PFS Risk Trade-Off Continuum


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PFS Risk Trade-Off Continuum

  1. 1. Risk Trade-off Continuum for Different Structural Approaches to Pay-for-Success FinancingApril 2012Nonprofit Finance Fund’s work in the Pay for Success Financing field is generously supported by theRockefeller Foundation, the William and Flora Hewlett Foundation and The Joyce Foundation.Over the past 18 months, Nonprofit Finance Fund (NFF) has served as the recognized, independent voice in theemerging Pay-for-Success financing (“PFS Financing”) field in the United States. This objective role has given NFF anunbiased platform for education and information dissemination on the potential benefits and challenges of PFS Financingin the United States.In this and future reports, NFF will present our views on the significance of the trends and developments we areobserving in the strategic path of the PFS Financing field. NFF’s views on these issues will be informed by the:• diverse field data we have collected over the past 18 months and will continue to collect;• insights derived from this data through our unbiased perspective; and• trends we have observed through our system-wide rather than transactional perspective.PFS Financing: 3 Key Stakeholders, 3 Unique PerspectivesPFS Financing projects require significant collaboration and resource commitment from 3 key stakeholders: investors,providers, and government.Field data increasingly suggest that each potential way of doing PFS Financing [for example, the Social Impact Bond(“SIB”) and the Human Capital Performance bond (“HUCAP”)] involves a number of potential risk trade-offs for each ofthese stakeholders. Oftentimes, these trade-offs impact each of the three stakeholders differently. They also can makeone way of doing PFS Financing or another more effective in meeting the needs of investors, providers and governmentinvolved in a given project. This is particularly the case with the proof-of-concept pilots under discussion and© 2012, Nonprofit Finance Fund®. All rights reserved.
  2. 2. development in a number of locations across the U.S. Because of this, these trade-offs need to be identified, understoodand managed collaboratively in developing PFS Financing proof-of-concept pilots. This will help the three stakeholdersachieve an acceptable collective balance of advantages and disadvantages in a more timely and productive fashion.Among these trade-offs are factors such as:• measurable social impact potential• the ease of identifying and capturing the economic value of social impact• financial risk and return to each stakeholder• reputational risk for each stakeholder• transaction execution and due diligence costs• cost of capital to the government funder and service provider(s)• transaction management and governance structures• legislative requirements• procurement and contracting systems change• the potential for transaction structure replication and scalabilityTo date, NFF has observed that the comparative trade-offs between and among various ways of doing PFS Financinghave not been thoroughly examined in the United States. Also, to NFF’s knowledge, there has not been significantconsideration or analysis of possible HUCAP or SIB hybrid structures or alternative ways of doing PFS Financingsuggested by HUCAP and SIB. Such alternative and hybrid structures have the potential to provide stakeholders with ablend of trade-offs that can help them reach agreement on launching proof-of-concept pilot projects more easily. Theyalso have potential to support a wider range and type of PFS Financing projects.As a first step to address this current knowledge gap, NFF has developed a series of infographics. These infographics,all of which are referred to under the general heading, Risk Trade-off Continuum for Different Structural Approaches toPFS Financing, are designed to:• depict and initiate a dialogue about NFF’s current assessment of the diverse trade-offs for investors, service providers and governments that are inherent in different execution structures or “ways of doing” PFS Financing, such as SIB and HUCAP; and• suggest some alternative and hybrid transaction execution structures for PFS Financing.Transaction Execution Structures or “Ways of Doing” PFS FinancingNFF uses the term “PFS Financing” to describe the broad category of innovative structures and approaches to financingsocial programs that have the following characteristics:• they finance prevention and early intervention services;• they access private sources of working capital and/or risk capital to finance these preventative and early intervention services;• they reduce both the cost and risk of government funding for social programs by virtue of their focus on prevention and early intervention;• they direct private capital to social programs that “work” by achieving independently measured, positive outcomes for individuals, families and communities of need; and• they provide private investors with satisfactory and inextricably blended social and financial returns, i.e., they are impact investment vehicles. 2
  3. 3. To illustrate the extent to which a particular way of doing PFS Financing can affect the trade-offs for various stakeholdersand, thereby, the potential effectiveness of PFS Financing in a given location, NFF has selected five types of transactionexecution structures or “ways of doing” PFS Financing that we believe achieve fidelity to the concept of PFS Financingas we have described it here. Brief summary descriptions are provided below of the five ways of doing PFS Financingdepicted in the infographics.Core Structures Depicted in the Infographic HUCAP (Human PFS Financing is executed through state moral obligation bonds issued in the U.S. municipal Capital bond market—the structure Minnesota is planning to pilot in Minneapolis/St. Paul under Performance) Bonds legislation passed in the State last year. (For more information on HUCAP bonds visit Privateinvestors purchase Minnesota moral obligation bonds. Working capital for intervention delivery is borrowed by providersfrom a loan pool established as part of the HUCAP structure. Providers shoulder all of the financial risk for outcomeperformance. Government has a small financial risk through negative arbitrage that arises from the investment ofHUCAP