Pay For Success

Pay For Success is a public-private partnership in which a non-government funder pays the up-front costs for a social service intervention and is repaid by a government actor based on the achievement of previously agreed-upon target outcomes

The term “pay for success” (“PFS” in shorthand) is most commonly used in the United States. The concept originated in the United Kingdom under the name “social impact bond.” When the concept was introduced in the United States, the name “pay for success” was adopted because not all projects are formulated with a traditional bond structure. In emerging markets, the term “development impact bond” has emerged to describe this concept in an international development context. 

CHARACTERISTICS

The principle characteristics of a Pay For Success project are as follows:

  • A focus on outcomes, rather than outputs. Payments are made based on the outcomes experienced by the people served by the social service intervention, rather than the number of people served. This is a structural shift from how most social services are funded. 
  • Up-front funding by a non-government funder: The social service intervention is paid for by a private investor, philanthropy, or other non-government funder, who can expect to be repaid only if target outcomes are achieved. If the project is unsuccessful — and the target outcomes are not achieved — then that non-government funder is not repaid for the investment. Therefore, taxpayers are not responsible for paying for an intervention that did not work as planned. 

HISTORY

The concept was originated by Sir Ronald Cohen in the UK.

The first social impact bond was implemented at Peterborough Prison near York, UK. In that project, a private investor paid for people who were preparing to be released from prison but deemed to be at a higher risk for re-offending to participate in a new recidivism diversion program. The UK government agreed to repay the investor if recidivism among the participants was reduced by a targeted percentage. The project launched in 2010 and concluded in 2015, with findings that showed a reduction in reoffending. Results: https://www.rand.org/randeurope/research/projects/social-impact-bonds.html

In 2010, the US federal government under President Barack Obama began adapting the concept for use by state and local grantees of federal funding from the US Departments of Labor, Education, and Justice. This work was centralized under the White House Domestic Policy Council’s Office of Social Innovation and Civic Participation. The first projects in the US launched in 2012.

ACTORS IN PAY FOR SUCCESS

Each pay for success project or initiative has the following actors participating:

  • Government actor: A government agency is responsible for paying for outcomes upon achievement, based on terms agreed upon by all parties in the project negotiation. Repayment is generally expected to be consistent with the money the government is saving due to the intervention. For example, a reduction in the number of formerly incarcerated people reoffending leads, in theory, to fewer prisoners that the government must support. 
  • Service provider: The social service intervention is provided by a non-profit or for-profit organization. The service provider contracts with the non-government actor making the up-front investment, so they are paid for delivering the intervention regardless of impact. Typically, the service provider is selected by the investor, with review or approval from the government, through a competitive process and must demonstrate expertise or a track record of success in delivering the service to the target population. 
  • Non-government funder: A non-government funder pays the upfront costs of the service provider to deliver the social service intervention to the target population. This non-government actor is often a private investor, but could also be a philanthropy, community foundation, high net worth individual, or other funder. If the social service intervention reaches agreed-upon outcomes, the actor is repaid. If not, the actor is expected to take the loss. 
  • Evaluator: An independent evaluator is contracted to perform an independent evaluation of the social service intervention provided to the target population, to determine whether agreed-upon outcomes were met. The rigor of the evaluation, including the use of a control group, is determined by the parties involved. 
  • Intermediary organization: Most PFS projects have an intermediary organization that serves a mediation and management role. This organization brings the parties together to create the project and agree on the target outcomes to be achieved. The work of the intermediary organization is often funded by philanthropic donations. 

PAY FOR SUCCESS PROJECTS AND SOCIAL IMPACT BONDS

CRITIQUES / CONTROVERSIES / CONCERNS

Overview of valid critiques of the model —

  • Concern that PFS would siphon money from existing social programs and/or private them has not come to fruition. Model is intended to validate/test whether a new service/intervention is more effective then status quo — governments may or may not end up using that information
  • Evaluations: An independent evaluation is a core part of a pay for success project. The expectations for the rigor of that evaluation have been debated, particularly in the wake of Urban Institute and other early field leaders have argued that PFS project evaluations should be randomized control trials (RCTs) unless there is a compelling reason to use a less rigorous method. 
  • Scalability: Since the launch of the first pay for success projects, a major critique of the model has been the cost of putting projects together. Philanthropic grants are generally still required to fund the 18-to-24-month process.  
  • Concern that governments will not scale successful projects – too early to tell
  • Capacity building for nonprofits

Case Studies

In 2015, India pioneered the world’s first development impact bond (DIB) where the outcome payer was a private foundation. Read more in the following case study from AVPN:

Additional Resources

Video: https://pfs.urban.org/library/content/pay-success-importance-evidence

Contributors

Collective Investment Vehicles

Collective Investment Vehicles aggregate capital from multiple investors into a single investment entity. Generally, the purpose of Collective Investment Vehicles is to invest in a portfolio of companies or projects, although, in some instances, special purpose vehicles are created for a single investment whose capital requirements exceed the available capital that a single investor is willing to commit.


