At present, the most investable product for the institutional market – social bonds – can struggle to tick all the boxes on impact measurement. For instance, the “social bond (gender equality)” issued by National Australia Bank (NAB) in 2017 was excluded from Responsible Investment Association Australia (RIAA)’s total of Australian impact-investment securities because the proceeds could not be directly ascribed to specific positive impact.

Meanwhile, the debt product with the clearest link to positive social outcome – SIBs – presents significant challenges to institutional investors. In fact, takeup in Australia has largely been limited to the likes of charitable trusts, philanthropic foundations and family offices with radically different investment mandates from mainstream funds.

The question is whether the two worlds of social projects and capital markets can be united by a common language. The answer is as yet unknown.

SIBs allow a government entity to incentivise private investment in an organisation or project targeting a specific social outcome by offering a higher rate of return when outcome hurdles are met by the organisation. A typical project might target rehabilitation of prisoners, where the government commits to paying a higher rate of return if recidivism is rediuced by at least a target rate.

Successful projects can be mutually beneficial. Governments are able to save money because even a higher rate of direct funding is more than offset by the savings generated by the success of the project – in the example case, this would be less future incarceration. Meanwhile, investors receive a higher return when the desired outcome of the SIB is achieved.

According to UK-based non-profit organisation, Social Finance, the equivalent of US$392 million has been raised across 108 SIBs globally. The majority of these have been in the UK and US. In Australia, there are currently 12 SIBs in various stages of development from four jurisdictions, with the New South Wales (NSW) Office for Social Impact Investment (OSII) recently beginning the process of taking proposals for two more.

Ben Gales, Sydney-based executive director, economic strategy at NSW Treasury, says: “It is a challenge for governments to find the right solutions on issues like homelessness and recidivism. We think social-impact investment provides a good alternative to traditional government policies by leveraging the expertise of non-profit organisations and providing reward for outcomes.”

Christine Crain, Brisbane-based director of Queensland Treasury’s Social Benefit Bonds Pilot Programme, tells KangaNews: “The cost of interventions is considerable. On the other hand, the long-term cost of not having interventions that make an impact is the continued consumption of acute services – which is of course even higher over long periods.”

There are signs that some institutional investors are at least trying to engage with the concept. QBE Insurance (QBE) was one of the earliest institutional movers in the space, announcing in 2014 a plan to invest US$100 million in SIBs globally. James Pearson, manager, responsible investments at QBE in Sydney, says in committing these funds the firm wanted to stimulate the market and bring attention to the space, which it hopes will in turn lead to more institutional interest.

But deal sizes remain relatively small, even in the jurisdictions where the product is most developed and has most scale. Some of the critical features of a SIB structure are inherently difficult for institutional investors to address.

First and foremost, risk assessment in SIBs takes a completely different form from a standard bond. Daniel Madhavan, chief executive at Impact Investment Group in Melbourne, says: “Institutional investors are used to taking on balance-sheet risk in fixed-income investments. Effectively, SIB investors are taking on contract risk: the ability of the organisation to deliver the outcomes mandated in its contract with government.” 

The credit work an institutional investor would usually apply to a bond investment is therefore inapplicable to the assessment of a SIB. Most institutions have neither the experience nor the mandate to undertake the type of work Madhavan describes, particularly when the volume on offer is less than the threshold of participation for these investors.

KangaNews understands some Australian superannuation funds have looked at investing in SIBs. But the cost associated with evaluating the transactions is too high for most.

Nor do SIBs feature the quick path to market of benchmark bonds. Market users say the typical timeframe for a SIB to go from first conversations with an organisation to the beginning of service delivery is two years. It may be another two years before the programme begins to deliver results, with income flow in the interim likely to be below market rate and question marks lingering about exactly how success should be measured (see box).

David Carrington, London-based consultant and adviser to Giving Architects, suggests the complex and time-absorbing process to go from proposal to implementation and outcomes means it is unlikely the majority of institutional investors will be able to justify devoting the appropriate time to SIBs in their current form and volume.

This introduces the issue of scale. In theory, simply having larger and more frequent transactions might incentivise institutional managers to devote resources to the SIB product – even more so given the growing trend, especially at superannuation fund level, for environmental, social and governance factors to be made integral to the investment process.

Building track record, and proving results, will clearly be crucial in achieving scaled-up SIB deals. Market users agree that as more SIBs come to market it can be expected that a common approach to things like impact measurement will start to emerge – paving the way for wider investor engagement.

The problem is that SIBs as currently construed tend to be built around highly targeted projects with relatively small subject cohorts. This may be required given the complex world of long-term impact measurement, but it is hardly ideal for building institutional scale.

James Waddell, director, capital markets origination at NAB in Sydney, highlights the On TRACC SIB, which addresses recidivism in NSW – currently for 600 parolees per year. This will shortly increase to 900, but Waddell says this is close to a reasonable limit for such a programme in NSW. “If you scale up an intervention in recidivism you eventually need more people to be in prison. This is clearly not ideal as a societal outcome,” he says.

