By Izzy Boggild-Jones and Emily Gustafsson-Wright from the Brookings Institution. Originally published on the Brookings Institution website.

Last week, in the margins of U.N. General Assembly, we, in partnership with Convergence, launched a report on the early lessons from impact bonds in developing countries. As of August 1, 2017, there were nearly 90 impact bonds contracted in high-income countries (many of which were followed in our 2015 landscape report), but the tool is still relatively new in the developing country context with four contracted to date. Evidence so far suggests that they have the potential to shift funding from remedial to preventive services and from service delivery inputs to outputs and outcomes which could improve both the efficiency and effectiveness of financing in low- and middle-income countries. In the report, we take stock of the current state of impact bonds in developing countries—who’s engaging in them, where they’re being used, the challenges and obstacles they face, and what needs to happen to drive this new paradigm in development finance.

How does an impact bond work? In an impact bond, private investors provide upfront capital to service providers to deliver an intervention or program to a population in need. Upon the achievement of a set of agreed-upon results, the investors are then repaid by an outcome funder; in a social impact bond (SIB), this outcome funder is the government, while in a development impact bond (DIB), outcomes are financed by a third-party organization, such as a foundation or donor.

Impact bonds in developing countries: What do we know?
The report includes a Deal Book with individual factsheets on each of the impact bonds in developing countries, both contracted and in design. Only three DIBs have currently been contracted: the Educate Girls DIB in India, the Cocoa and Coffee DIB in Peru, and the ICRC Programme for Humanitarian Investment, in Mali, Nigeria, and the Democratic Republic of Congo. Only one SIB has been launched in a middle-income country, the Colombia Workforce SIB, which was contracted in March 2017.

We track 24 impact bonds that are either in early or late stage design in low and middle-income countries. The two countries with most impact bonds in design are South Africa (four) and Uganda (three). Across the impact bonds both contracted and in design, health is the most predominant sector, with 11 impact bonds, followed by employment, with six. This contrasts with high-income countries, where the two most dominant sectors are employment and social welfare – reflecting both the different needs in the two contexts, as well as the priorities of outcome funders.

Many of the impact bonds in the Deal Book are still in design phase, which means that the information is subject to change, and many of the key components still need to be finalized. However, for the deals with available data, government—both domestic and foreign—has emerged as the main outcome funder. For investors, foundations and philanthropists are the key players, followed by multilateral, bilateral and intergovernmental financial institutions.

What needs to happen to drive this new paradigm in development finance? The report provides key takeaways drawn from analysis of the data, workshop discussions with key stakeholders, and in-depth interviews with participants in the few contracted impact bonds. In order to take impact bonds or related components of payment by results forward in developing countries forward, and to ensure the sustainability of this paradigm shift, we recommend the following:

1. Expand the evidence base: Accurate and timely data needs to be collected on the success of interventions and on the achievement records of service providers so investors and outcome funders can reliably select organizations with the capacity to deliver results.

2. Build capacity of service providers: Many potential service providers will need support to become the kinds of organizations who can use data to monitor their own performance and adjust their programs in response to feedback.

3. Educate potential outcome funders and investors: Impact bonds are a new way of doing business, and even for organizations with experience of results-based financing or impact investing, time and energy will need to be spent learning about the process, and adapting to the requirements of the new financing mechanisms.

4. Support legislation: Contracting an impact bond can be constrained by legal issues—which will likely vary by between (and even within) different countries as well as donor organizations. Supporting efforts to modify or introduce laws or regulations that allow this type of outcomes-based contracting will be an important step for facilitating future impact bonds.

5. Establish outcome funds: Poor human development outcomes persist despite the current levels of donor spending and domestic resource mobilization, and the effectiveness of donor spending is not always guaranteed. Tying resources to outcomes is one way of ensuring that this money is well spent. Outcome funds provide a way in which donors can pool resources, and direct the funds to the most urgent goals.

6. Create global investment funds: Private capital can help bridge the funding gap that currently exists in the financing of the sustainable development goals (SDGs). While investment in impact bonds is currently fragmented, creating global investment funds could help to unite impact investors to increase the scale of financing, at the same time as reducing the high transaction costs currently associated with designing each impact bond contract.

The social and environmental problems that we face today on a global level are overwhelming. It is estimated that $1.4 trillion will be needed annually to achieve the Global Goals. To get anywhere near that sum, there will need to be a radical paradigm shift in development finance. While impact bonds by no means offer a solution to every development challenge or even a fraction of them, they do represent a shift in thinking within the broader system. By investing in preventive measures that avoid higher costs down the road, development finance could be much more efficient. By paying for outputs and outcomes rather than inputs, supporting monitoring and evaluation, and allowing for adaptive learning, development finance could be more effective.

Download the full report.