A Fresh Angle On Social-Services Funding

A Fresh Angle On Social-Services Funding

Could human capital performance bonds be the future of social-services funding?

Steve Rothschild has peered into the future of social services. The waters are murky.

Rothschild foresees an increasingly heavy demand for such services—and a state increasingly unable to meet it. According to a state budget trends forecast updated in 2010, the State of Minnesota was paying about 30 percent of its annual budget in health care costs. “If you look at the projections that the group put together out 25 years to 2032 or 2033, state-paid health care could approach 60 percent of the state budget,” Rothschild says. “If that happens, and K-12 education is at 40 percent and you have it grow with inflation at 2 percent a year, everything else has to decline at about 4 percent a year. Everything else.”

To Rothschild’s thinking, that means that nonprofit organizations—including the one he founded, Minneapolis-based Twin Cities Rise—will need to pick up some significant slack. But where will those organizations find the money they’ll need to provide their services? And how will the state determine which nonprofits will provide the most bang for its increasingly limp, thin buck?

Rothschild, a former General Mills executive vice president, believes that he has at least part of the solution. It’s called “human capital performance bonds”—“hucaps” for short. Rothschild came up with the idea, refining it with the help of numerous financial and social service experts. Hucaps are part of a growing movement in the U.S. and elsewhere called “pay for performance” or “pay for success.” Governments that have given money to social service nonprofits without closely monitoring how well those organizations fulfilled their missions are starting to demand proof of successful outcomes. With hucaps, if the nonprofit can’t prove an economic benefit to its work, it isn’t paid.

Another element of hucap bonds is that they’re designed to tap private capital for funding. States have a long history of issuing bonds to private investors to fund infrastructure projects; issuing bonds for social services is uncharted territory. But Rothschild argues that the financial markets are now where the money for state-sponsored social programs can be found, since raising taxes is a live wire few politicians want to touch. “Virtually all improvements in social value lead to economic value,” Rothschild asserts. “And that’s the basic thesis of this.”

Last year, the Minnesota Legislature approved a $10 million pilot project for hucaps. Its launch has been delayed for reasons that aren’t due directly to the bonds themselves. Once they’re issued, will investors buy them?

Rothschild expounds on his idea, on the page and in person, with measured, crafted sentences reminiscent of a business-school professor. As he details in his new book, The Non Nonprofit: For-Profit Thinking for Nonprofit Success, Rothschild started Twin Cities Rise in the 1990s after a 22-year career at General Mills, where he began working after earning his MBA from the Wharton School at the University of Pennsylvania in 1969. Among his positions at General Mills was the president of the company’s Yoplait USA unit, where he launched the yogurt brand. In 1991, feeling as though he’d “hit a wall,” Rothschild left General Mills; within a couple of years, he began to design the entity that became Twin Cities Rise.

Twin Cities Rise helps African Americans, particularly those who’ve served prison time, find and keep steady employment. In 1994, Rothschild approached Gary Stern and Art Rolnick, then the president and the chief economist respectively at the Minneapolis Federal Reserve, to help him put the idea of a pay-for-performance model into a formula. Rothschild took that formula to the Legislature and governor’s office and offered them a deal: If any organization can prove that by getting someone a higher-income job, that person doesn’t use as many publicly financed services—and in fact contributes to the state’s bottom line by paying taxes—then the state should pay that organization a percentage of the state’s return that the organization has created.

In 1997, the Legislature passed a bill with bipartisan support stating that any nonprofit organization that can take someone from less than $10,000 to $20,000 with health benefits and sustain them there for a year will get paid $9,000 at placement and $9,000 a year later if that person is still holding that job or has gotten a better one.

Twin Cities Rise “has monetized the social value of raising people’s incomes,” says Rothschild, who says that since his organization’s founding, the state has invested $4.6 million and received $34 million in economic value.

A few years ago, with the partisan battles over government spending growing more and more pitched, Rothschild became increasingly aware of a potential social services shortfall. The idea for hucaps arose during discussions with numerous friends and contacts in the business, government, and the nonprofit sectors. He assembled an august group of financial and social-service mandarins, among them Rolnick, Jay Kiedrowski, Pam Wheelock, and retired Wells Fargo public-finance expert Bill Gabler, to “poke holes” in the idea in order to refine it. Once Rothschild believed the idea was ready for political prime time, he put together an organization called Invest in Outcomes, raising money from the General Mills and Medtronic foundations, among others, in order to hire lobbyists, economists and analysts. Funds also are being used to create a pool of money that nonprofits participating in the pilot could borrow from while awaiting payment from the state.

