Equity Financing of Higher Education

Luigi Zingales had an op-ed in the NY Times a few days back proposing equity financing of higher education combined with IRS collection of educational debt. Sound familiar? It should to Credit Slips readers.  I suggested the very same thing right here on this blog back in April. 

In thinking about it further, it strikes me that there are a few fundamental problems and concerns with an equity financing system.  

First, no one, absolutely no one knows how to price equity financing of education on either side of the market.  The financiers don't know what cut of future income they should be demanding and the students don't know what cut of future income they should agree to pay.  Over time the market would figure this out, but it won't happen immediately--in fact, it would take, well, if not a lifetime, then at least the term of an equity financing contract round or two for everyone to figure it out. In the meantime, someone (financiers or students) is likely going to be stuck with a bum deal, and that could sour the market pretty fast. I don't see a great way of cutting through this thicket, as trying equity financing on a small scale raises enormous adverse selection problems. I think it's either got to be an all or nothing so there isn't adverse selection. 

Relatedly, the difficulty in pricing (and the delayed cash flows) means that equity financing would almost certainly have to come from private risk capital, rather than from schools themselves. A school like mine, which is a cash flow operation with a very small endowment, cannot risk any cashflow disruption. Nor does it want to assume the risk of underpricing equity financing. Schools could securitize their equity financing interests, which enable up front cashflows to schools, but what's the market for this product?  I guess it is essentially a call option on the US economy or on US higher education graduates or graduates of particular institutions.  How bullish are you feeling on the teenager down the block? 

Second, equity financing could be just as distortional to education as debt financing. Government guaranteed debt financing means that there is no market discipline in education financing. The Harvard MBA pays the same rate as the community college associate's degree poetry major for an uncollateralized loan, even though their future ability to repay is likely to be quite different. Removing government support from the market--either moving to entirely private student loans or private equity financing would reverse the effect. But I shudder to think of the effects on our higher education system. "Impractical" departments would disappear.  (A wag might say this is exactly the aspiration of the UVA Board of Visitors and already in place at USC.)  

Consider what that means in the long-term.  20-30 years ago, areas that are now hot were "impractical" (say Chinese or Turkish, instead of German).  These departments don't just spring up over a summer. They are long-term investments. For languages and area-studies, Defense Department funding can help a bit, but it's not a substitute, just a complement for a commitment from a university. 

Now equity financing might help reduce some distortional choices---perhaps I'll be a poet or a historian instead of going to law school if I don't have a large student debt burden.  But I may not have that option, as equity financing could be made contingent upon a particular course of study, at least or even upon working in a certain profession for a period of time.  We could have a bifurcated system of equity financing for some types of education and debt financing for others, and that might make some sense, but there's a deeper issue to resolve here, which is what we are hoping to accomplish via higher education, and that issue cannot be separated from the financing debate, as education financing should be the means to an end, not the end itself. 

Third, I would not underestimate the entrenched educational bureaucracy and education finance industry that likes the system as is. Shifting to equity financing means a seachange in alumni relations. I would predict that schools that do equity financing would see a major drop off in alumni giving.  The alumni-school relationship is complex and affects school governance (Boards of Trustees and the like) and is a substantial employment component in schools.  I don't know what all the frictions would be here, but I would anticipate some.  

All of this is to say, if we were starting ab initio, equity financing has a lot to commend it. But to shift from debt to equity financing raises a bunch of issues that are not easily resolved.  

Comments

[Simon Thornington]

There would also be some disturbing incentives for your shareholders to steer you towards high-profit and even positive-skew careers. Equity-financed engineer quits corporate life to build wells in Asia? No sir, you've got to join YYY-Combinator and create a startup -- we won't help with seed or angel financing, but we demand preferential terms on the first round.

[C Hokanson]

I like this idea from a theoretical standpoint.

I especially like something of a corollary to it, which is the system employed by the military and some employers where the consideration for the tuition is years of service (rather than a percentage of future income). But, practically speaking, I think a true equity financing scheme would be worse for students than the debt scheme currently in place.

When I was an incoming freshman to a top private school, I had no realistic understanding of my future earnings. In fact, I had very unrealistic views of my future wealth (as I think do many students). I would have gladly given away a too large percentage of my perceived future income -- its all pie in sky projections, not real money anyway - in exchange for tuition since I had few resources. Essentially, that is the same thought process that leads to mountains of debt.

Perhaps that is just a "pricing" issue. But it seems to me that equity financing hits those students in lower socio-economic classes the hardest as (judging by my own experiences only).

[Peter]

Isn't alumni giving at the super-selectives equity financing in all but name ony?

I give to my Ivy alma mater so that it has the resources to seed the next generation of leaders, with full knowledge that I may see nothing in return: if that's not "equity," what is?

[ds]

My two-word critique is Modilgliani-Miller.

[Adam Levitin]

Um, Modigliani-Miller holds true only in very particular circumstances, which do not exist here, and it is only a proposition about cost of financing, not management decisions about course of study or career.

[Greg Taylor]

Equity financing for specialized programs that lead to state licensure might make some sense and minimize the problems with alumni relations noted in the post. Trade a state-enforced protection on the right to practice medicine for a piece of the earnings. Getting the details right would be difficult but caps on the total cost might keep students from getting ripped off too badly. I'd agree that transitioning to equity financing isn't realistic for typical undergraduate liberal arts education.

I've posted some additional thoughts at http://spiriteddreams.com/2012/04/23/would-new-financing-models-produce-useful-higher-education-reforms/

[Curtis]

The Mormons know how to do this. The military used to have the same approach. 4 years of college = 4 years of public service. That seems too simple. It might be difficult to figure out what constitutes public service. A lot of bad jokes could follow this....Ha!