Reducing Transaction Costs in Development Impact Bonds

By Waka Itagaki

Development Impact Bonds (DIBs) are a results-based financing mechanism that leverages private capital for international development. Since the first DIBs were created in 2014, one of the mechanism’s key challenges has been high transaction costs: Each DIB project is unique, and this customization increases legal fees and requires financial intermediary and technical services. This article highlights two ways to reduce these costs: sharing data and knowledge about DIBs among stakeholders, and limiting the focus of DIBs. The reduction of transaction costs will promote greater use of DIBs for international development.

Introduction and Background

DIBs catalyze private investment that generates social impact as well as financial return, so called “impact investment,” by engaging private investors, service providers, host-country governments, donors, and intermediaries. Once all stakeholders agree on a common goal and an evaluation method, private investors provide upfront funding for a development project and work with service providers. If and only if the pre-agreed development outcomes are achieved, host-country governments or donors repay the investors. An intermediary organization coordinates among the stakeholders and contributes to the creation of a deal that meets all stakeholders’ interests.

The first DIBs were launched in India in 2014 and are a useful model with which to understand how the mechanism works in practice. The Educate Girls Development Impact Bond aims to improve education for 18,000 children in Rajasthan, India. A private investor, the UBS Optimus Foundation (UBSOF), invested $267,000 in a service provider, Educate Girls, to cover the program costs over three years. An outcome payer, the Children’s Investment Fund Foundation (CIFF), promised to pay back UBSOF the original amount plus financial returns as long as pre-agreed outcome targets are met. The financial returns depend on the success rate of the program and are set at a maximum rate of 15 percent for three years. The outcomes measured are learning outcomes (students’ performance on a national standardized test) and enrollment outcomes (the percentage of out of school girls who are enrolled on school rosters by the end of three years).  The outcome measurement is conducted by IDinsight, an independent evaluator, and learning outcomes are measured in a randomized controlled trial. In this DIB project, Instiglio, an experienced intermediary in the field of impact bonds, designed the outcomes, payment structure and financial model, and provides performance management services.

DIBs offer several advantages over traditional development projects. The Development Impact Bond Working Group, a collaboration between the Center for Global Development (CGD) and Social Finance, defines three values of DIBs: access to finance for development projects, a focus on results, and a platform for development cooperation. Results-based development funds a program only after the goal is achieved, and relies on developing country governments or service providers to supply upfront funding. However, developing countries and service providers sometimes cannot secure the upfront funding due to budget constraints and a high degree of uncertainty of the program’s outcomes. Also, high interest rates and their low credit-worthiness make it difficult to borrow from capital markets. DIBs address these issues by having investors provide pre-financing. Secondly, DIBs focus on results by engaging the private sector. Since private investors will not be repaid if the program fails, they have an incentive to put in place the necessary feedback loops, data collection and performance management systems required to achieve pre-agreed outcomes. Lastly, DIBs provide a platform for development cooperation where all the stakeholders work together to achieve the agreed outcomes.

While DIBs bring these benefits, a key challenge is high transaction costs. The nascent nature of the industry makes each DIB project unique. Customization increases legal fees and requires financial intermediary and technical services. The Nonprofit Finance Fund, a non-profit organization that raises awareness of Pay for Success (PFS is a US-based variation of DIBs), said that the problem of transaction costs is one of the most frequently asked questions by stakeholders. The Brookings Institution stated in 2015 that impact bonds are time-intensive and expensive. High transaction costs are an obstacle that prevents people who consider initiating DIBs from taking action. In order to promote DIBs for international development, professionals in international development must consider how to reduce those costs. This article highlights two ways to reduce transaction costs: sharing data and knowledge among stakeholders, and limiting the focus of DIBs.

  1. Share data and knowledge

Stakeholders should share data and knowledge and communicate challenges and successes to uncover industry-wide trends on specific types of projects.  The Development Impact Bond Working Group reported in 2012 that DIBs encourage innovation and learning in service delivery and those lessons are most valuable if they are shared. Stakeholders should share outcomes data, intervention costs, pre-project cost-benefit analysis, contract documents, legislation for introducing DIBs, and Requests for Proposals (RFPs). Data on outcomes and intervention costs will make it possible to analyze when DIBs are effective and efficient. This information could inform templates for designing new projects and thus reduce initial costs.

A centralized platform can facilitate the sharing of this kind of data. The Development Impact Bond Working Group suggested a DIB Outcomes Fund to enable joint funding and learning among donors. Taking this recommendation into consideration, the Multilateral Investment Fund (MIF) of the Inter-American Development Bank launched Social Impact Bond Pilot Facility, a new facility to support Social Impact Bonds (SIBs) in Latin America and the Caribbean in 2014 (SIBs are a UK-based variation of DIBs). The facility aims to provide investment capital and build SIB ecosystem, and their responsibilities include knowledge management and communications. Although no SIB projects have yet launched under the program, the facility will be able to promote the openness of the market.

Another way to promote knowledge-sharing is for donors and host-country governments to establish a protocol to report project data to the public, as the Development Impact Bond Working Group recommends. The Educate Girls DIB has developed a protocol and is planning to deliver data and outcomes reports to the Working Group as needed.

Accumulated DIB data should be categorized based on sector, country, and type of intervention. If the sector/country/intervention-specific knowledge and experience are shared, it becomes easier to create standard replicable DIB structures in each category. The Nonprofit Finance Fund argues that standardized impact bonds will reduce transaction costs.

  1. Limit the focus

The second way to reduce transaction costs is to limit the topical focus of DIBs in the initial stage. DIBs are not always the most efficient and effective way to address a variety of social issues. The industry should focus on specific issues where DIBs successfully work, and keep costs down. When selecting promising DIB projects, following Social Finance’s scoping exercises would be useful. Social Finance provides analysis that DIBs are mainly used in sectors such as healthcare, education, employment, and private sector development. They also mention that DIBs are feasible when outcome metrics can be clearly defined and agreed, the data for benchmark and outcome metrics can be collected, and outcomes are attributable to interventions. These scoping exercises would enable stakeholders to reduce the costs for designing a new DIB project.

Another way to limit the focus is to set a minimum amount for the size of DIBs. According to the Young Foundation, most private finance initiatives under about $35 million are inefficient due to transaction costs and a similar lower limit may exist for DIBs. Large-scale DIBs could reduce relative transaction costs based on the principle of economies of scale.

A limit on the number of stakeholders could also minimize costs and ensure efficient communication. Within one transaction, limiting the number of service providers, intermediaries, and private investors would decrease communication costs. Even throughout the marketplace, utilizing a small number of intermediaries would be advisable. The intermediaries would be able to accumulate knowledge and experience on DIBs, and if there are more experienced stakeholders, the time and associated cost of project development may decrease, as the Nonprofit Finance Fund insists.

Conclusion

To promote DIBs and mobilize private capital for international development, it is critical to reduce transaction costs. This article has presented two such ways – sharing data and knowledge across the industry, and limiting the focus of DIBs. If DIB stakeholders appropriately implement these recommendations, DIBs will become a more manageable approach to address international development issues. The progress of mechanisms to finance development means a step forward towards a better world.

Please check back on Prosper for the author’s next blog post, which will discuss and analyze trends in the role that impact investors play in international development.

One thought on “Reducing Transaction Costs in Development Impact Bonds

  1. Pingback: Impact Investors Are Changing: Analysis from the GIIN Surveys | Prosper

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