A new approach to fighting poverty and solving some of society’s other big problems is emerging at a time when the federal government and states are cutting back on safety-net spending.

Instead of relying on tax revenue or straightforward charity, state and local governments are signing contracts with Wall Street investment houses and banks as well as foundations. These contracts, often called “social impact bonds,” leverage capital from investors and expertise from service providers to do everything from rehabilitating young offenders to helping the homeless find shelter.

As professors who teach economics, public administration and management, we believe that social impact bonds have the potential to bring needed financing to support innovative ways of delivering social services – such as the rehabilitation of formerly incarcerated people and housing the homeless. At the same time, funding projects this way will probably cost more due to the additional coordination and evaluation required.

How they work

Despite their name, social impact bonds are not securities sold in capital markets. Rather they are multiparty contracts between governments seeking financial support for innovative programs and policies and funders with money to lend them. These contracts include incentives and safeguards to make it more likely that the parties will fulfill their obligations.

Whether investors are repaid – and to what degree – depends on how much progress the underlying program makes toward achieving its goals.

The contracts typically specify some minimal level of success that must be achieved before any money gets paid back. If the program’s performance beats those expectations, the investors get repaid along a sliding scale. In a best-case scenario, there’s a full repayment and even a small profit.

Ideally, these ventures save taxpayer dollars by reducing the need for government services at no additional cost to the public. Rather than pocketing the proceeds, the backers are encouraged to recycle this capital to back other projects.

Juvenile justice

In a recent study published in the Nonprofit Management & Leadership Journal, researcher William Winfrey and the three of us followed what happened when a social impact bond raised money for the Massachusetts Juvenile Justice Pay for Success Initiative.

Goldman Sachs, along with several foundations, provided financing for a program working with 929 youthful offenders. Instead of the more traditional punitive approaches, it uses cognitive behavioral therapy – getting people to spot the beliefs and feelings that feed their problems and then replace them with more productive thought patterns and behavior – and job training to prevent former inmates from re-offending and returning to prison.

The results of the Massachusetts Juvenile Justice Initiative are not yet in, so it is too soon to tell whether this experiment will prove successful. But we have been able to estimate that the administrative costs associated with using the social impact bond structure may have only increased the project’s cost by 10 percent, a relatively low percentage given how complicated the social impact bond contract is with many different parties involved.

The nation’s debut social impact bond sought to help Rikers Island inmates stay out of trouble after their time behind bars through education and counseling. This project failed to meet its benchmarks. The second U.S. social impact bond program targeted early childhood education in Salt Lake County, Utah. This program was declared a success because it achieved a 99 percent success rate in reducing the need for special education in elementary school.

About half of the 20 social impact bonds launched so far in the U.S. have backed efforts to solve criminal justice issues. For example, they have aimed to reduce juvenile offender recidivism or the incarceration of mothers of young children.

The Obama White House strongly encouraged state and local governments to harness these bonds in an experiment the Trump administration has also embraced.

Do they work?

In the eight years since the first social impact bonds were launched, a total of 108 have raised about US$392 million, impacting more than 700,000 people in 25 countries.

This approach has also amassed many supporters. Rockefeller Foundation President Judith Rodin, for example, is excited to see a new avenue opening up for impact investing.

There are also skeptics, however. Many of these critics, such as nonprofit scholar Mark Rosenman, do not see why profit-seeking investors should have a say regarding the delivery of services for people facing economic hardship.

Another potential limitation of relying on social impact bonds is that such arrangements are most suited to innovations in the delivery of social services that save money, something that not all improvements in social services can do.

Based on the mixed track record so far, we believe it’s too early to tell if social impact bonds can help resolve intractable problems like mass incarceration. But as long as investors, nonprofits and government agencies can heed the lessons from successes and failures alike, we are cautiously optimistic regarding their potential to supplement taxation and charitable donations as a source of revenue to do good.

The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.