Third Sector Capital Partners

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					    Third Sector          capital partners

    Pay for Success/Social Impact Bonds: RFI
    Response from Third Sector Capital Partners
    June 10, 2011

    We are delighted to respond to the Pay For Success/Social Impact Bond RFI, and to be part of this
    very exciting and innovative movement.

    Who are we?
    Third Sector Capital Partners is a nonprofit boutique investment bank. Our purpose is help capital
    flow into the social sector in healthy ways, and our focus is the fledgling Pay For Success/Social
    Impact Bond industry. We believe that financial intermediaries like ourselves will be vital to
    PFS/SIB success, just as they are to all the other capital markets that make our economy work.

    Our role:
    We can help to architect the initial vision of a promising PFS/SIB arrangement: Which issue? Which
    providers? Who plays the lead contractor role? How much capital is required? What are the impact
    targets? What is the payoff? Etc.

    Ÿ As a PFS/SIB transaction comes together, we can help to identify and coordinate the many steps
       that need to take place among providers, government, investors, lawyers, auditors, evaluators,
       administrative agents and others.

    Ÿ If a service provider hopes to participate in a PFS/SIB deal, we can assess whether it is capable of
       doing so, and, if not, identify the gaps that need to be closed.

    Ÿ If risk capital needs to be raised for a SIB transaction, we can help to quantify how much is
       needed, draft a detailed investment prospectus, and support the capital raising process.

    Ÿ If SIB investors need a better understanding of a SIB/PFS deal's risks and rewards, we can
       conduct due diligence on their behalf.

    Ÿ If the parties of a PFS/SIB transaction need a better understanding of the interplay between
       funding, performance and returns, we can build and communicate detailed financial models.

    Ÿ As contracts between the government, investors, lead contractors and administrative agents are
       negotiated, we are able to advise how they might best be structured, and to furnish detailed
       proposed contract terms.

    As transaction specialists, we do not plan to play an intensive post-transaction management role. We
1   do plan to monitor the outcomes of the deals we have supported, and to facilitate follow-on
        Our core team:
        George Overholser, a Boston-based former venture capitalist and member of Capital One's
        founding management team, has spent the last ten years working full time to advance nonprofit
        capital markets. As the creator of NFF Capital Partners, a boutique nonprofit investment bank, he
        innovated the “philanthropic equity” concept, helping 16 high-performing nonprofits secure over
        $300 million in equity-like growth capital. Mr. Overholser is a recognized thought leader in the field
        of nonprofit finance and first pitched the idea of providing SIB-like “philanthropic guarantees” to
        government in 2007. Over the past twelve months, he has participated energetically in PFS/SIB
        discussions at the federal, state and local levels.

        Drew von Glahn has for twenty-five years held senior positions in investment banking, at the
        predecessor firms to J. P. Morgan and at Credit Suisse First Boston. There, he worked in the areas
        of corporate finance, capital markets, project finance, venture capital and public finance,
        implementing numerous “first-of-kind” solutions for corporations and governments. He recently was
        the CEO of the behavioral health social venture of the Alliance for Children and Families. He has
        co-authored several papers on the PFS/SIB construct, including recent papers for the Federal
        Reserve Bank's Community Development Journal and for APHSA's Policy & Practice Journal.

        Caroline Whistler recently returned from a Fulbright Fellowship in Brazil researching nonprofit
        sustainability and philanthropy with Ashoka, where she analyzed the Brazilian philanthropic sector
        and potential for impact investors. Previously, Caroline was an analyst for NFF Capital Partners,
        providing transaction analysis and structuring for the growth capital campaigns of high-performing
        nonprofits. She is a Robertson Scholar from Duke University with degrees in Political Science and
        African Studies.

                                                          RFI Response from Third Sector Capital Partners
    Third Sector
           capital partners                                                               June 10, 2011
        A Perspective on PFS/SIB
        Before diving into particulars, we would like to make some framing comments about the fledgling
        PFS/SIB innovation.

        Ÿ The most profound feature of the PFS/SIB innovation is its shift to a procurement system that
           focuses on social outcomes, not inputs. A well-structured PFS arrangement frees up providers to
           innovate and invest in ways that a prescriptive cost reimbursement system simply does not permit.
           It invites investment towards innovation, and it replaces “Fund What Once Worked” with “Fund
           What's Working Now”.

