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.