proceeds at a rate that is expected to be lower than the rate on the bonds. PFS Financing is executed through the private equity structure utilized in the UK SIB (Social Impact Peterborough transaction. For additional information on SIB go to Bonds) purchase a project-specific SIB under customized contractual arrangements. Working capital for interventiondelivery comes from private investors at no cost to providers. Investors shoulder all of the financial risk for outcomeperformance. Government has no financial risk. SIB with a Full PFS Financing is executed through the SIB structure above with success payments to Private Guarantee investors fully or partially guaranteed by a private (non-government) enterprise. With a full guarantee, the private guarantor shoulders all of the financial risk for outcome performance. Under a partial guarantee, private investors and the private guarantor share the financial risk SIB with a Partial for outcome performance, with this risk sharing apportioned up front in the contracts. Working Private Guarantee capital for intervention delivery comes from investors at no cost to providers. Government hasno financial risk. (N.B. A full or partial guarantee from government is also a possible, albeit potentially controversial,structure. For the purposes of clarity, NFF chose to leave a depiction of that potential adaptation for a subsequentversion.) PFS Financing is executed with a hybrid HUCAP/guaranteed SIB structure in which providers Hybrid: HUCAP and receive working capital upfront from private investors at no cost via HUCAP bond proceeds. SIB with Private Providers shoulder all outcome performance risk, but are backstopped by a private Guarantee guarantee. Government has a small financial risk through negative arbitrage. Although this isnot yet a mainstream structure under consideration for a specific proof-of-concept pilot, there is an effort afoot to developa workable, hybrid SIB and HUCAP structure.The Risk Trade-Off Continuum: Breaking Down the Three PerspectivesDisaggregating the risk trade-offs continuum for each of the three main stakeholders in a PFS Financing is revealing.The continuum demonstrates why each stakeholder—investor, provider, and government— may have a distinctperspective on which structure best suits each of their particular needs. This, in turn, would imply that aligning thesestakeholders on a single, prepackaged way of doing a PFS Financing might be difficult. Indeed, field experience to-datehas tended to support this assessment. 3
  4. 4. Lower Risk Higher RiskLower provider performance risk High provider performance riskLower expected financial return Higher expected financial returnLow transaction due diligence and execution costs High transaction due diligence and execution costsPublished public ratings No published public ratingsHigh liquidity Low liquidityLower political risk Higher political riskIndirect impact investing incentive and blended return metrics Direct impact investing incentive and blended return metricsHigher market scalability potential (pace and scope) Lower market scalability potential (pace and scope)Lower Risk Higher RiskRequires no working capital or risk capital Requires both working capital and risk capitalHigh readiness and capacity barriers to access High readiness and capacity barriers to accessHigher provider reputational risk with private investors Lower provider reputational risk with private investorsHigher third party management and oversight of program delivery Lower third party management and oversight of program deliveryfor investor risk mitigation for investor risk mitigationHigher dependence on collaborating providers Lower dependence on collaborating partnersLow Risk High RiskNo intervention funding risk – pay only for what works Low intervention funding risk (negative arbitrage on payment pool)Higher cost of capital Lower cost of capitalHigh requirement for ‘lock-box’ recoverable cash savings to pay Low requirement for ‘lock-box’ cash savings to pay privateprivate investors investors (ROI driven)High reputational risk High reputational riskHigh procurement and contracting systems change High procurement and contracting systems changeUnfamiliar execution infrastructure that needs to be built Familiar, pre-existing execution infrastructurePotential requirement for full faith and credit legislation No requirement for full faith and credit legislation 4
  5. 5. Combining Stakeholder PerspectivesWhen we look at the threestakeholder perspectivescombined, we get a fullerpicture of how certainstakeholders might favor someways of doing PFS Financingover others in terms of theperceived risk trade-offs. Thiscombined view also suggeststhat there might be ways ofdoing PFS Financing thatcould be more acceptablethan others to all threestakeholders.For example, the combinedperspective implies that SIB with a Full Private Guaranteemight be the PFS Financing execution structure most acceptable to all three stakeholders for a proof-of-concept pilot: itrepresents the lowest combined risk trade-off position for all three parties.By using graphic structures to model out stakeholder perspectives in this fashion, these infographics can provide a usefultool for facilitating productive conversations in both the initial and ongoing planning stages of PFS Financing. Having saidthis, NFF recognizes that these infographics are works in progress that will be influenced by ongoing commentary frommarket participants and observers, as well as future developments in the PFS Financing field. NFF also recognizes thatwe:• may not have captured the full extent of the trade-offs involved in each of the structures depicted,• may not have fully captured the order of magnitude or relative importance of some trade-offs, and• may have captured some trade-offs that other participants or observers of the PFS Financing field feel lack sufficient materiality.With these factors in mind, NFF enthusiastically invites commentary, suggestions and proposals for refinements to theseinfographics as well as for other ”ways of doing” PFS Financing that we can:• share with the entire PFS Financing community of interested parties;• evaluate and discuss in a public forum; and• where applicable, incorporate into updates of the infographics on an ongoing basis.To facilitate this dialogue, NFF will be posting this report and the series of infographics on the Pay for Success LearningHub website ( and ) and soliciting your comments and suggestions through socialmedia. 5
