Impact bonds are increasingly gaining prominence as financing mechanisms for a wide range of development activities. According to the Brookings Institution, as of February 2020, there were 192 impact bonds across 32 countries, totaling more than USD 420 million in investments. While the popularity of, and interest in, impact bonds has grown, the conversations around it often lack an understanding of how they work and when they can be most useful.
Here, we summarise the truth behind five commonly expressed myths, and suggest ways to use them effectively.
The use of the word ‘bond’ misleads development practitioners into thinking that impact bonds resemble instruments used in financial markets to raise money as a loan agreement. In fact, impact bonds are neither bonds, nor financial instruments at all. Rather, they more closely resemble multi-party contracts for sharing risk and paying for social outcomes.
Under an impact bond, an investor provides up-front risk capital to an implementing organisation or service provider, to run a programme with pre-decided social outcomes. If the outcomes are achieved, an outcome funder pays back the risk capital, plus interest, to the investor. It creates an opportunity for the investor to earn a return, and incentivises the achievement of social good.
Impact bonds can be structured either as social impact bonds (SIBs), with outcome funding provided by the government, or as development impact bonds (DIBs), with funding from the development community (a foundation or philanthropist).
Related article: IDR Explains | Development Impact Bonds
Impact bonds can be crucial tools for driving innovation and risk sharing, but they rarely bring truly new money to the table. One of the key ways in which impact bonds create value is by unlocking additional funds from private equity investors, but this is only true in a minority of cases. Typically, an impact bond requires the outcome funder—a government or philanthropic entity that funds development work anyway—to provide a grant covering the costs of achieving outcomes, interest for the investor, and fees to other third-party partners that structure, measure, and manage the outcomes achieved.
Impact bonds may not bring new money to address social challenges, but they can be useful in driving innovation, and creating value for both risk-adverse outcome funders (those who want guaranteed outcomes), and for investors who are willing to take on the risk for an appropriate reward. Therefore, it is crucial to ensure a balanced level of risk between funders and investors, such that both parties find the terms of the bond and the risk level, acceptable.
By remaining aware that their partners may harbor one or more of these myths, funders, investors, and implementors will be able to use impact bonds successfully. | Pictur courtesy: Pxhere
Impact bonds are one of many results-based financing (RBF) tools available, and each of them caters to a different set of parameters and priorities. Traditional RBF mechanisms include conditional cash transfers and performance-based contracts that are arranged directly between funders and implementers. Newer mechanisms include Social Success Notes (SSNs), where the implementing organisation (typically a social enterprise) repays the principal to the investor, and a philanthropist or government pays the interest; and Social Success Incentives (SSINs), where financing is provided to scale interventions that have proven results at preliminary stages. We estimate that the total investment under RBF was approximately USD 3.3 billion in 2016, and forecast a strong 15–20 percent per year growth, reaching USD 6–7 billion 2020.1
Many nonprofits with a good reputation and track record of success, are willing to undertake the role of service provider as part of an impact bond. But because service providers can’t ever lose financially2—it’s either the investor or outcome funder who bears the financial risk always—they may need additional incentives to drive them to achieve outcomes. These could be linking funding to success, or the risk of a loss in reputation.
Under the impact bond model, an inability to collect data and adapt programmes when there are signs of failure can be costly.
For example, while designing an impact bond, we considered working with public hospitals in India as service providers. However, these hospitals did not have the right incentives to perform better with an impact bond structure than without one, undermining the likelihood of achieving results. Most nonprofits have an incentive to deliver outcomes even if they are not losing financially, because their reputation is at stake, and this can hamper their fundraising abilities in the future. Public hospitals, however, are not as sensitive to such reputational risks as they will continue to get funding from the government, no matter their performance on the impact bond. Moreover, the demand for their services from low-income populations often exceeds supply in any case.
Service providers must also have a data-driven decision-making culture and the ability to pivot and innovate based on lessons learned during implementation. Under the impact bond model—where payment is contingent on innovation, learning, and results—an inability to collect data and adapt programmes when there are signs of failure, can be costly. Thus, it is critical that service providers think carefully about their incentives before entering into an impact bond structure to fund their programmes.
The core value of the impact bond mechanism is to transfer the risks of a development programme to someone who can better absorb and manage them. Internal risks, such as the ability to hire on-ground staff to deliver the programme, are more straightforward to price in and manage for. Certain external risks can also be managed or outsourced further. For example, the risks of external stakeholder disruptions (such as, from a teachers’ union) may be anticipated based on past experience, while weather risk for an agricultural impact bond may be mitigated by purchasing weather-based crop insurance.
Related article: To DIB or not to DIB
However, there may be external risks that are simply not predictable or preventable, such as the COVID-19 pandemic we are currently experiencing, or a change in regulation outlawing a certain model, where a force majeure may apply to allow for a suspension or termination of the agreement. In case there are ongoing costs despite a suspension or a termination of contract, the investor and outcome funders would need to renegotiate who takes that on, as nonprofit service providers may not be able to absorb them. In today’s pandemic scenario, for example, laying off economically vulnerable on-ground staff would not be advisable, and nonprofits might not have extra reserves to cover their salaries. Over the next few weeks, we will see how these negotiations pan out, as COVID-19 impacts continue. A well-designed bond should be able to price in higher returns for taking on higher risks, and allow for an exit in scenarios where the risk cannot be priced in or managed.
We believe that understanding the five important aspects of impact bonds outlined above can counter the misperceptions that undermine the efficacy and usefulness of this innovative social financing tool. By remaining aware that their partners may harbor one or more of these myths, funders, investors, and implementors will be able to better judge when and how to use impact bonds and other RBF tools successfully.
- Mainstreaming Results-Based Finance: Actionable Recommendations for USAID, May 2016, Dalberg Advisors. This forecast does not take into account the current COVID-19 effects.
- Unless they are a risk investor (either fully or partially), which is possible if they are a for-profit.
This article was edited at 2 PM on May 5th, 2020 for accuracy in the last point.
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Know more
- Explore the latest insights on how the COVID-19 pandemic is affecting outcome-based development contracts.
- Learn more about what impact bonds are, the evidence to date, and how they work in practice in different countries around the world.
Do more
- Write to the authors at [email protected] and [email protected] if you are working on impact bonds and/or would like to learn more about it.
