Wall St sees social-impact bonds as way to do good and do well

Reuters

(Corrects time span of Goldman loan in Utah to five years, notseven years, and clarifies that payback is over seven years,last two paragraphs)

By Jessica Toonkel

NEW YORK, Nov 12 (Reuters) - Wall Street banks are eyeing anascent market that improves their public image at a low riskand still offers them a reasonable return on capital.

The market is in so-called social-impact bonds, also knownas pay-for-performance contracts, through which private capitalcan be funneled into philanthropic projects usually funded bygovernments and charities. The investors will receive a returnbased on whether a project saves public money by addressing thesocial ill it targets.

Goldman Sachs has launched two such bonds in the past16 months - one for $9.6 million aimed at reducing recidivismamong teenagers at New York's notorious Rikers Island jail, andthe other for almost $5 million, intended to help children fromlow-income families in Utah prepare for kindergarten. Thismonth, Goldman also said it is raising a fund to allow itsclients to make investments that have "measurable socialimpact," including social-impact bonds.

Now Bank of America Corp is set to launch asocial-impact-bond investing program, three sources familiarwith the situation said. Details of the program are not known.

Other banks, such as JPMorgan Chase & Co, DeutscheBank and Morgan Stanley, are keeping a closeeye on these projects before getting involved, bank executivessaid. In some cases banks see the bonds, which were firstlaunched in Peterborough, UK, as a product to sell to theirwealth management clients, said George Overholser, chiefexecutive officer of Third Sector Capital Partners, a nonprofitinvestment bank helping to structure various pay-for-performancedeals.

A Bank of America spokeswoman declined comment.

The growing interest of banks in these bonds bodes well forcash-strapped governments and charitable foundations that wantmore private-sector cash to fund projects that serve a socialneed. Nonprofits and governments are hoping to develop a widermarket for such securities, betting that the bonds would becomea way to finance social programs that struggle as governmentbudgets tighten.

"We do these deals to get strong financial-risk-adjustedreturns that have a strong impact," said Alicia Glen, head ofGoldman's Urban Investment Group, which oversaw the creation ofthe two social-impact bonds. The group has been structuring andfinancing community revitalization projects for the past 12years.

Critics say that so far social-impact-bond deals haverequired that philanthropies or other investors give too muchsupport to the banks, raising questions about whether subsidiesare the best way to create a sustainable market in the longterm.

Both the Goldman deals are structured to reduce the bank'srisk. In the Rikers deal, a charity affiliated with New YorkCity Mayor Michael Bloomberg has agreed to absorb $7.2 millionof the losses if the program fails, while American businessmanand philanthropist J.B. Pritzker is providing a subordinatedloan of $2.4 million for the Utah program, meaning that if theprogram fails, he has agreed to take losses before Goldman.

"If you want to mainstream it, you need to mainstream it in away that you do not have a 75 percent guarantee," said GaryHattem, who heads Deutsche Bank Americas Foundation, whichoversees the German bank's philanthropic activities in the U.S.,Canada and Latin America, and is managing director overseeingthe bank's community development finance group.

Goldman said the risk-adjusted return on the two projectsis between 6 percent and 8 percent, in line with its othercommunity reinvestment deals. When the Rikers deal was announcedin August 2012, junk bonds were yielding around 7 percent.

Goldman's venture into social-impact bonds comes as thefirm is trying to rebuild goodwill with the public after eventsthat were deeply damaging to its reputation during the 2007-2009financial crisis.

As an added bonus, Goldman can also include thesocial-impact bond in its Community Reinvestment Act applicationto its regulators. Banks need high CRA ratings to engage intransactions such as merger and acquisition deals. Otherwisethey risk facing vocal opposition from community activists.Goldman is currently rated "outstanding," the highest CRArating, by the Federal Reserve Bank of New York.

'TRIAL-AND-ERROR PERIOD'

In his 2013 federal budget, President Barack Obama included$300 million to bolster social-impact bonds.

Supporters say credit backstops from government andcharitable foundations are necessary to get such programs offthe ground, since the cash flow from the securities is notalways clearcut and the risks are hard to gauge. The concept isin a "trial-and-error period," said Overholser.

Goldman's Glen said credit enhancements are commonly used asan incentive to get the private sector involved where itnormally would not. The U.S. Small Business Administration, forexample, regularly guarantees bank loans to small businessesunder a program called the 7A Guarantee, providing creditprotection on 75 percent to 80 percent of the loan.

Executives involved in the Goldman transactions said it alsomakes sense for the bank's risks to be limited given how manyhours the bank has devoted to getting these projects going.

Goldman will make a $2.1 million on the Rikers deal if therate of repeat offending declines by 20 percent in four years.At one point during discussions, Goldman asked for even largerprofits if the program reduced the recidivism rate by more than20 percent, said David Butler, a senior adviser with MDRC, asocial policy research nonprofit involved in the Rikers program.

"That was a sticking point in the negotiation," Butler said.Goldman finally got comfortable with the number, given that thecity would retain all the cost savings beyond that, said Glen.

'PROOF OF CONCEPT'

City and nonprofit backers of both Goldman deals said theinvestment bank served a crucial role.

Kristin Misner, the chief of staff for Linda Gibbs, New YorkCity's deputy mayor for Health and Human Services, saidGoldman's funding meant the Rikers program - a therapy programfor 16- to 18-year-olds in jail - could run for longer than itwould if it were just relying on the Bloomberg foundation money.The Bloomberg funds could also be earmarked for future projectsif the Goldman-funded effort were successful.

Misner also said that by working with Goldman, the city hopedto demonstrate that social-impact bonds could be funded byprivate means.

In Utah, home to Goldman's second-biggest U.S. office, thebank's loan allowed the early education program to quickly getstarted for a pilot group of 600 three- and four-year-olds,allowing backers to make a case for state legislative support.

The program provides a targeted curriculum to better preparethree- and four-year-olds for kindergarten, thus attempting toprevent the need for special education or remedial services downthe road.

Bill Crim, senior vice president of collective impact andpublic policy for the United Way of Salt Lake and the program'sadministrator, said the pilot was intended to verify that the idea was practically feasible, calling it a "proof-of-concepttransaction."

Goldman provided a $1.1 million loan for a year to financethe pilot, increasing it to up to $4.6 million over five yearsif the state passes legislation to allow for private funding ofpublic education this year.

If successful, Goldman and J.B Pritzker can make up to $1.35million for the one-year pilot program alone, which includes the$1.1 million return on principal to the investors and interestpaid over the seven years, Crim said. It has not yet beendetermined how much Goldman could make for the full seven-yearprogram. (Editing by Prudence Crowther)

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