Yet few of us learned to ride a bike without using the insurance policy known as training wheels. Such a guarantee against falling also exists in the capital markets. From credit enhancements on fixed-income products to first-loss protection for equity funds, financial guarantees have lowered capital costs and facilitated the growth of new industries that were initially perceived as too risky. However, deciding when to take the training wheels off is quite similar to determining when an investment is ready to go to market aEUR" and may be just as difficult to pinpoint.
Recently, a new financial product has received equal amounts of praise and criticism for this very concept: to guarantee or not to guarantee. Social impact bonds (SIBs) were created in the United Kingdom in 2010 to attract private investors to help fund social services. This pay-for-success model creates a contract between government, nonprofits and investors to achieve a defined social goal while generating financial returns if the goal is met, typically based on reducing the costs associated with government programs. The bonds are structured to meet the needs of investors and service providers, and their different roles have sparked debate on how best to appeal to the marketplace.
A 2012 SIB between the city of New York and Goldman Sachs, for example, included a 75 percent guarantee against downside risk. Bloomberg Philanthropies backed the deal with a grant to ensure that the investors received most of their capital back. Late in 2013, another New York-based SIB between the state government and Bank of America Merrill Lynch was structured to include only a 10 percent guarantee backed by a grant from the Rockefeller Foundation. Both bonds fund programs that aim to reduce recidivism at prisons in the state.
Some Observers have criticized the Goldman Sachs deal as being overly protected from what would likely be minimal risk. With this guarantee strictly limiting investorsaEUR(TM) skin in the game, however, the terms signaled high risk around SIBs in the eyes of some players. Indeed, investors have varying tolerance for risk and expectations of a return, and particularly when it comes to new and innovative products, one size does not fit all. BofA was willing to take on more risk aEUR" hence the relatively low 10 percent guarantee. Remember that when we learned to ride a bike, it took some of us months before the training wheels came off, while others needed only days. The flexibility of the SIB structure is a compelling selling point, enabling investors and governments to negotiate the best terms to coincide with their goals.
SIBs are a recent arrival within the impact investing marketplace, itself an emerging collection of financing options to achieve both financial and social returns. Results are just now coming in from the first UK bond, and the initial social outcomes are positive. This suggests that the investors will be financially rewarded. As SIB track records build, we expect to see more creativity applied to the guarantees needed to indicate creditworthiness and bring in new investors.
Financial innovation takes time, patience and a tolerance for risk. Some SIBs will succeed easily while others will require extraordinary measures to ensure that investors donaEUR(TM)t lose. The field will evolve and learn from experience. Just like riding a bike, once you learn, even if you fall, you can get up and ride again.