Pay for Success: A New Model for Nonprofits?

Posted on May 24, 2023 12:00 PM

Pay for Success - Nonprofit

An innovative way to fund social-service programs is slowly catching on in the United States—and it has the potential to transform the way larger nonprofits and mission-driven companies go about their business.

Pay for Success (PFS) is a funding model that relies on public-private partnerships to provide services that have traditionally been provided by the government. The idea originated in Great Britain in the early 2010s and gradually made its way across the Atlantic to the U.S., where it is now being employed in the social-service, healthcare, criminal-justice, and housing sectors.

The fundamental premise of PFS is simple: many government services can be provided at lower cost and with greater efficiency by nonprofit organizations or other non-governmental groups. The initial funding or “upfront money” for these service-delivery projects comes from private investors and investment banks, such as Goldman Sachs, Santander Bank, or BofA/Merrill Lynch. (PFS financing is essentially the same thing as a social impact bond, a term that is more commonly used in Europe.)

Let’s say your nonprofit or mission-driven company runs a program that has been successful, on a small scale, in achieving some desirable social result—providing job training for ex-convicts, maybe, or expanding early-childhood education services for at-risk children. Your state government runs a similar program on a much larger scale. You believe that your organization can do a better job of running the state’s program, but you don’t have the resources to scale up to that level.

That’s where PFS comes in. In a PFS arrangement, your organization would enter into a contract with the state government to provide your service for less than the state is currently spending. To expand your existing program to a very large scale, you would partner with private investors or investment banks, who would provide the financing for the expansion. Under the terms of your contract, an independent evaluator would assess the program’s results; if the evaluator decides that your organization has met all the goals specified in your contract, then the state would repay the private investors with interest.

If that’s the case, everyone wins: your organization greatly expands its programming, the state saves money, and the private investors make a profit. If your organization doesn’t meet all its required goals, then the state pays nothing, and the private investors take the loss.

It’s important to remember that to be successful, the new program has to achieve both its desired social goal and the financial goals specified in the contract. As a practical matter, that means the program must deliver services for significantly less money than the government is currently spending. The difference must be great enough that the government can afford to repay investors with a profit, but still spend less than it would have paid to do the job itself.

Upsides and Downsides

The advantages of PFS are threefold:

  • The PFS system system opens the door for a large influx of private capital into the social-service system, potentially reducing the need for taxpayer financing.
  • PFS provides strong financial incentives to deliver services more efficiently.
  • The PFS model shifts the risk for program failure away from government and onto the private sector.

For all these reasons, PFS has gained a strong following among academics, politicians, policy experts, and some investment banks. But on a practical level, PFS has yet to catch on in a big way here in the U.S.: to date, fewer than 30 PFS projects are in operation.

Why is that the case? For starters, the PFS process can be difficult and time-consuming. Negotiating the terms of a PFS contract can take many months, and the timeframe for evaluating program results can stretch out for several years.

Second, attracting private capital is not easy: the rates of return on PFS investments are typically on the low side, and may not be enough to convince many investors to take a risk. (To address this issue, some private foundations have had to step in as junior lenders for PFS projects, sweetening the deal by offsetting some of the risks to private investors.)

Finally, convincing an evaluator that your organization has fulfilled all its contractual obligations requires a rigorous program evaluation process marked by detailed, ongoing data collection. Most nonprofit organizations simply are not equipped to meet the PFS requirements for data collection and analysis.

For all that, though, the PFS approach is slowly gaining political and financial traction. In 2018, the federal government authorized $100 million over ten years for PFS projects and similar ventures. Several states— including New York, California, Massachusetts, Ohio, and Utah—have also authorized their own PFS projects.

If this trend continues, it could lead to a future in which the provision of social services is partly subject to market forces, and large nonprofit organizations compete not for donors but for investors. Those changes could radically alter the nonprofit world as we know it—but whether those changes would be for good or for ill, it is still too early to say.


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Topics: Nonprofit, Nonprofit Management, Fundraising

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