Collective Investment Vehicles are managed by professional investment managers in order to leverage their professional experience, full time dedication, and comprehensive risk management practices.

The aggregation of capital in a single vehicle also improves economies of scale by spreading transaction costs (such as due diligence costs) over a larger pool of capital, as well as the risk return profile by diversifying the assets of the vehicle through a portfolio of investments.

Fund Managers’ view

Collective Investment Vehicles are managed by professional asset managers, who are the agents of the firm. The managers take investment decisions on behalf of the collective investment vehicle, and are remunerated for the management of the vehicle as well as for the performance of the investments.

In the impact investing industry, impact fund managers often have relevant industry investment and thematic experience, ability to operate in frontier or undercapitalized markets, and relevant professional networks which they can make available to investors in an investment vehicle.

Among the most important factors for managers are that the Collective Investment Vehicle be adequately capitalized and that the managers have the time and flexibility to execute their investment strategy.

Investors’ view

For the investors in the Collective Investment Vehicles, it is important that the investment thesis implemented by the manager delivers the expected financial returns and social and environmental impact, while maintaining adequate risk mitigation practices.


The benefits of pooling capital into a single Collective Investment Vehicle include:

  • Having access to a portfolio of investments
  • Diversification
  • Professional management team dedicated to managing investments

Traditional impact fund structure

Limited Partnership Closed Ended Fund

The most common structure for Collective Investment Vehicles in venture and private equity is the limited partnership. This structure separates the fund managers, the General Partners (GPs), who manage the fund and take investment decisions. The GPs bear unlimited liability for the obligations of the fund. They raise capital from investors in the fund known as Limited Partners (LPs), who are not involved in the investment decisions and have limited liability (for the amount the invested in the fund?). The limited partnership is a closed ended fund with a fixed life, and standard provisions that regulate the distribution of capital to protect the invested capital of Limited Partners before capital distributions are made to the General Partners.

https://www.investopedia.com/articles/investing/093015/understanding-private-equity-funds-structure.asp

“A Limited Partnership Agreement regulates the relationship between the General Partners and the Limited Partners, covering terms, fees, investment structures, and other items that require mutual agreement before investment.

A limited partnership model usually also includes an advisory committee and an investment committee.”
(Source: GIIN Developing a Private Equity Fund Foundation and Structure)

Compensation of the General Partners

Carried interest

Carried interest, also known as “carry” or “profit participation,” is the share in the profits generated through the investments that the general partner receives from the fund. The terms of the Carried Interest vary, and may or may not be payable to the GP only after achieving a Hurdle Rate.

Management fee

The management fee is the fee charged by the General Partner to the fund for running the day-to-day operation of the fund, and is paid from the paid in capital annually.

Alternative Structures

Even though Limited Partnerships are the most common vehicle to structure funds in impact investing (GIIN), alternative terms or collective investment vehicles structures have emerged In impact investing to overcome intrinsic features of the Limited Partnership model.

Alternative performance incentives

In a conventional limited partnership, the Limited Partners handle all the investment decisions and management of the investment portfolio over to the General Partners. As a result of this delegation, the Limited Partners have no control over the impact management of the portfolio investment.


In order to better align the financial incentives of the General Partners to the impact expectations of the Limited Partners, innovative structures to align the financial remuneration of the General Partners to the impact results have emerged.

The Carried Interest is the profit participation of the General Partner in the fund, which is calculated on the returns of the fund that exceed the invested capital. The Carried Interest can be tiered or unlocked based on the achievement of specific social impact metrics.

Holding Company Structures

Holding Companies (HoldCos, or permanent capital vehicles, or evergreen investment structures) are deployed to extend the lifetime of an investment vehicle beyond the traditional 10 years plus extension of a close ended fund (limited partnership investment fund).

