This introductory guide focuses on the aspects of social impact investing that are most relevant to impact bonds and the financing of outcome-based contracts. We do not aim to be a comprehensive source of information on all aspects of social impact investment, we do recommend resources for those who would like a more comprehensive discussion of the space.
We start with a broad definition of the concept and some basic fundamentals. We then give an overview of how return and impact are calculated before going on to explain how social impact investment relates to government contracting and social interventions.
Social impact investment can mean many different things.
Firstly, it is not the same as ethical investment or responsible investment. This type of investment seeks to avoid any negative impact (for example by not investing in arms or oil companies). But it does not necessarily actively seek to create positive impact.
By contrast, social impact investment (which might also be called just “social investment” or “impact investment”) has “intentionality” i.e. investors actively seek an opportunity to make a social impact.
But it is still investment. The money paid out is repayable (meaning there is an expectation that money given out will come back in), usually with a return (meaning the investors might get back a different amount of money from what they started with). This distinguishes it from philanthropy or grants, where there is no expectation of repayment.
Social impact investment is also distinguished by the commitment that investors make to report on the social impact that their investments create.
Often, social impact investment is used to help an organisation achieve its social purpose. It may also be used to finance the delivery of outcome-based contracts with governments or outcomes payers, as in the case of impact bonds.
When people refer to a “social investor”, they can sometimes mean quite different things. A useful distinction to make is between asset owners, and fund managers. This distinction applies in ordinary or “mainstream” investment, too. It is especially important when discussing finance for impact bonds because they can be more complex than other types of investment.
The first category, asset owners, consist of people who possess money (an asset) that they would like to invest so that it grows over time. Asset owners can be individuals like you or me (our savings and pensions), or institutions. Many grant-giving foundations are large asset owners, and the interest on those assets allows them to make grants. The money these people seek to grow is usually referred to as “capital” or “principal” in investment-speak. The growth on top of that is known as “interest” or “return” (depending on how that growth happens).
The second category, fund managers, is people who manage that money on behalf of the asset owners. The job of fund managers is to find ways to invest the money in ways that meet the preferences of the asset owners. They always either charge an agreed fee for this, or take a portion of the returns for themselves. In some case cases, asset owners are their own fund-managers – they manage their own money.
Generally, the owners of assets need to make a choice: keep their money safe but not make much return, or target a higher return if things go well, but risk losing money if they don’t. Put simply, the traditional investment equation is: less risk, expectation of lower return; more risk, expectation of higher return. People in the first category might be said to have a low “risk appetite”, and in the latter, a higher one. The fund manager needs to consider the “risk appetite” of the asset owners, and choose investments that meet that. If the asset owners want their money to grow faster, they are going to need to take bigger risks with the money, and might lose it. A fund manager might specialise in these sorts of investments.
Increasingly, asset owners and/or fund managers are considering how their investments impact the world positively or negatively. In these cases, social and environmental considerations are added to the investment decision, and the capital might be referred to as “social impact investment”. If the asset owners want to consider the social or environmental impact of how their money is invested, the fund manager needs to consider that, too. There is a lot of debate about whether this means sacrificing some of the return. Some people argue that social impact investment can offer the same returns as any other type, for an equivalent amount of risk. Others say that making an impact means more risk for less return. In general, though, it depends on the type of social impact on offer: a business set up in a poor community is still a business at heart and it is reasonable to expect ordinary business returns. But some fund managers will invest in charities whose core mission is about creating impact, so a compromise on returns may be completely reasonable. Over the last couple of decades, more and more fund managers have been set up to invest money specifically in social ways.
Confusingly, the terms “investor” and “social investor” are often used to refer to both asset owners and fund managers but it is important to have in mind the distinction between them.
One important thing to understand in the world of investment is how returns are spoken about. The first distinction is between “fixed” returns and returns that vary according to the performance of the investment. Capital with fixed returns is often provided as a loan. With a loan, a fund manager (who in this case might be a bank) will choose investments where the risk is relatively low. The organisation receiving the loan must pay it back at a fixed rate, regardless of performance. Even if things go disastrously wrong, they are obliged to repay the money. But even if things go spectacularly well, the fund manager and capital owners only get the money back at the fixed rate that was agreed at the start.
Other investments are linked to the performance of the organisation in which the investment was made. They are inherently riskier. With these investments, the capital owners will lose some of their capital if things go wrong – but if things go well, they will share some of the spoils. These types of investments include what are known as “equity” investments. This is because they are made by owning a stake or “shares” in the organisation receiving the investment. This can only be done if the organisation is a company. If it is a charity, NGO or not-for-profit, it is not possible to buy a share, but a type of loan can be made that mimics an equity investment. This is called “quasi-equity”.
Returns for both loans and equity are often expressed as a percentage, but this can be very confusing and can lead to a lot of misunderstanding.
