Social Benefit Bonds – There are risks to funding a social benefit

Social Benefit Bonds (SBBs) have the potential for material growth as government balance sheets come under increased pressure going forward. While SBBs provide investors with the ability to assist in the provision of social programs investors need to recognise that the key risks involved differ materially from traditional bonds.

What is a Social Benefit Bond (“SBB”)?

An SBB is a financial instrument in which private investors provide up front funding to a Non Government Service Provider (NGSP), usually a charity or other not-for-profit organisation, in order to deliver improved social outcomes. The determination of what constitutes an improved social outcome is defined according to an outcomes-based agreement with a government. The prime objective of such outcomes-based agreements are to deliver cost savings to governments which can then be used to pay back the up-front funding as well as provide a return to investors and savings to the government. Importantly the return to either some or all of the investors providing funds will be determined by the magnitude of savings realised by the government.

Why do SBBs exist?

SBBs exist to facilitate the coordination of NGSPs, community services and social-minded investors to achieve a common good. As such, they lend themselves to innovative approaches to implementation in order to gain the optimal results. The complication in providing such services is the conflict between the provision of long term funding and the need for innovation in such outcome based projects. On the one hand while governments may be in the best position to fund such long term outcome based projects, they may not be the best organisations to cultivate innovation in delivery, due to their size and structure. Further as the finances of governments become more strained there may be an increased requirement for non government agencies to take on an increasing role in the provision of services. In contrast while NGSPs may be in the best position to introduce innovations with respect to outcome based projects, their typical short term revenue based funding models do not naturally lend themselves to funding such projects.

Providing the potential to bridge the gap between government and NGSPs are SBBs. SBBs bring into the equation investors who are seeking to achieve a greater balance between commercial returns and the social benefits created from their investing. In return the investors are not only assuming some of the risks associated with provision of the program but also share in the potential upside.

Can any social service be funded using an SBB?

The mechanism for which investors are paid, are through the savings to government expenditure, through the existence of a social benefit program. This inherently limits the types of programs which SBBs are suitable for funding. Importantly SBBs only work where there is scope for measurable innovation; i.e. can tie returns directly to improved outcomes/reduced costs. Due to this, to date, SBBs have been most readily applied to fund preventative, innovative interventions that tackle the underlying causes of a range of social issues. This follows as the more effective provision of preventative services can be more clearly linked to the public sector spending significantly less money on expensive services. Conversely SBBs are less likely to be appropriate where the service provided is heavily proscribed by statutory obligations thereby inhibiting the scope for innovation and/or the success of the underlying programs are susceptible to material impacts from external factors making quantification of outcomes problematic; e.g. where potential changes in government legislation may materially alter the outcome.

SBBs are fundamentally different to traditional bonds

SBBs are fundamentally different from regular bonds in that, for the purposes of analysing the potential returns to investors, the outcome value is narrowly defined in terms of the cost savings accruing to specific public sector budgets. This is important for investors to keep in mind for while there may be broader social outcomes which reflect important social benefits, these do not release cash from public sector budgets that can be used to make outcomes based payments to investors in a realistic time frame. It is only the direct cash release from the public budget by the specific program which is available for payment to investors.

It is this requirement to directly link the payout to investors with the quantifiable cost savings to the public sector which results in the underlying complexity of an SBB. Effectively any SBB requires the development of a financial model which aims to reflect the economics of the program. The model estimates the cost of interventions, overheads and other fixed costs which together determine the level of investment required over the period of the program. Set against this will be the share of the cost savings agreed to be distributed to investors should a sufficient improvement in outcomes be achieved. Basically the financial model requires consideration of three factors:

1. intervention costs;
2. outcome values; and
3. time horizon to realise investment returns.

The key point for prospective investors to keep in mind is that SBBs are really structured securities and hence investors need to be comfortable with the model underlying the payment of returns. This in turn, as with many structured vehicles, introduces material levels of model risk which are not normally present in traditional bonds.

SBBs provide the opportunity for investors to participate in the provision of programs which have the potential to provide material social benefits. With that said investors need to appreciate that the underlying features driving the returns to investors are not the same as traditional bonds. SSB are highly structured investments where the underlying models determine the returns to investors. While the tranching of SBBs may provide for clearer risk allocation it does not necessarily remove the underlying risk of modelling the program. Though for some investors the potential social benefits may be sufficient to justify the additional risk it is important to recognise that investing in SSBs can entail material risks which may be difficult to clearly identify. Accordingly, investors need to take care to clearly understand the risks associated with such vehicles before investing.