Last month, the U.K. Government announced almost £200m of funding for 22 programmes backed by social impact bonds (SIBs), via the Life Chances Fund – providing an additional boost for this innovative impact investment approach.

There have now been well over 100 SIBs commissioned around the world. Pioneered in 2012 by Social Finance as a way to reduce recidivism in the UK, these programmes are now helping migrants find work in Belgium, preventing diabetes in Israel, improving girls’ education in India and supporting micro-enterprises in Kenya.

Different countries have adopted different models, but they all share two core characteristics. They’re based around an outcomes contract – so a social enterprise or non-profit agrees to deliver some kind of social service on a “pay for success” basis, whereby a funder (usually the Government) only pays if the service achieves some pre-specified outcomes. And an impact investor provides the working capital and management support required to deliver the programme successfully.

For governments, the appeal is clear. Social outcomes contracts offer a way to target spending on the most effective solutions to pressing challenges (often by focusing on prevention rather than treating the symptoms), with the help of private capital and expertise – while the data-centric approach also improves the evidence base to inform future policy. And that’s not just true in developed markets: there’s also huge potential to use this approach in developing countries, perhaps funded by NGOs or large charities (a variant sometimes called ‘development impact bonds’).

These contracts also resolve a perennial challenge for impact-driven investors: how to align impact and financial goals without the need for unwanted trade-offs. The only way the provider gets paid, and the investor sees a return, is if the provider delivers the social outcomes governments want. So impact goals and financial goals are perfectly aligned. What’s more, as an investment, it has the potential to deliver risk-adjusted returns that are not correlated with stock markets, interest rates or commodity prices.

However, SIBs are not without their critics. Some believe that it’s wrong to put a financial value on improving the lives of vulnerable people. Some suggest that Government shouldn’t impose performance requirements on providers, or that doing so might create the wrong incentives. Others argue that it adds unnecessary cost and complexity to public sector commissioning.

If investors (like us) want to achieve positive impact and returns by investing in projects that are ultimately funded by public money (or philanthropy), we must acknowledge and address these challenges. We have to prove that this approach drives better outcomes and better value for money to Government than any other viable alternative. Happily, there are three reasons why I think this will be the case:

The first is that paying for outcomes rather than a prescribed set of activities (as happens with standard contracts) changes the way contracts are delivered. Providers have much more freedom to be nimble and adapt their service to meet the individual needs of beneficiaries, which typically helps them deliver better results. They’re also directly incentivised to deliver as much impact as possible, and to capture data that will help to inform future policy innovations and efficiencies.

Second, this structure allows Government to award outcomes contracts to a broader range of providers. Any organisation taking on one of these contracts will need working capital, to fund the programme until the payments arrive.  If the provider has to raise this capital via their own balance sheet or via normal bank finance, the Government’s pool of options is likely to be restricted to larger organisations.  SIBs allow smaller mission-driven providers, who may be best-placed to address the problem, to partner with a social investor to raise the up-front funding they need, on terms that are far more flexible than the typical bank loan.

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