Practical analysis for investment professionals
20 June 2012

Social Impact Bonds: Turning the Recidivism Rate into an Internal Rate of Return

Is it possible to earn a return by investing in reducing recidivism among prisoners?

The link between the economic activity of investing and the social problem of prisoners who are repeat offenders may be far from obvious, but the answer is yes, it is possible. In fact it is being done through what are known as social impact bonds, which represent an innovative structure within the small niche known as impact investing.

To help investment professionals learn about these instruments, CFA Institute recorded a video interview with Toby Eccles in May 2012. Toby is founder and development director at Social Finance, a not-for-profit organization based in London, and has led the development of social impact bonds from concept to implementation in the United Kingdom.

In the interview, Eccles explained that a social impact bond is essentially a contract between a special purpose vehicle and the government in which the government commits to pay for improved social outcomes, such as reduced recidivism rates for prisoners. Social impact bonds give investors a chance to address social problems through investing. They strike a balance between giving money away altruistically and seeking a financial return solely for one’s own benefit — an economic return plus a social return.

Eccles pointed to the Peterborough social impact bond, described as the world’s first social impact bond, as an example of how these instruments work. The offering was launched in 2010 to address the recidivism rate prisoners at Peterborough Prison in the UK. The recidivism rate at some prisons in the UK is reported to be more than 70%. On one hand, many lives are being ruined in a vicious and expensive cycle of crime and punishment, and on the other, taxpayers’ money is being used to finance it — a losing scenario for the prisoners, government, and society.

Through a social impact bond, investors commit capital to a special purpose vehicle to pay for a range of services, such as counseling for prisoners serving short sentences. Depending on the drop in the recidivism rate that can be attributed to the services provided to the prisoners, investors receive payments from the government, which ultimately repays the initial investment plus a financial return. This, in short, is how the Peterborough social impact bond converts a reduction in recidivism rate for prisoners into an internal rate of return (IRR) for investors. Toby explained that through Peterborough social impact bonds, investors committed £5 million and are expecting up to a 13% IRR with an eight-year investment horizon, depending on the success of the intervention. The bond is currently a work in progress, given the time it takes to work with the prisoners and measure success.

Measuring the drop in recidivism rates that can be attributed to the services provided is a critical element in the Peterborough social impact bond. The recidivism rates are measured for the prisoners who have received the services (the experimental group) and others with a similar profile who have not (the control group). The government will only pay the investors if the drop is 10% or more for the experimental group than for the control group.

All parties involved in the structure have an incentive. Investors get an investment opportunity in which they can earn a financial return and address a social problem; the service providers get the funding they need to provide their services; and the government avoids the risk of wasting resources by paying for services that may later prove to be ineffective. The government also gains the potential opportunity for saving the money spent on conviction and imprisonment.

If the services are successful at reducing recidivism, everyone, including the prisoners and society at large, gains. If they are not, everyone loses but the most direct economic loss is shouldered by the investors.

It is important to note that because the capital of the investment remains at risk, social impact bonds are not bonds in the traditional sense. For the investors, they are much closer to equity investments and, more specifically, longer-term and illiquid private equity investments. Perhaps “social impact partnerships” is a more befitting name for these structures.

While the example that Toby shared was one pertaining to criminal justice, social impact bonds can be used to address other issues such as education and housing.

Social impact bonds, and impact investing more generally, clearly have a long way to go. However, at a time when the financial services profession seems to be getting predominantly negative press for its many failings, the potential social utility of social impact bonds strikes me as a breath of fresh air. These instruments show that finance can help solve, and not just create, social problems — and that investment bankers, or “reformed investment bankers,” as Toby likes to put it, can be a part of the solution.

Watch the interview with Toby Eccles on social impact bonds.

About the Author(s)
Usman Hayat, CFA

Usman Hayat, CFA, writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals;" the literature review, "Islamic Finance: Ethics, Concepts, Practice;" and the research report "Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in development economics. He has served as a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP) and former CEO of the Audit Oversight Board (Pakistan). His personal interests include reading and hiking.

4 thoughts on “Social Impact Bonds: Turning the Recidivism Rate into an Internal Rate of Return”

  1. Vinayak Chuni says:

    I am a little confused.I have been hearing about these social impact bonds for a while now but I am very skeptical as to their financial viability. Why would an investor(leaving those with only social motivations) invest in such kind of instruments where their entire capital is at risk(as you said their is no capital protection)?
    In the Peterborough social impact bonds, the payoff is dependent on reductions in the the rate of recidivism which is based on something which cannot be quantified easily as human behavior is irrational.
    I feel an investment like this is highly risky and very few investors would like to buy these social impact bonds.

    1. Vinayak Chuni

      Thanks for reading the blog and posting your comment. Social impact bonds are a fairly new phenomenon and I think it is too early to judge how they will perform financially and what exactly will be the social impact.

  2. Vinayak raises two good questions. (1) Why invest in social impact bonds, unless the investor is specifically guided by social inclinations? And (2) Do social impact bonds really shift the risk to investors? Or is there some form of risk mitigation for investors?

    Some answer the first question by pointing to the benefits of portfolio diversification. And some claim that the returns on SIBs may be competitive with other kinds of investments. But this leads to the second question: risk.

    Assessing the Peterborough pilot, the Rand Corporation says that the pilot project appears to provide “no cashable savings to government.” Yet, the failure to meet the target doesn’t seem to place the investment at risk. It seems to be mitigated through a third party, in this case, the public organization BIG Lottery Fund. It seems that public agencies, philanthropies, and foundations are playing this risk mitigation role in order to develop to social impact market.

    So, even where SIBs fail to produce the intended social impact, and fail to reduce public budget expenditures, (in this example, for the Ministry of Justice), they nonetheless produce returns for investors. So, they appear to function by redistributing capital from public and private hands to private investors.

    In the New York City pilot project, which also focuses on recidivism reduction, the Bloomberg Foundation is playing this risk mitigation role. In that example, the investor is not a traditionally “social” investor, but rather Goldman Sachs. Why are they investing in SIBs? Aside from improving the firm’s public image following strong public criticism in the aftermath of the financial meltdown, there is another reason. It appears that by investing in SIBs, the firm fulfills certain obligations connected to its receipt of federal bailout funds. Under the Community Reinvestment Act, Goldman Sachs must invest a certain amount of its funds in social investment. The SIBs therefore function as a kind of money laundering system, as the returns on these investments are then freed from federal restrictions, and can be invested in other assets.

  3. r_ogman

    Thanks for sharing your views. I think it will be good to withhold judgement on social impact bonds as they are quite new. At the same time, I do agree that one should try to look at SIBs objectively and freely raise the possible objections that comes to mind.

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