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'Social Impact Bonds' Generate Buzz in New York, Massachusetts

New York City and Massachusetts are tapping the capital markets to fund social intervention programs under a new mechanism called social impact bonds.

Target areas include chronic homelessness and youth crime. Backers say if well-executed, the program would benefit investors, social service providers and governments alike, especially in the financially squeezed Northeast.

Essentially, the program enables the public sector to leverage upfront funding from investors. They are also called “pay for success” contracts, with governments paying only if programs meet goals, in which case all parties benefit financially. But the idea is in its infancy, with only a two-year-old prison program in Peterborough, U.K., serving as a model. “Assessing a nascent market — or one that isn’t clearly defined — is a tricky undertaking,” consultant McKinsey & Co. said in a report.

“It’s a novel approach to funding social projects run by nonprofits. These nonprofits do a lot of good things to minimize recidivism and homelessness and keep kids in prevention programs, but they’re the first to get reduced or go altogether during budget cuts,” said Anthony Figliola, vice president of Uniondale, N.Y., lobbying group Empire Government Strategies.

While “bonds” is a misnomer — they’re not bonds in a muni sense — they could open doors for new funding mechanisms.

“This does not behave like a traditional municipal bond because of the risk transfer. The government only pays if the program is a success. The issuing entity is not the government, so this does not affect the credit rating of the state,” said Tracy Palandjian, co-founder of Social Finance US, whose sister organization in Britain serves as intermediary with the Peterborough program.

Palandjian said the Peterborough prison, just north of London, serves as a model because its 60% recidivism rate for short-sentence inmates — those with one year or less — roughly parallels statistics in the United States. “We know that six out of every 10 persons who walk out of a prison walk back in shortly after — that is not good,” she said. Peterborough is in the second year of an eight-year, £5 million ($8 million) program.

New York City and Goldman, Sachs & Co. last month announced an initiative to support a program to reduce reincarceration rates among youth from ages 16 to 18 on the city’s Rikers Island prison. Private investors fund the intervention through a nonprofit contractor and the government pays the contractor only if the program meets the goals.

Goldman will fully fund the program — called Adolescent Behavioral Learning Experience, or Able — over four years, structuring its investment as a loan to MDRC, a nonprofit, nonpartisan education and social policy research group. The latter will contract with the city and monitor the organizations that will deliver the intervention programs to the adolescents.

What the city pays MDRC hinges on program success. If the program falls short of reducing reincarceration by 10%, the city will pay nothing. Goldman would break even with a 10% goal. Exceeding the target means the city would pay MDRC on a capped, sliding scale.

Because MDRC will pay investors based on payments it receives from the city, a successful program means Goldman would profit from its investment.

Mayor Michael Bloomberg’s private charity, Bloomberg Philanthropies, is backstopping $7.2 million of the loan. Deputy Mayor Linda Gibbs ran point for the city.

“Goldman Sachs’ involvement, working with the Bloomberg administration, is a wonderful thing for the development of this. [City officials] were very, very sophisticated, the way they thought of credit enhancement,” Palandjian said.

In Massachusetts, also last month, Gov. Deval Patrick’s administration targeted juvenile justice and chronic homelessness programs. Massachusetts selected two-year-old nonprofit Third Sector Capital Partners, in partnership with New Profit Inc., both of Cambridge, Mass., to negotiate with the commonwealth as social innovation financial intermediaries for the juvenile justice contract. Nixon Peabody LLP is pro-bono law firm for the project.

“It appeals to different people for different reasons,” said Navjeet Bal, who is coordinating Nixon Peabody’s effort. Bal served as Massachusetts’ revenue director from 2008 to 2011 and also worked at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC for 17 years. Bal said states receive needed funding, social services providers can build upscale, and investors get their money back if the program works. Quantifying performance is vital.

“Because the whole industry is really in its infancy, the need to have good baselines is key. It will work in some areas but not all,” Bal said in an interview. “The issue is to create a baseline understanding and set up a measure of success.”

Palandjian said Social Finance will only work with proven nonprofits, which she hopes will offset skeptics who question the program. “The only innovation at play is the financial instrument,” she said.

“I got a phone call from someone who said, ‘I want a stable so I can treat autistic children through horse therapy,’” she said. “I said, ‘Oh, wow.’ We’re not going to try any new, experimental programs. We will focus on programs that perform year in and year out, and produce consistent results.”

Palandjian has had to answer questions from skeptics. “People ask, ‘Can you measure the results? Can you track these people over time? This is a four- to five-year instrument, so what will happen when Bloomberg is out of office? How do you measure appropriate risk?’ We’re prepared to answer those questions one by one.’ ”

Philanthropically inclined investors figure to be an easier initial sell.

“I would say a lot of the people doing the giving were already givers. This gives these people a chance to get a return on their investment,” said Figliola. “These are test cases. If they work, the derivatives market could be interested.”

People interviewed for this story agree that reaching profit-driven investors — what Palandjian has called “socially agnostic” — won’t come right away. “Tapping trillions in the institutional market will take some time, while we build ecosystems,” she said, noting that portfolio diversification appeals to some investors.

Laura Callanan, a senior expert at McKinsey, said as the SIB program grows, community development finance institutions and venture funds could repurpose themselves to serve as intermediaries.

“These are organizations that have been around for 20, 30 years, many of them,” Callanan said during a McKinsey web seminar. “They understand how to raise capital. They understand how to deploy capital in a socially focused way that is also economically sound.”

Social impact bonds could also provide new means to gauge performances of government programs. “Government has always been motion without progress. But now you can put people’s feet to the fire and force them to pay attention to metrics,” Figliola said.

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