You know that thing where you’re feeling guilty about that huge stack of unread Economist magazines, so you grab one and flip through it to make yourself feel better? So I was doing that, and I ran across the article on the “world’s first development impact bond” (DIB). I’d followed the deal from the beginning but had gotten a little hazy on the details. There was no surf and nothing interesting at our neighborhood movie theater, so I decided to spend Sunday afternoon digging in.
For those who haven’t spent an afternoon geeking out on this stuff, a DIB is a scheme wherein investors provide upfront funding to a doer, an evaluator measures the doer’s results, and if those results hit predetermined targets, an outcome payer provides investors a return on their capital. It takes a lot of work to put the deal together and shepherd it along, so there is typically an intermediary acting as a sort of broker. The notion is that investors will bring new money into the sector, that incentives and pressure will improve doer performance, and that outcome payers will be attracted to these deals and spend their money better, because their risk has been eliminated.
In this case, the DIB was a sort of demonstration pilot, where both investor and outcome payer were private foundations. The investor was UBS Optimus Foundation, the evaluator was IDInsight, and the doer was Educate Girls, an NGO in India that gets unenrolled girls into school and improves the school so that they get a decent education when they get there. The outcome payer was Children’s Investment Fund Foundation (CIFF), and Instiglio put the deal together. All in all, this was the A-team.
The “Risk Reduction Premium”
The DIB’s target outcomes were based on Educate Girls’ track record to date. If Educate Girls hit the target, the investors would get a 10 percent annualized return (characterized as internal rate of return, or IRR), with a schedule for higher or lower (or zero) payment, depending on the results of the evaluation.
Educate Girls exceeded the targets by a considerable amount, triggering a three-year, 15 percent IRR payout—a whopping 52 percent return on investment. UBS put up $270,000 upfront to fund the work, so CIFF paid them $420,000. UBS gave $50,000 of that $150,000 “profit” back to Educate Girls as a predetermined performance bonus.
These figures don’t include the transaction costs of the deal itself—legal, intermediary, and technical service costs normally borne by the investors—which were about three times the amount of money Educate Girls’ spent on implementation. Don’t freak out, though, this was a relatively small pilot deal; the costs for a much bigger DIB would be similar, and these deals will probably get more efficient over time. However, they’ll always be complicated, and the costs will always be substantial.
Let’s imagine a much bigger deal on the same terms—say, $10 million of implementation funding and $1 million deal costs for a total investment of $11 million, and with real private sector investors and real government or Big Aid funders. If Educate Girls hit the target, the payout would be $14.5 million ($11 million over three years at an annualized 10 percent). In effect, the payers would pay $14.5 million for impact that cost $10 million to generate. You could think of that extra $4.5 million as a “risk reduction premium” shelled out by the outcome payers.
That’s a lot.
So what would justify paying that extra 40 percent? Well, DIB boosters say it will make way more money available up front for implementation. Breathless press releases speak of the potential of early successes to “have a transformative impact on how development is financed in the future” and “unlock vast sums of private capital for other projects.”
I seriously doubt that. We’ve heard this song before. It wasn’t that long ago that impact investors were going to create a wave of high-impact businesses to meet the needs of the poor. It didn’t happen—it turns out that the vast majority of “impact investors” are looking for market rates of return. After a few years, mostly what we heard was muttering about the “lack of deals.” I don’t know any reason why it would be any different this time around.
We’ve already got a mechanism for performance-based financing—one that skips all the gymnastics, intermediaries, and added costs. It’s called “unrestricted funding on the basis of impact.”
And look—if there really is risk to investors, they’re going to ratchet up expectations accordingly. Some simple math: Imagine that an investor has a portfolio of four DIBs. She figures that one of those DIBs could bomb completely. To get a portfolio return of 10 percent IRR, then, she has to go for 21 percent on each of the three remaining DIBs in her portfolio (four three-year projects at 10 percent IRR = three projects at 21 percent IRR). A targeted 21 percent IRR in a three-year DIB means you’ve jacked up the “risk reduction premium” to almost 80 percent. (Most DIBs are capped way below that, so she’ll probably take a pass anyway.)
Faced with those numbers, I doubt outcome funders would be all that eager to join in. There’s a Catch-22 here: If there isn’t much risk, there’s no point; if there is real risk, it’ll be priced too high. A DIB might even be a liability for public-sector funders: Imagine facing your constituency and saying, “Well, we spent $14 million to get girls into school, but $4 million or so went into investors’ pockets.” Even if there were a case to be made, it’s a complicated one, and by the time social media got through with it, somebody’s out of a job.
And then imagine how weird things could get for an evaluator when millions of dollars—literally—are on the line based on your findings. If you’ve ever been around the kind of fight that can blow up around an equivocal RCT, well, imagine the volume turned up exponentially.