Specific sponsor circumstances only exacerbate the challenge. For instance, Crain says scaled-up deals may be even harder to deliver given the focus of some of Queensland’s SIBs falls outside the populous south-east of the state.

The long-term horizons of many social interventions also make it hard to predict that governments will massively ramp up their support of SIBs. Governments typically want results to fall within near-term budget and election cycles, while the results of a wide-scale intervention in an area such as housing may not be fully realised for years or even decades.

Ideology and political forces also play a part. Indeed, the very first SIB – designed to reduce the rate of recidivism at Peterborough Prison in the UK – was ultimately cut short. Market sources say the SIB succeeded in reducing recidivism and saw investors repaid in full, but it was abandoned early as the UK government implemented a new national programme.

Carrington says the Peterborough Prison deal taught all involved a lot about how to structure and execute this sort of transaction. However, he believes it would have been even more successful were it allowed to run to completion.

The fate of the UK project also hints at a further risk for investors. “The possibility of a government changing policy direction before the maturity of an intervention certainly doesn’t encourage long-term, patient investors to participate in these deals,” Carrington adds.

In New Zealand, the former National government was eager to use SIBs to tackle issues such as mental health and youth unemployment. However, the new Labour-led government has announced that it is not planning any SIBs.

The door has been left ajar for other types of social investment in New Zealand, though. Clive Pedley, Auckland-based director and chief executive at Giving Architects, says a recent social-impact-investment transaction has many of the characteristics of a SIB but without the payment-for-success piece – which he says provides more certainty for investors.

To date, the context in which a SIB is developed arguably has more influence on its format than considerations of investability. Carrington says: “There are now 18 countries with national advisory boards for social-impact investing. Each is developing at a different pace and in different ways, as you would expect, though there are a lot of similar themes between them.”

Carrington says the Global Steering Group for Impact Investment is allowing stakeholders in the space to pool their learning.

Despite some false starts, there appears to be relatively consistent desire from governments, intermediaries and some progressive institutional investors to bring SIBs into the institutional light. Madhavan reveals that some institutional investors have already participated in SIBs as a market-building exercise.

Social Finance’s London-based chief executive, David Hutchison, says institutions are tracking the market and, in this context, the positive returns of the first SIBs is reassuring. He says some transactions have been structured to attract institutional investment, for example through principal guarantees, though this may not be a long-term fix. “The net effect of this has been to offer unsustainably generous returns on the proportion of capital at risk,” Hutchison explains.

While this initiative may not be the answer, limited institutional-investor participation in the SIB market should not be taken as a failure, market participants insist. For one thing, no-one involved in the sector expected institutional funds to be early adopters.

Furthermore, the ramifications for economic and social policy would be immense if governments successfully mobilise mainstream private investment funds for SIBs and other debt-based impact-investment models in the volume that a regular government bond deal might achieve.

Pedley says: “The idea of government de-risking, rewarding or incentivising private wealth to participate in social and environmental purpose is essential. SIBs provide a model to do this, but the model doesn’t fit very well at the moment for institutional money. There needs to be innovation from all parties for this to work at scale.”

One way of removing some of the due diligence and time cost for potential institutional investors is to create an aggregated fund. The first of these have already been established abroad, with QBE providing the cornerstone for the first US-based SIB fund in 2017.

Pearson tells KangaNews: “Aggregation of SIBs into a fund vehicle mitigates some of the risks and transfers a lot of the time-intensive factors that are difficult for institutional investors onto a fund manager, who is likely to be closer to the service provider and more experienced with the social-impact area.”

Whether there is enough SIB scale in Australia to establish a fund is debatable. But Pearson believes this innovation would be more than welcome in the market as a signal of intent and commitment to the product from investors.

Hutchison says another route to scale that has been observed in the UK is for an intervention with a track record of success to be commissioned by multiple local partners. He highlights a successful intervention to support the families of adolescents at risk of entering the care system in Essex, launched in 2012 and terminating this year.

“This has established a value-for-money case that has encouraged five London boroughs to commission the same service off the same platform on identical terms. It required the raising of £5 million [US$6.5 million] of risk capital with the prospect of at least the same required again to support the expansion of the intervention across the Greater London area,” Hutchison says.

Innovation in the way SIBs are structured to deal with risk is evolving to enable greater participation from institutional investors – and Australia is playing a role in the sector’s development (see box).

It may also be possible to engage institutional investors in a way that allows scale to come into the market without requiring the mainstream funds sector to familiarise itself with the most challenging aspects of social-project funding. Most non-profit organisations and NGOs have backing from philanthropic supporters, and Waddell says these can provide leverage as guarantors to the working-capital provider should the programme not deliver the contracted results.

SIBs could effectively take on a guise similar to the securitisation market, where the investors providing the higher-risk but smaller-volume capital at the mezzanine and equity level are often completely different from those contributing the bulk of funds in the top tranches.