        Ÿ By layering SIB financing onto PFS contracting, we address several of its most significant
           obstacles. SIBs shift risk of failure away from government. SIBs provide private financing to a
           sector that is profoundly strapped for cash. SIB investors are disciplined and help to maintain
           focus over periods of time that may outlive the tenure of government champions. SIB investors
           bring valuable “skin in the game” due diligence and risk management know-how to government
           contracting. And SIBs bring added transparency to a system that can sometimes feel byzantine
           and obscure.

        Ÿ Administrative data is a key enabler. Contingent contracting is certainly not new to government.
           Nor is the private financing of government receivables. But without rigorous, affordable and well-
           trusted metrics, the PFS/SIB vision will never lead to large-scale improvements to our social and
           fiscal outcomes.

          We believe there is a quiet revolution taking place: for the first time, fueled by advances in
          information technology, administrative data can now be captured in a way that truly produces
          rigorous, affordable and trustworthy measures of social impact. Indeed, before recent advances in
          administrative data management, most PFS/SIB contracts would probably be untenable.

          Ÿ Administrative data is ongoing: movies, not snapshots. This provides the feedback loop needed
              for program management and continuous improvement.

          Ÿ Administrative data makes it easier to create standard metrics.

          Ÿ Administrative data lends itself well to Randomized Control Trials (RCTs). It makes it easier
              to use whole populations (like a whole prison, a whole school or a whole zip code) as the unit
              of analysis. This helps to overcome issues of “skimming” or “creaming” that are of central
              concern to RCT designs. Also, in a randomized way, administrative data make it easier to
              employ the elegant “comparative interrupted time series” methodology that supports the UK
              SIB demonstration.

          Ÿ We see great promise in the mining of multiple databases to understand the interconnection of
              actions in one area of government (education, for example) that may affect others (justice,
              healthcare and TANF, for example).

          Ÿ Ultimately, PFS/SIB needs to be about reallocations of government resources, not just
              infusions of private capital. Even if the SIB asset class were to become twice as large as the
              entire CDFI industry - $60 billion – it would still represent only a small fraction of the nation's
              K-12 education budget, let alone TANF, justice, Medicaid and the many other government
3             social spending streams.

                                                            RFI Response from Third Sector Capital Partners
    Third Sector
           capital partners                                                                 June 10, 2011
            How should Pay for Success contracts and Social Impact
            Bonds be structured?
            At this stage of the PFS/SIB industry's evolution, we believe it would be a mistake to pre-suppose that
            a “best structure” for PFS/SIB can be known. The respective pilots in the UK and New South Wales
            are materially different in structure. Indeed, the correct structure for any given PFS/SIB will depend
            strongly on specific circumstances, including the skills and preferences of the parties involved.

            For these reasons, we feel it would be best to allow PFS/SIB structures to cater to specific
            circumstances, and therefore to make future RFP language quite flexible in this regard.

            Below, we depict a form of the construct that is similar to the one piloted in the U.K.

            Ÿ        It makes use of both the PFS and the SIB features
            Ÿ        It involves a lead contractor that does not provide direct services
            Ÿ        It places 100% of nonperformance risk onto financial investors
            Ÿ        It provides investors with a positive return on investment
            Ÿ        And it depends on independent evaluators to assess impact

    Government                      .for Services
                                   1 Contracts                           2.Provides $’s
                                                                           for Program
  . that meet government established
 7 Program acheives social outcomes
                                                                                                    8.Return on

                                                 Lead Contractor
6.Analysis of
  Outcome Metrics                                                                                 3.The Leadmanages and funds
                                                                                                    service provider(s)

          Independent Evaluator                                                Service Providers

                                           Target Population
               Outcomes                                                                          4.Social Services
                                                                                                   are provided

    1: The government contracts the Lead Contractor for services. 2: The investors provides the resources for the Program.
    3: The Lead Contractor selects, manages and funds service providers. 4: The Service Providers offer social services to a
    target population. 5: The Lead Contractor manages providers to ensure social outcomes are met. 6: Independent
    Evaluators and Lead Contractor verify outcomes through rigorous processes. 7: Program acheives social outcomes that
    meet government established targets. 8: If social outcomes meet government set targets, investors receive a return on
    investment. Otherwise, government is not obligated to make any payments.

                                                                     RFI Response from Third Sector Capital Partners
    Third Sectorcapital partners                                                                     June 10, 2011
        Alternatives to Consider
        As alternative structures are contemplated, we believe that it will be important to consider the

        Ÿ Multi-year, contingent commitments from government are essential. As powerful participants in
           the negotiation process, both investors and providers will insist upon contract terms that are
           resilient and transparent.

