Development impact bonds are a revolutionary new type of bonds which are being introduced in the market. These bonds have been introduced to ensure that the profit motive of the financier is also met while meeting the development needs of the social entrepreneur.
What are Development Impact Bonds?
Development impact bonds are a three-way financial instrument which are meant to meet the development needs of society. The three parties to the contract are a donor, a financier, and a recipient NGO or social entrepreneur.
There are many donors across the world who want to give money to the poor. However, they want to ensure that their investments do not go waste. As a result, they are only willing to give money to entrepreneurs who can guarantee an impact. The development impact bonds allow this to happen.
When these bonds are issued, a tripartite agreement is drawn up. At first, a financier provides money to an impact entrepreneur. Since the financier is taking a risk by lending money to an entrepreneur, they do all the due diligence and ensure that only projects which are worthwhile really get selected.
In the second step, the entrepreneur completes the development tasks as per some predefined objectives. Once these tasks are completed, the proof of their completion is provided to the donor. The donor then refunds the entire cost of implementation along with a premium to the investor.
Why Development Impact Bonds are a Win-Win for Everyone?
Development impact bonds are a win-win for all the parties involved.
- The donor does not have to evaluate each project. Instead, they have delegated this responsibility to financiers who already have an infrastructure in place to judge the financial viability of development projects. It is a known fact that the funding cycle of donors is very long. They tend to vet each project in extreme detail. It is not uncommon for donors to ask for a wide range of metrics associated with the plan to ensure its success. The problem is that social entrepreneurs do not really have the time or expertise to prepare such detailed plans. Also, the administrative tasks just add more to the costs. On the other hand, private financers are known to have shorter funding cycles. They can evaluate more projects in a short span of time and still make accurate decisions.
- The social entrepreneur does not have to go through the bureaucracy and red-tape that is typically associated with obtaining funds from donors. Instead, they have easy access to funds from financiers who later get their investments reimbursed from donors
- The financier also benefits since they have a steady inflow of projects which they can fund. Also, they get a guaranteed return as long as they ensure that the entrepreneur implements the project as planned.
How Impact Investments are Evaluated?
Impact investments are evaluated in a different manner as compared to traditional investments. This is because the parameters to make a purely financial investment are relatively simple. Capital flows towards investments which offer the highest risk-adjusted rate of return.
The evaluation criteria become very different when impact investments are considered. These investments are typically sacrificial investments wherein investors willingly take a lower risk-adjusted rate of return. Instead, they want to focus on certain social aspects. The problem is that these social aspects can be different for each investor. Some may care about the situation of homeless people in the United States. Others may care about the availability of clean water in Bangladesh. Some investors may prefer to alleviate the hunger crisis in Africa.
Social entrepreneurs, therefore, need to be aware of the objectives of their respective donors. They cannot make a single pitch and present it to all investors.
The truth is that impact investing requires a lot more work as compared to traditional investments. When a donor has to make philanthropic decisions, they only have to optimize the social outcomes. On the other hand, when an investor makes financial decisions, they are purely based on numbers.
When development impact bonds are involved, both the outcomes need to be optimized. This limits the number of viable projects since normally these objectives are mutually exclusive.
Problems with Development Impact Bonds?
The development impact bonds are funded by financiers. They are primarily concerned about making a profit. Their ability to make a profit totally depends upon the entrepreneur’s ability to execute a project. This is the reason why only tried and tested models get financed via these bonds. Financiers want to minimize the risk of failure while executing social impact projects. Hence, they only finance models which have been tested before and have a high rate of success.
The problem here is that these bonds don’t support innovation. As per a report by JP Morgan, there are about $46 billion which are invested in social impact projects. Only 3% of this amount has been given for seed funding to new and innovative projects. Hence, in a way, development impact bonds are stalling innovation in the social entrepreneurship sector.
The bottom line is that development impact bonds are certainly a revolutionary financial instrument that will make a huge difference in the lives of people in underdeveloped areas. However, it also needs to be understood that these instruments are not perfect. They should be fine-tuned to ensure that they also support innovation and entrepreneurship.