Say No To Venture Human Capital

a | A

By Josh Barro

The blogger Evan Soltas has a couple of posts making the case for equity finance of higher education. Basically, instead of taking on debt, students would agree to pay a percentage of their lifetime income to the schools that educate them. You can think of this as venture-capital investments in humans. The goal is to avoid saddling students with debts that are outsized relative to their earnings, and to make it easiest to obtain capital for the most useful college degrees.

Unfortunately, this proposal is fatally plagued with adverse selection problems. Students know more about their post-college plans than people who might invest in them do, and the ones who plan to earn the least money will be the most inclined to take the equity financing deal.

Soltas discusses this as just another example of the "duds and studs" problem: Some students will make more money than others after graduation, and the venture investors might have some difficulty identifying which are which. If venture capital works despite this problem, so could equity finance of education.

The difference is that, in the venture capital space, both the startup founders and the venture investors have the same goal: to make as much money as possible. The VCs only have to figure out whether the firms they invest in have high earnings potential. But students have the added ability to mislead investors about their earnings desire.

This is an especially big problem at the top of the market. Some students come out of Harvard and Yale and try to make a lot of money. Most will be successful and a few will be wildly successful. These students should be able to bargain for equity investment terms that demand only a small share of their future income as repayment.

Such deals would look extremely appealing to students who have the same earning potential -- and likely look the same on paper -- but know they won't try to make a lot of money. Those students would be the ones who will be most inclined to take the equity finance deal, and venture investors would lose a ton of money on them. To guard against that, investors would have to demand a higher share of earnings.

The result, much like in badly regulated health-insurance markets, would be an adverse selection death spiral: Only students who plan to earn less money would opt for equity financing, which would require the investors to demand an even higher percentage of future incomes, which would lead more students to opt out of equity financing, and so on.

As a result, we're going to have to stick with a regime where students own 100 percent of the equity in themselves. Matt Yglesias of Slate notes that the impulse for equity finance of college arises from the fact that college has gotten too expensive; that, not the capital structure behind college educations, is what we need to fix.

(Josh Barro is lead writer for the Ticker. Follow him on Twitter.)

Read more breaking commentary from Josh Barro and other Bloomberg View columnists and editors at the Ticker.


-0- Jul/17/2012 19:25 GMT