“The Caging of America” — an article in The New Yorker written by Adam Gopnik — paints a disturbing picture of the human toll and costs of the nation’s prison system. In it, Gopnik notes that between 1980 and 2010, the number of people incarcerated in the United States more than tripled — from 220 Americans for every 100,000, to 731 for every 100,000. “No other country even approaches that,” he writes.

Tracy Palandjian, CEO and co-founder of Boston-based Social Finance, cited Gopnik’s article during a keynote address at a recent Wharton Social Impact Conference. “It’s a huge number of people who are neglected in society,” said Palandjian, who left the world of consulting early last year to launch the sister organization of the U.K.-based Social Finance, Ltd., which aims to help the disenfranchised. She understands that getting people to care about criminals is a tough sell, but it’s part of her nonprofit’s mission, one with the potential to break the social-good funding mold.

According to Palandjian, getting Wall Street to join forces with nonprofits and governments will help solve major societal issues — everything from the swelling prison population to chronic homelessness. The “Social Impact Bond” is at the heart of Social Finance’s strategy, and she came to tout the idea during a presentation at the Wharton conference, whose theme was “A Look Inside the Enterprise of Social Change.”

Social Impact Bonds (SIBs), also known as “Pay for Success Bonds,” are essentially financial instruments in which investors can front working capital for nonprofits that deliver social programs — a way to connect the social sector with the capital markets. If the nonprofit meets predefined metrics, public-sector savings are realized and the government then pays investors back their principal plus a rate of return. However, if the savings are not realized, the investors get no repayment. In terms of investment risk, then, these vehicles are more like an equity investment than a typical bond purchase. Last year, President Obama earmarked $100 million for various pilot programs involving SIBs in his 2012 budget proposal.

“The Social Impact Bond has an incredible set of opportunities ahead,” Palandjian said, noting that the public-private investment instrument brings both money and higher accountability to social services. If it works, she added, everyone wins.

Drinking the ‘Kool-Aid’

Handing over a piece of direct government savings to investors, however, may be hard for some people to accept, and Palandjian is aware of that. “We hear that criticism often,” she said, but in the end, “no one gets rich on this.” While there are philanthropies trying to combat many social issues, there are not enough charitable funds, or public will, to deal with all the problems, she noted. The U.S.-based Social Finance was launched in February of last year, and Palandjian joked about having “drunk the Kool-Aid” when it comes to the concept of SIBs. “Social Impact Bonds are an elegant and simple theory,” she stated.

Her first exposure to SIBs came while working in London with Social Finance, which pioneered the bond’s model. The British organization launched its pilot project at a prison in Peterborough, England, in 2010. The goal of the investment is to help reduce the recidivism rate of ex-convicts and, in turn, lower taxpayer costs. About 60% of offenders in the U.K. re-offend within one year.

The Rockefeller Foundation, among other investors, contributed more than $8 million to a bond to be used to fund social service organizations that provide counseling, housing and employment services to the recently released. If the project succeeds in cutting the recidivism rate by 7.5% or more, investors will receive returns from the U.K. government up to 13.5%. If that doesn’t happen, the government will have no obligation to pay the investors any money.

Initially, Palandjian was skeptical about the SIB concept. “When I first heard about the bond, I thought, ‘Are you for real? It sounds too good to be true. The government sees net savings, but all the financial risk is off-loaded to the private sector? It sounds like a Ponzi scheme,'” she quipped.

However, she soon became convinced it was not an investing scam but an innovative, socially responsible investing model. “Traditional capital markets have a role to [play in enabling] social progress. The massive social issues in front of us are huge. Traditional government funding and philanthropy are not enough.”

A ‘Mid-life Moment’

A native of Hong Kong, Palandjian graduated from Harvard College with a B.A. in Economics, and then got her MBA from Harvard Business School. She has a unique work background, straddling the nonprofit, business and investing worlds. Before launching Social Finance in the U.S., she was managing director of The Parthenon Group, a global strategy consulting firm where she formed and led the nonprofit practice. In that position, she was a consultant to foundations and nonprofits, helping with strategy development, corporate social responsibility, knowledge development and innovation. She also worked at Wellington Management and McKinsey, and serves on the board of the Robert F. Kennedy Center for Justice and Human Rights, among other organizations.

After building and scaling social enterprises at Parthenon for almost 12 years, Palandjian had a realization. “It was one of those mid-life moments where I asked myself, ‘Am I going to be a consultant in the private sector for the rest of my life, or am I actually going to do something?'”

She made the break 13 months ago and hasn’t looked back.

For Palandjian, the Social Impact Bond is a whole new way of thinking about funding social programs and investing, and the time couldn’t be better for its birth. She pointed to a host of factors creating an SIB “perfect storm,” including government cutbacks preventing money from going into preventative programs, a growing cadre of investors looking for social issues to fund, and a near-zero interest rate environment.

While philanthropy plays a big role in seeding nonprofits, the funds are insufficient to deal with the escalating social problems communities face, especially during tough economic times, Palandjian noted. The key is prevention, she stressed, if governments are going to make a dent in problems that Social Finance sees as its potential targets: chronic homelessness, juvenile and adult offenders, and low-income senior citizens. “We are trying to monetize Ben Franklin’s axiom, ‘An ounce of prevention is worth a pound of cure.'” Today’s realities, she added, have taken the eye off the ball because “safety-net spending has completely crowded out any spending on prevention.”

Officials Kicking the Can

SIBs are different than grants or public-sector funding because they have the potential to generate financial returns that could be reinvested in the social sector. Social Finance acts as an intermediary between all project stakeholders — investors, nonprofits, government and communities — and also vets the nonprofit organizations to make sure they are up to the challenge and will produce the results they are promising to local governments. “We provide monitoring, trouble shooting, course correction. Then we hire a third party to be an independent evaluator” to decide when a nonprofit has met certain metrics and savings are realized, she noted.

To critics who say government doesn’t need a go-between and should just deal with social issues itself, she pointed to problems with government inefficiency and the short-term thinking by some officials who tend to kick the can down the road. “Often they say, ‘Let the next administration think about it; I have enough problems to deal with.'”

SIBs don’t come without risks, and Palandjian spelled these out during her talk:

  • Intervention model risk: If a nonprofit is not vetted carefully, the model the organization uses to deal with a particular issue may fail to produce results.
  • Execution risk: A lack of communication, measurement burdens or the inability to capture reliable data on how a service is working could doom a project.
  • Intermediary risk: If the middlemen, and women, in this process are not committed to the long haul, programs could suffer, especially if these individuals become unable to raise funds and administer the process.
  • Political risk: Governments may fail to pay back investors even if savings targets are reached, and repayments could be subject to political uncertainties that come with yearly appropriations.

While Palandjian said SIBs require a serious commitment and buy-in by all stakeholders, she stressed that the benefits outweigh the risks. At this point, Social Finance in the U.S. has not yet secured investors. “We are talking to a lot of investors, but it’s a chicken-and-egg issue. Until we have a specific risk-return parameter, a term sheet to set up, we’re not in a position to actually sign up investors.”

The first projects her team hopes to get include programs addressing young offenders and the chronically homeless in Massachusetts. Last month, the Commonwealth issued a Request for Information to seek input from organizations focused on performance-based financing about ways that SIBs can be implemented. Social Finance has submitted a proposal, and Palandjian hopes the Massachusetts programs will give her the chance to show how the SIB concept can make a difference. “If we can get it working, a lot of money will be saved, and a lot of individuals will be able to benefit.”