What are Social Impact Bonds?

More and more of us are concerned about investing in companies that practice ethical and environmentally-conscious business by engaging in socially responsible investing (SRI) and ESG investing. But that type of investing tends to involve stocks, ETFs, and mutual funds. Less well-known are social impact bonds.

Social impact bonds are a bit different from other ethical investing practices. You’re investing in a contract with a state or local government for a specific project that is meant to have a positive social impact. These projects can range from rehabilitation programs for young incarcerated people to homeless shelters to after-school programs in socially disadvantaged neighbourhoods. The thinking behind these kinds of bonds is that taxpayer dollars would be saved by finding alternate methods to fund public projects.

However, the term “bond” is a little bit misleading here. While bonds tend to be favoured by conservative investors because of their low risk profile and pretty steady fixed income guarantee, SIBs are actually not securities that are sold on a market. Instead, they’re multi-party contracts between governments seeking financial support for innovative programs and policies and investors. They’re also considered quite risky.

That’s because payment of interests, as well as of the original loan, are contingent on the outcome of the project. If the objectives of the project are not achieved, investors receive neither a return nor repayment of principal. Compared to the pretty straightforward and reliable payment terms of regular bonds, SIBs may be considered a riskier enterprise.

How social impact bonds work

As mentioned before, SIBs tend to represent a contract made between state or local governments and investors who support a specific project that’s intended to have a positive social impact. These contracts will usually include some type of incentives and safeguards to protect both parties.

The success of, say, a new after-school program is not that easy to measure. Is the project considered successful if 80% of the kids in the neighbourhood attend? If graduation rates in the area increase? The contracts would ideally specify some minimal level of success that must be achieved before any money gets paid back. But because this so-called “social impact” is often not quantifiable and subjective, it can be hard to ever really determine whether a project has achieved its desired goal or not.

Critics of SIBs also point out that shifting the financial risk associated with a project from service providers to investors can compromise the efficacy of a project since investors tend to be profit-oriented and may not be able to properly act in the best interest of the communities the project is supposed to be serving. Because the project will have to pay a return on investment if it’s successful, budgeting for that return takes away funds that could be used to further solidify the program or fund other programs.

Advantages of social impact bonds

Despite the fact that SIBs haven’t existed long enough to have accumulated a proven track record—the first one was issued in 2010 by Social Finance Ltd. in the UK—there are now more than 130 SIBs operating in several countries across the world, with more than $440 million in investments raised.

For SIB supporters, one of the primary advantages SIBs carry is the promise of innovation in tackling difficult social problems with the help of private capital. By bringing in the private sector and transferring risk onto them, SIB proponents believe that the incentive to find sustainable solutions to social problems increases. The theory is: The larger impact investors and service providers have on the outcome, the larger the repayment they will receive.

SIB supporters also note that the nature of the contracts allows for governments and service providers to collaborate with a wide net of private sector entities, which could theoretically lead to more capital being brought into previously neglected areas of healthcare, education, and other weak social sectors. SIB supporters also note that the nature of the contracts allows for governments and service providers to collaborate with a wide net of private sector entities, which would hopefully lead to more capital being brought into previously neglected areas of healthcare, education, and other weak social sectors.

Another benefit SIB supporters laud is the notion that programs funded by SIBs will have a more rigorous evaluation and oversight process, which creates transparency and also makes it easier to determine what approach works and what doesn’t. Theoretically, governments would then fund “what works” and allocate spending to cost-effective preventive programs.

However, as previously mentioned, SIBs haven’t been around for long enough for any conclusive data about their effectiveness to be gathered. While proponents see SIBs as another natural addition to the increasing demands for more transparent and ethical investing practices, critics see them as risky investments that have the potential to reduce public responsibility and put the fate of vulnerable communities in the hands of the private sector.