                    A main benefit of SIB investors is the role they will play in promoting long-term focus and
                    transparency, even as the political process moves on to other matters.

                    We are intrigued by the proposal put forth by Steven Rothschild in Minnesota whereby a
                    general obligation bond would be floated to act as a pool of monies to be used for payouts
                    against PFS contracts.

                    Another idea is to use incentives from other levels of government to promote follow-
                    through on PFS contracts. For example, the state could provide incentives to a
                    municipality that is contingent upon seeing the PFS/SIB program through its originally
                    contracted period.

        Ÿ In some cases, the SIB component may not be desired. As a general rule, we would recommend
        that PFS-only deals be avoided during these formative years. But in some cases, providers may
        possess balance sheets, or bank lines of credit that are large enough to finance/absorb the risk of
        missing impact goals on a PFS contract. In these cases, a non-SIB PFS may be viable.

        Ÿ The lead contractor role could be played by any of three types of organization: financial,
        provider, or independent management company. We feel that all three approaches are viable, and
        that the choice will depend upon the specifics of each program.

                    Financial. In the UK pilot, the intermediary plays a dual role. First, they act like an
                    investment bank to put the deal together. Then, post-transaction, they take on the lead
                    contractor role, managing a variety of procured services.

                    Provider. So long as the provider's contract with government is PFS and outcomes-driven,
                    we see no reason why a strong provider could not also play a lead contractor role.

                    Typically, an investment bank would assist in the up-front structuring of the contract and
                    the raising of SIB capital. Upon closing, the provider would take on the lead contractor
                    role, using subcontracting to complement its own in-house capabilities.

                    Independent Management Company. It may be that professional lead contract
                    management companies arise to serve the emerging PFS/SIB industry. This would be
                    analogous to property management companies that are commonplace in the real estate
                    development industry. They are professional operational managers and procurement
                    experts that orchestrate delivery, monitor day-to-day operational performance, gather and
                    report upon performance data, and otherwise ensure that adequate focus is kept on
                    achieving project success.

                                                            RFI Response from Third Sector Capital Partners
    Third Sector
           capital partners                                                                 June 10, 2011
        Ÿ In some cases, a sole provider, with no subcontracting, may be desired, in lieu of employing a
           lead contractor. For example, government may choose to contract directly with a particularly well-
           established and integrated provider of services. We believe that this may indeed be the right path
           in some cases, so long as the contract is outcomes-oriented and the provider has the full range of
           in-house capabilities needed to succeed.

        Ÿ Financial investors need not absorb 100% of performance risk. Indeed, as is the case in the New
           South Wales SIB demonstration, we believe it likely will be helpful in many cases for the
           government to retain a portion of the risk. This may unlock private investors that would otherwise
           shy away, and, through “skin in the game,” would bring about greater alignment and transparency
           between government and the other PFS/SIB participants.

        Ÿ It may be unrealistic to believe that early deals can offer market-level risk-adjusted returns to
           investors. We expect that most early PFS/SIB opportunities will not have high enough benefit-to-
           cost ratios to produce market level returns on investment, especially when risk of failure is taken
           into account. Also, even if the monies were available, there will be a reluctance to create the
           appearance of enriching private investors with taxpayer monies. Thus, as was the case in the UK,
           investor returns will likely need to be capped at a lower rate than would be required to attract
           mainstream capital markets.
          Tapping into mainstream capital markets is a worthy long-term goal. But we don't see a strong
          downside to having early investors accept below-market risk-adjusted returns. Indeed,
          philanthropic investors might be willing to accept “evergreen” arrangements, whereby there is an
          obligation to reinvest all earnings back into the programs they have supported. In this way, well-
          documented investment track records could be created, but issues of putting taxpayer money into
          the pockets of philanthropists could be set aside.

          Once PFS/SIB deals establish a track record (and this will take years), our view is that return-
          seeking financial markets will respond accordingly. Moreover, if history is a guide, tax legislation
          could become an additional stimulus to attracting large sums of additional private capital. For
          example, the Low Income Tax Credit was instrumental in sparking the growth of our large and
          flourishing CDFI industry.

        Ÿ There may be pressure to exclude independent evaluators. Impact measurement is a notoriously
           subtle science. All too often, impact analyses seem to be compelling, even in the eyes of experts,
           only to be debunked when put to a more rigorous test. Indeed, whether it be in medicine or in
           social sciences, it has become clear that the world is full of false-positive evaluations. This is due
           to a large number of factors: underpowered experimental designs, publication bias, low-fidelity
           execution, wishful thinking, regression to the mean, and many others.

