NEW YORK (Reuters) - Wall Street banks are eyeing a nascent market that improves their public image at a low risk and still offers them a reasonable return on capital.
The market is in so-called social-impact bonds, also known as pay-for-performance contracts, through which private capital can be funneled into philanthropic projects usually funded by governments and charities. The investors will receive a return based on whether a project saves public money by addressing the social ill it targets.
Goldman Sachs (GS.N) has launched two such bonds in the past 16 months - one for $9.6 million aimed at reducing recidivism among teenagers at New York's notorious Rikers Island jail, and the other for almost $5 million, intended to help children from low-income families in Utah prepare for kindergarten. This month, Goldman also said it is raising a fund to allow its clients to make investments that have "measurable social impact," including social-impact bonds.
Now Bank of America Corp (BAC.N) is set to launch a social-impact-bond investing program, three sources familiar with the situation said. Details of the program are not known.
Other banks, such as JPMorgan Chase & Co (JPM.N), Deutsche Bank (DBKGn.DE) and Morgan Stanley (MS.N), are keeping a close eye on these projects before getting involved, bank executives said. In some cases banks see the bonds, which were first launched in Peterborough, UK, as a product to sell to their wealth management clients, said George Overholser, chief executive officer of Third Sector Capital Partners, a nonprofit investment bank helping to structure various pay-for-performance deals.
A Bank of America spokeswoman declined comment.
The growing interest of banks in these bonds bodes well for cash-strapped governments and charitable foundations that want more private-sector cash to fund projects that serve a social need. Nonprofits and governments are hoping to develop a wider market for such securities, betting that the bonds would become a way to finance social programs that struggle as government budgets tighten.
"We do these deals to get strong financial-risk-adjusted returns that have a strong impact," said Alicia Glen, head of Goldman's Urban Investment Group, which oversaw the creation of the two social-impact bonds. The group has been structuring and financing community revitalization projects for the past 12 years.
Critics say that so far social-impact-bond deals have required that philanthropies or other investors give too much support to the banks, raising questions about whether subsidies are the best way to create a sustainable market in the long term.
Both the Goldman deals are structured to reduce the bank's risk. In the Rikers deal, a charity affiliated with New York City Mayor Michael Bloomberg has agreed to absorb $7.2 million of the losses if the program fails, while American businessman and philanthropist J.B. Pritzker is providing a subordinated loan of $2.4 million for the Utah program, meaning that if the program fails, he has agreed to take losses before Goldman.
"If you want to mainstream it, you need to mainstream it in a way that you do not have a 75 percent guarantee," said Gary Hattem, who heads Deutsche Bank Americas Foundation, which oversees the German bank's philanthropic activities in the U.S., Canada and Latin America, and is managing director overseeing the bank's community development finance group.
Goldman said the risk-adjusted return on the two projects is between 6 percent and 8 percent, in line with its other community reinvestment deals. When the Rikers deal was announced in August 2012, junk bonds were yielding around 7 percent.
Goldman's venture into social-impact bonds comes as the firm is trying to rebuild goodwill with the public after events that were deeply damaging to its reputation during the 2007-2009 financial crisis.
As an added bonus, Goldman can also include the social-impact bond in its Community Reinvestment Act application to its regulators. Banks need high CRA ratings to engage in transactions such as merger and acquisition deals. Otherwise they risk facing vocal opposition from community activists. Goldman is currently rated "outstanding," the highest CRA rating, by the Federal Reserve Bank of New York.
In his 2013 federal budget, President Barack Obama included $300 million to bolster social-impact bonds.
Supporters say credit backstops from government and charitable foundations are necessary to get such programs off the ground, since the cash flow from the securities is not always clearcut and the risks are hard to gauge. The concept is in a "trial-and-error period," said Overholser.
Goldman's Glen said credit enhancements are commonly used as an incentive to get the private sector involved where it normally would not. The U.S. Small Business Administration, for example, regularly guarantees bank loans to small businesses under a program called the 7A Guarantee, providing credit protection on 75 percent to 80 percent of the loan.
Executives involved in the Goldman transactions said it also makes sense for the bank's risks to be limited given how many hours the bank has devoted to getting these projects going.
Goldman will make a $2.1 million on the Rikers deal if the rate of repeat offending declines by 20 percent in four years. At one point during discussions, Goldman asked for even larger profits if the program reduced the recidivism rate by more than 20 percent, said David Butler, a senior adviser with MDRC, a social policy research nonprofit involved in the Rikers program.
"That was a sticking point in the negotiation," Butler said. Goldman finally got comfortable with the number, given that the city would retain all the cost savings beyond that, said Glen.
City and nonprofit backers of both Goldman deals said the investment bank served a crucial role.
Kristin Misner, the chief of staff for Linda Gibbs, New York City's deputy mayor for Health and Human Services, said Goldman's funding meant the Rikers program - a therapy program for 16- to 18-year-olds in jail - could run for longer than it would if it were just relying on the Bloomberg foundation money. The Bloomberg funds could also be earmarked for future projects if the Goldman-funded effort were successful.
Misner also said that by working with Goldman, the city hoped to demonstrate that social-impact bonds could be funded by private means.
In Utah, home to Goldman's second-biggest office, the bank's loan allowed the early education program to quickly get started for a pilot group of 600 three- and four-year-olds, allowing backers to make a case for state legislative support.
The program provides a targeted curriculum to better prepare three- and four-year-olds for kindergarten, thus attempting to prevent the need for special education or remedial services down the road.
Bill Crim, senior vice president of collective impact and public policy for the United Way of Salt Lake and the program's administrator, said the pilot was intended to verify that the idea was practically feasible, calling it a "proof-of-concept transaction."
Goldman provided a $1.1 million loan for a year to finance the pilot, increasing it to up to $4.6 million over seven years if the state passes legislation to allow for private funding of public education this year.
If successful, Goldman can make up to $1.35 million for the one-year pilot program alone, Crim said. It has not yet been determined how much Goldman could make for the full seven-year program.
Reporting by Jessica Toonkel; Editing by Prudence Crowther