Research Friday: Human Capital Performance Bonds. What are they? How do they work?
Welcome to Research Friday! As part of a continuing series, we invite a nonprofit scholar, student, or professional to highlight current research reports or studies and discuss how they can inform and improve day-to-day nonprofit practice.
The past decade has been rife with ideas on how to scale up successful nonprofit organizations. Calls for scaling have been amplified by the recent economic recession, which brought increased demand for social services coupled with shrinking government dollars. But a structural problem remains: philanthropy does not typically have available capital for scaling.
The Social Impact Bond (SIB), developed in the U.K., was recently adopted in Massachusetts. The SIB is not a traditional bond; rather, it is a capital equity investment pool.i As I discussed in my last blog post, with SIBs, money is paid up front to a nonprofit organization, which in return commits to predetermined benchmarks. The investors assume the risk that the nonprofit organization will meet the benchmarks and alleviate the social problem.
But what if the nonprofit organization was to assume the risk? What if the organization only received payment if the outcome was achieved? This type of bond is called a surety bond, specifically, a Human Capital Performance Bond (HuCap). Minnesota has enacted legislation to pilot the HuCap bond, in a program that will look at the “desirability of using state appropriation bonds to pay for certain services based on performance and outcomes for the people served” (Minn. HF 681, March 23, 2011).ii
A key part of this legislation is a return-on-investment calculation, the method of which is established and approved by an oversight committee. It requires that (1) state income taxes or other revenue are collected that would not have been collected and (2) the state avoids costs for services.
A Bond Primer
In order to understand how the HuCap bond works, it is important to understand some bond basics. Surety bonds are issued by banks or insurance companies to guarantee that an obligation will be met. A performance bond guarantees satisfactory completion of a project, and in the event of non-performance, the bond covers the monetary loss.iii These may be short, mid, or long-term bonds, depending on the project, the surety required, and the pre-qualifications met by the firm seeking the bond.
The HuCap bond is most similar to a municipal bond. “Municipal bonds (munis) are debt obligations issued by government entities. When someone buys a municipal bond, they are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of the original investment is returned.”iv The HuCap returns the original investment, plus four percent to the investor.
The Model: The “non–nonprofit” organization: Twin Cities Rise!
Steve Rothschild, a former senior executive with General Mills, became concerned about an issue facing the Minnesota Twin Cities. The issue was the number of recently incarcerated men returning to their communities with little opportunity for meaningful employment. He established Twin Cities Rise!, an intensive, year-long empowerment and skills-based training for the returning men, coupled with a marketing strategy of recruiting business customers to hire graduates of the program.
Rothschild’s organization established a performance outcome goal: every man who received training would make a living wage of at least $20,000 annually for a minimum of two years. Every time Twin Cities Rises! met this target, costs to the state for public support were reduced and tax revenues increased.
With the help of two Minneapolis Federal Reserve Bank economists, in 1995 Rothschild approached the state with a pay-for-performance proposal.They calculated that each time a graduate of the program secured a job that paid at least $20,000 annually that also included health benefits, the state netted $3,800.00 per year through increased taxes and lower subsidy payments (i.e., welfare).
Over a 15-year period, the state saved approximately a minimum of $31,000.00 per hire. Thus, a bond was structured so that Twin Cities Rise! was paid $9,000.00 per person, per placement. A second payment for $9,000.00 was paid if the person was still in the same placement after a specified period of time, for a total of $18,000.00. Investors received a four percent return on the investment, and the Human Capital Performance Bond was born.
The Mechanics of Human Capital Performance Bonds
There is a six part structure to the bond for it to be successful:
- An external investor buys a performance bond that is linked to specific economic criteria as established by the government; structured as normal, market rate of return.
- State deposits investors’ funds in a ‘Performance Pool’ where they are held until payout terms are met by the nonprofit.
- Pool pays out to nonprofit over bind term based on nonprofit meeting government performance goals.
- Nonprofit annually validates performance value (ROI)vi to state.
- If performance targets are met, government receives high ROI and cash flow to fund principal repayment and interest. If performance targets are not met, state has the use of funds for principal repayment, interest or other purposes until bond period terminates.
- Structure term ends at the end of the bond term. Alternately, performance pool continues operating, funded by cash returns re-investment by government.vii
The Risks and the Future
The Human Capital Performance Bond faces similar risks of social impact bonds. There is not much information available on how an oversight commission, or intermediary, actually works. Another question is how organizations fund their activities between the time they apply for a bond and receive payoff for success.
It will be exciting to see how the pilot for this bond performs in Minnesota and if other states adopt similar legislation. As rules and regulations are established, serious thought must focus on how performance measurement outcomes are determined. Mission drift often occurs when organizations follow pre-established outcomes set by government or philanthropy. The HuCaP, however, purports to avoid this type of mission drift.
Only time will tell.
Patsy Kraeger received her doctorate from the ASU School of Public Affairs in May of 2011. She also received a graduate certificate in nonprofit leadership and management from the ASU Lodestar Center for Philanthropy and Nonprofit Innovation.
i Refer to ASU Lodestar Center Blog post titled “Social Impact Bonds: A New Tool for Scaling.”
ii State of Minnesota, House of Representatives, House File No 681,87th session (2011): Minnesota Pay for Performance Act. There is a comparable Senate Bill which is not discussed in this blog post.
iii Performance bonds are typically used in construction projects and may be accompanied by bid or payment bonds as well.
v Rothschild, S. (2011). The Non Nonprofit: For Profit Thinking for NonProfit Success. San Francisco: Jossey-Bass.
vi ROI = return on investment.
vii Rothschild, S. (2011). The Non Nonprofit: For Profit Thinking for NonProfit Success. San Francisco: Jossey-Bass.