The simplest percentage is “rate of return” which simply looks at the how much is invested, how much is eventually repaid, and expresses the difference between the two. If you invest 100 beans, and you get 120 beans back, your rate of return is 20%. This is sometimes expressed as a “money multiple”, which is how many multiples of the amount invested are eventually repaid (e.g. half as much again, or twice as much). It just a different way to express the rate of return. So the money multiple for a rate of return of 20% is 1.2.
However, getting 120 beans back after one year is better than waiting ten years. If you invest those 120 beans again straightaway and are lucky enough to get the same return again, you will end up with 144 at the end of the following year. So a more useful measure is the annual rate of return (also known as “compound annual growth rate”), which looks at how much an investment grows on average year-on-year. It takes compounding into effect, meaning money repaid early increases the return (because you can re-invest it). Our investment that returns 120 beans after one year has a 20% annual rate, whereas our investment that returns 120 beans after ten years has an annual rate of 2% (or, if it is repaid by an equal amount each year, 2.05% - a bit higher because of compounding).
Another common metric for fund managers is "internal rate of return", otherwise referred to as “IRR”. This takes into account that money now is worth more than money in the future. It is used by investors to compare investments which might have different lengths, amounts, and patterns of repayment. This can be confusing, but it is helpful to remember that with IRR, just as with annual rate of return, the timing of repayment is an important consideration. The most effective way to really understand how an IRR is calculated, and the different factors that will affect it, is through a financial model that uses the actual figures for a given investment deal.
When capital is targeting social impact as well as financial return, as it does in social investment, there needs to be some way of measuring that impact. There are many different ways of doing this, each with pros and cons. Academic researchers and evaluators advocate scientific methods that can calculate whether additional social impact is created by the investment, or could have happened through other means. But these are expensive and often impractical. Others dream of ‘big data’ approaches where standard measurement approaches are used across the board, and results are transparently shared. Despite many initiatives towards this over several decades, we still seem to be a long way off realising it. Pragmatists advocate simpler methods where a suitable measure is chosen and its results reported. However, without wider comparability these results can be more easily contested.
The way that impact is demonstrated in social investment is a very important topic. Rather than cover it in detail here, for an in-depth discussion of the debates and considerations around setting and measuring outcomes, see our guide.
The main mechanism linking public service delivery or social interventions to social investment is the impact bond. As we explain in our introduction to impact bonds these are not really “bonds”. They are an evolution of a form of public contract that has been around a long time, often called “payment by results” (PbR), “pay for success” (PfS), or “outcome-based contracting” (OBC). Instead of paying outside parties for a service upfront to deliver a specific set of activities, the government or outcome payer specifies the results it wants, and if it gets it, pays for that after the service delivery has started. Because the payment is made in arrears, the service provider has to find a way to fund the service upfront. Some do this using cash reserves (money they have sitting the bank). Others will borrow from the bank, but this is risky - they will have to pay the money back even if they don’t get the results and the government doesn’t pay them. A third category will seek a financier willing to share that risk with them. When this happens, it is known as an impact bond, and social investors, often through social investment fund managers, tend to provide the capital.
Because of this risk-sharing element in impact bonds, the rate of return could appear higher than you might expect from a bank loan, or similar. Some of the return might be kept by the fund manager to compensate them for managing the investment. The rest will go back to the asset owners.
How much risk the asset owners are exposed to depends on the details of the contract with the government or outcomes payer. If the investor risks losing everything, it is reasonable to expect the possible rate of return to be higher. But if most of the investor’s capital is likely to come back to them, the anticipated return should be lower. The predicted return will be calculated through financial modelling. There are a lot of factors affecting how risky a contract might be deemed to be, such as how likely the investors think it is that the targeted group of people will achieve the level of outcomes desired (if they think it is less likely they will consider the contract riskier). These factors are discussed in detail in our guide to pricing outcomes.
Don’t forget, any PbR or OBC contract requires up-front capital to deliver it, and this will always come with a cost. This is true regardless of whether there are investors involved or whether a company or charity is delivering. The rate of return will vary according to how risky the contract is, but it will never go away as long as there is an up-front financing need. It is something that has to be built into the price paid by the government or outcome payer. This does mean you need to be confident that the outcomes are sufficiently ambitious, that the price paid for the desired outcome represents good value for money, and that the outcome measures are robust.
The UK is widely recognised as one of the most advanced social investment markets in the world. In 2016 the Government published its strategy on supporting the social investment sector in the UK. Big Society Capital is an independent financial institution with a social mission, set up to help grow social investment in the UK. Their 2016 report on social investment in the UK is available for download here. More information about social investment in the UK can be found on the Good Finance website. Some UK social investors have a track record of investing into impact bonds. A list of those is available here.
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