Rothschild distinguishes hucap bonds from general obligation bonds, the instrument that government uses to fund the construction of buildings, roads, and bridges; and from revenue bonds, which support revenue-yielding activities—often associated with business growth of some kind. Hucaps would function as annual appropriation bonds, a species of debt not backed by the state’s full faith and credit. As a result, annual appropriation bonds cost a little more. If the state’s general obligation bonds are rated AAA, for instance, annual appropriation bonds are rated AA. The risk is higher, but Rothschild says that such bonds are well-accepted in the financial marketplace. “States don’t renege on this, because if they did, their other bonds would get re-rated,” he adds. “That’s why they’re sometimes called moral obligation bonds.”

Under the hucaps program, Minnesota would take proceeds of the bond sales and put them into what Rothschild calls a performance pool. Participating social-service nonprofits “would be paid commensurate with the amount of economic value that their interventions create for the state,” Rothschild explains. “And the state would never pay more than it expects to get back on a present value basis. If nobody performs, nobody gets paid, and the state can pay back the money to the investors or can use it for another purpose.”

Invest in Outcomes estimates that the state’s cost of borrowing is around 13 to 14 percent: “That’s basically taking a 10-year taxable double-A bond—that’s the assumption that we have now—with an interest rate of between 3 and 4 percent,” Rothschild says. This calculation of cost also assumes an 8 percent amortization rate on a 10-year bond, with an additional 2 percent for managing the capital pool into which the bond money flows.

“If the social enterprise can generate a 14 percent rate of return to the state on their intervention, it will create enough value to make this worthwhile to both the organization and the state,” Rothschild says. “If it can’t currently reach that goal, it now has a target to improve its efforts for future participation, which will be good for everybody.” And if it goes above and beyond that 14 percent, “it would be paid more, and the state could enjoy positive arbitrage—a margin above its cost of capital.”

But profit’s not the driver: “The purpose of the hucap is to generate incremental investment capital for our highest performing social enterprises so that they can serve the community’s critical needs more effectively. By providing a return from increased taxes and lower public costs there is sufficient economic benefit to attract market-rate investors and social investors to invest in human services, because they get a market rate of return on a risk-adjusted basis comparable to other double-A bonds.”

Rothschild sees the primary market for hucap bonds comprising various institutional investors seeking a market rate of return. “The bond wouldn’t even say what the purpose was—it’s just a plain vanilla state AA bond,” he says. “Many market-rate investors wouldn’t care what it’s used for, as long as they get their returns.” But he also believes that social investors, such as philanthropic foundations, socially conscious wealthy individuals or socially oriented mutual funds, would be interested because they could pursue their social interests and obtain a market-rate return to boot.

Rothschild also asserts that these bonds would be more attractive to investors than social impact bonds, an investment vehicle recently introduced by the financially strapped British government. Social impact bonds offer investors in government services either a big return or, if a program doesn’t meet its target, nothing at all. These bonds, Rothschild says, are “more of a venture capital investment. It’s not really a bond—it’s a debt instrument. It’s misnamed. The investor takes all the risk, but they can get a higher return.” With hucap bonds, the risk to the investor is that the state reneges on its promise to pay, “which is relatively de minimis based on history.”

human-cap_640-(1).png

 

 

The hucaps idea has been lauded from many corners of the political landscape. One of the supporters is Dane Smith, president of St. Paul–based policy advocacy organization Growth and Justice. “Among progressive groups, I think we’re uniquely business-friendly. Economic justice flows from business growth. And we feel vice versa, too.” Growth and Justice, Smith says, focuses on “evidence, data, and what really works” in education, social services, and transportation.

