The world is getting closer to a more sustainable model for pay-for-success arrangements. Reinvestment Fund, out of Philadelphia, announced a $10 million fund last year to support pay-for-success projects in a portfolio approach that would diversify investors from the risk of any single project.
Not sure what “pay for success” is? Check out this quick primer on social impact bonds, one common example of this practice.
Background
So far, this industry has seen a slow, but steady increase in the number of projects undertaken that will pay investors based on the success or failure of the program. The problem is that the expected results of any given program can never totally be known, so the risk of failure would wipe out the entire investment and discourage future investors from engaging in similar activities.
This makes the results of each individual project so critical toward advancing the industry.
Source: Goldman Sachs
Reinvestment Fund’s approach
Reinvestment Fund is an organization that has already taken part in two pay-for-success projects in Cleveland and Silicon Valley. They’re now taking the first step toward mitigating this “single project” risk by announcing a new fund for a portfolio of investments.
This approach is unique, because instead of selecting a single outcome to address, the organization may choose to invest across a wide array of social outcomes (e.g., housing, food, education, health). This combination of different investments may be more resistant to wider macro-economic exposures that can take down any given initiative.
Think about a social impact bond investing in some affordable housing initiative. If a sudden bubble happens over the next few years in real estate prices, it could dramatically impact the profitability, and success, of the bond.
But imagine, instead, of combining that affordable housing investment with others addressing different social outcomes. A second investment might address pre-k education, another prison recidivism, another healthy food, and so on
By combining these different outcome goals, despite the individual risk of each program, the overall investment’s risk is reduced due to different economic factors impacting each one. Sure, many social outcomes may be interwoven with similar macro-economic trends, but the risk is at worst the same, and at best highly mitigated.
Source: Seeking Alpha
Take Scenario A, which is a single investment into a program with a 50% failure rate, and compare it to Scenario B, which is investment in ten different programs, each with a 50% failure rate. Total loss in Scenario A is no better than a coin flip. Total loss in Scenario B is 0.1%.
Potential headwinds
Before creating this pay-for-success portfolio, Reinvestment Fund has operated both traditional pay-for-success arrangements (or social impact bonds) and traditional bond arrangements. The Fund’s AA S&P bond rating (which is higher than nine states) helps attract private dollars for more of these traditional bond setups — e.g., the $50 million bond issue earlier this year.
This high rating coupled with its status as a Community Development Financial Institution (CDFI) and the consequential funding it receives from the Federal government has the organization in position to reach a lot of programs and a lot of outcomes.
Pay-for-success funding has a built-in mechanism to pay back its investors—through the programs being invested in. However, the Fund’s standard bond issues (yielding around 3-3.5%) are theoretically paid back to investors from program revenues, outside sources, or any other resources at the organization’s disposal.
If CDFI funding from the Feds makes up any substantial portion of the payback to investors on these standard Reinvestment Fund bonds, and the Trump administration follows through in eliminating all CDFI funding from the Federal government, then many of the current deals could fail and the organization could be at risk of bankruptcy if it cannot meet its obligations.
Of course, without knowing how most of Reinvestment Fund’s bonds are structured to pay out, it is not appropriate to say this will happen if Federal funding disappears, but it certainly is reasonable to assume.
Optimistic Future
Regardless of what happens with its outstanding bonds, the fund has positioned itself as an early mover into an excellent idea of diversifying pay-for-success projects into a more viable option for profit-driven investors.
If any of the programs succeed, the whole fund will be able to pay at least something back, as opposed to a single investment failing and blowing up the whole investment.
It is a good idea that should be watched closely and improved upon to a point where the industry can build a more sustainable stream of capital into programs that help society.