In late October, U.S. Labor Secretary Thomas Perez issued a ruling that now makes it easier for those who manage pension funds and 401k plans to include socially responsible investments. According to an article in ThinkAdvisor, the new guidelines counteract language issued in 2008 by the Bush administration that had warned fund managers away from such investments.

“This is a landmark ruling,” said Surya Kolluri, managing director for policy and market planning in Bank of America Merrill Lynch’s global wealth and retirement solutions business. Speaking at the recent Wharton Social Impact Conference, he predicted the new policy will catch on over time as managers become more comfortable devoting institutional dollars to social impact initiatives.

Secretary Perez’s announcement is an example of society’s increasing move toward investing for social impact in an effort to solve global challenges. Meanwhile, impact investing itself is still a fledgling field. How can individuals and companies weigh different investments and predict which will be successful? How is success measured? And is there still a role for traditional philanthropy?

Social Impact Bonds 101

Public, private and non-profit actors are experimenting with new models of financing, among them social impact bonds (SIBs) which are also known as pay-for-performance or pay-for-success contracts.

“From a business venture perspective, if we look at the future of our business, with the millennials coming up as clients, we do not want to be our father’s Oldsmobile.”–Surya Kolluri

Kolluri outlined the basics of the social impact bond, saying that four things are needed to create one. First, a target population or a group that needs help — for example, teenagers who are pregnant, or veterans who are homeless. Second, an intervention, or “what are we going to provide for that target population?” Third, a payor, which he said is typically the government. “Is there a government agency with funding that cares about this issue, and is actually spending dollars against this issue for that target population?”

And the fourth thing needed, said Kolluri, is individual investors. “Are there private investors interested enough in this cause, trusting enough of this intervention, that they’re willing to invest their private capital dollars?” Finally, he said, a third-party intermediary must “pull all these parties together, write a contract and create a financial instrument that can have the funds flow to the service provider … and measure the result.”

Kolluri, who works on social impact bonds at Bank of America Merrill Lynch, pointed out they are very labor-intensive and not particularly lucrative for his company. He said standard bonds, such as municipal bonds, generate about a half billion dollars and can be completed in a few weeks. But a social impact bond only involves around $15 million and takes 18 months.

“Why do we want to do it … 18 months of pain?” said Kolluri. “The answer is very simple: Our clients want it.”

He explained that in surveys done by his company, nearly half of Merrill Lynch’s three million clients said they wanted to express their values with regard to social or government issues in their investment portfolio. Further analysis identified a rising trend by age. Of the “silent” generation — those born between the mid-1920s and early 1940s — 30% said they were interested. “But by the time you climbed to millennials, [the percentage] was in the high 70s” said Kolluri.

“From a business venture perspective, if we look at the future of our business, with the millennials coming up as clients, we do not want to be our father’s Oldsmobile.”

Lessons from a New York City Prison

Kate Ahern, vice president of social innovation for the Case Foundation and the panel’s moderator, noted that social impact bonds are currently in progress in about 36 states, New York State being the leader. She asked Kolluri to comment on a 2012 New York City project that was intended to reduce prison recidivism among juvenile offenders on Rikers Island, New York City’s main jail complex. The project was halted in July 2015 because it was not meeting its effectiveness or investment goals.

Kolluri noted that in general “the data is strong” that prison recidivism interventions — such as work experience and supportive coaching — significantly reduce the rate at which offenders return to prison. This success rate and clear measurability is one of the things that makes prison recidivism a good target for a social impact project. In addition, the service provider that was used, Center for Employment Options, had a positive multi-year track record in this area.

While acknowledging that this early project in New York City (which Bank of America Merrill Lynch was not involved in) did not work out as intended, Kolluri noted that his organization is participating in another program that is still underway in New York state.  “We decided to take a harder road,” Kolluri said of the current project. “If we had done it off-balance-sheet … backstopped by some foundation, that would not make a financial instrument.” (Two foundations had in fact signed on to take the first loss — the Rockefeller Foundation and the Robin Hood Foundation — but only 10% of it.) Kolluri stated that the project, although it had been “stuck” with the name “social impact bond,” might be more accurately described as a private equity vehicle. “All the investors were high net worth … and they were fully cognizant of the fact that their investment dollars were at risk.”

