"These are not idealistic kids," the mastermind of the contest, David Chen, CEO of Equilibrium Capital Group LLC in Portland, Ore., said of the student financiers. "They are making a judgment call on the future. This is the equivalent of investing in hedging strategies or emerging markets, or high-tech 25 years ago. In each of those cases, the market efficiency and information efficiency gains went to those that were first."
HIGH FINANCE FINDS A HEART
"Impact investing" is catching on among investors who want to use finance to make more food, cleaner water, better health care, smarter children, and a richer bottom-of-the-pyramid. Morgan Stanley has an "investing with impact" offer for its wealthiest customers, and AOL founder Steve Case told The Economist that impact investing was the hottest topic of conversation among a group of billionaires gathered in Santa Barbara.
In the broadest view, impact investors are simply betting on fundamental trends. In a volatile and resource-constrained world, investments to provide food, water, energy, health care, education and sanitation to a growing and increasingly affluent global population arguably have lower risks and higher long-term returns. But on the ground, even innovative efforts to meet basic needs often are hampered by inefficiencies and market failures that prevent those who create value from getting paid for it.
Enter the financial innovators.
If J.P. Morgan can use credit default swaps to bet that corporate credit ratings would rise in a volatile economy, why not let other investors use newfangled investment vehicles to bet that job training can keep ex-offenders from returning to prison or that transitional housing can reduce the ranks of the chronically homeless? The savings to governments in unbuilt prisons and unfilled beds in homeless shelters could be significant.
HOW FINANCE CAN REDUCE CRIME
A British import offers a way to collateralize such win-wins. "Social impact bonds," sometimes called pay-for-success contracts, let private investors buy low-interest bonds to finance preventive efforts and get repaid, with a small premium, from those government savings. The new bonds effectively leverage the value of prevention, an ounce of which, Benjamin Franklin taught us, is worth a pound of cure.
If the social interventions meet its benchmark, a government agency pays off the bondholders out of the substantial savings from lower costs associated with jail-time, nursing homes and emergency room costs. If the programs flop, too bad. Budget-crunched agencies pay only for what works.
So far, exactly one such bond has been issued, to be repaid by the U.K Ministry of Justice if re-entry services for released prisoners lowers their recidivism rate by at least 7.5 percent. But Massachusetts is getting ready to back bonds to finance housing and other services for the chronically homeless, to improve their well-being, and reduce Medicaid costs. The Labor Department is committing $20 million for pay-for-success contracts for state-level workforce development; the Justice Department is backing contracts for prisoner re-entry programs.