There's Still No Free Lunch

We’re in big trouble if complicated, expensive schemes like Development Impact Bonds are what it takes to get big funders to fund for impact.


You know that thing where you’re feeling guilty about that huge stack of unread Economist magazines, so you grab one and flip through it to make yourself feel better? So I was doing that, and I ran across the article on the “world’s first development impact bond” (DIB). I’d followed the deal from the beginning but had gotten a little hazy on the details. There was no surf and nothing interesting at our neighborhood movie theater, so I decided to spend Sunday afternoon digging in.

For those who haven’t spent an afternoon geeking out on this stuff, a DIB is a scheme wherein investors provide upfront funding to a doer, an evaluator measures the doer’s results, and if those results hit predetermined targets, an outcome payer provides investors a return on their capital. It takes a lot of work to put the deal together and shepherd it along, so there is typically an intermediary acting as a sort of broker. The notion is that investors will bring new money into the sector, that incentives and pressure will improve doer performance, and that outcome payers will be attracted to these deals and spend their money better, because their risk has been eliminated.

In this case, the DIB was a sort of demonstration pilot, where both investor and outcome payer were private foundations. The investor was UBS Optimus Foundation, the evaluator was IDInsight, and the doer was Educate Girls, an NGO in India that gets unenrolled girls into school and improves the school so that they get a decent education when they get there. The outcome payer was Children’s Investment Fund Foundation (CIFF), and Instiglio put the deal together. All in all, this was the A-team.

The “Risk Reduction Premium”

The DIB’s target outcomes were based on Educate Girls’ track record to date. If Educate Girls hit the target, the investors would get a 10 percent annualized return (characterized as internal rate of return, or IRR), with a schedule for higher or lower (or zero) payment, depending on the results of the evaluation.

Educate Girls exceeded the targets by a considerable amount, triggering a three-year, 15 percent IRR payout—a whopping 52 percent return on investment. UBS put up $270,000 upfront to fund the work, so CIFF paid them $420,000. UBS gave $50,000 of that $150,000 “profit” back to Educate Girls as a predetermined performance bonus.

These figures don’t include the transaction costs of the deal itself—legal, intermediary, and technical service costs normally borne by the investors—which were about three times the amount of money Educate Girls’ spent on implementation. Don’t freak out, though, this was a relatively small pilot deal; the costs for a much bigger DIB would be similar, and these deals will probably get more efficient over time. However, they’ll always be complicated, and the costs will always be substantial.

Let’s imagine a much bigger deal on the same terms—say, $10 million of implementation funding and $1 million deal costs for a total investment of $11 million, and with real private sector investors and real government or Big Aid funders. If Educate Girls hit the target, the payout would be $14.5 million ($11 million over three years at an annualized 10 percent). In effect, the payers would pay $14.5 million for impact that cost $10 million to generate. You could think of that extra $4.5 million as a “risk reduction premium” shelled out by the outcome payers.

That’s a lot.

So what would justify paying that extra 40 percent? Well, DIB boosters say it will make way more money available up front for implementation. Breathless press releases speak of the potential of early successes to “have a transformative impact on how development is financed in the future” and “unlock vast sums of private capital for other projects.”

I seriously doubt that. We’ve heard this song before. It wasn’t that long ago that impact investors were going to create a wave of high-impact businesses to meet the needs of the poor. It didn’t happen—it turns out that the vast majority of “impact investors” are looking for market rates of return. After a few years, mostly what we heard was muttering about the “lack of deals.” I don’t know any reason why it would be any different this time around.

We’ve already got a mechanism for performance-based financing—one that skips all the gymnastics, intermediaries, and added costs. It’s called “unrestricted funding on the basis of impact."

And look—if there really is risk to investors, they’re going to ratchet up expectations accordingly. Some simple math: Imagine that an investor has a portfolio of four DIBs. She figures that one of those DIBs could bomb completely. To get a portfolio return of 10 percent IRR, then, she has to go for 21 percent on each of the three remaining DIBs in her portfolio (four three-year projects at 10 percent IRR = three projects at 21 percent IRR). A targeted 21 percent IRR in a three-year DIB means you’ve jacked up the “risk reduction premium” to almost 80 percent. (Most DIBs are capped way below that, so she’ll probably take a pass anyway.)

Faced with those numbers, I doubt outcome funders would be all that eager to join in. There’s a Catch-22 here: If there isn’t much risk, there’s no point; if there is real risk, it’ll be priced too high. A DIB might even be a liability for public-sector funders: Imagine facing your constituency and saying, “Well, we spent $14 million to get girls into school, but $4 million or so went into investors’ pockets.” Even if there were a case to be made, it’s a complicated one, and by the time social media got through with it, somebody’s out of a job.

And then imagine how weird things could get for an evaluator when millions of dollars—literally—are on the line based on your findings. If you’ve ever been around the kind of fight that can blow up around an equivocal RCT, well, imagine the volume turned up exponentially.

Getting the Upside Without the Downside

There is, however, a big positive lesson from the Educate Girls DIB: Clear incentives to perform against impact targets can make a big difference, and it is here that we owe UBS et al. a big debt of gratitude for this pilot. Targets and timelines, incentives and accountability—these are really important, and by all accounts Educate Girls had to go flat-out in the third year to make up for stutters in the first two. (By the way, DIBs may motivate an organization to shift their best people to the DIB project, to the potential detriment of other work.) What the experience suggests, though, is that we’ve already got a mechanism for performance-based financing—one that skips all the gymnastics, intermediaries, and added costs. It’s called “unrestricted funding on the basis of impact,” and it’s not that hard:

Find an organization with an impressive impact track record and/or potential.

Give them an initial, unrestricted grant to do what they do best or to try some important new thing.

Set verifiable delivery, impact, and cost targets appropriate to their stage. (Sometimes that requires an RCT, but it usually doesn’t.)

If they do well against those targets, give them more money. If you want to give their performance a squeeze, create a bonus structure tied to stretch impact targets. That way, the extra subsidy goes toward more good work, not to investors.


I know of three other organizations in the midst of launching variants of DIBs, namely Mothers2Mothers, Living Goods, and Village Enterprise Fund. These are fine organizations with well-documented impact and disciplined delivery. For God’s sake, if you like their impact, just fund them!

I’m pretty sure there will be valuable niche uses for DIBs, especially since they include a mechanism to pay for rigorous evaluation, but if the problem is—and it always is—that the social sector doesn’t function as a market for impact, DIBs aren’t the answer. They’re too complicated and they’re too expensive. If they’re about bringing in commercial capital to fund stuff that needs and deserves a subsidy, well, our overall experience of impact investing and grantmaking would indicate there really isn’t much of a role for that kind of capital. Functionally, DIBs are just handing a big chunk of that subsidy to investors.

What will transform the sector is for funders at all levels to: 1) commit themselves to funding for impact, 2) learn what it means to do it (don’t just fund activities, or pencils, or whatever), and 3) execute on it. It won’t be perfect—at least not for a while—but it will make a huge difference, and pretty fast, too. There’s a lot to learn from DIBs, and I’m looking forward to seeing what comes out of this next wave, but this isn’t the answer to impact-based funding at scale. I’d hate to see us distracted by a sideshow when we’ve yet to figure out the main event.

In the meantime, if anyone would like to give Mulago a 40 percent return on what we were gonna do anyway, please give me a call.

This article was originally published by Stanford Social Innovation Review on December 13th, 2018 with the headline - Development Impact Bonds: There’s Still No Free Lunch