Startups want to turn student debt into the next asset class. What could go wrong?

One person’s tuition is another’s investment. With US students mired in over $1.3 trillion of student debt, income-share agreements (ISA) are looking like a growth business. These contracts cover students’ tuition in exchange for a cut of their future income.

Today, ISAs make up just a tiny sliver of the more than $200 billion (pdf) in education loans and financial disbursement made each year. But more investors and schools are betting on their students’ future income. Eventually, retail investors could buy into portfolios of such agreements.

Startups and Silicon Valley investors want in on this new asset class. To develop new education models, ones often financed by ISAs, VC firms like University Venture Fund have been backing schools and startups laying the foundation. George Jian, an investor at the firm, says its $350 million fund has made about 75 investments since 2011, including in Vemo Education, which sets up and manages ISA programs for schools, and Credly, which offers credentialing services outside the traditional education system.

Jian sees the future of education being financed, in part, by schools and investors willing to share students’ financial risk by betting on prospects after graduation. The asset class, he believes, can compete well against the $10 billion or so in private student loans disbursed each year, approximately 10% of the total aid in student loans, grants, and aid. Subsidized federal loans (rates start at an attractive 4%) can’t always cover tuition, and private educational loans may be too expensive (13% interest in some cases). ISAs can fill the gap.

“The idea is that instead of taking out high-interest private student loans, you reduce your own risk and hopefully, when all is said and done, have lower-cost financing options as a student,” says Jian. “Over time, as more data comes in and investors become more comfortable, the cost of capital to schools and students will hopefully decrease and become very competitive to other alternatives.”

For now, the market is small. Robert Kelchen, an education researcher at Seton Hall University in New Jersey, estimated last year that just 1,000 students have signed up for ISAs at US colleges. (Far more did so at short-term coding “bootcamps” and vocational programs such as MissionU.)

But that figure is set to expand rapidly as the ISA options expand. At the moment, there are three basic models:

  • Traditional universities offer their own ISA. Purdue’s Back a Boiler fund was one of the pioneers. It has more than 850 contracts with students totaling over $10 million.
  • Vocational schools and boot camps operate entirely on the ISA model. Dozens of coding boot camps have adopted this approach to offer two- to nine-month programs in technical specialties.
  • Firms supporting ISAs sell them directly to students or to schools who want to add them to their mix of financing options.

One of the latter is Blair, a startup from the Y Combinator fund, which pools together students and pays for their tuition or cost of living at up to $50,000. Students will pay that back over about six years as a share of their income, with the total amount never exceeding 2.5 times the initial amount. Blair says investors can expect 10% returns per year based on historical data, while it takes a 2% cut on repayments.

Blair is now raising its second fund for financing ISAs—$250,000 for 25 students—from foundations and wealthy individuals. It ultimately hopes to attract family offices, hedge funds, and private equity.

Blair co-founder Mike Mahlkow says the most attractive feature of ISAs is that they align the students’ incentives with those of the school and financiers, while ensuring debt payments will start only when graduates have the ability to pay. Mahlkow and his fellow co-founders attended German private schools where ISAs are far more common, and collected European data to underwrite the ISA investments in the US market.

To improve returns, Blair works with its students on hiring and placement. It’s targeting more than just high-paid engineering students. Any field where graduates earn a reasonable and predictable income is potentially attractive to investors. “One of the biggest misconceptions is that ISAs are only for high-paying jobs,” says Mahlkow. “It’s not about the amount. It’s more about the variance and volatility of the expected income.”

That might be true, but a 2015 study by the American Institutes for Research found that just 7% (about 272,500) of students entering American universities would be likely to receive an ISA under the current lending criteria (even less for first-time, lower-income students).

Those standards may be changing. The ISA industry is starting to converge on key terms for their contracts. To balance the students’ interests with investors’ desire to earn a return, ISA must limit the downside for students, and the upside for investors. Too much for one side will kill the market or overburden students.

Today, says Jian, a generic set of terms for a graduate expected to earn $50,000 and paying a $10,000 tuition bill might look like the following:

  • Repay 2% of income for up to 10 years after graduation (or as few as two years if the share is higher)
  • A repayment amount is no more than double the original amount
  • A minimum income to trigger repayments is $30,000 to $60,000

But the details matter, says Jeremy Kagan, who runs Columbia University’s Eugene Lang Entrepreneurship Center. “There’s a moral hazard of tapping into students’ income,” says Kagan. ISAs could end up as another form of indentured servitude if the right terms are not enforced. At the moment, regulation is loose and players are charting their own path. “I’d hope there would be some guardrails from a regulatory or business perspective,” says Kagan.

But America’s way of financing higher education is unsustainable, suggests the Brookings Institute. As many as 40% of students who entered college in the early 2000s may default on their loans by 2023, based on historical trends, and a survey this April by financial website GoBanking Rates estimates 42% of Americans don’t believe their college degree justified their debt.

Investors may have a deal for them.





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