Americans celebrate innovation, a term that the dictionary says stems from the Latin verb innovare—to “make new.” We all sense that a wave of innovations—mobile internet, robots, artificial intelligence, driverless cars—will transform the way we live and work. Innovators are admired for their game-changing insights that upend old ways of doing business, and create economic opportunities.
Add the word “financial” to “innovation” and the love fest stops cold. Financial innovation is now considered something of an oxymoron, which is hardly surprising in view of the widespread wealth-and-job destruction of recent years, when credit-based derivatives and similarly engineered securities went catastrophically bad. What financiers call innovations are often nothing more than cleverly designed products for making old-fashioned, leveraged bets.
That said, the commonplace dismissal of financial innovation goes too far. A number of products in today’s financial ecosystem deserve the innovation accolade. Among them are Charles Schwab (SCHW) and discount brokerage, Vanguard and stock equity-index mutual funds, Grameen Bank and microlending in developing nations, PayPal (EBAY) and online payment services, and Kickstarter for funding home-grown ideas. Innovations such as these offer society a real return.
“Social finance” has a good chance of joining this list. In essence, these are fledgling financings that aim to tap global capital markets to help fund nonprofit programs dealing with some of society’s most intractable problems, from reducing chronic homelessness to therapeutic services for incarcerated youth. The big, tantalizing idea is that social finance could become a force for greater efficiency and effectiveness in tackling the roots of poverty.
The first financing was sold in the United Kingdom in 2010 and the tactic has since spread to Australia, Canada, and the U.S. (The Federal Reserve Bank of San Francisco has put forth a 147 page booklet of collected essays [PDF].) The basic concept is that investors earn a return only if the nonprofit program succeeds at meeting measured goals. The pay-for-success formula asserts a market discipline that rewards effective nonprofits, which will then find it easier to raise further funds from satisfied investors.
If mainstream investors end up embracing these securities, global private capital should come to the $300 billion philanthropic marketplace—welcome money in an era of tight government budgets. “What motivated us to be involved are the long-term prospects for the creation of a new market,” says Andrew Sieg, head of Global Wealth and Retirement Services for Bank of America Merrill Lynch (BAC). Adds Paul Bernstein, chief executive of Pershing Square Foundation: “This is an innovation in its early days—worth pursuing.”
Social finance is at the experimental stage. These are complicated financings that currently rely on such investors as foundations and venture-like philanthropies that are willing to earn below market-rate returns. Some recent financings act more like fixed income securities while others offer equity-like characteristics.
Take the recent $13.5 million offering funding a five-and-a-half-year effort by the Center for Employment Opportunities (CEO) to provide reentry employment services for 2,000 former prison inmates in New York City and Rochester, N.Y. The initiative represents a partnership between government (New York State and the U.S. Department of Labor), the nonprofit sector (Social Finance, an organization focused on nurturing the sector and CEO) foundations (Robin Hood Foundation, Rockefeller Foundation, Pershing Square Foundation, and others) and the private sector (Bank of America Merrill Lynch and Chesapeake Research Association). The federal and state government will make outcome-based payments when CEO achieves certain benchmarks. Investors will earn a return at that point. The investment may be worthless if CEO doesn’t perform well.
A major reason why social finance holds such promise is an under-appreciated shift among well-heeled investors: The embrace of values-based investing—values, as in moral or ethical values. It wasn’t all that long ago—the 1980s and ‘90s—that the concept of investments based on moral values raised hackles on Wall Street. The standard rap on the idea was the belief that marrying personal values to an investment portfolio—however noble an idea—would cut into returns.
Scholarly studies and investor experience have shown little proof that values-based investing has penalized performance. Some $3.74 trillion was invested according to socially responsible strategies in 2012, according to (PDF) the Forum for Sustainable & Responsible Investing. That’s up 22 percent since 2009 and 74 percent since 1999.
Even more important, the notion of investing goes beyond the confines of traditionally defined socially responsible investing. These days, people are trying to merge their money-making activities and their charitable giving. It isn’t always easy, but the goal is widely embraced. “Our high net-worth clients are more focused on the broad productivity of their wealth. They see their investment portfolio magnifying their values,” says Sieg of Merrill Lynch. “The next generation feels more strongly about this.”
That’s progress. It’s a safe bet that if the current generation of social finance doesn’t take hold, a further financial innovation based on values will take its place. The lure to invest well and do good at the same time is powerful. And if there is one thing a capitalist society can’t stand, it’s an unmet demand.