By John Stroud (complete bio at the bottom of article)
By now it’s possible you’ve heard of social impact bonds (SIBs) or even been regaled with their benefits for all parties. If not, allow me to summarize.
Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?
In broad strokes, these innovative financing vehicles are a powerful tool for municipal policymakers to use their existing resources more efficiently, catalyze environmental and social good, and improve the quality of services, even in the face of shrinking public budgets.
With all the positive developments surrounding social impact bonds, many are asking why local officials are circumspect and where the hesitation toward mass adoption lies.
This article will delineate three main areas of empirical push-back from municipalities – affordability, financial risk transfer and competition - and provide specific and constructive points to assuage these concerns going forward.
On the question of affordability, the point is sometimes made that the administrative costs during the pre-contract or set-up phase are often relatively high. Forward-looking firms such as Quantified Ventures (quantifiedventures.com) in Washington, DC have anticipated this objection and pro-actively taken steps to remove it as a barrier.
QV understood from the early days of SIB consideration that by subsidizing the administrative, contract, and document-creation cost of projects they could explore more projects with more local governments.
By working with non-profit groups throughout the country and leveraging these entities’ program related investments (specifically, grants) they could cover the initial costs while allowing the non-profit groups to adhere to their mandates.
On the concern of financial risk transfer, the calculus of this structure dictates that improved metrics for private investors (the funders of the program) will result in worse prospects for the government agency. For this reason, it is critical that an experienced intermediary, one with both private investment and public-sector experience, as well as a thorough understanding of acceptable parameters for all parties involved, be fully vetted and chosen.
Additionally, safeguards can be put in place. For example, The District of Columbia Water and Sewer Authority (DC Water) issued an Environmental Impact Bond last year. In this project, the goal is to avoid substantial future investment into combined sewer and water piping by employing lower cost and environmentally friendly “Green Infrastructure”.
In the terms negotiated within the Private Placement Agreement (PPA), DC Water will receive a $3.3MM Risk Share Payment from investors if the project underperforms. This payment will be realized by the reduction in interest and principal payments from project revenues to the investors.
By establishing a prior legal claim to these project revenues, DC Water prevented a scenario in which they would need to collect timely payment directly from the SIB investors in the event of underperformance. By establishing this mechanism in the PPA, DC Water has categorically eliminated this investor counterparty risk.
The exculpatory measures employed by DC Water led the EPA’s Water Infrastructure and Resiliency Finance Center to propose that “The DC Water EIB represents a new financial structure that could serve as a model for utilities throughout the water sector”.
Finally, on the question of competition. Municipalities will need to contract with an intermediary to manage the structuring and oversight of the SIB as well as the ultimate selection of the qualified service provider.
On this point, the mechanism of the SIB many times works in the municipality’s favor. The intermediary is building out a portfolio of projects. They have a reputational and business-growth, if not specific financial, stake in the success of the project. This provides a substantial inducement for effective due diligence in the critical selection and on-going management of the service provider.
Additionally, more recent projects are now being structured such that the chosen service providers (contractors) can share a specific, pecuniary interest in the relative success or failure of projects they participate in.
However well-aligned with the interests of the municipality, the intermediary that is ultimately chosen should still be properly vetted.
They should be able to demonstrate experience and a deep well of understanding related to the use of social impact bonds as well as to the specific intervention being undertaken. They should possess expertise in both selecting and evaluating service providers and exhibit a proven track record in setting realistic performance goals.
Although a critical evaluation of the social impact bond mechanism is necessary before implementing such a structure, municipalities would greatly benefit by incorporating this option into their decision-making process.
John Stroud is co-founder and Managing Partner of NRJ Capital.
A former senior executive at Greenworks Lending and Lehman
Brothers, he maintains a particular expertise in optimizing the financial performance of income-generating assets.
John advises institutional and high net worth private clients on identifying, vetting and incorporating impact and mission-related investments into their broader portfolios.
His work has included the hands-on creation of demand-side efficiencies as well as on-site clean energy generation in the building industry with specific emphasis on commercial, industrial and multi-family properties.
John has spoken extensively to the built and investment communities on the benefits of incorporating environmental and social metrics into broader, strategic decision-making .
He received his undergrad degree from James Madison University, his MBA from The McDonough School of Business and has completed post-graduate work in sustainability at Harvard Business School.
