Pay for Success and Innovation in Financial Structuring

Marcia Chong ; John Grossman

Originally published July 7, 2014 by the National Council on Crime and Deliquency. Authors Marcia Chong is an analyst, and John Grossman is a partner, with Third Sector Capital Partners.

The nascent Pay for Success (PFS) market has experienced rapid growth in the past several years thanks to leadership from governments, social service providers, and funders. In the past five months alone, state and local government and various federal departments have experienced a flurry of activity to drive the adoption of PFS and other evidence-based strategies.

The following are examples of recent federal PFS-related opportunities:

• The US Department of Housing and Urban Development announced $15.18 billion in Hurricane Sandy remediation funds, instructing recipients to explore allocating some of those dollars through PFS.

• The Corporation for National and Community Service announced its intention to award $14 million in grants to support PFS by the end of 2014.

Examples of momentum at the state and local levels include the following:

• The James Irvine Foundation and Nonprofit Finance Fund jointly announced their support for five projects across the State of California that are likely to develop and close PFS contracts over the next two years. These five projects are being driven by San Diego County, Los Angeles County, the City and County of San Francisco, and Santa Clara County.
• Cuyahoga County, Ohio, is currently in deal construction for its first PFS project and is leading county-level leadership and engagement with PFS nationwide.
• In late April 2014, the State of Illinois announced the launch of its first PFS project. It focuses on youth who are involved in both the child welfare and juvenile justice systems, with up to $30 million to be allocated in success payments.
• New York State announced its selection of four finalists for the state’s second PFS project on officers and family court judges for placement and detention of high-risk youth.

As the number of implemented PFS projects grows and an increasing amount of funding is allocated to PFS, those interested in this market are encouraged to capture lessons learned and real-time learning from existing projects.

The Massachusetts Juvenile Justice Pay for Success Initiative

In January 2014, we worked with the Commonwealth of Massachusetts to launch the Massachusetts Juvenile Justice Pay for Success Initiative (MA JJ PFS Initiative) as the nation’s largest PFS project to date. This project will pay out up to $27 million in success fees primarily based on the service provider’s ability to reduce the days spent in jail among young men involved in the juvenile and criminal justice systems. In order to finance the project until the commonwealth begins to make success payments five years from now, seven different funders have provided $21.3 million. In many cases, the form of financing is new to PFS.

The MA JJ PFS Initiative’s Financial Structure

The initiative will draw on a capital stack that comprises four layers of funding.

1. A $9-million “impact loan” that serves as senior debt. This loan will be paid back with the first success payments and will have a base annual interest rate of 5.0%. Depending on the success of the project, the senior lender may receive repayment of principal and interest, plus a success fee (up to $1 million). Notably, the entire principal is at risk. If the project does not deliver outcomes, the commonwealth will not make success payments and the loan principal will not be re-paid.
2. Program-Related Investment type loans totaling $3 million. These junior loans have a base annual interest rate of 2% but are subordinate in repayment order to the senior debt. Because this junior debt comes from institutions with philanthropic missions, the junior lenders were willing to take on more risk than the senior loan but receive a lower base return. Depending on the success of the project, the second layer may also receive repayment of principal and interest plus a success fee (up to $300,000 each).
3. A total of $6 million in three philanthropic grants that serve as a first-loss position to encourage junior and senior lender participation. The MA JJ PFS Initiative is the first of which we are aware that seeks to recycle grant capital. If the project has a high impact, all of the grants will be available to re-grant to new initiatives. This is a new form of philanthropy. Historically, the $6 million in grants would pay for $6 million in services and generate substantial social returns, but no more. In this case, the $6 million in grants are leveraged to deliver more than $18 million in services, and it is possible that the grantors will see those funds re-granted at the end of the project.
4. Deferred service fees of $3.3 million from Roca ($3.25 million), the nonprofit provider that will be responsible for delivering the project’s outcomes, and Third Sector ($50,000), which is serving as project manager. This “skin in the game” will be repaid following senior and junior lender repayment and, depending on the success of the project, these funders may also receive a success fee (up to $1 million combined). These deferred fees served to vouch for Roca’s and Third Sector’s confidence in the intervention and to align our interests with those of the project’s other funders.

The NY State PFS Project

In December 2013, New York State announced a $13.5-million transaction that is being funded through a private offering of equity interests in a single purpose vehicle backstopped with a $1.3-million philanthropic commitment. This project is designed to train and employ 2,000 formerly incarcerated individuals who are at high risk of reoffending, boosting their employment and thereby reducing crime.

The Path Forward

We are now witnessing participation from multiple types of funders—service providers, high-net-worth individuals, PRI lenders, and commercial capital—putting up their money in multiple forms—senior and junior debt, equity, deferred fees, loan guarantees, and subsidies to a private offering.

The two most recent projects draw on capital structures that appear more sustainable and replicable as they rely less on pure philanthropy as compared to the two US projects that came before them. This is critical to the growth of the PFS market, as the pool of potential commercial capital is vastly larger than that of philanthropic capital. (The two previous projects took place in New York, where a 5 1/2-year PFS program focused on comprehensive reentry employment services to formerly incarcerated individuals in New York City and Rochester, and Utah, which delivers targeted curriculum to increase school readiness and academic performance among 3 and 4 year olds through the Utah High Quality Preschool Program.)

If the PFS market is to reach its potential, we will have to continue to maximize the sources and types of funding while, at the same time, making deal construction significantly more routine.