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Pay for Success /
Social Impact Bonds
Valuation Model and
Risk-return Characterization
Pay for Success / Social Impact Bonds
Primer for Funders
Last updated July 2015
BY: ANDREW WONG
@akwwong
/in/akwwong
www.a...
Pay For Success (PFS)—Overview
A PFS contract is a financing vehicle that provides a financial return to funders
contingen...
Pay For Success (PFS)—Model
For funders, evaluating a PFS contract consists of 3 steps—characterizing the
intervention, un...
Pay For Success (PFS)—Model—Intervention
PFS contracts begins with an understanding of the optionality embedded of the tar...
Pay For Success (PFS)—Model—Pricing
The pricing function translates the social outcomes from the intervention into financi...
Pay For Success (PFS)—Model—Stakeholder risk
The discount rate captures the financial risk upon realization of any given s...
Pay For Success (PFS)—Model—NPV Distribution
After discounting using a risk-adjusted rate, the resulting NPV distribution ...
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Social Impact Bonds - Pay for Success - Investor Primer

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The following is a short primer outlining Social Impact Bonds / Pay for Success investments. It provides a generalized overview of stakeholders, and a valuation model to highlight risk and return drivers.

Published in: Government & Nonprofit
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Social Impact Bonds - Pay for Success - Investor Primer

  1. 1. Pay for Success / Social Impact Bonds Valuation Model and Risk-return Characterization
  2. 2. Pay for Success / Social Impact Bonds Primer for Funders Last updated July 2015 BY: ANDREW WONG @akwwong /in/akwwong www.andwong.com blog.andwong.com This document will be periodically updated. For the latest iteration of the slides, or to get an Excel template for simplified valuation model, contact Andrew on Twitter or Linkedin.
  3. 3. Pay For Success (PFS)—Overview A PFS contract is a financing vehicle that provides a financial return to funders contingent on social outcomes Simplified PFS Structure and Stakeholders (2) Provider (3) Payer (1) Funder Funders put up the capital ($P) to finance an intervention targeting a specific social impact outcome Providers conduct an intervention targeting the specific social impact outcome on a specific target population Contingent on the achievement of certain outcomes for the target population, the payer pays return ($P+r) to the funder 1 2 3 $P $P+$r Roles/Responsibilities Ex: NYC Rikers Island PFS/SIB * Goldman Sachs and Bloomberg Philanthropies (funders) provide a loan and grant respectively to fund a recidivism intervention *MDRC and 2 NPOs (providers) implement the recidivism intervention for a cohort of incarcerated youth at Rikers Island *The City of New York (payer) pays a return to funders based on recidivism reduction outcomes
  4. 4. Pay For Success (PFS)—Model For funders, evaluating a PFS contract consists of 3 steps—characterizing the intervention, understanding the pricing function, and discounting for stakeholder risk A. Characterizing the intervention Adjust for provider experience Adjust for target population C1. Funder cost of capital C1% C2% C3% Intervention effectiveness (ex. % reduction) Intervention effectiveness (ex. % reduction) A1. Distribution of intervention outcomes A2. Adjustment for execution risks B. Pricing Intervention Outcomes Undiscounted payoffs ($) B1. Translating outcomes to payoffs Continuous pricing function Undiscounted payoffs ($) B2. Translating outcomes to payoffs Discrete pricing function C. Discounting for Stakeholder Risks C2. Payer credit risk C3. Funder Illiquidity prem. D. Final NPV Distribution C. Constructing a risk adjusted discount rate E(x), V(x), other distribution qualities or Discounted payoffs ($)
  5. 5. Pay For Success (PFS)—Model—Intervention PFS contracts begins with an understanding of the optionality embedded of the target social outcomes both inherent to the intervention itself, and with execution Part A. Characterizing the Intervention * PFS contracts directly link social impact outcomes to financial outcomes/cashflows * Understanding the true optionality embedded in the intervention (A1) requires not just one point estimate (e.g. via an academic study or randomized control trial), but ideally, replication to characterize the full distribution * The intervention outcomes distribution can then be adjusted for execution risks (A2): — Adjustments, while harder to quantify, may be appropriate depending on provider experience, the target population outlined by the PFS contract, etc — These effects can be reflected as a parallel shift (shifting the distribution mean), multiplicative shift (changing the volatility), or both Adjust for provider experience Adjust for target population Intervention effectiveness (ex. % reduction) Intervention effectiveness (ex. % reduction) A1. Distribution of intervention outcomes A2. Adjustment for execution risks
  6. 6. Pay For Success (PFS)—Model—Pricing The pricing function translates the social outcomes from the intervention into financial payoffs—with the “price” typically established by payer Part B. Pricing Intervention Outcomes * The pricing function that translates outcomes to payoffs (cashflows) is one of the innovative features of a PFS contract * The pricing function is usually proposed by the payer, but can be a negotiation between the payer and funder. The pricing function is determined by: — The maximum economic savings or benefits corresponding with a certain post-intervention outcome — The amount that a payer is willing to pass on to the funder — The certainty that the payer has in realizing the projected cost savings and/or benefits based on post-intervention outcomes * Pricing functions can be continuous (B1) or discrete (B2) — Though, certain pricing functions must be carefully considered as it can have unexpected effects on the payoff profile (e.g. concentrations, skews) Undiscounted payoffs ($) B1. Distribution of payoff outcomes Continuous pricing function Undiscounted payoffs ($) B2. Distribution of payoff outcomes Discrete pricing function
  7. 7. Pay For Success (PFS)—Model—Stakeholder risk The discount rate captures the financial risk upon realization of any given social outcome and can vary widely depending on who the funder and payers are x% C1. Cost of capital (CoC) A function of funder cost of equity, cost of debt y% z% C3. Illiquidity risk A function of the intervention and cost/benefit time frames, and secondary market C2. Credit risk A function of the payer’s financial strength, budgeting rules, etc. Part C. Discounting for Stakeholder Risk * The discount rate (DR) captures financial risks and is the final risk adjustment to the payoff cashflows * DRs will vary significantly depending on the contract structure, funders and payers preferences. For eg: — C1. CoC will be higher for banks lending off their balance sheet vs. foundations and impact investors — C2. Credit risk depends on the payers—if the payer is gov’t, it may be a function of budget finances, regulations; if payer is a corporate, it depends on credit rating —C3. For interventions with longer payoff timeframes (and absent of a liquid marketplace) certain funders may ask for higher returns to compensate for illiquidity
  8. 8. Pay For Success (PFS)—Model—NPV Distribution After discounting using a risk-adjusted rate, the resulting NPV distribution characterizes the range of returns, volatility; these can be inputs for further diversification analysis Expected Value—E(x) Measure of the volatility—V(x) Other distributional characteristics Part D. Net Present Value Distribution * Getting to a final NPV distribution captures the full range of optionality embedded in these instruments, and provides descriptors like: — Expected value for risk-adjusted returns — Volatility of returns — Potential diversification benefit based on the distribution shape * With this data, funders can evaluate where PFS investments fall within their financial and risk appetite Discounted payoffs ($)

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