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What Are Social Impact Bonds, and Should I Invest in Them?

Bonds are debt securities that allow the issuer to borrow money from the buyer, with set terms for key features like interest rate and length of the loan. Even though they share the same name, social impact bonds have many features that don't resemble traditional bonds at all. Instead, social impact bonds represent a way for investors to provide much-needed funding for social services projects aimed at achieving a certain public good. With payoffs that depend on benchmarks that reflect the success or failure of the project, social impact bonds give private investors an incentive to help in areas where the government has previously been the only player willing to take action on key public policy priorities.

How social impact bonds got into the limelight

Social impact bonds came to the U.S. in 2012, when Goldman Sachs (NYSE: GS) entered into a trial of the concept. The project that the Wall Street giant chose for its first social impact bond was an anti-recidivism program at the New York prison of Rikers Island.

Under the terms of the social impact bond, Goldman agreed to provide about $7.2 million in funding for the program. Thanks to a guarantee of $6 million from the outside group Bloomberg Philanthropies, Goldman stood to lose only a portion of its capital if the project failed to achieve its stated goals of reducing rates of repeat incarceration to below the 10% mark. However, if the project had succeeded, then Goldman could have earned as much as a roughly 30% return on its investment, depending on the extent to which recidivism rates fell.

As it turned out, the project didn't lead to any decrease in repeat offenses, and so Goldman didn't get anything back from the government. However, because of the Bloomberg guarantee, Goldman's losses were limited to $1.2 million.

Image source: Getty Images.

Subsequent investments in social impact bonds have had a better track record. An investment from Goldman and the Pritzker Family Foundation of about $7 million in total allowed almost 600 three- and four-year-old children to attend preschool in Utah. Under the terms of the deal, 110 students were expected to need special education services, but after enrolling in preschool, 109 of those students didn't need those special services. Goldman and Pritzker received $2,500 for each of those 109 students in 2015, representing the approximate amount that it would have cost the school to provide special education had it been needed. If the students remain out of the special education system, then the terms call for continued payments in declining amounts through the sixth grade.

Can you invest in social impact bonds?

Thus far, social impact bonds have generally involved collaboration between private sector companies, philanthropic organizations, and government entities. As a result, directly investing in social impact bonds hasn't been an option for most individual investors of ordinary means.

The way that Goldman Sachs has structured its Social Impact Fund serves as a good summary of the current state of the market. The fund is open to investors and "seeks to provide clients with access to 'double bottom line' investments that can provide both a financial return and a measurable social impact." However, the fund is structured as what Goldman calls an "alternative investment," which qualifies for exemptions from normal SEC securities registration because they aren't offered to the public at large. The investment is therefore open only to qualified investors under SEC guidelines, and Goldman notes that the fund is extremely illiquid, difficult to value, and potentially unable to redeem or sell to other investors.

In the future, interest in social impact bonds might grow to the point at which the instruments will be more readily available to average investors. For now, though, the universe of social impact bond investors is limited to the large institutional investors that have the most to gain from the positive reputational impact that being socially minded can bring. That's especially important in the financial industry, in which events over the past decade have tarnished the public image of major banking institutions.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.