Zipline Obstacle course 2.”

Social impact bonds—also known as “pay-for-success” contracts, since they are not true bonds, but rather performance-based contracts—aim to help governments experiment with new ways of providing social services. The basic concept is this: Private investors provide the original funding, and the government only pays if the program achieves targeted outcomes. This lowers the cost of testing new policy ideas. In exchange for this ability to test new policy ideas that may or may not work, the government pays the private investors a premium if the experimental program reaches or exceeds the performance targets. In short, private investors finance experimentation and innovation.

The government naturally funds R&D on its own. But while government funding for science R&D is $176.8 billion in the FY 2018 approved budget, politicians are highly reluctant to finance R&D to improve public-sector operations. As social impact bond investor Bridges Fund Management explains in a 2016 report, traditional government fee-for-service contracts favor proven interventions, and providers have neither the flexibility to experiment nor the incentive to exceed expected results.1 As another example of public sector risk aversion, a 2015 article from the Kauffman Foundation reports that in the area of public procurement, “of the top 25 firms in the United States winning government contracts, the youngest was founded in 1969.”

The Solyndra scandal during the Obama administration illustrates some of the drivers of public sector risk aversion. Solyndra, you may recall, was a startup solar panel manufacturer that received a $535 million government guarantee in 2009 and went bankrupt in 2011. In sum, the Department of Energy’s Loan Programs Office made $30 billion of loans to 30 companies with varying success as it sought to develop the renewable energy industry as a whole.2

Overall, the program succeeded beyond expectations. In Slate, Daniel Gross writes, “From nothing before the loan guarantees, utility-scale solar now…is a genuine growth industry, financed largely by private funds.” But the public mainly remembers the failure of Solyndra, while few credit the federal government with being a venture capitalist that catalyzed the solar industry.

Given the political costs of risking public capital, offloading the risk of public sector innovation via social impact bonds is highly attractive. According to Bridges Fund Management, a social impact bond gives providers far greater flexibility to adapt their programs to achieve desired outcomes.3

To date, social impact bonds have generated inconclusive results. We should expect more mishaps and crashes—like Solyndra—that hone the design of financial tools that optimize public-private partnerships on social problems. Still, the potential of public sector R&D to improve outcomes is great. This article examines how this potential could be realized.

Stumbling out of the Starting Gate

Limited Success. The world’s first social impact bond, launched in March 2010 by Social Finance and the UK Ministry of Justice, aimed to reduce reoffending, or recidivism, among prisoners released from Peterborough prison. Primarily foundations and charitable trusts invested £5 million to provide intensive support to 3,000 prisoners over seven years. The greater the decline in recidivism, the more investors could receive, up to £8 million.4

The Peterborough program reduced recidivism by nine percent—1.5 percent above the Ministry of Justice target. The 17 investors in the social impact bond received a 3-percent return, as well as return of capital.5 But there are caveats. As is common practice to date, the government was not willing to offer much of a premium to investors, and the maximum possible return was 13 percent. Philanthropic support from the Big Lottery Fund to the tune of £6.3 million6 was required to make this offer. Basically, the government relied on philanthropy to pay upside returns, rather than investing in R&D itself. This works, of course, but it also means the project was more like a grant-funded initiative than true investor-financed R&D.

Failure. New York City launched the first US social impact bond in 2012 to reduce recidivism among 3,000 male prisoners at Rikers Island aged 16–18 with a three-year intervention.7 The Urban Investment Group at Goldman Sachs provided a $9.6 million loan and Bloomberg Philanthropies provided a $7.2 million guarantee to fund the project. The decline in recidivism did not meet the threshold 8.5 percent target; as a result, investors lost $2.4 million (the remainder being covered by the Bloomberg guarantee).8 

Why Getting This Right Matters—Saving Billions of Dollars and Improving Millions of Lives

It would be all well and good to dismiss social impact bonds, if only the problems that the public sector needs to solve were not so pressing. For example, the direct annual cost of incarcerations in the US is $80 billion.9 But as a new study, The Economic Burden of Incarceration in the US, points out, when one includes the costs to the individuals jailed and to their families and communities, the total cost to society exceeds $1 trillion.10 Reducing reoffending, or recidivism, would have enormous societal benefits. For example, DC Central Kitchen is a nonprofit that reduces the recidivism rate of the people it trains to