Social Impact Bonds Help Investors Bridge Philanthropy and Business Goals

Long before doctor and entrepreneur Paul Polak began trying to revolutionize social investing — before he could even drive a car — he was planting the seeds for a movement he hopes will change the way some people do business.

It was 1939, and Polak’s father was making a good living as a peasant farmer in Czechoslovakia, but the Germans were moving in and his family needed to leave.

“My father was active politically in the party that opposed the Germans, so we were on extermination lists,” recalled Polak, who is now in his late 70s. “We all would have been killed.”

Canada had an interest in foreigners with farming experience, so the Polaks packed their bags and moved to a town just outside of Hamilton, Ontario, 40 miles from Toronto. They worked as day laborers, picking strawberries at five cents a quart. On a good day, Polak could pick 200 quarts worth of strawberries and make ten dollars. But he thought he could do better.

“I said to myself, well, listen, if I can make 10 bucks picking strawberries, just think about what the owner of the strawberry fields is making,” he said.

At just 15 years old, he struck a deal with local farmers: Let me plant on your land, he told them, and I’ll make you richer. He didn’t know why he felt so confident that his plan would work, but he didn’t feel like he had anything to lose by trying.

A year later — thanks to seven acres of strawberry seeds and a horse named Dick that had “bad gas” — the young day laborer was providing strawberries for half the town of Hamilton. The first summer Polak made $700 and paid back the farmers who initially let him plant the seeds. He eventually partnered with Loblaws, a major Canadian supermarket chain, and became their exclusive strawberry dealer. They made money, he made money, and everyone was happy.

“It wasn’t charity,” Polak said of the farmers who had trusted a 15-year-old kid to plant on their hard-earned land. “I delivered the goods. We were doing business.”

Today, 60 years later, Polak is expanding on that idea — combining business principles with the business of charity and philanthropy — and investing in farmers on a global scale. With a focus on the “2.6 billion people in the world who live on less than $2 a day,” Polak said that, although providing a social good is the crux of his work, he doesn’t want to help them just for charity’s sake. Instead, he wants to start businesses that are profitable and that can succeed and sustain themselves on their own.

“All I’ve ever done is problem solving, creative problem solving,” he says. “Later on, I found out I was a social entrepreneur, but I was simply doing what I thought was obvious before anyone started talking about it.”

Now everyone’s talking about it — from state and city governments adopting new “pay-for-success” models of social investing, to countless non-profits soliciting help from major private sector donors who wish to invest in social needs. The movement also includes ordinary people, who can contribute microloans — through websites like Kiva.org — of as little as $25 to causes they believe in.

In a recent Rockefeller Foundation survey of just 42 investors, they reported approximately 2,200 impact investments last year worth nearly $4.5 billion, with sources ranging from private equity, to community banks, to the big guns like JP Morgan and Goldman Sachs. And the trend shows no signs of slowing down in the next year.

Polak says there “will always be those businesses that want to have positive social impact, and businesses that do not.” The question in the next few years, he said, will be whether entrepreneurs, governments and forward-thinking businesses choose to take the risks necessary for social change in the United States and abroad.

Will they invest in products like “social impact bonds,” a relatively new financial tool that could aid millions but may not prove fruitful for a long time?

“People I meet with always say: ‘Oh, this idea is too high risk for us, we need something low risk,'” he says. “But everything that makes money starts out impossible. Look at Apple. Apple started in a garage.”

CREATING WEALTH

About 30 years ago, Polak was working full time as a psychiatrist when he decided to take a trip to Bangladesh. There he met farmers living “on basically nothing,” and who wished to improve their lives. The simplest solution was to increase the value of their crops, and Polak realized these farmers could do that with a simple device known as a “treadle pump.”

Treadle pumps irrigate crops during the dry season, and also improve drinking water. “If a farmer could get access to a treadle pump,” says Polak, “[he] could go from a buck a day to two bucks a day. They could grow more vegetables and sell them when other people couldn’t.”

The next hurdle: How to get these pumps — which typically cost $25 to purchase and install — into the hands of poor farmers. If Polak simply rounded up private donors to donate the pumps as charity, they might go untracked, or they might break and nobody would notice. At the time, UNICEF was subsidizing hand pumps and they were getting lost and sold as scrap iron. Polak decided that if the farmers bought the pumps themselves they might have a more tangible stake in the outcome.

Polak raised private funds to build pumps to sell back to the farmers and worked on marketing the devices as well, even getting them featured in a Bollywood movie. Between 1982 and 2012, Polak has contributed to the sale of more than 2.5 million pumps to farmers under the umbrella of his non-profit organization, International Design Enterprises. The farmers using the treadle pumps earned an average net income of $100 in their first year, and Polak said that just under one-fifth of them earned $500 over that same period.

“When somebody invests in something, they treat it differently than when they get it as a gift,” Polak said. “Are they social enterprises? No, they’re businesses trying to earn a living. They’re creating wealth for poor people.”

