Key Considerations in Negotiating Impact Bonds in India

The Indian 'development impact bond' (DIB) market is at a nascent stage but the instrument is gradually gaining popularity as a pay-for-success instrument. DIBs are an effective solution to implement at-scale quality interventions targeting social outcomes while increasing accountability and enabling the pooling of capital from diverse stakeholders.

Given the complexities of this instrument, only a few DIBs have been successfully launched in India till date. However, despite this, we have seen that the interest in DIBs is growing, with philanthropic capital playing a catalytic role in drawing private mainstream capital to underserved areas in order to maximise social or environmental impact outcomes, in addition to returns.

Based on our experience with various DIB transactions, we discuss some of the key considerations and learnings that could help potential investors and stakeholders navigate DIBs more effectively.

• Funder-first structure or Structure-first/template approach

  In many DIB transactions the first step is to line up the risk investors and outcome funders (which could be anyone from a philanthropic organisation, for-profit investor, government entity, banks or Corporate Social Responsibility (CSR) funders, across different jurisdictions), the implementation agencies and the evaluator, and thereafter create the appropriate legal and tax structure that works for all the parties involved. While a funder-first approach provides flexibility to accommodate varied types of funders, it also means higher cost and effort, increased perception of legal risk with untested structures, complex time-consuming negotiations, and voluminous documentation.

  To mitigate these challenges, we've seen a few DIBs that have adopted a reverse approach by first creating the structure and templates for the DIB and then searching for suitable funders who fit the legal structure/template. A possible downside to the structure first/template approach is that since the structure tends to be simple, it is not flexible enough to accommodate certain types of funders (such as non-profits under the CSR or FCRA route or banks who are subject to additional regulatory restrictions or compliances) who may be excluded from participating in such DIBs. This can be a potential challenge in launching the DIB or in increasing the pool of capital available for the DIB.

  Since the Indian DIB market is not yet mature enough to limit the pool of potential funders, a composite approach could be adopted where market precedents-based templates of some of the key/most-negotiated aspects of a DIB could be created, such as: (a) fund-flow structures (e.g. payment by offshore risk investor to be ideally made directly to the offshore outcome funder), (b) role of the DIB parties, (c) DIB governance structure (e.g. potential board composition and decision-making mechanics), (d) exit and termination events, (e) dispute resolution process, and (f) common DIB policies (e.g. privacy policy, intellectual property rights (IPR) ownership policy and safeguarding policy). Having such templates and mandating DIB parties to make minimal modifications to them could ensure quick closure.

• More funds or lesser parties

  Typically for a DIB to be able to provide at least muted returns to investors, the minimum investment size of the DIB should be such that the transaction costs remain at an acceptable level. Recent DIBs in the market are in the range of INR 100+ crore and are getting bigger to build in better cost efficiencies. However, to hit this size of funding, the type of funders cannot be limited and the DIB needs to be able to accommodate as many types or sources of funding as possible including for-profit funding, CSR, FCRA, bank loans at concessional rate, etc.

  This diversity in funders not only increases legal and tax complexities when designing the DIB structure, but also brings with it the practical challenge of convincing each party of the workability of the structure for them with sufficient protections. Therefore, the right balance between the size of the DIB and the number of parties is important to ensure that with the increasing number of parties, no single party becomes so critical as to impede the launch of the DIB. Additionally, having a single transaction counsel for all parties who would look to align everyone’s interests may also help in such a situation.

• Alignment of commercials and timelines

  Being complex financial instruments where outcome payments are typically recycled through the lifecycle of the project, there are multiple legal and commercial funding deadlines (based on internal funder requirements to fund a certain project within a specified period) that need alignment. The finalisation of fund flows and timing may often require multiple iterations, tweaks and negotiations (if it involves changing agreed commercial positions) to make it legally compliant and commercially feasible and therefore with more parties involved in the DIB, decision-making and building consensus may take time. Typically, bespoke DIBs take an average 1-2 years from design and structuring, onboarding investors, negotiation and documentation, till launch. Parties should therefore be prepared for such timelines and should take internal approvals accordingly to avoid, for instance, the internal funding deadlines set by boards of funders, or legal deadlines to spend CSR funds, from lapsing.

• Alignment of key legal policies

  An interesting dynamic in DIB negotiations is that funders often have their own globally implemented standards for privacy, beneficiary protection, integrity and ethics, confidentiality or trademark use, etc. In the absence of acceptable common standards for such items, negotiations on these issues become quite protracted or one-sided, with funders insisting on negotiating as equals (irrespective of whether they are risk investors or outcome funders).

  With some DIBs already launched, efforts to standardise some of these items should be stepped up, and market precedents created, to make the negotiating process for DIBs easier and more effective. Further, as parties become more sophisticated and experienced in dealing with DIBs, having market precedents and uniform policies or standards that already have internal legal sanctions will lead to better time and cost efficiencies in implementing future transactions. The more experienced players (funders, transaction managers and transaction counsels) in the DIB market could therefore consider getting together to undertake this one-time effort of creating model policies.

As parties become more sophisticated and experienced in dealing with DIBs, having market precedents and uniform policies or standards that already have internal legal sanctions will lead to better time and cost efficiencies in implementing future transactions.

• Technical cost structuring and legal limitations

  From a structuring perspective, an important but often overlooked point is how the technical and administrative costs for a DIB are sourced and paid. For a DIB to go live, it must be designed, structured (from a legal perspective), negotiated, documented and launched, all of which require the support of external consultants. Further, party performance managers are typically engaged by risk investors to manage service providers/implementation agencies and ensure that outcomes are achieved. Additionally, once the outcomes are achieved, external third-party evaluators are engaged to confirm this.

  To undertake some of these support tasks, some work may be necessary before the launch of the DIB. The costs for this may be secured from a single funder or all the funders. While it may seem intuitive to secure these costs from multiple funders, this may create some challenges. Firstly, there could be legal limitations for end-use of funds sourced from certain funders. For example, CSR funders may not be comfortable funding legal costs as it may not be considered a permitted CSR expense under the law. Secondly, the exit of even a single funder could potentially threaten the stability and continuity of the DIB, as such funder may not under law or otherwise, be able to justify continuing to bear these costs to its board, especially if it exited for a cause that was serious from the board’s perspective. In such a scenario, if a portion of the technical cost funding meant to be sourced from an exiting funder cannot be paid, then the DIB could break down, unless other parties agree to share the increased cost, which again may be problematic to achieve since internal approvals would already have been taken for a specific amount for the DIB. When a DIB breaks down, the impact on the beneficiaries (for whose benefit the DIB was launched) would also have to be considered by the DIB governance board set up to monitor the implementation of the DIB. Therefore, it is recommended that a single funder take on an entire cost head or, better yet, such costs be secured from a funder who is not otherwise a risk investor or an outcome funder to the DIB, to ensure the stability and continuity of the DIB.

Recently, we are seeing an increased interest in DIBs with the bond sizes getting progressively bigger. On most counts, the legal regime has become more supportive, particularly CSR and tax laws. More parties are keen to explore blended financing models (like impact bonds) that mix for-profit and philanthropic capital to achieve impact-oriented goals. Considering some of the key issues upfront can help reduce the time and effort of parties in successfully launching impact bonds in the market.

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