The longer lifetime of the investment vehicle gives additional flexibility to the fund manager in investing patiently in a social enterprise, and does not require exiting the investment within the closed ended lifetime of a traditional limited partnership structure. Patient capital and a longer investment period can facilitate a mission aligned exit of the investment in social enterprises when the company has fewer prospective target buyers and chances of an initial public offering.

Liquidity to investors

  • Liquidity to investors
    While limited partnerships must return the invested capital after returns and fees to the investors throughout the lifetime of the limited partnership, typically HoldCos do not have a limited lifetime. In order to provide liquidity to investors, in addition to providing dividends, HoldCos can redeem and buy back existing shares, facilitate secondary liquidity by transferring shares among investors, or list on the stock market to raise additional capital and provide liquidity to existing investors.

  • Potential for listing on the stock market
    Holding companies are investment vehicles that can offer secondary liquidity to investors, as well as attract new capital from new investors, through an Initial Public Offering.

Budget

While limited partnerships operate through the yearly management fee calculated on committed or invested capital, holding companies typically are managed on an operating budget. Innovative approaches to determine a cost based fee calculation have emerged, which limit the operational expenses to the actual operational expense and is capped to the invested capital.

Contributors

  • Dario Parziale, Toniic

Benefit Corporations

Unlike traditional corporate structures, in the US, a benefit corporation obligates the board to consider the interests of all stakeholders in its decision making, not just shareholders. The company must pursue a public benefit purpose, and must report on its impact performance to shareholders and potentially to the general public (depending on the state). The definition of public benefit varies by state, but it is most often expressed as a purpose of creating a positive impact on society and the environment as a whole, or of operating in a responsible and sustainable manner. The statutes also allow (or in some states require) the company to specify one or more specific public benefit purposes that it will pursue, each of which must fall within statutory definitions. For example, Delaware requires the specific public benefit purpose to be stated in the certificate of incorporation, and allows it to include positive effects of “an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”

Some states, including New York, also allow the company to specify which purposes have priority. Practitioners should keep in mind that provisions prioritizing one purpose over others run the risk of limiting the board’s discretion.

Benefit corporations are often conflated with certified B Corporations (or B Lab certifications or B Corp certifications). Benefit corporation is a legal status conferred by state law in the US; whereas B Lab certification is issued by a private organization and has no legislative framework. B Lab certification is not needed to obtain benefit corporation status.
Non-profit B Lab, which issues B Corporation Certifications to organizations that commit to a set of impact “best practices”, also advocates for the adoption and improvement of benefit corporation.

Term sheet language specific to benefit corporations may be useful in the following situations:

  • the corporation will be formed at the time of the investment, and so the specific public benefit has not yet been defined;
  • the investors want to modify the definition of the specific public benefit in connection with the investment;
  • the investors or entrepreneurs want to require that the benefit report be distributed more often than is statutorily required;
  • the investors or entrepreneurs want to require the company to publicly share its benefit report;
  • the investors or entrepreneurs want to require the enterprise to assess its performance with respect to its specified public benefit against an independent third party standard;
  • the investors want a voice in any future changes to the benefit purpose and related concepts; and
  • if the company has multiple specific benefit purposes, the investors or entrepreneurs may want to specify that the company prioritize one or more purposes over others.

With some of the sample language, we identify a state or states for which the language is designed. Adjustments may be required to this language for corporations formed in other states.

  • Agreeing on a company’s specific public benefit purpose:

Sample language: The [Certificate][Articles] of Incorporation of the Company shall identify as the Company’s specific public benefit purpose(s) [definition of specific public benefit purpose(s)].

  • Requiring more frequent benefit reporting:

Sample language: The Company shall provide to its shareholders its benefit report [insert time period, which is more frequent than statutorily required].

  • Requiring public dissemination of benefit reports:

Sample language: The Company’s benefit report shall be posted on the Company’s website. The Company may omit from the posted reports any financial or proprietary information included in the reports.

  • Requiring assessment of social performance with reference to third party standards:

Sample language: The Company’s benefit report shall include an assessment of the overall social and environmental performance of the Company against a credible, independent third party standard].

  • Requiring investor approval of specific benefit purpose and related items:

(Sample language – Delaware Debt): During the term of the Loan, the consent of the Investor shall be required to (1) change the Company’s specific public benefit purpose(s), (2) adopt or change the objectives the Board is required to establish to promote its public benefit purpose(s) and the interests of those materially affected by the Company’s conduct, or (3) adopt or change the standards the Board is required to adopt to measure progress in promoting such public benefit purpose(s) and interests.