Polak started understanding then what is quickly becoming more commonplace now: that simply donating to a cause is not always enough. Today, a smart, socially-minded businessperson might actually invest in an idea, before it has been proven, whether it’s strawberries or treadle pumps. And if you’re patient and willing to take risks, Polak said, you might actually make some money.

Sonal Shah is in this camp, and thinks we can apply these same ideas closer to home.

The former head of Global Development Initiatives, a philanthropic arm of Google.org, and director of the Office of Social Innovation and Civic Participation in President Barack Obama’s White House, Shah agrees with Polak that taking risks on new ideas is essential, and investors can actually “think of the poor as a market.”

“If an innovation is showing results, someone should let them do more with it,” she says. “The question becomes: How do we scale these [innovations] even more?”

As social investments gain traction and more businesspeople and young entrepreneurs look for socially minded ways to spend their money, Polak and Shah note that local city and state governments are looking for similar opportunities to invest in potentially radical innovations. That’s why all eyes are on “social impact bonds,” a new and somewhat risky form of social investing that seeks to get nonprofits, governments, and big businesses to work together to deliver tangible results.

A social impact bond, sometimes referred to as a “pay-for-success” bond, is a partnership between governments, private investors, and nonprofits. The “bond” is actually a loan made by investors to pay for the implementation of a social program, and they require a government to pay the investors a return on their principal investment only if the program meets its agreed-upon goals.

The world’s first SIB was used at the Peterborough Prison in the United Kingdom in 2010, launching a wave of subsequent research questioning whether or not they can actually work — whether they can be the treadle pumps of the developed world.

“These are new models that haven’t yet been fully tested,” Shah said. “We currently call charity giving money away and business as business, and this is somewhere in between.”

Under the Peterborough SIB, private investors contributed 5 million pounds to the St. Giles Trust’s prisoner rehabilitation efforts, which are sponsored by the British government. If the Trust can reduce recidivism at Peterborough by 7.5 percent over 8 years, the investors will get their money back from the government. If that rate is surpassed, the investors will actually earn a profit. If the goals are not met, however, the investors lose their money.

Alisa Helbitz, of Social Finance, an ethical investment bank that coordinated investors for the Peterborough project, said the concept is revolutionary in its simplicity, which is part of the reason it’s drawing so much attention.

“We went to prisoners and asked them what would be useful when they got out,” she said. “Most said they come out with 46 pounds in their pocket, no benefits, they need doctors to get prescriptions filled, they basically have no support. So we sat with them and asked what would help them, and we structured our intervention based on what we heard.”

When Social Finance approached investors with the idea, Helbitz said, the response was overwhelmingly positive. “We simply said, ‘look, we want a new way of working,’ and then we just started bringing people along on the journey.”

Though official results of the project will only become available starting in 2014, Helbitz confirmed “anecdotally” that the project is doing very well, and said she has received an “overwhelming” amount of phone calls each week over the past two years, “from the U.S., Canada, Australia, Israel, elsewhere in Europe” inquiring as to whether or not a program like this would work for their own constituencies.

If the program does work, similar ones could save taxpayers and governments millions of dollars. In the US, for example, the Center on Sentencing and Corrections estimated that taxpayers in 40 states paid $39 billion in prison-related taxes last year, “13.9 percent higher than the cost reflected in those states’ combined corrections budgets.”

Some remedial programs can offset those rates in the short-term, but states need long-term results.

“[Social impact bonds] offer a long-term, sustainable model of funding, where we can actually focus on outcomes,” said Helbitz. “What works? What doesn’t work? This pays you only for success, and taxpayers only pay if it works.”

The bonds have also arrived on U.S. soil, with the first being pioneered by New York City Mayor Michael Bloomberg in August 2012. Using a similar model to that of the Peterborough bond, Bloomberg’s SIB focuses on the prison at Rikers Island, and especially on inmates between 16 and 18 years old, nearly half of whom return to prisons within a year of their release.

Goldman Sachs is providing $9.6 million for an adolescent rehabilitation program at Rikers, sponsored by the nonprofit MDRC, a nonpartisan education and social policy research organization. Goldman will only get its money back if recidivism dips by 10 percent, and they stand to make as much as $2.1 million if the reoffending rate further declines.

David Butler, who heads up the social impact bond project for MDRC, said the program will begin rehabilitation efforts while offenders are still at Rikers, offering educational and mental assistance, as well as job training opportunities. He added that Bloomberg and Goldman Sachs are trusting MDRC with this program because data shows that similar efforts have had positive effects in the past.

“Everyone’s looking at this program, which is positive in some respects, because it’s important we all do it right,” says Butler. “On the other hand, it can be distracting that so many people want to look at this one program.”

Kristin Misner, chief of staff of the New York City deputy mayor’s office, said the city’s SIB is attracting attention because it’s “exciting” people, and because the often-derided Goldman Sachs is initially covering the bill.

“We’re still in tough financial times,” Misner said, “And this gives us the ability to get upfront investment into a program we believe will ultimately save the city lots of money.”

But Misner didn’t shy away from the word “risk” as she spoke of the bonds. In fact, its inherent risk is part of its appeal.

