Investor hammer smashes social logic

It has been observed that if you are holding a hammer every problem looks like a nail. Similarly, in the world of impact investment every problem looks like an opportunity to apply the tools and mindsets of finance.    

While sometimes this is appropriate, in many cases it is not. For example, I've argued previously that this 'investor mindset' is responsible for the widespread assumption that cashable savings are required to finance SIBs (they aren't). The latest example of inappropriate finance-driven thinking is the growing popularity of first-loss capital and the assumption that this is a neat way of making SIBs attractive to investors.   

The rationale behind first-loss capital is simple. First-loss helps to take some risk off the table making deals possible that wouldn't otherwise attract 'serious' investors. Of course, that risk hasn't disappeared completely, it has just been absorbed by a 'philanthropic' investor who may be willing to accept a real loss for the sake of getting the deal done.   Taking a closer look, it is easy to see that the use of first-loss capital has several significant drawbacks. For example, reducing the risk faced by the investor weakens the incentive for the service provider to innovate. This undermines the primary purpose of social impact bonds which use financial risk to drive social innovation. First-loss capital also risks distorting price signals by supporting outcome payments at unsustainably low levels. Not helpful to anyone. From the philanthropist point of view the payment structure created is also rather odd as the worse the outcomes, the more they pay. Exactly the inverse of what you might expect a philanthropist to seek.   

But, as some argue, at least the provision of first-loss capital make deals possible. Perhaps we should be prepared to overlook the obvious flaws of this approach if the alternative is fewer SIBs.   However - not everyone in a deal thinks (or should think) like an investor.  In fact, the philanthropist would be better advised to think and act more like a commissioner. Rather than providing capital they can provide revenue through top-up payments which supplement the 'price' per outcome. The effect is to make the investor payout line steeper rather than shifting it upwards (see graphic).

Instead of making the deal seem less risky, the philanthropist is helping to ensure the price paid is a fairer reflection of the real risk. Far more sensible and far more sustainable in the long run.   Such an arrangement counteracts all the weaknesses of the first-loss structure. Incentives are sharpened through greater rewards for better outcomes. The true 'price' per outcome is now clear for everyone to see so there is no risk of distortion and the philanthropist pays more when better outcomes are achieved. It really does tick all the boxes.   

So what's the catch? Presumably top-up payments are more expensive? In fact this approach needn't cost a penny more. Mathematically, it is always possible to switch a first-loss structure to a top-up arrangement at no additional cost. Indeed for any first-loss structure there is an equivalent top-up arrangement with exactly the same risk-adjusted payouts for investor, philanthropist and commissioner. The difference is simply the distribution of risk and return is now far more sensible and better aligned with impact.  

What then could possibly be the rationale for pursuing the first-loss model? To find the answer simply look who's holding the hammer. Investors threaten that without first-loss arrangements they won't participate. Apart from the fact that I simply don't believe thoughtful impact investors actually believe this, why should we let the investor hammer smash the social logic of SIBs?