Pearson says a structure has been used in the US with layering of capital in junior and senior tranches. “As an insurer that is focused on capital preservation and lower volatility, being invested in a senior tranche – where the junior tranche would be exposed to the first loss – would be very attractive,” he adds.

When it comes to political risk, Madhavan suggests a possible way to mitigate policy change would be for institutions at least one step removed from the political realm to become the issuers of SIBs. Development impact bonds – where institutions such as aid agencies or NGOs are the outcomes payer – are becoming popular in emerging markets.

The concept has yet to be taken up by the private sector, according to SIB market participants, but how it might work is clear at least in theory. For instance, in the health sector a SIB might be used to fund prevention of diabetes or heart disease, where there are well-known steps that can be taken to reduce the risk of the disease developing. Pearson says this could present tremendous cost savings not only for government but also for health-insurance companies.

SIB issuance by institutions other than governments could potentially serve as the springboard needed to introduce more scale and entice institutional money. The long-term prospects of projects run by private-sector entities, and therefore the SIBs they issue, could be less contingent on the whims of government policy. With more actors able to participate, the quantity of transactions could also be greater.

Madhavan also identifies SIBs as theoretically tempting to institutional investors as a diversification tool. If transaction risk can be successfully mitigated, the returns SIBs offer for successful interventions should be very attractive to investors as they increasingly look for assets that provide an uncorrelated opportunity.

SIBs are a unique asset class, and Pearson agrees that they would offer portfolio diversity. However, he stresses that at their current size SIBs are relatively immaterial in diversifying an overall institutional-size portfolio.

At this stage, any realistic assessment of the state of the SIB market has to acknowledge that it is not yet close to being an institutional product – and that the majority of mainstream fund managers are not close to allocating.

SIBs are a small segment of the overall impact-investing space. According to a report by RIAA, there was a total of A$5.8 billion in committed funds in Australian impact investing by the end of 2017. Of this, the report states SIBs account for A$43 million (see p14).

Part of the challenge lies in identifying sectors where scale might be available. Areas like health and housing, wheregovernments spend billions of dollars on solutions, are perhaps the most readily applicable to a scaled-up SIB. 

Both sectors have had vanilla bond issuance in various jurisdictions. Housing New Zealand’s recent capital-markets return and International Finance Facility for Immunisation’s “Gavi bonds” are examples of large, institutional investor-backed deals which produce positive social outcomes.

Even so, a SIB product with returns directly linked to positive outcomes could have a substantial impact in critical service provision if the institutional investor base can be attracted to the asset class. The question is whether this direct link is absolutely critical to mobilising institutional funds for social benefit, and indeed whether the two sectors can ever realistically interact in scale.

Gales says OSII will be working closely with NSW Treasury Corporation for its proposed sustainability bond, which was announced in June 2018. The transaction will not include payment for outcomes, however.

But Carrington says: “It is fine for an institutional investor to want their money to be going towards positive outcomes without being as involved in the process as they would be in a SIB. The most important step for these investors is wanting their money to be used in this way, and many are beginning to take it.”

Waddell points out that not all societal problems should be looked at in relation to SIBs, and in fact it would not be appropriate for governments to do so. Australia’s federal government announced in its 2017 budget plans to establish the Australian Housing Finance Corporation (AHFC), a bond aggregator which will raise low-cost debt and provide loans to not-for-profit community housing providers.

With any bonds issued by AHFC guaranteed by the government, and volume likely to be substantial, institutional investors would likely be more immediately interested in this transaction than they would in a SIB addressing a similar issue.

Even so, the existence of other government plans to bring a greater quantum of institutional funding into social-policy prerogatives does not necessarily mean SIBs will inevitably only ever be a niche component of the social-impact-investment scene. It is evident, however, that the choice of projects to which SIBs are applied is critically important, even more so if it is to be done at scale.

The reality for now is that SIBs, despite their potential for higher returns when outcome hurdles are met, simply cannot provide the scale of return necessary to attract widespread takeup from mainstream investors. However, the funds being dedicated to impact investing continue to grow and so too does the desire from many investors to see real impact outcomes from their allocation decisions.

Pedley tells KangaNews: “The fundamental driver of this is that money is being looked after on behalf of conscious consumers who are now becoming conscious investors. Fund managers and institutions are having to behave differently to respond to this.”

The forces driving these types of investments, as well as those prompting governments to seek private investments in the provision of social services, are likely to continue.

This is evident in QBE’s Premiums4Good offer, which has committed an additional A$100 million to impact investing in 2018. The funds are available to the full spectrum of impact investing, from SIBs to green bonds, with the scale expected to increase in future years.

Pearson says: “We knew coming into these deals that they would be small. We look at the transactions for social and financial returns. But it is also about showing our credibility to the impact-investment market and offering our policyholders, through our Premiums4Good offering, the chance to align their beliefs around community and the environment with their purchase of insurance.”