          For all of these reasons, we believe that the number one risk of PFS/SIB failure is tied to
          the possibility of non-rigorous evaluation. We are particularly concerned that PFS
          contracts could be designed in conjunction with non-rigorous evaluation. In this case, every party
          of the transaction might have “good news” to report, and yet society would be worse off. Thus, we
          feel the continued presence of highly rigorous independent expert evaluators, with a strong focus
          on counterfactuals, and a power to audit, is absolutely essential.

        Ÿ Several other types of firm will need to play independent supporting roles. An audit firm will
           need to be appointed to audit each PFS/SIB arrangement throughout its lifecycle, as will an
6          administrative agent. (Administrative agents collect information as in compliance with contract
           language, manage cash flows in accordance to contract terms, and disseminate required

                                                            RFI Response from Third Sector Capital Partners
    Third Sector
           capital partners                                                                 June 10, 2011
        documentation/reporting to all parties.) The administrative agent role should be independent and
        not played by the lead contractor.

        What makes for a promising PFS/SIB opportunity?
        We believe that the PFS/SIB model fits best when there are:

        Ÿ      Social needs that are unmet, high-priority and large-scale
        Ÿ      Target populations that are well-defined and can be measured separately
        Ÿ      Impact metrics that are clear, valid and auditable
        Ÿ      Interventions that are highly likely to achieve targeted impact goals
        Ÿ      Service providers that are proven and prepared to scale with quality
        Ÿ      Cost-benefit propositions that are compelling
        Ÿ      Administrative, regulatory, legislative, evaluation process feasibility

        Which social service areas hold the most promise?
        Ÿ Community-Based Services as a Replacement for Residential Treatment in Foster Care and
            Juvenile Justice. Several states have already made strong PFS inroads in the areas of redirecting
            youth away from expensive residential foster care and juvenile detention while also improving
            future recidivism. Several reputable and scalable providers seem to be poised to experiment with
            PFS/SIB in Massachusetts.

        Ÿ Dropout Prevention and School Turnaround. Dropouts and graduation rates are strongly tied to
            juvenile justice, Medicare, TANF and tax revenue economics. Several providers have
            demonstrated an ability to move the needle for whole schools, which lend themselves to
            straightforward and rigorous evaluation. Philanthropic markets are interested in this area.

        Ÿ Student Achievement Programs. We feel that early learning, summer learning, after school, and
            other education-related programs would be well-suited to act collectively as part of the wrap-
            around philosophy that a PFS/SIB lead contractor arrangement fosters. Long-term fiscal benefits
            have been well documented. We expect that near term benefits may also hold promise.

        Ÿ Medicaid. Medicaid spending is so large and lends itself so well to data analysis that we feel it will
            be important to float at least one Medicaid-oriented RFP. Asthma appears to be a particularly
            cost-effective area, with already existing capacities to roll out proven interventions. Transitional
            Care Nursing (led by Mary Naylor of the University of Pennsylvania) is a highly evidence-based
            intervention that reduces re-hospitalization profoundly. Nurse Family Partnership's home nurse
            visitation for first-time pregnant young women is also a highly proven, scalable and cost-effective

        Ÿ Homelessness. The homelessness area has many existing programs and providers, many of which
            have already experimented with extensive subcontracting and collaborations. In such a complex
            environment, particular care will need to be taken when framing up experimental designs that
            handle counterfactuals. Programs that target and prevent chronic homelessness, particularly heavy
            users of Medicaid, look promising as a cost-benefit proposition. Programs that divert families from
7           the shelter system also show potential cost savings in Emergency Assistance.

                                                            RFI Response from Third Sector Capital Partners
    Third Sector
            capital partners                                                                June 10, 2011
        Ÿ Workforce Development. A growing number of interventions have been shown to produce
          rigorous impact and scalable models. Keys to the PFS/SIB include (a) creating experimental
          designs that overcome issues of “skimming” and (b) ensuring that the economic gains with placing
          an individual into a job are netted against the losses that may have been incurred as another
          individual is displaced from filling the same job.

        For more information, please contact:
        George Overholser -
        Drew von Glahn –
        Caroline Whistler –

                                                       RFI Response from Third Sector Capital Partners
    Third Sector
          capital partners                                                             June 10, 2011