Smith believes the organization that would benefit most from hucap bonds are those involved in workforce development—nonprofits helping bring people “up to speed with the skills that it takes to compete today.” He adds that “other nonprofits do things that are harder to measure. We’re under no illusions, and I don’t think Steve is either, or any of the supporters, that this is some panacea. It’s just a very intriguing concept. And this is a state that’s known for innovation in human services delivery, so we hope it germinates and catches hold and that other groups like Twin Cities Rise can attract this capital.”

Tom Hesse, the Minnesota Chamber of Commerce’s vice president of government affairs, says that there’s a great deal of interest from Chamber members in redesigning government services and looking at new ways to deliver those services. “I think members generally know that the demographics are going to cause budget difficulties not only for the next few years but probably for the next couple of decades,” Hesse observes.

When Kate Barr first heard of the hucaps idea a couple of years ago, she contacted Rothschild, who quickly tapped her as a source of ideas and input. Barr is executive director of the Minneapolis-based Nonprofits Assistance Fund, which provides nonprofits with financial management consultation and assistance, including loans and training programs. She believes that pay-for-outcomes “is the direction we’re all headed” in the nonprofit realm, noting that Hennepin County and the state are already testing the idea in some contracts. Pay-for-performance makes sense “because it’s very hard to discern the quality from the not-so-high quality.” Barr is now listed as endorsing the concept on the Invest in Outcomes website. (Other endorsers include General Mills CEO Ken Powell and Ecolab CEO Doug Baker.)

Barr does have some questions, however. One concerns the gap between when a nonprofit delivers the service and when it gets paid. During that time, the organization is incurring costs and adding staff. Barr and her staff ran different scenarios on how long and deep the working capital gap might be. They determined that could be from 15 to 50 percent, she says, depending on the length and the costs. How would the nonprofit hang on during that time? Would Invest in Outcomes’ capital pool be sufficiently liquid? If the organization needs a loan, “we’re a pretty obvious home for that,” Barr says.

Speaking as a former banker, “the hardest thing that I’m still grappling with is, how do you underwrite the financing? How much is that nonprofit likely to get paid? We can look at the history of success with their programs,” Barr says. “But we’re still really grappling with how to underwrite the risk of how likely it is that they’ll earn at least $10,000 to cover their costs, or even more.”

Another question: How will the nonprofit’s outcomes be measured? “Normally when a nonprofit is delivering a service, it is also in a way the master of the data that’s being collected about the participant, about the service delivery. In this case, the data that’s going to be used to determine the payment that they’re going to get is not in their hands, and it may not be acceptable to them because of privacy concerns and data concerns.”

Even organizations like Twin Cities Rise that provide job training, where outcomes are relatively easy to measure, could be hamstrung by a pay-for-performance model. “The nonprofits could deliver exactly what they intended to do in terms of the readiness of their participants to have and keep a job that pays [a good salary],” Barr observes. “But if there are no jobs, there’s little that they can do about it.”

Another question: “One of the things that’s going to have to be carefully thought about is how all of the intersecting services happen. There’s a childcare organization over here or supportive housing organization over there that is also serving my person. My work doesn’t work without their work. And yet I’m the one with the contract with the state.” Might pay-for-success create a “weird internal competition”?

And what about organizations whose services don’t provide a relatively fast return? Thanks to the work of Art Rolnick and others locally and nationally, there’s a general consensus that early-childhood education can help at-risk children sidestep innumerable pitfalls in later life. “But financing something that’s going to pay off in 20 years? That’s not going to work,” Barr says. And “how do you quantify, how do you monetize that?”

Even with all of these qualifications, Barr supports the hucaps idea. “One of the reasons that I endorsed the pilot—and it was me, not necessarily my organization—is that I think pilots are good,” she says. “We could talk all day about how things could work. But until you do a market test, you don’t know.”

How long will she have to wait for that test? That depends mostly on the Minnesota Supreme Court, which must first decide a complicated bit of business regarding the state’s tobacco bonds. That decision is expected this summer. In the meantime, the state has set up an oversight committee, which has been meeting monthly since February. While awaiting the bond pilot’s liftoff, Rothschild is keeping busy spreading the word about the idea locally and across the country. While marrying pay-for-performance with “something that already exists—namely state bonds,” may seem like a new concept, he says that it’s simply “applying ideas already in practice.” And hucaps might mean at least a little clearer future for citizens who depend on critical state services.

Related Stories