Sample language (Delaware equity): As long as the Investors hold at least [X percent] of the Shares purchased, [the vote of at least X percent of the Shares, voting as a separate class] OR [the approval of the Board, including the approval of the Series X Director(s)], shall be required to (1) change the Company’s specific public benefit purpose(s), (2) adopt or change the objectives the Board is required to establish to promote its public benefit purpose(s) and the interests of those materially affected by the Company’s conduct, or (3) adopt or change the standards the Board is required to adopt to measure progress in promoting such public benefit purpose(s) and interests.

Sample language – NY/CA debt): During the term of the Loan, the consent of the Investor shall be required to (1) change the Company’s specific public benefit purpose(s), or (2) adopt or change the third-party standard used to assess the Company’s social and environmental performance.

Sample language (NY/CA equity): As long as the Investors hold at least X percent of the Shares purchased, [the vote of at least X percentage of the Shares, voting as a separate class] OR [the approval of the Board, including the approval of the Series X Director(s)], shall be required to (1) change the Company’s specific public benefit purpose(s), or (2) adopt or change the third-party standard used to assess the Company’s social and environmental performance.

  • Establishing priority of multiple public benefit purposes

Sample language: The [Certificate][Articles] of Incorporation of the Company shall identify as the Company’s specific public benefit purpose(s) [definition of the specific public benefit purpose], and shall state the Company’s intention to give priority to [definition of the priority purpose].

Low Profit Limited Liability Companies (L3Cs)

The Low-Profit Limited Liability Company, or L3C, is an alternative form of LLC that builds key program-related investment (PRI) requirements into the form’s charter documents. L3C statutes require, for example, that it must be organized to further a charitable or educational purpose articulated in its operating agreement. Financial returns cannot be a significant purpose of L3Cs, and they are prohibited from pursuing political or legislative purposes.

Given these restrictions, the promoters of the form hoped that investments in L3Cs would automatically qualify as PRIs, but the IRS has not issued any guidance to that effect. But even without automatic qualification, users of the form argue that it makes it easier for private foundations to conduct the due diligence necessary to complete PRIs and to comply with expenditure responsibility rules.

Term sheet language specific to L3Cs may be useful in the following situations:

  • the L3C will be formed at the time of the investment, and so the charitable or educational purpose has not yet been defined;
  • the investors want to modify the charitable or educational purpose in connection with the investment; or
  • the investors want a voice in any future changes to the charitable or educational purpose.
  • Identifying purpose with a L3C

Sample language: The [L3C state formation document] of the Company shall identify the Company’s purpose as [charitable or educational purpose definition].

  • Changing purpose with a L3C

Sample language: As long as the Investors hold at least X percent of the outstanding membership interests of the Company, [the vote of at least X percent of the preferred membership interests, voting as a separate class] OR [the approval of the Board, including the approval of the Series X Manager(s)], shall be required to change the Company’s [educational or charitable] purpose(s).

Case study: convertible revenue loan for green cleaning product

A Latin American company produces and distributes green household cleaning products. Investors have funded the company with a convertible loan that is repaid monthly through a percentage of revenues as opposed to fixed interest payments, allowing the company more flexibility for growth than with traditional debt.

The company had limited sales and marginal EBITDA, which made valuation challenging, so the investor designed a tailored senior convertible loan that would be paid back through an escalating percentage of sales.

Target IRR: 20-25%

Type of investment: Senior convertible loan to a non-US-based enterprise

Investor: An impact investment fund focused on supporting the early growth of social and environmental companies in Latin America. It invests in a wide range of sectors, such as education, sustainable consumer products, health, housing, organics and clean energy. It seeks to tailor its transaction structures to the needs of each portfolio company.

Company: A producer and distributor of 100% non-toxic and biodegradable household cleaning products. Company is generating revenues and is cash flow positive.

Key innovations

Revenue-based loan: The company’s total loan obligation is fixed, and repayments are determined as a share of revenue, escalating over time until the entire obligation is repaid.

Conversion option for investors, at investor discretion: The loan may convert into equity at a pre-determined multiple of trailing revenue or EBITDA, at the discretion of investors.

Key terms

Investment amount: The investment was broken down into two tranches: (1) US$300k immediately, and (2) US$150k after 12 months, contingent on reaching predefined operating and financial milestones.

Repayment timeline: The target term is 5 years, with an 18-month grace period for both principal and interest.

