(Bloomberg News) New York City and Massachusetts are turning to a mixture of philanthropy and profit to fund projects tackling homelessness and inmate recidivism, using a program that can offer investors returns as high as 13 percent.
It's the first embrace in the U.S. of a public-private funding method known as social-impact bonds. Also called pay-for-success contracts or social-innovation financing, the model allows governments to transfer the risk of expanding prevention programs to investors. Taxpayer money is spent only if the results exceed a measurable goal set by both parties.
"This makes it possible to invest more in prevention, which are often the first programs that get cut in fiscal stress," said George Overholser, chief executive officer of Third Sector Capital Partners, a nonprofit financial-advisory firm in Cambridge, Mass.
"It's also a way to be sure that the programs that get funding are also the programs that work," he said. "And it's a way to align socially progressive goals with fiscally conservative goals, which is a real political winner."
Overholser, who was on the founding management team of Capital One Financial Corp., has been advocating innovations in social financing since 2001. His company is advising the nonprofits that will run Massachusetts's programs.
Private Capital
State and local governments are seeking private capital to fund projects after the 18-month recession that ended in June 2009. Local-government revenue has fallen for six straight quarters, according to a report this month from the Nelson A. Rockefeller Institute of Government in Albany, N.Y. State tax revenue was still 1.6 percent lower in the first quarter of 2012, when adjusted for inflation, than it was four years ago, the group said.
Social-impact bonds don't function like traditional debt. They're more like pooled equity vehicles in which investors provide financing with no promise of a fixed return, according to the Rockefeller Foundation.
The New York-based philanthropy helped fund the first social-impact bond program in 2010 at HM Prison Peterborough in the U.K. and promotes those in the U.S. Officials in New York state, Connecticut, Los Angeles and Ohio's Cuyahoga County have also expressed interest, said Justina Lai, a foundation associate.
U.K. Pilot
The U.K. pilot program focuses on the rehabilitation of 3,000 short-term prisoners incarcerated at the correctional facility north of London. If recidivism drops by more than 7.5 percent, investors receive an annual return that can rise as high as 13 percent, according to Social Finance U.K., which developed the financing structure.
The original lenders, including the Rockefeller Foundation and the London-based Esmée Fairbairn Foundation, were mostly charitable trusts and nonprofits, though proponents want to attract a broader range of investors.
"Early investors will have a high risk tolerance, and their return expectations will range from principal repayment to returns that keep pace with inflation," according to a May report by the consulting firm McKinsey & Co.
New York City is trying to reduce recidivism among young male convicts housed in the Rikers Island lockup with a four- year program run by nonprofits and financed by a $9.6 million loan from Goldman Sachs Group Inc.
Cutting Recidivism
Recidivism must drop at least 10 percent for Goldman Sachs to earn a profit. The most the New York-based bank can make is $2.1 million if recidivism drops 20 percent and saves more than $20 million in incarceration costs, according to city officials.
Failure would stick Goldman Sachs with a $2.4 million loss, with the rest borne by Bloomberg Philanthropies, Mayor Michael Bloomberg's private charity, which is backing some of the Goldman Sachs loan. The mayor is the founder and majority owner of Bloomberg News parent Bloomberg LP.
By comparison, debt sold by New York state and its municipalities, including New York City, has returned 10.6 percent in the 12 months through Aug. 17. That beat the 8.97 percent gain for the broader municipal-bond market, a Bank of America Merrill Lynch index shows.
Both Democrats and Republicans have praised social-impact bonds for their potential to cure social ills caused by poverty and crime while allowing governments to remain fiscally prudent.
Bipartisan Support
In a January opinion article in the Washington Post, James Q. Wilson, the late Ronald Reagan professor of public policy at Pepperdine University in California, cited social-impact financing as a better way to reduce income inequality than taxing the wealthy. Massachusetts Governor Deval Patrick, a Democrat, is also a proponent, and President Barack Obama proposed $100 million in support in his last two budgets.
"Any time something's run more efficiently, if it could be done to relieve some of the operating burden and expenses on a city or state budget, then you can't help but look at it favorably," said Howard Cure, head of research at New York- based Evercore Wealth Management LLC, which oversees about $3.5 billion.
In Massachusetts, three quarters of males outgrowing the juvenile justice system are convicted of a new crime within seven years of release. Care for the chronically homeless, who spend an average of five years on the street, costs the state an annual $33,000 per person, for a projected total of $40 million next year.
Societal Benefits
If those populations can "achieve more stable, positive, and productive lifestyles and avoid all of these outcomes, it's much better for them and society as a whole, and it's much cheaper for us," Massachusetts Secretary of Administration and Finance Jay Gonzalez said.
Officials said they plan to announce investors and contract terms in the next few weeks.
New York's ability to attract Goldman Sachs shows the potential for social-impact bonds to expand beyond the philanthropic world, said Alicia Glen, the head of the bank's Urban Investment Group in New York.
"If the capital markets and financial institutions can get comfortable with the return profile and the risks associated with it, and also have a double bottom line as part of their business, that's