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PSC’s Jeff Guilfoyle writes about what’s possible with social impact bonds (SIBs). Mr. Guilfoyle specializes in school finance, tax policy, intergovernmental fiscal relations, and issues pertaining to Michigan’s economy and the state budget.

Social Impact Bonds 101 

‘Government’ and ‘innovation’ aren’t terms that usually go together. So it might come as a bit of a surprise that an innovative, new financing tool referred to as social impact bonds is not only being discussed, but also deployed in our state. In August, the state issued a request for SIBs proposals. Proposals were due a couple weeks ago (October 9), so I thought it might be useful to provide this brief to explain what SIBs are and their potential appeal to investors and state government.

What Are Social Impact Bonds, and How Do They Work?

A SIB is an arrangement where private investors fund new public services that result in highly efficient and effective programming, and ultimately, savings to the taxpayer. If the new public service produces agreed‐​upon outcomes, the state repays the investors for the full program cost, plus a rate of return paid from the savings.

For example, a group of investors is contributing $17 million to fund a preschool program for 2,600 children in Chicago (1). The program is expected to reduce special education costs. Investors will be paid back in stages as children meet certain benchmarks in kindergarten and on later standardized tests. The city of Chicago believes it can pay for the bonds with the savings it achieves from lowering the district’s overall special education costs.

Michigan is calling its SIB program “Partners for Success” in order to avoid confusion with traditional state bonds. Michigan’s RFP is seeking programs that improve birth and early life outcomes with a focus on high‐​risk infants and their mothers.

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Family benefits from Partners for Success

To achieve desired outcomes, Partners for Success will require the coordination of:

  • Service providers (public or private entities, such as school districts or nonprofits, that provide services for the public)
  • Investors (generally, private foundations or philanthropically minded wealthy individuals that fund programs)
  • Intermediaries (organizations that help connect the private service providers with investors, which can also help facilitate arrangements with state government)
  • State government (contracts with either the service provider or the intermediary; the contract includes the outcomes that need to be achieved prior to the state paying the agreed‐​upon amount)
  • Evaluators (neutral third parties that determine whether or not the outcomes have been successfully achieved)

Why Would Investors be Interested in Funding SIBs?

SIBs can often be a risky investment. If a program does not meet objectives, financers can lose their entire investment. Private investors generally require a very high rate of return before they are willing to invest in an instrument that can lose its full value. Governments, on the other hand, are unwilling to pay a very high rate of return on SIBs.

Given that the rate of return for SIBs is likely to be low (relative to the risk), the market for SIBs will be dominated by private foundations and philanthropically minded wealthy individuals. Private philanthropists often invest in social programs without the expectation of receiving any of the investment back. If a foundation invests in a SIB and the program is successful, it can receive its money back plus a rate of return. This allows the foundation to reinvest these funds in other programs, allowing the foundation to increase its overall impact. It also provides a way for private philanthropies to get government funding for promising programs.

Why Would the State be Interested in SIBs?

On the one hand, SIBs seem like free and easy money for the state. Conceptually, private investors put up the funds for programs by buying a “bond” (SIB) and then the state makes the bond payment using the savings produced when the programs meet certain outcomes. Unfortunately, it’s not quite that simple. For successful programs, SIBs actually cost the state more money in terms of real dollars than funding a program with a direct state appropriation. This is because if the program is successful, the state pays for the full cost of the program and the rate of return promised to investors. In essence, the state is asking private investors to demonstrate program success prior to the state paying for the program. Demonstrations are often a difficult sell to legislative bodies, and SIBs help remove that barrier and mitigate risk in the event the programs fail to meet outcomes. In a way, SIBs are like derivatives in which the state is selling its risk to investors. The state pays a fee to insure against the risk of investing in an unsuccessful program. Investors are willing to buy this risk because they believe that the program will be successful.

So why is this a good deal for the state? Because of the potential for long‐​term benefits. These benefits can include things like improved public health or an increase in kindergarten readiness among at‐​risk children. The long‐​term benefits often significantly exceed the costs of the programs, but investment in these programs require legislators to take a leap of faith that promised outcomes will actually materialize. SIBs greatly reduce the risk of making a bad investment by allowing the state to withhold payment until agreed upon outcomes are met.

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Jeff Guilfoyle, PSC’s VP for Education

So What Happens Next?

The jury is still out on how SIBs work can work in Michigan. In the U.S., these programs are in their infancy, and few are far enough into the data collection and outcome measurement phase to gauge how well they really work. There is a lot to be said for Michigan taking the initiative to try this financing mechanism, if for no other reason than that state dollars are scarce and Michigan needs to be highly selective in terms of the programs in which it invests. SIBs provide opportunities to identify successful programs that save taxpayers money prior to the state committing funds to the programs.

Assuming the programs selected are solid in their base of evidence for success, the contractual outcome mechanisms are valid and rigorous, and investors are willing to take risks (none of which are small hurdles), SIBs may prove to be an innovative and effective means of identifying and funding promising programs in Michigan.

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