Managing investor risk in pay for success
All investments carry risk. Pay for success (PFS) projects are no exception.
In a PFS project, a private or philanthropic funder invests in an evidence-based intervention to improve the lives of vulnerable individuals, and only receives a return if the intervention meets agreed-upon outcomes. This potential for social impact makes PFS projects attractive investments. However, due to the newness and nature of the model, the risks faced by investors can be especially unfamiliar. The two primary types of risk to repayment are as follows:
- Programmatic risk: When the project’s outcome targets are not met.
- Appropriations risk: When the government does not appropriate sufficient money to repay the investor for the outcomes achieved.
Several tools have emerged to help investors manage these programmatic and appropriation risks. Philanthropies have played a particularly important role, developing strategies like the following:
- Development grants: Many PFS projects rely on support from philanthropies, governments, and the private sector to fund a feasibility study or technical assistance before a project’s formal launch, increasing the chances a project will meet its outcomes.
- Project grants: Some projects receive philanthropic funding for a particular element, such as implementing an evaluation. Paying directly for a portion of a project can reduce the total amount of investment needed, and the potential amount the government needs to repay.
- Junior loans: Traditional investments sometimes have two types of lenders: junior and senior lenders. Typically senior lenders get repaid before junior lenders, and junior lenders get a higher rate of return for this increased risk. In PFS, foundations invest as junior lenders without asking for a higher rate of return, which encourages more investment by lowering the amount needed to be repaid if the project succeeds.
- Guarantees: A guarantee—perhaps the most direct mechanism to increase the creditworthiness of a project—outlines the terms for guaranteed payment to primary investors. In this setup, if the PFS project meets its target outcomes, a foundation pays nothing. If a project fails to meet its target outcomes, the philanthropy steps in and covers a portion of the primary funders’ original investment.
- Funding specific outcomes: If a PFS project affects multiple outcomes, foundations can fund the outcomes that may seem riskier to traditional investors but align with the foundations’ impact investing priorities and expected repayment time horizon. In the Housing to Health Initiative, a project providing housing and other services for chronically homeless individuals, foundations invested in two outcomes: increased housing stability and jail–bed days avoided.
Governments participating in PFS projects have also taken several steps to reduce the risk that they (or future administrations) cannot provide outcome payments if the project is successful:
- Multiyear appropriations: Using legislation, governments can set aside money now for success payments in future funding years. This strategy avoids burdening future governments with allocating funding for a previous administration’s project.
- Backing the contract with the full credit of the government: Massachusetts backed its PFS projects with the full faith and credit of the state and assured investors that the state would fulfill its financial obligations.
- Creation of prepaid fund: Governments can put money in a prepaid fund at the beginning of a project so the funding is available to make future outcome payments.
- Other support: PFS projects have been enhanced through other means, including setting aside public resources (like housing vouchers) and technical assistance (like that from the Harvard Government Performance Lab).
Not every risk-mitigation tool is appropriate for every PFS project. Most projects use some combination of the above. For example, Partnering for Family Success in Cuyahoga County, Ohio, a project seeking to keep homeless children out of the foster care system, used development grants for a ramp-up period, junior loans from philanthropy, annual appropriations into a set-aside fund, and other support in the form of Medicaid reimbursements and housing vouchers.
This risk mitigation, which we describe in more detail in our new brief, has helped attract private investment. These tools will likely continue to evolve as more PFS projects develop.