As cash-strapped governments continue to tighten their belts, 'social impact investing' – in which the wealthy fund schemes or projects that benefit society but also provide a return – is becoming more and more appealing.

Government budgets are being hit by austerity while the fortunes of private entrepreneurs have never been larger – hence the call at one end of the political spectrum to raise taxation and carry out more redistribution.

But taxation as a method of solving society’s ills has its limits. Raise the rate too high and the total amount collected falls (as illustrated by the Laffer curve) while outcomes in tax-funded projects can often be poor. 

Enter social impact investing, described by one of its pioneers as “the invisible heart of the market” working on top of Adam Smith’s famous invisible hand. 

Social impact investing looks at a desired outcome and measures the benefits of achieving it. Using this knowledge it is then possible to tap private sector money to invest in public sector projects that provide both a social benefit and a financial return. Banks can act as a conduit between the two. 

Reoffending by released prisoners is one such example of social impact investing.

If each prisoner costs, say, $30,000 to keep in jail, a programme that reduces reoffending from 750 in 1000 released prisoners to 250 will save $15m – i.e. 500 multiplied by $30,000. This means that investors wanting to earn 10% a year while doing social good at the same time could raise $5m for the project. If it hits the target the investors would get their capital returned plus 10% (i.e. $5.5m), reoffending would be down and the taxpayer would save $9.5m – in other words, all parties win. If the programme doesn’t work, the investors lose their money but can feel compensated by the fact that their losses were in a good cause. 

It’s easy to see that the scope of this can extend to getting school dropouts back into the classroom, getting the unemployed back into work and rolling out vaccination programmes that save on healthcare costs. 

Investors are starting to get increasingly interested in the idea of social impact investing. Entrepreneurs who have sold businesses and are engaged in philanthropy find this an appealing way to direct their funds because they can measure exactly what has been achieved. At the same time, institutions are being encouraged to invest responsibly and sustainably so social impact investing is starting to suit their purpose too.

For banks there is work to be done on structuring social investment bonds while private banks are including impact investing in their philanthropy divisions. 

The latest list of Forbes billionaires puts their combined wealth at roughly $7000bn – about one-tenth of world gross domestic product. This money has already been taxed, so from that perspective the funds are out of reach, but persuading their owners to funnel them into social impact investing would help reduce the huge task list placed on cash-strapped governments. 

Brian Caplen is the editor of The Banker.

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