CDFI’s Play a Vital Role in Orienting Communities for PFS and Outcomes Contracting

As discussed in our first blog, the Pay for Success (PFS) field is evolving from initial Social Impact Bond-style projects launched by governments and supported by third-party (i.e., non-government) funding to agency and multi-agency engagements that shift the practice of how existing public funding streams are deployed for specific social programs. Across these projects, traditional cost-reimbursement service contracts are being amended or replaced to align funding, policy, data, and services together to the ultimate goal of achieving outcomes for our nation’s most vulnerable populations.

Funding is needed to scale the implementation of these new outcomes-oriented contracts. However, we haven’t seen participation by many of the original funders who supported early SIBs. Third Sector believes that if we can demystify the work stages and risks involved in broader outcomes-oriented engagements, we can demonstrate many new funding opportunities that might appeal to both new and traditional investors and align with their respective investment guidelines.

Our first blog post focused on understanding market trends and general investor appetite as the industry has changed. The next few posts in the series will focus on specific types of investors, and we chose to interview Community Development Financial Institutions (CDFIs) first, due to their key funding and agency support for PFS and outcomes-oriented contracting. We are excited to have interviewed five leading CDFIs to  discuss the key investment strategies and risk/return tradeoffs they face as stakeholders in this field:

  • Reinvestment Fund (RF)
  • Nonprofit Finance Fund (NFF)
  • IFF
  • Local Initiatives Support Coalition (LISC)
  • Low Income Investment Fund (LIIF)

CDFIs have always been valuable community investors

Traditionally, CDFIs have been important investors in community-based initiatives to expand economic opportunity, making strategic investments, providing services, and leading impact in a few key areas:

  • Increasing access to financial products and social services. Low- and mixed-income housing, community health, and small businesses and community organizations have all benefited from the asset-based capital roles of CDFIs. CDFIs have often exhibited patience in understanding each borrower’s unique timing, interest rate, and repayment needs.
  • Expanding local nonprofit capacity through capital and other support, such as strategic and financial consulting. This desire to expand the ability and improve the financial stability of crucial local organizations also ties into much of Third Sector’s work on both Pay for Success (PFS) and outcomes-oriented contracts -- helping the service provider validate their program outcomes and expand their delivery of services.
  • Pushing the edge of what investments can look like. From Enterprise Zones to Opportunity Zones, and into early PFS investments, CDFIs have been purposeful players in how investments can lead to community development and drive real outcomes.

As we’ve seen in the field and from our interviews, CDFIs are willing to take a risk when mission aligns with a risk/return profile, and we are excited by their thoughtfulness on the challenges that some of the current PFS project have faced -- and what could change going forward.

Traditional Pay for Success financing has posed challenges for CDFIs

A number of the CDFIs we spoke to see a real value and impact proposition with the PFS sector, and agree that in many cases the investments are aligned to their missions. However, many CDFIs are hesitant to participate in future deals, citing a few reasons:

  • The enormous efforts needed to get a traditional PFS deal off the ground, including negotiating a bespoke capital stack and agreement for each contract. A few CDFIs cited the “tremendous lift” needed, especially while balancing the other initiatives within an organization.
  • The uncertain risks in paying for outcomes tied to human behavior (e.g., housing stability outcomes) versus a hard asset (e.g., mixed-income housing). One CDFI indicated that the primary risk is around performance. They wondered how they could be certain of the outcomes, especially if there is no historical evidence base for an intervention.
  • The expectations of investment committees are mis-aligned with the investment proposition of traditional PFS projects. As one CDFI felt they are lenders, and PFS is riskier than secured capital lending. They think of their investments in PFS transactions as carrying equity-like risk with a debt-like return. As most CDFIs don’t have grant capital and already operate with low margins that can only absorb limited losses, complex PFS investments can be quite risky.

