David Streim, Associate Director of Investment Underwriting at Nonprofit Finance Fund (NFF), proposes a new kind of repayment coverage ratio for Pay for Success financing
Lenders love their Debt Service Coverage Ratio (DSCR), the universal shorthand for a borrower's ability to make payments on a loan. It's satisfying to reduce a mess of numbers with complicated back stories into a single fraction. And the calculation is elegantly simple: cash flow divided by debt service.
But the numerator contains no less than every single operating assumption of and about the borrower. At face value, the ratio doesn't mean much until you've spent a lot of time looking under the hood, unpacking those assumptions, stress testing the inputs. Then the DSCR really can be a useful tool, assuming you want to relate cash flow to debt service - a perfectly reasonable assumption, unless repayment has nothing to do with operating cash flow. (Enter Pay for Success.)
Goodbye cash flow, hello outcomes
Pay for Success (PFS) is a form of contracting with social service providers that shifts the focus from quantity to quality, from outputs to outcomes. Private investors cover the upfront costs of services and are repaid by a sponsoring government or other third party only when desired social outcomes are achieved and certified by an independent evaluator.
So with PFS, how do you incorporate the likelihood of achieving social outcomes in the numerator of a cash flow ratio? And what would the denominator even be? After all, payments are made on a sliding scale based on the actual outcomes achieved, so there is no fixed periodic payment to divide into the numerator.
No cash flow, no required fixed payments. This doesn’t bode well for our beloved Debt Service Coverage Ratio.
But if Pay for Success does away with the two main ingredients of the DSCR, it also introduces a new element: evidence. Most PFS projects rely on existing research that provides the evidence basis for projected social outcomes. And while existing evidence of past success is by no means a guarantee of future performance, the same can be said of cash flow.
A new kind of coverage ratio
Part of underwriting any PFS investment is a thorough review of that existing research and determining a reasonable expectation for project outcomes. This is easier said than done, but using the best evidence available to establish a baseline outcomes expectation opens the door for a new kind of coverage ratio for outcomes-based financings like PFS - the Best Evidence Coverage Ratio, or BECR. (I work in finance, not marketing. PM me if you think of a better name.)
Here's how it works: let's say a PFS project aims to increase the job placement rate for a target population using an innovative workforce development program. Considering the level of scientific rigor and applicability of existing studies as well as the provider’s past experience and track record delivering the intervention, an investor reasonably determines that the PFS project will increase placements by at least 30%. Based on the price per outcome that the contracting government will pay, the investor will get a return of principal and accrued interest if the project achieves a 24% increase in placement outcomes. By dividing 30% by 24%, we get a ratio of 1.25. This is the BECR, which tells us the relationship between what the investor expects to happen and what they need to happen to get fully repaid. It answers the same fundamental question as a DSCR: "what is my cushion for repayment if things don't go as expected?" In this example, the cushion is 0.25, or 25%.
Of course this new coverage ratio is just as fraught with assumptions as the DSCR. The determination of the baseline outcome expectation is subjective. It requires a solid understanding of the existing research, which is at best an approximate indicator of future performance. And there are still other risk factors related to project implementation, politics, and policy (to name a few) that aren't easily quantified.
Even so, the Best Evidence Coverage Ratio gives us a framework to relate the evidence to the investment. It gives us a way to compare one project to another. It pushes us to consider just how well existing research may or may not apply in another context. And as we look back on completed projects, maybe it will even help us develop benchmarks and best practices for future underwriting.