Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Goldman Sachs, hedge fund billionaire back $27M social impact bond

Goldman Sachs, hedge fund billionaire John Arnold and other philanthropic partners funded the largest ever social impact bond Wednesday, a $27 million effort to prevent young men in Massachusetts from going back to jail or prison.

Thinkstock Images | Stockbyte | Getty Images

Social impact bonds are a hot new form of philanthropy where private donors provide money to fund social impact programs. If the tangible goals of the program are accomplished—in this case, more people stay out of jail or prison—then government funding pays back the donors with a modest profit. The government also wins, in theory, by saving money from the related reductions in the social services it must provide.

The Massachusetts Juvenile Justice Pay for Success Initiative was announced by the state's governor, Deval Patrick, as a "smart financial solution" to a difficult problem. Nonprofit group Roca will work with 929 young men between the ages of 17 and 23 in the state over seven years by providing personal outreach, life skills and employment training to help reduce recidivism.

Third Sector Capital Partners, a nonprofit advisory firm, collected $18 million for the project. That includes loans of $9 million from the Goldman Sachs Social Impact Fund; $1.5 million from The Kresge Foundation; and $1.5 million from Living Cities. Another $6 million in grants comes from the Laura and John Arnold Foundation ($3.7 million), New Profit ($2 million) and The Boston Foundation ($300,000).

(Read more: Here's a switch: Big hedge funders going nonprofit)

Success will be measured starting in five years by looking at reductions in the number of days men in the Roca program spend in jail or prison and improvements in employment, according to the announcement.

Goldman is essentially the senior lender for the bond and will be paid back the $9 million plus 5 percent annual interest if the project achieves its targeted impact of a 40 percent reduction in incarceration. "Junior" lenders Kresge and Living Cities will be paid their base plus 2 percent.

At higher levels of success—more than a 40 percent reduction in jail or prison time—the funders can receive a small return on their funding for assuming the upfront financial risk, including up to $1 million for Goldman Sachs. Arnold and other grant-makers plan to recycle any payback they receive into the program and Roca. Massachusetts has a total of $27 million reserved for potential payouts.

The rise in income disparity
The rise in income disparity

Josh McGee, vice president of public accountability at the Laura and John Arnold Foundation, believes social impact bonds could be used nationally.

"We are very interested in using this innovative financing tool to help focus service delivery on prevention outcomes and measured impact," McGee said. "We think it can be scaled across the country."

(Read more: Battle of the billionaires erupts over Keystone)

The Massachusetts program, the largest by dollar amount ever in the U.S., is Goldman's third social impact bond investment.

Goldman's first effort was in August 2012, when the bank committed $9.6 million in a partnership with Michael Bloomberg to a New York City jail program.

The second came in June 2013, when Goldman partnered with the United Way of Salt Lake and J.B. Pritzker to commit up to $7 million to finance preschool in Utah.

"We are pleased to work with Governor Patrick, Roca and all of our partners to help high-risk youth in Massachusetts secure access to life skills training and employment opportunities," said E. Gerald Corrigan, managing director and chairman of Goldman Sachs Bank USA, in a statement.

"We are proud to be an investor in projects such as this that rely on public sector-private sector cooperation to better achieve social and economic public policy goals."

(Read more: Why Jamie Dimon and Bill Gates have teamed up)

Social impact bonds—sometimes called "pay for success initiatives"—were started in 2010 for a prison program in the U.K. The idea has since caught on in the U.S., with Goldman Sachs and others funding a small number of projects.

"Social impact bonds offer an innovative way for public, private, philanthropic and nonprofit actors to come together and align their skills and resources in pursuit of measurable, positive social change," said Kristina Costa, an expert on the topic at the Center for American Progress, a think tank.

"Like all tools, social impact bonds have limitations—but I think they have real potential to help move the needle on some of our country's toughest social problems, from recidivism to chronic health conditions."

—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.