The below is an essay of mine from 2010 when I was at business school, incurring high student debt, and wondering if there is a better way to finance education.


 

“We must dare to think ‘unthinkable’ thoughts. We must learn to explore all the options and possibilities that confront us in a complex and rapidly changing world. We must dare to think about ‘unthinkable things’ because when things become unthinkable, thinking stops and action becomes mindless.”

James William Fulbright

 

Meet Yuchi. 17-years old high school student, originally from northern China, the only son of middle-class parents. Likes sports, music, and going out with his friends. Yuchi is not an average teenager though. He is the winner of the national mathematics competition, one of the most competitive contests in the world, with hundreds of thousands participants selected in multiple rounds from all over China. He graduates from his high school next year and is determined to go to a top university abroad, as the first one in his family. Yuchi dreams about becoming a world-class scientist, developing solutions for some of the world’s most pressing problems.

The financing is a problem though. Yuchi’s family cannot afford the high costs of tuition, books, and living expenses of studying abroad. Scholarships are unlikely to cover all the costs. Bank loan is not an option either. Yuchi’s parents do not have adequate income or assets to secure the loan, and the cost would be prohibitively high. Even if they could obtain a loan, they would be reluctant to incur debt several times larger than their life-long savings. Yuchi is not confident about his ability to repay the loan either. As a scientist, his earning power is highly uncertain – it can range from very low levels working at a public university to several hundred thousands of dollars working in an R&D lab of a large corporation. Yuchi’s dream may thus remain only a dream.

Imagine there is a solution – a solution that would enable Yuchi to fulfill his dream and fully develop his talents. Imagine that someone will be willing to finance Yuchi’s education at a top scientific institution in the world, without requiring Yuchi or his parents to incur high debts. The solution is a new asset class – Human Capital. Instead of taking on loan, Yuchi agrees to pay a fixed percentage of his income for a given number of years after graduation, in exchange for receiving funds to finance his education today.

In the world of finance, there are two basic asset classes – debt and equity. Investors in debt instruments (also known as bonds or fixed income) receive an agreed rate of interest plus a return of their original investment (assuming there is no default). Investors in equity incur higher risk, in exchange for potentially higher return. Their return is not guaranteed and they see any money only after the debt investors are satisfied. On the other hand, if things go well, they receive all the residual profit and can become rich.

In the world of education financing, debt is the standard option. Students take bank loans, which they need to repay (including interest) after their graduation. The rate of repayment is largely fixed (exposed only to interest rate fluctuations), and does not depend on the level of income. The main drawback for the student (borrower) is the risk of not being able to service the payments, in case of low-income jobs or long periods of unemployment.

Human Capital is the equity-equivalent instrument in education financing. Instead of taking a bank loan, students enter contracts with investors whereby the investors finance the costs of the education, in exchange for a percentage of the students’ income. For example, an investor promises to pay all the costs of Yuchi’s education at a top university in the US, while Yuchi promises to pay the investor 10% of his salary for 15 years of employment after graduation (excluding periods of further education or unemployment). The percentage and duration of payments would be calculated based on the size of funds invested, choice of university, country of residence, or selected major, and take into account expected rates of default (similarly to loan assessment in banks or setting premiums by insurance companies). If Yuchi becomes a professor at a public university with a small salary, he may end up paying less than the total cost of his education. If, however, Yuchi becomes a top scientist acquiring multiple successful patents, he will pay much more than he originally received. The investor thus faces a risk of not being paid in full, in exchange for the potential of becoming rich. The investor thus effectively invested in Yuchi’s human equity.

An additional feature of “Human Capital Option” could be introduced. Yuchi could purchase an option at the time he receives the funds, which will enable him to “buy out” the investment and terminate the contract prematurely at a later stage. Thus, if 5 years after graduation Yuchi is a successful scientist earning high salary, he can pay a lump sum to the investor and thus terminate the contract, instead of paying a percentage of his (high) salary going forward. If, on the other hand, Yuchi receives a small salary, it is more beneficial for him to continue paying a percentage of his (low) income. Thus, Yuchi gained a protection against significantly overpaying for his loan, in case things turn out very favorably in his career.

