Combine a crisis in college affordability with yield-starved investors and you get one of the more unusual financial products of the past decade: shares in students.
Income share agreements are an alternative to student loans that are gaining ground in the US. From only a handful several years ago, this academic year almost 50 American universities and technical academies offer them. Next year, about 100 will.
A student funding their education with an ISA gets money upfront in exchange for offering a share of their income after graduation — ranging from nothing if they are unemployed or on a low salary to potentially several multiples of what they received. Graduates continue paying a slice of their income until the ISA expires, usually after about a decade, or when they hit a repayment cap. Risk, in short, is shifted from borrower to lender.
“They might go backpacking for eight years and not pay you a dime, they’d be well within their rights,” said Charles Trafton, president of Edly, a recently-launched marketplace in New York that connects investors with ISA programmes.
ISAs are not a new idea — Yale briefly offered one in the 1970s — but today a group of universities, investors, and start-ups claim they have managed to make ISAs work. If they are right, ISAs could be part of the answer to the mounting US student debt burden, sitting at more than $1.5tn, that has become a central issue for those competing for the Democratic presidential nomination.
ISAs are also attracting rare bipartisan interest in Washington. A bill being considered in Congress to give ISAs a regulatory framework has been co-sponsored by the Republican senator Marco Rubio and Christopher Coons, a Democrat. Nonetheless, proponents of widespread debt forgiveness such as Elizabeth Warren and Bernie Sanders are wary.
Yet for now ISAs remain a niche product with much to prove; they compete in the $10bn-a-year private debt marketplace, rather than with $100bn-a-year government-subsidised loans. Borrowing from a bank or the government is still the dominant way to fund higher education in the US.
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The most common way to administer an ISA is through a university or technical school, which will usually determine eligibility and co-invest alongside external investors. Some companies, though, offer direct-to-consumer ISAs, where students apply for the money directly.
Paul Laurora, a recent graduate of Purdue University in Indiana, said university involvement in ISAs gave them credibility in the eyes of students.
“Purdue is not going to be involved with an Enron Corporation that will screw you over,” he said.
He took out an ISA for $33,000 to cover his tuition fees after exhausting federally-subsidised loans.
A university-administered ISA also appears to align the incentives of universities and students. The better that universities prepare students for the workforce, the greater the returns they will reap from their ISA programmes. ISAs have become particularly popular at institutions that offer crash courses in professionally-oriented skills such as coding or welding.
Mr Trafton is eager to stress the benefits for investors: “They’re totally unique assets, high quality, uncorrelated with anything else [prospective buyers] are investing with.”
As major government bond markets offer negligible returns, the ground is certainly fertile for products that promise much more. ISAs for undergraduate degrees offer investors yields in the high single digits, said Mr Trafton, while those for technical schools offer yields in the low double digits.
Line chart of Outstanding student loans per college graduate ($000) showing High costs of funding a US degree
The tiny size of the market is a key impediment for major institutional investors. So far, only a handful of smaller investors have taken the plunge.
Peter DeCaprio, president of Crow Point Partners, a $1bn Massachusetts asset management company, is one. He invests in a blend of university and coding school ISAs.
“You have to take small bites. You can’t put $20m-$40m to work in a month,” he said. “We’re lucky that we’re small and can take smaller bite sizes, that’s been helpful.”
Michael Prober, a family office investor, is also a buyer. “I felt that you could get equity mezzanine type rates of return for credit risk,” he said, adding: “There’s a window in this asset class, maybe it’s a year, maybe it’s three years, where you can make nice rate of return before capital markets swallow it.”
Mr DeCaprio concurs: “Selfishly, I hope people take their time. We have the asset class to ourselves.”
Anyone entering the market faces major risks. There is no case law on ISA defaults, nor bespoke regulation — although legislation currently in Congress may change that. Many institutions issuing them are only a few years old.
“Some of the breathless coverage of investor interest, it doesn’t materialise, and it makes you look foolish as a breathless coverer. It can’t happen that quickly if you do it responsibly,” said Tonio DeSorrento, chief executive of Vemo Education, which administers Utah and Purdue’s ISAs.
Marketing ISAs directly to students, without university involvement, is a more scalable but also more challenging model. “How do I even underwrite 3,000 students from 3,000 different schools from 3,000 different majors? It’s a credit card portfolio of twenty-somethings,” Mr Trafton of Edly said.
A trio of German entrepreneurs — Mike Mahlkow, Constantin Schreiber, and David Nordhausen — claim to have managed to. ISAs are more prevalent in Germany, and they hope to export their expertise to the US.
Their company, Blair, finances 25 students and is planning to fund several hundred over the next year. Mr Mahlkow said direct-to-consumer ISAs can succeed by stressing non-monetary benefits, rather than competing solely on cost.
“What many people forget is that humans are not hyper-rational. Students are often uncertain about their future, but also don’t want to worry about their future. With an ISA you get the peace of mind that you can afford it in the future,” he said.
Mitchel Kenney, a student at the University of Utah, agrees. “There’s an opportunity for me to go and live in Italy for nine months next year. The pay won’t be as great as the US, but I can take a closer look since a federal loan isn’t going to come knocking,” he said.
Mr Kenney is funding his final year of study through the university’s pilot ISA programme.
Blair’s ISAs are funded by foundations and wealthy individuals, but Mr Mahlkow hopes to transition to institutional investors.
However, many remain doubtful that ISAs are viable at all at a large scale. David Klein, chief executive of online lender CommonBond, once planned to offer ISAs, but faced pushback from students and investors.
“We discovered that people viewed [ISAs] as indentured servitude,” he said. “Investors believed that if you chose an ISA over debt, it meant your confidence in your future ability to earn was low.”
He suggested less radical shifts to accomplish similar goals: mandating that universities cover some student defaults; making employer student debt contributions tax-free; and increasing transparency on graduate incomes.
In a sign of the financial challenges in American higher education, ISAs are by no means the most unconventional product available to universities.
Pending final regulatory approval, Illinois universities will soon be able to purchase, for several thousand dollars per student, “American Dream Insurance”: a five-year student income guarantee.
If a student fails to earn above an income threshold — determined by the university they attend and the field they study — then Education Insurance Corporation, the start-up selling the insurance, will pay them the difference five years after they graduate.
Chief executive Wade Eyerly stressed the urgency of reducing the risks of paying for university.
“Higher education is the only place you would counsel someone you love to borrow 10 to 20 times their net worth and make a single investment [a university degree] with it and hope it works,” he said