Revenue share rate and repayment cap: After the grace period, the company pays an initial 3% to a maximum of 9% of revenues (escalating over 3.5 years) until the investor receives a total of 2.3x its original investment.

Conversion option: Convertibility provision allows the investor to convert into equity at its own discretion and at a valuation equal to the higher of 1x TTM sales or 5x TTM EBITDA. At the time of conversion, the investor can only convert the balance of the total obligation still owed calculated at 2.3x the total loan provided, less any loan repayments made up to that date. Conversion is only allowed after an initial 18-month lock up period.

Governance: The investor assumes one Board seat and has veto right over a number of pre-defined “Major Decisions”, including new share issuance, new debt issuance, CAPEX and budget decisions.

Special considerations

Tax considerations: The local tax regime does not have any special treatment for flexible debt schedules, so not a concern for the issuer in this case. For a U.S. lender, “original issue discount” tax implications could be significant given the grace period, variable nature of payments, and lack of”original issue discount” reporting by the company.

More detailed deal rationale and context:

  1. Company has to be close to profitable or already profitable, so that it can service debt at a % of revenue after about 12-18 months.
  2. Margins need to be strong, if investors are to take up to 9% of revenues by year 5.
  3. Company should not have significant prior debt.
  4. Company should not expect to have a large need for additional equity/debt requirements during the term of the investment.
  5. Structure appealed to investor over equity because it would allow the company to grow and thrive over the longer term without needing to be acquired in the short to medium term to provide a liquidity event, for two reasons: (1) It was not obvious that the company would appeal to a strategic buyer within the life of the fund, and (2) The investor was concerned that sale to a strategic buyer could compromise its mission.
  6. The structure also appealed to the company because the founders liked its equity-like alignment of incentives (the faster the company grows, the higher the IRR for the investor), however they got to retain more ownership than they would have under an equity deal and the investor’s returns are capped.
  7. Local business environment: local founders are often comfortable with the idea of building a company for the long-term, with potential generational succession plan. Therefore, the idea that they wouldn’t be acquired in the next 5-7 years was not off-putting.

Case study: redeemable equity direct investment for emerging market green manufacturer

A family office with an environmental mandate invested directly into an emerging market manufacturer, and plans to earn a return when the company redeems investor shares.

Neither investors nor founders believed that a sale or IPO was a viable option within 5-7 years from investment. In addition, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments.

Target IRR: 15% +

Deal type: Redeemable preferred equity

Company: The company manufactures various products using recycled materials. The company had been cash flow positive for more than two years at the time of the investment, but local capital was unavailable to invest in increasing production capacity. There is no history of M&A or IPO activity in the sector in which the company operates.

Investor: The investment was led by a family office that invests globally to optimize both financial return and social and environmental impact. The other investors consisted of a European foundation and two individuals. The investor group seeks a reasonable return given the risk profile of the investment, with a targeted floor of 15% per year over 5 years.

Key innovation

Redemption incentive when investors cannot elect for redemption: The investor group initially sought to structure a redemption right at the election of the investors. They learned, however, that the law of the country under which the company was organized prohibits redemptions at the election of the investors. As an alternative, they allowed investors to mandate profits be set aside for a “redemption fund,” which can only be used for redemption initiated by the company.

Key Terms

Financial terms: Total raise of $450,000 at $775,000 pre-money valuation.

Legal structure: The terms are structured to closely approximate standard U.S. “Seed” preferred equity investment model (except for the redemption provision, which is not standard in U.S. Seed Preferred model).

Redemption: The company has the right to initiate a redemption at its election after 5 years, but the redemption is only effective if accepted by the investors. The investors have the right to require the company to set aside a reserve fund out of profits to fund a redemption. The objective with the set aside is that the company will be motivated to redeem the shares because of the restriction on the use of funds.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 12% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Special Considerations

Tax considerations: The relatively short redemption period of 5 years would normally cause concern that the IRS might recharacterize this instrument as debt rather than equity. The risk here, however, is probably very low because the redemption option requires “exercise” by both parties. Other factors may weigh in favor of equity treatment as well (e.g., otherwise “thin” capitalization). The instrument most likely avoids the “original issue discount” rules as exempt “participating preferred stock”, due to its participation in dividends and liquidation proceeds.

Other considerations: This structure would be useful in any scenario in which legal rules prohibit investor-initiated redemption and in cases in which the investors would like to control the timing and amount of any reserve that is set aside to fund a redemption.