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P(r)ay for Success Bonds

Screen shot 2011-09-27 at 10.49.48 AM

In March 2010, the first Social Impact Bond (SIB) was announced in Britain and since then, there has been a growing interest across the world to develop more SIBs. President Obama, in fact, set aside $100 million in his proposed 2012 budget to test ways to utilize SIBs (which he refers to as “Pay for Success Bonds”) in the public sector.

The plan uses private, profit-motivated investment money to fund prevention and early intervention of social problems. The government only pays if the services deliver as promised, and only out of government cost savings. Moreover, by focusing on preventative and early intervention measures rather than on costly crisis intervention programs the potential savings can be substantial.

To many skeptics, such a scheme seems too good to be true.

There are many challenges in putting together an SIB but the key one is to get potential investors and the government to agree on the appropriate social outcome to be measured and how to share the government cost savings after the intervention has succeeded. The government needs to be provided an incentive to devote resources to participate in the program and investors need to believe that they are fairly rewarded for the risks they are assuming.

If the government and investors believe that the payoff structure of an SIB is a “zero-sum” one, then they would have no incentive to work together. Instead the designers of SIBs might wish to consider using Game Theory to design payoff structures that encourage the government and investors to cooperate and work out “win-win” situations, in other words, “non-zero sum” games for both parties.

The challenge is to find ways to capture the non-monetary utilities of these two players. Many investors, for example, also look for social impact in addition to financial returns. Capturing the appropriate social impact in the payoff function for these investors may encourage them to invest in SIBs even though these bonds may offer a poorer risk-return payoff when analyzed on a pure financial basis.

Government departments need to look beyond their narrow self-interests in deciding whether they wish to participate in SIBs. For example, an SIB program that deals with homelessness may save money for the social welfare department working with homeless people while the health department may have to pay out money if this SIB’s intervention program is successful. These government departments need to make their decisions based on social optimality.

Another complexity to modeling the SIB using Game Theory relates to the uncertainty surrounding the intervention’s success or failure because a successful intervention will result in a positive payoff to the investors while a failed intervention will result in a zero payoff. As SIBs evolved over time and become more common, this complexity would, hopefully, become more manageable as an intervention’s expected success rate would likely become easier to predict and can then be incorporated into the game’s payoff matrix.

SIBs are in their infancy but their potential to allow private capital to be invested for public good is huge. They deserve every chance to succeed and an appropriate dose of Game Theory may be just what is needed to increase their chances of success.


2 Responses to “ P(r)ay for Success Bonds ”

  • James Leung

    This is awesome! Never heard of SIB’s before. Who exactly are the investors? Are SIB’s peer funded (by ordinary people)? Or is there some sort of qualification for investors (e.g. net worth)?

    Institutional investors would probably prefer to see some sort of track record with a new security before investing. So maybe SIB’s will have a greater success if open to public investment (Although it would be difficult to get through the SEC and other regulatory figures these few years).

  • Zoe Wong

    The one and only SIB so far raised 5 million pounds from a mix of philanthropic foundations and high net worth individuals. Social Finance USA is working on a US$100 million program to solve homelessness in the state of Massachusetts. Perhaps they will consider including a tranche for smaller investors (via some sort of KIVA type model).

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