Human Capital has a potential to become a new global alternative asset class. Instead of one-on-one relationships between students and investors, pooled investment vehicles will be set up. Similarly to private equity funds, Human Capital funds will raise funds from qualified investors (limited partners) for the investment into Human Capital. They will select the students, finance their education, and then collect the payments (which will be paid out to investors as dividends). These funds will be long-term in nature (min. 15-20 years), and thus will attract long-term investors – pension funds, insurance companies, or endowments.

The evolution of the private equity industry gives us an idea what the evolution of Human Capital funds and overall industry could look like. Specialized funds will invest in students from a particular country, course of study, or university, offering targeted exposure and risk-return profile to investors. Given the long-term investment commitment, it is likely that secondary trading would develop, thus enabling investors to trade their investments before the fund’s maturity. Funds of funds may emerge to provide superior fund-selection service and greater diversity. Eventually, Human Capital funds may go public and acquire permanent capital through listing on a stock exchange (as the leading private equity players, Blackstone or KKR, did in the last few years).

Besides Human Capital funds, it is possible to imagine other solutions for the operation of the scheme. Banks or universities could serve as the providers of capital and be responsible for the selection of students. The investments could be subsequently pooled and securitized (similarly to debt and mortgage securities) and sold off to other investors to enable higher liquidity and better risk management. In some countries, state governments could finance the education of their citizens and collect payments through mandatory deductions from people’s incomes (similarly to social, health, or tax deductions).

There are three major benefits of the Human Capital investing, one for each of the main stakeholders. First, talented students worldwide will get access to quality education, and thus will be able to fulfill their dreams and ambitions. Second, investors will be able to earn attractive returns by investing in a good cause, and thus “do well by doing good.” In addition, given the limited correlations with other asset classes, Human Capital has a significant diversification potential, which is highly valued by investors when constructing their portfolios. Third, the society will benefit by harnessing unprecedented amounts of high quality talent, which would not be otherwise developed to its full potential. This will lead to rising GDPs, improving standard of living, and potentially finding cures to many of the society’s pressing problems.

The idea behind Human Capital investing is not new. It was mentioned for the first time by Milton Friedman in 1945. Since then, several academicians played with the idea, most notably Miguel Palacios Lleras in his book “Investing in Human Capital” in 2004. Yale University experimented with the idea in early 1970s, when it offered income-contingent loans to its students. One of the earliest commercial attempts to leverage the idea on a limited scale was MyRichUncle, a service mark of MRU Holdings, which went bankrupt during credit crisis in 2009. Two of the companies which are pursuing the idea today are Lumni (http://lumni.net) and Enzi (http://www.enzi.org).

There are several obstacles, which hinder the development of Human Capital investing. First, some people see investing in human equity as a form of a “modern slavery.” This could be a valid concern, but only in the case when investors could force or influence their students to pursue certain (higher-income) careers, thus depriving students of their free choice. Second, the enforceability of contracts, collection of payments, and taking corrective actions in case of default could be a challenge in many jurisdictions. This is of special concern in case of highly-mobile students, who will move from one country to another during their careers, and thus will be more difficult to track.  Third, students may be incentivized to hide their true incomes, similarly to different tax-optimization schemes today. The accuracy of one’s income statements may be particularly problematic in emerging markets, from which a large proportion of students will come from.

Human Capital investing has a significant potential to change the approach to education financing globally. Coordination of governments (legal, regulatory, and tax policies), universities, students, investors, and society at large is essential to overcome the current obstacles and launch the effort on a global scale. There are millions of students like Yuchi in China, India, Russia, Latin America, Africa and the rest of the world waiting to fulfill their ambitions and unleash their full potential. The entire society will benefit by their cumulative talent, knowledge, and energy. As Benjamin Franking concluded more than two centuries ago, “Investment in Knowledge Always Pays the Best Interest.” It is time to start earning the interest now.

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