Third Sector sees a few opportunities for CDFIs to continue their role in tying funding to outcomes

We’ve really valued the honesty and insightfulness of everyone we interviewed. There is a collective understanding that more liquidity is needed to scale community impact. Although CDFIs may be struggling to find an appropriate role in traditional PFS transactions, we challenge CDFIs to continue playing their crucial funder and advisor role in other ways:

  • Continue as a thought partner in the financing needs of outcomes-oriented contracting. Many projects that have only partially-contingent payments to providers may not require upfront investment in the same way as traditional PFS, but have other financing needs. CDFIs could consider new community investment products such as:
    • Using net assets to backstop or guarantee new grants to communities for outcomes-oriented contracting projects
    • Provide working capital loans to providers who have holdbacks/bonuses contingent on outcomes

    These are just a few ideas, but we look forward to seeing how CDFIs could create risk and/or grant capital that investors are comfortable with, perhaps providing flexibility while protecting investors via portfolio diversity.

    • Exemplify the value of an outcomes orientation through the broader CDFI mission and investment portfolio. When making investments, think about how performance feedback loops, data, and financial and non-financial incentives can encourage better outcomes for communities. CDFIs welcome an outcomes orientation, and we look to them to bring that framework more creatively into stakeholder negotiations.
    • Be upfront about what you can and cannot support. As we discussed in our last post, there is a lack of clarity about what is needed at each project stage of an outcomes contract, as well as a lack of transparency around the different risk, return, and strategic needs of each stakeholder. We were excited to hear directly from these five CDFIs about the challenges and opportunities they see, but believe that more regular and frequent communication would help grow the field. Potential outcomes payors, particularly governments, often have unrealistic expectations about the risk/return profile of CDFIs. Earlier information flow to outcomes payors regarding risk mitigation and return needs will help position realistic project development, help alleviate the high transaction costs of current deals, and even move projects to launch in a shorter time frame.

    Appendix: Key Strategy Questions Asked 

    The following are questions we asked CDFIs, organized under two categories: Strategy and Risk/Return.

    How does PFS & outcomes-oriented contracting fit into your organizational mission?

    As an asset class, how does a potential PFS investment compare to other assets you could invest in? What else is competing for the same pool of money?

    CDFIs often act as lenders, fiscal agents, and/or intermediaries for projects. What other roles could you provide for new initiatives?

    • Could a CDFI act as an earlier stage investor (e.g., during feasibility) in PFS initiatives? What sort of financial products or structures would you consider investing in? How can we leverage the vast community funding experience of CDFIs in the new, unsecured, high-risk space of outcomes-oriented contracting?
    • “Startup capital” is limited for new PFS or outcomes-oriented contracting. Third-party technical assistance advisors (like Third Sector) need to be paid for critical early assessment and implementation work but are having trouble locating that upfront, exploratory funding. How could CDFIs alleviate this type of challenge?

    Broadly speaking, how do you view the CDFI-government relationship?

    • Are CDFIs a replacement for the activities government should be doing but doesn’t have the money for?
    • Are CDFIs the initial risk taker, funding unproven initiatives to prove they work?

    What do you see as the value of a PFS project beyond financial return and outcome generation? Are there any deliverables which are byproducts of PFS that you also find very valuable?

    • Breaking down data silos
    • Expanding/scaling programs that work
    • Tying dollars to evaluation
    • Place-based improvement
    • Public-private partnerships

    What “hard and fast” rules do you follow when investing in PFS?

    • How would you prioritize the most salient risks? Some risks we've seen are below; are there other risks you know that we haven't listed?
      • Program doesn’t work
      • Program doesn’t target the population of interest]
      • The project won't move from an "assessment" to "building" (or construction).
      • Project doesn’t affect meaningful change
      • Low ROI (financial or social) per dollar spent on a project
      • Poor legal documentation
      • What early risk mitigants do you look for? What are early indicators that a project has successfully dodged those risks? What are early signs of success?

    How do you evaluate your impact?

    • How does your organization evaluate social/impact ROI?
    • How do you balance that with financial ROI?

    Launched projects to date have had mixed results. How does your organization think about this as a risk factor? Is this concerning when evaluating a potential PFS investment?

    How do you think about aligning multiple investor goals and differing return expectations when investing in these human capital projects?