Third Dimension- Social Impact Bonds: Can your organisation harness its power?

February, 2017

By James Thomson

Anyone involved with the not-for-profit sector knows the increasing difficulties that charities face in creating sustainable sources of income. For many charities, gone are the days when they could rely solely on donations and government grants as their principal sources of income.

Nowadays, many charities are turning to commercialisation and investment in order to meet their financial demands, which has given rise to a new form of investment commonly known as Social Impact Investment. This area is, however, not without its challenges. Not-for-profits are subject to strict regulations in respect of the distribution of their income that do not apply to for-profits, making attracting investors comparatively more difficult. Further, the legislative framework that regulates financial investment in Australia, has not caught up with the Social Impact Investment trend.

One facet of Social Impact Investment, is a type of security known as Social Impact Bonds (or, Social Benefit Bonds).

So what are Social Impact Bonds, and what challenges will charities face in utilising this investment tool.

1. What are Social Impact Bonds?

In some ways, Social Impact Bonds are like any other form of investment. That is, investors invest money up-front, in the hope and expectation that there will be a beneficial return in the future. However, in addition to this financial motivation, Social Impact Bonds have an altruistic motivation, in that the funds invested by investors are used to improve social or environmental issues. The key difference between Social Impact Bonds and other financial investment products, is the way in which the returns to investors are determined.

Let’s take the example of a typical “start up” for-profit company. A small pool of investors are offered securities in the company, in return for providing start up capital to launch the company’s operations. In circumstances where the company’s products and/or services are commercially viable and a profit is made, the investors will then see a return on their investment. Where the company makes no money or a loss, the investors are unlikely to see any return on their investment. The focus of this model, is on generating profits.

So how does a Social Impact Bond differ? A Social Impact Bond essentially involves a payment for results contract. Although the structure of each transaction will differ, broadly speaking, a Social Impact Bond involves the following:

(a)    Benevolent Project

A Service Provider proposes to undertake a project which addresses a pressing social or environmental issue (generally referred to as an intervention);

(b)    Agreed Outcomes

The Service Provider and government agree on agreed outcomes, formalised in a Service Agreement (or similar arrangement). Those agreed outcomes are designed to not only provide positive social or environmental outcomes, but also to reduce the costs of government associated with the subject matter of the project;

(c)    Investment

Investors are invited to contribute funds towards the project;

(d)    Return

Assuming the agreed outcomes are reached, the investors will receive a repayment of their principal investment plus a financial return, which is paid from the monies which the government would have otherwise spent if the project or intervention was not undertaken.

In other words, a Social Impact Bond is results focused, rather than profit focused.

As with a government grant, the Service Provider will be required to enter into a Service Agreement with the government. However, the key difference between those models, is that the Service Provider will typically not receive any funding up front from the government, that funding being provided instead by the investors. Any payments received from the government are made in arrears, once the agreed outcomes have materialised.

2. What does it look like?

Although these transactions can potentially be structured in a number of ways, below is an example of how such an arrangement can operate.

3. What are the potential benefits?

Social Impact Bonds are an innovative way to fund social and environmental projects, and have the potential to give charities access to the amount of capital that traditionally they would not be able to access through conventional financial products and markets. Although Social Impact Bonds will not be suitable for every transaction, the model offered by them has the potential to inspire the type of creativity and entrepreneurship that was traditionally only seen in the for-profit sector.

From a societal point of view, Social Impact Bonds have the potential to address social and environmental issues that might otherwise struggle to compete for funding from government grants, or other sources of funding. Of course, an added bonus is that investors can potentially see returns on their initial investment.

4. So, what is the catch?

An arrangement such as that outlined in section 2 of this article, involves the coming together of a number of parties. Like any legal structure, the arrangements between those parties must be negotiated and documented. These negotiations and formalities take time and money, as professional advisers will inevitably need to be involved owing to the complexity of the arrangements.

Further, in Australia, the Corporations Act 2001 (Cth) creates a financial and securities regulation framework which necessarily puts in place onerous disclosure obligations on entities offering certain financial products or securities. Social Impact Bond issuers may be able to rely on exemptions created by the legislation, such as the “sophisticated investor” and “professional investor” exemptions. However, this has the unfortunate implication of limiting the audience to which an offer of Social Impact Bonds can be made.

The legislation has, unfortunately, not yet caught up with the Social Impact Investment trend, and there is some uncertainty as to how the exemptions created by the legislation apply to certain investors, such as Private Ancillary Funds.

On 28 January 2017, the Australian Government released a discussion paper titled Social Impact Investing. That paper identifies a range of ways in which the Australian Government might be able to facilitate and promote the use of Social Impact Investment. Part of that discussion paper deals with the possibility of legislative reform, to reduce the regulatory barriers around Social Impact Investment and to clarify the position under the disclosure exemptions.

5. Summary

Social Impact Bonds are a reasonably new and innovative platform that is available to address funding shortages around Australia’s most pressing societal and environmental issues. While the financial regulatory system in Australia has not yet caught up entirely with the Social Impact Investment trend, there are promising indications from the Australian Government that it is willing to look at reforming the regulatory system, in order to reduce the barriers and uncertainty surrounding investment in the sector.

1 http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2017/Social-impact-investing

 

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