract public and private contributions to leverage commercial financing for high value projects and initiatives; Strengthen the capacity of recipient organizations by improving cash flow, increasing access to capital, building financial capacity and fostering longterm sustainability; Enable foundations to manage and increase their distributions through economic cycles; and Build track records through demonstration projects to transition investees to more commercial forms of capital. 13 The PFS Financing Capital Structure Given their experience in grantmaking, foundations may be better positioned than more commercial investors to underwrite the outcome performance risk of PFS financings. In terms of deal participation, foundations may also provide partial guarantees or collateral or take subordinated positions within a PFS capital structure. PRIs can be used as subordinated risk capital to attract more commercial capital into specific projects. For example, PRIs have traditionally been used to catalyze more commercially-oriented capital across a range of sectors such as affordable housing through structures such as the New York City Acquisition Fund. While PRIs have many desirable features needed to build the PFS market, the total amount PRIs is small relative to the potential PFS demand New York City Acquisition Fund (NYCAF) The NYCAF is a collaboration between the City of New York, foundations and New York s public and private community investment groups. It was created to provide predevelopment debt to affordable housing developers on more favorable terms than would otherwise be available, with the goal of creating or preserving 30,000 housing units over 10 years. NYCAF has a $40 million pooled guarantee provided by foundation PRIs and the City of New York. This guarantee pool can credit enhance up to $210 million of loans funded by a commercial bank group. In the case of loan losses, the NYCAF will draw on the guarantee pool based on a multi-tiered waterfall. Source: New York City Acquisition Fund LLC and has historically been invested primarily in bricks and mortar projects in housing, education and community development. In the most recent survey of PRI making, The Foundation Center 14 reports that foundations made a total of $735 million in PRIs over the two-year period of 2006 and Foundation PRI makers do not have deep experience in underwriting business enterprises or social service provision. However, a new cadre of foundations could develop the skill to underwrite PFS financings over time. PRIs are a good tool to mitigate the downside risk to other investors within a PFS capital structure. This mitigation can include credit enhancements, senior/subordinated tranching, creditrisk tiers and principal floors. Eventually, the amount of subordinated support would be reduced as PFS financings using specific interventions and service providers develop more investable track records. 13 PRI Makers Network, for more information about PRIs, see Mission Investing Exchange, 14 Lawrence, Steven, Doing Good with Foundation Assetas: An Updated Look at Program-Related Investments, The Foundation Center, BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 13

16 Donor-Advised Funds as SIB Funding Vehicles Donor-advised funds (DAFs) are an interesting structural option for capitalizing PFS financings since DAFs can contribute grant funds and also make PRIs. In a DAF, a donor makes a charitable contribution to a sponsoring organization (typically a public charity), but the DAF donor retains discretion over the grantmaking as well as the ongoing investments of the DAF. 15 DAFs also allow taxdeductible contributions of up to 50% of a donor s adjusted gross income, which is more than that allowed for contributions to private foundations. A DAF structure could also diversify a portfolio of PFS interventions or serve as an efficient means to aggregate capital from individuals and corporations focused on specific regions or issues. The Other 95% of Foundation Capital The ability to execute PFS financings out of foundation endowments is currently very limited given the need for clear demonstration projects and the perceived risk of PFS financings. It would be irresponsible for a fiduciary to invest in a product with zero track record. We will need at least five years to have experiments and see the successes and failures of the SIB model, said a foundation investment officer. Yet foundation endowments can play a catalytic role in attracting commercial capital. (Foundation endowments will also be included in the Commercial Investor section later in the report.) In the Peterborough SIB transaction, foundations led the transaction of 17 funders that included a group of UK foundations, 2 US private foundations making PRIs and a group of private individuals investing based on the social impact goals of the project. It is reported that approximately 2/3 of the Peterborough investors made their investments from their endowments rather than using program funds. Foundations can provide cornerstone capital by making a clear allocation to PFS transactions or to impact investment with a portion reserved for PFS financings. Insights, Concerns and Preferences PFS financing builds on effective grantmaking strategies and techniques; program alignment will matter. Foundations can aid the creation of PFS financings by building the infrastructure by funding research, evaluation, and convening the stakeholders especially within their communities and program areas. PRIs are expected to provide capital for early transactions and to be the cornerstone for risk-sharing capital structures. Community Development Financial Institutions (CDFIs) and Community Reinvestment Act (CRA) Banks While philanthropy is expected to fund the initial demonstration projects, CDFIs and CRA capital may be a bridge between the first philanthropicallyfunded PFS financings and other investors. 15 For a more detailed description of donor-advised funds, see 14 BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

