Social Impact Bonds: Definition, Mechanism, & Example

With a 10.2% growth, the total bond market in India has reached ₹238 lakh crores. The rapid expansion and keen investor interest have led to the presence of bond categories beyond the most common ones, like corporate or government bonds. One such unique subset is the social impact bond. Although called a bond, this investment asset behaves differently from traditional bonds. SIBs and their variants, development impact bonds (DIBs), are still in their early adoption phase. Therefore, this might present an opportunity for first-mover advantage for interested investors. However, to determine the suitability of social impact bonds, investors must first understand what they are.

What Is a Social Impact Bond (SIB)?

Unlike ordinary bonds, a social impact bond (SIB) is a contract in which investors finance a social initiative and only get returns if certain conditions are satisfied or specific goals are fulfilled. A type of pay-for-success instrument, SIBs are an outcome-based financing mechanism to address social concerns.

Suppose the government want to help homeless people find jobs. Rather than taking debt through bonds or others, which will lead to compulsory repayment obligations, the government decides to issue the social impact bonds. If the project is successful and gives the desired results, investors will be paid back with returns. However, an adverse scenario might lead to capital loss.

Therefore, although called a bond, social impact bonds are unlike traditional bonds since the payout is not guaranteed and depends on the success of the underlying projects. In such a scenario, investors must understand how these assets operate as their unique attributes stem from their differentiated working methodology.

How Social Impact Bond Works

Discussed here is how a social impact bond operates, along with a real case study to illustrate the working methodology further.

• The Cause: Issuance of a social impact bond begins from any social cause that the issuer wants to address. As the name suggests, the cause for which a SIB raises funds is a social challenge that needs to be solved, like youth unemployment, low primary school enrolments, etc. Moreover, the problem must be measurable, with clear data to track improvements.

For instance, in 2010, one of the first social impact bonds was issued by the Peterborough Prison in the United Kingdom to minimise the re-offending rates among short-term prisoners.

• Defining Outcome: Before the bonds accept investment, the issuer has to specify the specific goal they wish to achieve in quantitative terms. The target ascertained is specified in a legal document, and the return payment depends on the fulfilment of the goal.

In the UK, the objective was to reduce the reconviction rates in Peterborough Prison to at least 7.5% below the rates of a given standard control group. The investors of the SIB would have received the return only if this goal was met.

• Investors Invest in SIBs: Once the bonds are issued, investors provide capital to run the particular program, which is aimed at solving an underlying cause. Given the nature of this asset, the key investor categories of SIBs are philanthropists, impact funds, banks, etc. In the case of the Peterborough Prison SIB, 17 social investors had invested 5 million pounds to finance a pilot project to reduce the re-offending rate.

• Utilisation of Proceeds: The funds generated will then be used to solve the social cause through the particular program. In this stage, different service providers like non-profit NGOs, social enterprises, etc., work on the ground to deliver the results.

• Evaluation and Outcome: Independent third-party evaluators evaluate the success of the program and judge whether the goals have been achieved. The evaluators often use random control group trials, comparison to standards, and other verified metrics to reach their conclusions. The involvement of a third-party assessor ensures transparency and credibility. If the result matches the standards set, the investors are paid their return and principal. However, if it fails, capital might be lost.

For example, in India, the government introduced the Skill Impact Bond, intending to benefit 50,000 young Indians over four years, with 60% female beneficiaries. The outcome funders are the Children’s Investment Fund Foundation, JSW Foundation, Dubai Cares, and HSBC. Furthermore, Oxford Policy Management is its independent evaluator. As of 31 March 2023, the enrolments reached over 42,285, with 73% female enrolment.

Let us now analyse the characteristics of these bonds to help understand them better.

Characteristics of Social Impact Bonds

Social Impact Bonds are a novel outcome-based financing mechanisms that address social challenges through private investment and public return depending on performance. Discussed below are some of its key characteristics.

• Core Structure: SIBs include several parties, namely the governments, who identify issues and set goals, investors giving initial funding, intermediaries managing funds, service providers performing operations, and independent evaluators who assess success. Repayments are made only if predetermined, quantifiable results are met, transferring risk from the public to the private sector.
• Payment Mechanism: Repayment is success-based, meaning that investors only recover principal plus returns when the predetermined goal is met; otherwise, capital can be lost. In core SIBs, returns are frequently 100% outcome-linked and correlate with government savings. However, the actual return terms might differ from one SIB to another.
• Risk Transfer: Since there is no upfront government support or direct intervention throughout implementation, investors assume full performance risk. This tends to promote effective service delivery. While providers concentrate on evidence-based interventions, governments avoid spending money on unsuccessful projects.
• Outcome Measurement: Using meticulous procedures to guarantee authenticity, independent assessors evaluate predetermined, measurable indicators at the conclusion of the project. Long-term social effects are prioritised by metrics. Furthermore, evaluation by third-party evaluators allows fair and transparent results.
• Time-Bound Nature: Projects are run for fixed durations, which aligns financing with cycles of intervention and the achievement of results.
• Capital Sources: Funds are gathered through intermediaries from commercial, impact-focused, or philanthropic investors looking for both financial and social gains. No set interest rate, unlike typical bonds; returns are uncertain and subject to change.
• Performance Management: Strong oversight entails continuous monitoring, dynamic management, and data-driven modifications that optimise results. This promotes accountability and evidence-based procedures.
• Social Intent: This investment mechanism is designed to address persistent challenges such as education inequalities, health access, and employment for underprivileged communities while putting social benefit above profit.