“It’s risky for government because it’s a new way of thinking for government,” she said. “We’re used to paying people to do what we tell them to do. We control it, we oversee it, we have ultimate authority with it. Here, we’re saying we will only pay for outcomes. We’re asking you to help x many people, with x amount of service, over x amount of time — and we’re trusting you to deliver.”

While Misner admitted that SIBs might not work for every city in the country, she did say this particular one allowed the government to test out a program it might not have otherwise been able to. They’re taking a bet on an innovation, she noted, and everyone — Goldman Sachs, MDRC, the Department of Corrections, and the New York taxpayers — is hoping they win.

“With such tight budgetary times, this sense of risk-taking has decreased,” she said. “But in this situation, everybody has assumed some portion of the risk.”

‘VIRGIN’ IDEAS, SCALABLE GOALS

Whether it’s marketing treadle pumps or lowering recidivism rates, every positive investment in social change has been built on a gamble. David Chen, co-founder ofEquilibrium Capital, a major impact investment fund based in the U.S., brought to mind another major innovation that dramatically altered the business landscape.

“If you’ll pardon the analogy, at one point in time a hundred years ago, the home mortgage was a financial innovation,” Chen said. “There have been some very pretty inventions the last 10 years, which contributed to the downturn, and the social impact bond is another financial innovation, but it happens to be rooted in something very important.”

Chen said this kind of program has not been implemented before simply because “nobody’s really thought of it.” Now that the idea is out there, he says more people are listening.

The White House believes so strongly in pay-for-success bonds, in fact, that the 2012 budget has set aside up to $100 million to fund “pay-for-success” initiatives in workforce development, education, juvenile justice and care for children with disabilities. Shah said innovations like these had been a goal of the Obama administration from the outset.

“We created a framework so all other government agencies can look at how this could work for themselves,” she says. “We created the space for conversation.”

State-specific programs, which offer slight tweaks on SIBs, are being implemented in Minnesota, Ohio, Massachusetts and California, and in countries like Australia, where“performance based contracts” are already being used. And Manhattan borough president Scott Stringer recently announced his own plans to launch a social impact bond to finance an expansion of Early Head Start, a program for families with very young children.

Last April, the U.K. announced the creation of “Big Society Capital,” which refers to itself as “the world’s first social investment bank.” Recently launching with 37 million pounds in investments, the bank’s goals are tied to socially positive outcomes.

Kristina Costa, a researcher at the Center for American Progress, an educational institute dedicated to progressive ideas and action, said a unique benefit of these new social investment programs is that they are inherently bipartisan.

“Conservatives like it any time you’re bringing outside groups into the sort of domain of government to provide private sector managerial practices,” she said. “Whereas our organization, a progressive organization, is a long-running project focused on creating a more efficient effective government. These [SIBs] encourage metrics and measurement and using them intelligently, which is something the left has been pushing for years.”

Costa said these bonds could be effective in many areas, including job training, health care, foster services for at-risk kids, drug rehabilitation programs, and combating homelessness.

“When times are good, we don’t need to come up with new ways of doing things,” Costa said. “But if these things are built into the model, to educate kids and to actually give nonviolent offenders the tools they need to reintegrate, it achieves goals from both sides.”

As Paul Polak says over and over in every speech he gives, this is about scale. You can’t reach people with just an idea, and you can’t change anything with an idea, it has to be large-scale. It has to reach millions and you need to get as many sectors involved as possible.

“Social impact bonds do that, they get people involved,” he said. “A lot of people jumping on the bandwagon, that’s a good thing.”

Polak is currently working to develop three organizations abroad, all with the goal of changing not just the way one village does business, but changing the way a hundred villages, working together, can do business.

For example, he’s pursuing water purification efforts that aim to reach a hundred million people over the next few years by partnering with local “mom and pop” shops to help run systems he installs. He also wants to revolutionize the coal industry, creating a cheaper, more sustainable coal alternative using four billion tons of agricultural waste as fuel. As he nears his 80th birthday, he’s also trying to spearhead solar power adoption in the developing world.

“If this works, they’re all going to make huge money!” he said. “I want to create three global companies, and each of these companies will be capable of serving 100 million people living on $2 a day.”

Multinational corporations like Walmart, Apple and General Motors could do much more to appeal to the poorest customers around the world, Polak said, and they have the opportunity to do so.

“If some entity — some company that was well-financed — if they sold a nutritious soft drink for a nickel to $2 a day customers, they’d be in a position to compete with Coke and Pepsi,” he said. “There are huge opportunities to create new multinationals, to create new markets.”

A few years ago, speaking at a TED talk, Polak said he felt like an “18-year-old virgin in a 77-year-old’s body.” At the SOCAP conference in San Francisco last week, where social and impact investing on a local and international level was what everyone wanted to talk about, Polak said he finally feels like he’s “slept around” a little bit. Since he began tinkering around in this field, he’s helped 20 million people out of poverty.

“The punchline is that doing this as a business seems to be the best way,” he says.