Letting investors take a shot at curing social ills

September 23, 2014
Author: John C. Williams
http://online.wsj.com/articles/john-c-williams-letting-investors-take-a-shot-at-curing-social-ills-1411515133

What if there were a way to solve the country's most intractable social problems—homelessness, crime or inequities in education, for example—without putting taxpayer money at risk? There might be.

Rather than paying upfront for social services, a number of states and local governments are testing initiatives that pay upon completion, based on results. No success, no payday. This "social impact bond" financing, or SIB, is a new approach to contracting that allows government, businesses, nonprofits and investors to find solutions to some of the country's most deeply rooted social ills.

Consider Massachusetts: This year about 4,000 young men will be considered "high-risk" as they move out of the juvenile justice system. Roughly 55% of them are expected to be re-incarcerated in the following three years, spending an average of 28 months behind bars at an annual cost of $47,000 each. To reduce incarceration and improve employment prospects, the state began an SIB earlier this year, allocating up to $27 million.

The project follows a basic SIB model: An intermediary organization is awarded the contract and functions as project manager. In Massachusetts, the organization is Third Sector Capital Partners, one of two national SIB intermediaries, the other being Social Finance U.S. That organization either hires a social-service provider, manages a provider hired by the state or locality, or delivers the services itself. Massachusetts chose the organization Roca to deliver two years of intensive behavioral and workforce services and two years of follow-up services to 929 at-risk young men. Private investors, such as banks or foundations, provide the working capital—$18 million in Massachusetts.

An independent organization in the Bay State will verify outcomes over the next seven years and evaluate the project based on reduction in incarceration time and increases in work-readiness and employment. If the project is a success, the intermediary and service provider receive deferred services fees and the loan providers are repaid their investment, plus a rate of return: 5% for the senior loan and 2% for the junior loan. Payments begin at a 5% reduction in prison-bed days and lenders are fully repaid at 40%, with bonus payments for further reductions. If the project fails to deliver, the state pays nothing.

People of all political persuasions can get behind this approach. SIBs allow governments to address problems at the appropriate level—be it local, state or federal—in innovative ways, with market discipline. If the Massachusetts program works, the project will improve life for at-risk young men and reduce the commonwealth's $300 million annual incarceration bill.

The benefits wouldn't end there. Fewer people in prison reduces the burden on law enforcement, the courts and the penal system. Reductions in crime create safer neighborhoods, which increases property values. Redirecting people away from crime and toward employment means more people with paychecks to spend, which stimulates economic activity.

In Utah, Salt Lake County is using an SIB to solve a local problem: Children who are unprepared when they arrive for kindergarten are often diverted into special-education classes, even though sometimes they simply need to catch up with their peers. This takes special-education resources from children who truly need them and denies others the chance to reach their educational potential.

The Utah SIB, with the United Way of Salt Lake acting as the intermediary, enabled 600 3- and 4-year-olds to attend high-quality preschool last fall, getting a jump-start on learning so they're ready for kindergarten.

The program participants took the Peabody Picture Vocabulary Test, an evaluation used to predict which children are likely to need special-education services. Students who scored considerably below average will be tracked through sixth grade. The success payments to the upfront funders—a financial institution and a high net-worth investor—will be based on how many of those students avoid special-education services and for how many years. Though the success payments end at sixth grade, many students will continue in mainstream classes through middle and high school, saving the state even more.

Utah funds special-education programs at a rate of around $2,600 per student annually. If successful, investors will receive 95% of the savings as repayment plus 5% interest, until their initial investment—a modest $1.1 million for the first cohort—is recouped. After that, success payments will drop to 40% of the savings, about $1,040 per child a year. Students would learn at their proper level, and Utah both saves money and reaps the benefit of better educational outcomes.

There is no panacea in public policy, and there are some caveats. SIBs are still new to the U.S., though they have seen some initial success in the United Kingdom and Australia. Governments must structure the contracts in a way that best achieves their goals without allowing anyone to game the system.

Still, SIBs may have the potential to help governments address some of our nation's most obstinate problems and score wins for everyone: the private sector, nonprofits, government at the local, state, and federal level, and, most important, citizens across the country.

Mr. Williams is president and CEO of the Federal Reserve Bank of San Francisco.