  6. 6. Top Ten List of Systemic Issues in the Development of the PFS Financing Field in the United States To accompany the infographics, NFF has also compiled the following Top Ten List of Systemic Issues in the Development of the PFS Financing Field in the United States. This Top Ten list reflects NFF’s assessment of the systemic issues most likely to shape and drive the development of the PFS Financing market in the U.S. going forward.1. PFS Financing is accelerating the transition of the United States social sector from an output-driven funding model to an outcomes-driven funding model. This has broad systemic implications for the U.S. social sector.2. PFS Financing proof-of-concept pilots open the door to systemic change in the way governments fund social programs, the way service providers deliver programs, the ways that capital flows into the social sector and the way that everyone in the sector measures success or “what works”.3. Cities, counties and states rather than the federal government will be the government entities that launch PFS Financing proof-of-concept pilots in the U.S. The U.S. federal government can and is beginning to provide a variety of resources to facilitate the development and launch of proof-of-concepts pilots by cities, counties and states. This federal government support may also contribute to the development of further PFS Financing adaptations and innovations.4. There are potentially many transaction execution structures or “ways of doing” PFS Financings successfully and with fidelity in order to meet the unique needs of U.S. cities, counties and states.5. The openness to and support of hybrid and alternative transaction execution structures or “ways of doing” PFS Financings will provide more, and more diverse, ways of allocating and apportioning risks, returns and other material trade-offs to private investors. This will accelerate the development of the PFS Financing market by presenting structures that appeal to a broader pool of potential investors and increase the magnitude and pace of private, impact investing capital flows into the U.S. social sector.6. Although the success of PFS Financing is dependent on the performance of service providers, there is a limited number of PFS Financing-ready providers in the U.S. Incubation of broad-based provider readiness is needed to build a pipeline sufficient for the replication and growth to scale necessary to build a sustainable U.S. PFS Financing market.7. Among the small number of PFS Financing-ready providers in the U.S., there are established, high-performing multi- state service providers that can act as program intermediaries in their social issue areas. These organizations have current capacity to act as first-mover providers in PFS Financing proof-of-concept pilots. They also have the capacity to act as intervention intermediaries in partnership with financial/structuring intermediaries in PFS Financings and to take a leadership role in building capacity for PFS Financing among other providers in their social issue areas.8. The focus on using foundation capital as seed investments in PFS Financing proof-of-concept pilots in the U.S. is too limiting and short sighted. A complete capital approach in which foundations provide, among other things: (i) guarantees to facilitate investment from the broader private investment community and (ii) general operating support and change capital to providers to build the capacity to become PFS Financing-ready can significantly accelerate PFS Financing replication and market growth to scale.9. Early attention to issues involving transparency, potential conflicts of interest and displaced incumbent constituencies that are associated with PFS Financings can reduce potential barriers to the development of the PFS financing field.10. The community of interest in PFS Financings will need to provide opportunities and a forum for soliciting the interests of the individuals, families and communities of need who are the intended beneficiaries of PFS Financing and to involve them in the ongoing dialogue on the development of the field. 6
  7. 7. The Future - Diverse Local Needs Will Increasingly Shape New “Ways of Doing” PFSFinancing with Fidelity in the United StatesThe ability to adapt to the unique “local needs” of the social sector in the United States is essential in order for PFSFinancing to deliver on the promise of measurable improvements in the lives of individuals, families and communities ofneed that is the source of so much enthusiasm for this still largely unproven concept. Local needs have clearly emergedas key drivers of the shapes that proof-of-concept PFS Financings are likely to take as they continue to adapt to the comparison to how PFS Financing has developed in the United Kingdom and how it is developing in, for example,Australia and Canada, the development of the PFS Financing field in the United States is a “bottom up” phenomenon.Because of this, cities, counties and states will undoubtedly launch the first wave of proof-of-concept PFS Financingpilots. As a result of this bottom-up phenomenon in the United States, there will be local differences in, among otherthings:• the relative importance and impact of social issues for which PFS Financing pilots may be applicable;• the political will, inclination and supporting infrastructure to advance PFS Financing pilots;• private investor appetite for transaction-specific risk trade-off dynamics; and• the availability of service providers with readiness for effective participation in PFS Financing pilots.As is already proving to be the case, these local differences will suggest a unique set of requirements necessary for thelaunch of PFS Financing proof-of-concept pilots. In each case, these local requirements will influence the blended arrayof risk trade-offs and produce a way of doing the PFS Financing that satisfies all three stateholders. These localvariations will give rise to further ways of doing PFS Financing that NFF looks forward to capturing and analyzing withyou and adding to future versions of the Risk Trade-off Continuum for Different Structural Approaches to PFS Financing. 7