“Hopefully [they will] end up distributing [mosquito] nets in a much more efficient way than if we had just written the government of Nigeria a check.”–Suprotik Basu

He added, “If we step back from the noise of, ‘did it work, did it not work,’ looking at social impact bonds as an innovation, I would say … that’s how it’s meant to be. Market discipline means if an investment doesn’t work, it is not refunded.” Kolluri said he envisioned a portfolio approach for social impact initiatives, with for example, 10 different projects, some of which might work out and some not.

An audience member mentioned that in the New York City situation, a portion of the loss was paid back by Bloomberg Philanthropies. She wondered if the social impact space would ever achieve a point at which philanthropy was unnecessary.

Ahern observed that back-stopping social impact initiatives might in fact be a perfect fit for philanthropy at the present time. “A lot of us feel that is our role in philanthropy, to take the risks where the market won’t — especially in these brand-new transactions. People don’t understand them; they think they’re going to lose their money.” But it would be “wonderful to get to the point,” she said, where that need no longer exists.

Moving from Billions to Trillions

Suprotik Basu supplied a different perspective on social impact investing. He is the CEO of the MDG Health Alliance, an initiative of the Office of the UN Secretary-General’s Special Envoy for Financing the Health Millennium Development Goals (MDGs) and for Malaria. The financial instruments he works with are development bonds, which are issued to governments, rather than social impact bonds involving individual investors.

He described his job as being “at a slightly public-private crossroads.” He manages the work of philanthropist and former New Jersey Nets owner Ray Chambers, who is best known for being the co-founder with former U.S. Treasury Secretary William E. Simon of Wesray Capital Corporation, a private equity holding company that made notable leveraged buyouts in the 1980s. Basu said Chambers was asked a few years ago by the UN Secretary General to become a special envoy for financing many of the UN’s health goals. “So we look at [things] both from a quasi-UN [perspective]… and from a private investment family office [one].”

Basu spoke about the “vast agenda” the UN recently adopted in the form of its Sustainable Development Goals. There are 17 goals with specific targets to be achieved over the next 15 years, involving things like eradicating hunger and poverty and promoting good health, economic growth and climate action. Basu sees an important role for development bonds, quoting Jim Yong Kim of the World Bank as saying, “We’ve got to move from our framework of billions of dollars of overseas development assistance … to trillions of dollars of private and public investment and financing.”

“We need to be creative,” said Basu, describing a situation with Nigeria that his office dealt with a few months ago: 50 million insecticide-treated mosquito nets were in need of replacement. He explained, “[The bed nets] break the cycle of malaria transmission. That’s the good thing…. The bad thing is they have to be replaced every three years, and it requires a massive replacement campaign.”

Fifty million bed nets costs about $300 million, but “Nigeria has tapped out…. They’re maxed out on all the pots of money they could have from donor financing … they’re maxed out on their World Bank credit…. So how do you bring them some new capital?” asked Basu.

“A lot of us feel that is our role in philanthropy, to take the risks where the market won’t — especially in these brand new transactions.”–Kate Ahern

Basu and his team asked the government of Nigeria if it would accept the money on loan terms, under a pay-for-performance contract. Nigeria agreed. “We have now set up a $900 million fund that the World Bank has and that will be used to do pay-for-performance contracts…. If Nigeria hits an x, y, or z bed net distribution target, it will get paid out on straight grant terms out of its pay-for-performance fund. If you do half the job, you get half the money.” He further noted that half the nets are going out through private contracting and half through the public sector, creating an “interesting experiment in the distribution scheme.”

“Hopefully [they will] end up distributing nets in a much more efficient way than if we had just written the government of Nigeria a check,” said Basu.

‘Use the Right Arrow’

The panelists agreed that especially in what Basu termed the “toddler days” of the social impact investing space, social impact bonds and pay-for-performance contracts were not necessarily the right answer to every social problem. Other avenues such as philanthropy and government aid were still necessary.

Kolluri noted that one challenging area is early education, because of the difficulty of putting hard numbers against the intervention. By what metric — and at what point in a person’s life — would the outcome be measured? And if it were measured in adulthood, that would mean the measurement would be separated by decades from the intervention. On the other hand, the area of early health — the issue of preventing preterm births, for example — is much more specific, so it is a better problem for impact investing.

“It’s really important to know what problem you are solving for,” Basu agreed. “We have to look at all the arrows in our quiver and use the right one for the right target.”