Based on these characteristics and the working methodology of social impact bonds, let us now analyse their strengths and risks.

Benefits of Social Impact Bonds

Social Impact Bonds (SIBs) enable innovative funding for social projects by linking payments to tangible results, resulting in advantages for governments, investors, service providers, and society. Discussed below are the benefits of social impact bonds.

• Fosters Innovation: SIBs provide for the trial of new, evidence-based initiatives that traditional financing might not support. Given the dynamic and result-oriented return incentive, the project fulfilment can be expected to have greater innovation and commitment to success, compared to traditional models.
• Promotes Collaboration: Various key stakeholders collaborate in the successful implementation of the SIB projects. Multi-stakeholder partnerships unite governments, non-profits, investors, and evaluators. This pools the expertise of these key partners to address complex issues.
• Investor Appeal: SIBs create an opportunity for the financial year, alongside social impact, attracting key philanthropic investors, impact investors, and more.
• Optimising Social Causes: SIBs create an opportunity to make a financial commitment to social concerns economically lucrative. This can not only help attract greater contributions to key causes but also provide a keen opportunity to philanthropic investors.
• Enhances Accountability: Independent examination of SIB goals enables thorough, transparent evaluation and data-driven modifications. This can promote confidence and demonstrate social impact.

Risks of Social Impact Bonds

Social Impact Bonds (SIBs) involve various inherent risks due to their complicated, outcome-dependent nature. Discussed below are some of them.

• Financial Risks for Investors: The investors of SIBs face the risk of total investment loss if the outcome fails. Due to this, despite high potential yield, the high risk deters broad participation beyond philanthropists.
• High Setup and Transaction Costs: Negotiating multi-party contracts, conducting independent reviews, and managing performance all increase costs, making SIBs inefficient for smaller projects in resource-constrained countries.
• Accountability Gaps: Complex contracts conceal transparency and controllability. Moreover, the profit angle in social causes can put private incentives at odds with public purposes. Moreover, governments risk responsibility evasion.
• Sustainability Issues: While SIBs are time-bound, most social causes, like unemployment, require long-term overview and management. Therefore, programs may falter post-term without ongoing funding, resulting in incomplete redressal to systemic issues.

Therefore, due to this unique risk and strength profile of SIBs, investors need to analyse various factors closely before investing in them.

How to choose social impact bonds

Investors must consider the key factors illustrated below before investing in social impact bonds.

• Understand the Nature of the Asset: SIBs are unlike most investments since their primary consideration is to address key social causes. The tie-up of returns and assets is key to making solutions innovative and dynamic. These are high-risk, outcome-oriented assets where repayment is tied to the success of the program. Even the capital might be lost partially or fully if the underlying concern is unmet.
• Investor Profile Analysis: Investors must consider their own objectives and risk profile before undertaking this investment. For instance, if an investor wants fixed-income, SIBs might not be a suitable fit.
• Examine the Social Cause and Outcome Metric: Investors must carefully analyse the social cause the SIB wants to address, along with the qualitative metrics set. Evaluating them against the performance of other government projects and comparable programs can help understand if the quantitative metrics are possible to meet.
• Review the Fine Prints: The terms of repayment might vary from one SIB to another. Therefore, investors must analyse the duration, terms of capital repayment in case the standards are not met, along with other factors.
• Liquidity: SIBs have a maturity of medium to long-term. Unlike traditional bonds, these assets do not have a secondary market where holding can be liquidated. Therefore, before investing, investors must analyse if the time horizon fits their requirements.

Bottomline

The social impact bonds allow issuers to raise funds for social concerns in an economically optimal manner. However, investors are eligible for return and repayment only if the underlying concern is successfully addressed, based on the fulfilment of standards set. Therefore, although these investments are called bonds, they are unlike regular traditional bonds. Thus, investors must consider their objective and profile before investing. The terms of the asset are a key consideration as well for optimal investing.

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