17 Community Development Financial Institutions As mission-driven financial institutions that provide financial products and services to people and communities underserved by traditional financial institutions, CDFIs can play an important role in the development of this market. CDFIs operate as banks, credit unions, loan funds, venture capital funds or community development corporations. They typically finance affordable housing, businesses and community facilities, including health centers, daycare and educational facilities. 16 CDFIs are capitalized by a range of investors including individuals, banks and thrifts, non-depository financial institutions and corporations that are attracted by CDFIs double bottom line combining financial returns with social impact. Within a PFS financing, CDFIs could invest, aggregate capital and/or act as the intermediary. Challenge of Underwriting Social Services PFS financings will require organizations that can underwrite the performance risk of non-profits, attract commercial capital and work across the public and private sectors. As these are all core competencies of CDFIs, PFS financings represent an attractive diversification opportunity. Many CDFIs also have systems in place to measure their social impact. However, PFS financings will also demand new underwriting and collaboration skills from CDFIs. As they seek to open up new pools of capital to fund social service provision, CDFIs will have to deepen their ability to underwrite these services since they have historically funded supportive services as part of capital projects rather than stand-alone programs. Abby Sigal, Senior Vice President at Enterprise Community Partners, is interested in SIBs as a way to bring additional and diversified capital to service provision. Enterprise has provided financing to housing with services, but it is always a challenge to find the funding for services. SIBs are attractive as an innovation for foundations and policy makers, but this is not how investors typically approach new products. Investors want something that is predictable, tried and true. Community Reinvestment Act (CRA) Banks The Community Reinvestment Act encourages depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound operations. 17 For most US banks, CRA considerations drive their community development investing. This particular pool of capital can be an early source of investor capital for SIBs. Like CDFIs, CRA banks target community development, economic development and community services. CRA Credit Matters In order to receive CRA credit from bank regulators, a bank s investment must connect directly to low- and moderate-income communities in a bank s market area. Given the multiple layers of bank regulators, CRA strategies and compliance vary significantly across institutions. Some banks only lend to CDFIs, while others are more open to innovative structures such as SIBs. 16 CDFI Fact Sheet from the CDFI Coalition, BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 15

18 Government as Payor and Credit Enhancer? While philanthropic capital should be adequate to fund the initial PFS transactions, it will be insufficient given the potential pipeline of PFS projects. In addition to investors such as CDFIs and CRA banks, the public sector may be called upon to provide early stage capital. Although PFS financings have been positioned as a way to provide cost savings to the public sector and transfer risk from taxpayers to investors, government support could attract and leverage other sources of capital and signal the government s commitment. Banks would like to have their CRA regulators signal that PFS financings would earn CRA credit before committing time and resources to specific transactions. Complex PFS financings will also need to compete with more straightforward community development lending transactions which would offer the same CRA credit to a bank. Given that wholesale banks that do not operate branches in specific markets have somewhat more flexibility in their CRA evaluations than their retail banking counterparts, wholesale banks may be more likely participants in early PFS financings. Safety and Soundness Standards PFS financings are subject to the same investment committee safety and soundness underwriting standards as other bank investments. Underwriting social service intervention based on social science research is difficult and will require the banks to assess new risks. This is new work for the banks, was a common theme at a recent meeting of financial institutions to discuss SIB opportunities. The perceived subjective standards and metrics driving the terms of repayment are a barrier. Until there is a clear track record of performance, banks will require risk sharing among the stakeholders instead of a complete risk transfer to the investors. Some bankers compared SIBs to the Low Income Housing Tax Credit (LIHTC) as an example of a community development financial product which required banks to assess new risks. 18 LIHTC has now become a standard tool of the CRA banking industry and does not rely on philanthropic support. Organizational structure and strategy will influence a bank s capacity to participate in the PFS financing market. Banks that have closely aligned foundation and CRA functions have more flexible capital to use for PRIs in early transactions. Given that PFS financings require banks to think differently about risk, the early transactions will need banks seeking to demonstrate their leadership in this new social funding tool and have on-theground teams to structure, negotiate, close and monitor transactions. Structuring Considerations Most bankers see bank participation in the first demonstration projects as critical to building the capacity to underwrite PFS financings and build a sustainable market. While early transactions may require close to full credit enhancement for commercial investors to participate, some level of outcome performance risk participation by commercial investors will be needed to build their capacity to assume more outcome performance risk and position themselves to participate in more deals in the future. As PFS financings develop a track record, the amount of credit enhancement will likely decrease. Structures with more level repayment schedules could also have lower credit enhancement requirements. Some institutions would not be willing to take any principal risk in an early transaction but would consider some variability in the yield-based outcomes. Others thought that some portion of the principal repayment could be contingent on the successful achievement of outcomes. Banks were also generally of the view that any intermediary should assume some level of outcome performance risk. However, unless investors ultimately 18 For a history of the Low Income Housing Tax Credit, see Doug Guthrie, An Accidental Good, Stanford Social Innovation Review, Fall BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE

19 assume significant outcome performance risk, PFS financings may simply cannibalize philanthropic and public funding and fail to increase the capital available to fund the needed interventions. Insights, Concerns and Preferences Favorable treatment of PFS financings by CRA regulators will be a key issue for engaging banks although the ability of specific institutions to get CRA credit will vary with wholesale banks appearing to have more flexibility. Banks with foundations that provide PRIs may be more likely to participate in early transactions. Underwriting outcome performance risk is new for CDFIs and CRA banks and will require a willingness to invest resources to build this capacity. Until PFS financings have a clear track record of repayment based on outcome performance, banks will most likely require credit support of at least a portion of principal. Bank participation in early transactions will require strong institutional leadership as well as a team to structure, negotiate, close and monitor transactions. Commercial Investors Much of the PFS structure remains unfamiliar to commercial investors, and pricing this new risk will require time and resources. PFS financings can share characteristics across a number of asset classes making them difficult to categorize. Therefore, we sought the perspective of various types of commercial investors in order to understand how they would approach valuing PFS financing risk. The following summary of PFS risks and risk mitigation strategies is relevant for the different types of commercial investors we spoke with, and to some extent for all potential investors including the CRA Banks, CDFIs and Foundation Endowments. Commercial View of PFS Financing Risks Outcome Performance Risk Performance risk encompasses both intervention model and scaling risk. The intervention model itself will have distinct risks, while scaling risk speaks to the challenges that come specifically with setting up the intervention to serve more people or to serve them more comprehensively. Certain interventions have a track record of success at a specific scale. Evaluating an investment within the context of this track record should reduce some of the intervention model risk. However, scaling risk is a distinct challenge. As one private investor said, the foundation of the house must be built to support a scalable model from the very beginning. Commercial investors also expressed concern as to whether the existing leadership team of a service provider would be the best team to take the intervention to scale. Outcome Performance Risk Mitigation Outcome performance risk should generally decline as track records for PFS financings and for particular interventions grow. The participation of an intermediary organization (or active direct investor) to source deals and manage relationships throughout the life of the deal will help to ensure that only qualified service providers are selected, reasonable benchmarks are set, and communication among BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE 17

20 Commercial Players Wealth Advisors, Family Offices and High Net Worth (HNW) Individuals: Family offices and HNW individuals could be promising PFS financing investors because of their flexibility and ability to invest in accordance with specific interests and mission. While some see PFS financings as a philanthropic option, a small group of HNW individuals may participate because of the compelling prospect of being an early investor in an innovative social financing tool. On the other hand, family offices typically have limited staff and time to perform due diligence on new structures and would struggle with PFS allocation. There may be an opportunity for larger institutional investors or originators to facilitate Family Office and HNW individual participation by issuing notes. Banks: Banks may participate based on regulatory incentives but safety and soundness underwriting standards will require significant credit enhancement for early transactions as well as the commitment of time and resources. (See previous section for CRA bank and CDFI specific factors.) Pension Funds: While pension funds have experience investing in esoteric asset classes and launching new asset classes, their stringent hurdles for fiduciary duty will require a track record of proven PFS financings prior to their participation. Public pension funds could potentially invest in PFS financings under the rubric of economically targeted investing (ETI), a double bottom line investment strategy that requires intermediaries to invest in predetermined geographic areas typically in sectors such as infrastructure. The California Public Employees Retirement System (CalPERS) announced in September 2011 that it had earmarked up to $800 million for ETI in California infrastructure over the next three years in transportation, energy, natural resources, utilities, water, communications and other social support services. Washington and Florida have also expanded their ETI efforts. 19 Public pension funds may find PFS financings of interest because of their potential cost savings for the public sector, but they may also have concerns about the impact of PFS financings on their public sector employee participants. Insurance Companies: Similar to pension funds, insurance companies have the expertise to assess esoteric asset classes but are not expected to be early participants in PFS financings given their fiduciary duties. Insurance companies have also participated in community development financing with CRA banks, but are not subject to the CRA regulations. Rating Agencies: The rating agencies have the opportunity to develop new tools to help assess PFS financing risk. While they currently do not have the internal capacity, certain agencies expressed interest in the PFS instrument and in developing these capabilities or working in conjunction with industry specialists (e.g. social science evaluators or foundations focused on evaluation) to go along with a suite of related existing products (e.g. social impact assessments or management evaluations). However, they will require solid deal flow projections before moving into the sector. stakeholders is clear. There is also an opportunity for external risk evaluators that specialize in non-profit evaluation to generate tools or conduct performance assessments for investors. Government Counterparty Risk As a new structure, no precedent exists to optimize the government s payment obligation in a PFS financing. Political and appropriations risk can arise given the multi-year contingent obligations of the government. The contracts underlying a PFS financing are not standard government procurement contracts and will require the government to create new templates and procedures. 19 See Insight at Pacific Community Ventures & The Initiative for Responsible Investment, Impact at Scale: Policy Innovation for Institutional Investment with Social and Environmental Benefit, February BUILDING A HEALTHY & SUSTAINABLE SOCIAL IMPACT BOND MARKET: THE INVESTOR LANDSCAPE