Adding Profit Incentives to Nonprofit Work

Impact investing—using private funds to achieve social benefits along with financial returns—has been growing over the past five years, and one recent technique in particular shows promise. It’s called Pay for Success, and it allows investors to fund experimental health and social programs by betting on their effectiveness—with no downside for taxpayers.

Here’s how it works: A government agency contracts with an intermediary—such as the nonprofit Social Finance US—which in turn contracts with the nonprofit groups that will deliver the planned services. The intermediary also recruits investors, who fund the program. If the program achieves its specified outcomes, the government agency pays back the investors, plus an agreed-upon return. If the program fails, the investors swallow the loss. An independent evaluator verifies the outcomes.

Pay for Success has attracted financial heavyweights such as Bank of America and Merrill Lynch, and philanthropies such as the Rockefeller Foundation. It is being applied to programs as diverse as the management of asthma patients, child welfare and education.

In the fickle world of government and philanthropy, a program’s success is no guarantee that its funding will be renewed—yet ineffective programs may keep drawing dollars for years. Pay for Success financing aligns the incentives of private investors, government and nonprofits to fund innovative programs, to ensure they are rigorously evaluated, and to cut off the ones that don’t work.

That’s the promise. Here are some perils:

Perverse incentives. Suppose a Pay for Success program provides services to keep families together after incidents of child abuse, with the goal of reducing the number of children entering foster care. With that goal in mind, service providers might leave children in dangerous situations. So service providers generally should be held accountable only for implementing the program, and not receive any outcome-based payments.

Evaluation bias. The organizations that evaluate Pay for Success programs must remain completely independent of investors and nonprofit service providers. The outcomes of programs also should be as objectively measurable as possible. Recidivism is a good example: There is no wiggle room on whether someone has been rearrested after release from jail or prison.

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