CHICAGO – The use of "social impact bonds" as an alternative financing tool is on the rise and news that Chicago's first venture into the space will pay off for investors demonstrates the benefits, market participants said.

As of March, 10 projects have launched in the U.S. and dozens of projects are potentially in the pipeline, said panelists who discussed the topic at The Bond Buyer's Midwest conference in Chicago Tuesday. At least 20 states are considering legislation to boost such "pay for success" ventures.

Social impact bonds are performance-based contracts in which private and/or philanthropic lenders loan funds to accomplish a specific objective and are repaid based on whether the program achieves its goals. Projects to date have clustered in three issue areas: criminal justice and recidivism; early childhood education; and homelessness.

The so-called bonds shift risks of paying for social programs from government to private investors, said Amy Curran, a partner at Chapman and Cutler LLP.

While called "bonds," the deals are structured in a contract form with a state or local government that typically contracts with one or more service providers to obtain social services seeking outcomes such as reducing obesity or the percentage of juvenile offenders who end up in prison within five years.

The government will pay based upon the provider's meeting certain specified performance targets, such as 10% reduction in recidivism. If targets are not met, the government does not pay. There is often a several-year lag between when services are delivered and when the results can be measured and government payments are made.

Private investors bridge that gap, providing capital to fund the upfront operating expenses of the service provider. Typically a nonprofit entity helps develop the project, raises funds from investors, and coordinate key activities such as the contract and evaluation parameters.

Most projects have involved multiple investors, and the most common arrangement emerging is a layered capital stack with investments divided into senior and subordinate positions. Investors in the space are banks and foundations with the latter typically taking the first loss piece in a transaction.

Chicago stepped into the SIB arena in 2014 with a $17 million privately funded investment used to expand early childhood education and the first results were circulated this week.

The expansion, which relied on an additional $4.5 million of state grants and $10 million in city capital funds, allowed the Chicago school system to provide pre-kindergarten to more than 2,600 additional children over the four-year term of the project.

The lenders -- Goldman Sachs Social Impact Fund and Northern Trust in senior roles and the J.B. and M.K. Pritzker Family Foundation as a subordinate lender -- are only repaid if students realize positive academic results. The program's goals include increasing school readiness, improving third-grade literacy, and reducing the need for special education services.

Based on those metrics, the initial outcomes has met the established criteria and investors are now assured a $500,000 "success payment," said panelist Deborah Kasemeyer, senior vice president at Northern Trust Co.

While supporters say the model offers an alternative financing vehicle, critics of Chicago's use of the model argue that it's more costly than tax-exempt borrowing. The interest costs on the Chicago investment could hit 6.3% if all benchmarks are made.

Panelist Mollie Foust, Illinois social impact bond fellow for the Government Performance Lab at the Harvard Kennedy School, said that the program can benefit any government looking to save costs.

Denver, for example, set up a program funded by a SIB in February that is aimed at providing housing and supportive case management services to at least 250 homeless people who frequently use the city's emergency services.

Foust said that shifting the focus to preventive services saves taxpayers millions of dollars a year. The cost of providing safety net services to the 250 homeless people is approximately $7 million per year. The savings and benefits from reduced costs in the criminal justice system will be captured by the city and used to repay lenders for their upfront investment to cover the cost of the program.

"A lot of deals have been political in nature which is what happened in Chicago, where Mayor Rahm Emanuel said he wanted to get it done and in Denver where Mayor Michael Hancock pledged under the Clinton Global Initiative to do a social impact bond," said Kasemeyer.

The flipside for investors is risk that the targets won't be met and they won't get paid. "You have to be really committed to make things work out," said Kasemeyer. "You are making a loan on an unguaranteed, unsecured basis and the risk is that you may not get repayment."

Last year, a Riker's Island program aimed at reducing the percentage of offenders who end up in prison within five years after release showed no difference from historical data in recidivism rates over the two year period following their enrollment in the PFS-funded program.

As a result, no success payments were made to Goldman Sachs, the sole investor, which triggered the use of a 75% guarantee by Bloomberg Philanthropies, acting as the guarantor. Goldman Sachs decided not to continue funding for a fourth year of services, a right defined in the project contract, and the project was ended.

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