By Morgan Anthony

Outside of the stock of mortgage debt, one type of debt stands out above all else in the US. Student loan debt. Student loan debt has swelled in the last ten years, from $850 billion in 2011 to $1.57 trillion in the second quarter of 2021, its growth outstripping every other type of non-mortgage debt.

The premium on university education is continuing to rise beyond the 73% of extra earnings a university graduate can expect to earn compared to a high school graduate. On top of this, the number of people taking the plunge and getting an undergraduate (and postgraduate) degree is rising sharply, with US college enrolment rising from 17.49 million students in 2005 to 19.64 million in 2019. Whether it is due to the greater technical ability required for many jobs in the economy or the signalling effect of a university degree (differentiating skilled workers from one another), university seems more attractive than ever. This rise in demand for limited university places, coupled with a rise in the wages of top academics as universities compete to bring in the best staff, has only lead to prices rising and student debts increasing.

The current student loan situation is obviously not working for many people. Although on aggregate a university degree has a return on investment of 15% compared to 7% for stocks, every year 1 million people default on their student loans. Moreover, more than 25% of US graduates have over $100,000 in debt. There is also great deal of disparity amongst graduate experiences with student loan debt, with a range of factors such as degree choice, university and age impacting how easily someone will be able to repay their student debt.

Many solutions, ranging from student loan subsidisation and complete forgiveness to graduate taxes have been proposed to quell the rise in student loans and make financing university less burdensome for graduates, but very few have successfully reined in the problem.

One potential solution to the problem, frequently supported by economists over many decades, is equity finance. But what is this form of financing tuition and why hasn’t it become a predominant way of funding university despite the academic support it has received?

In 1955, Milton Friedman wrote ‘[Human capital] investment necessarily involves much risk. The device adopted to meet the corresponding problem for other risky investments is equity investment’. Equity financing for university tuition would work by companies and investors purchasing a stake in the future earnings of a student in exchange for paying a certain proportion of the students’ tuition. The investor agrees to pay a certain sum of money to the student to cover their tuition in return for receiving an agreed proportion of the students’ future earnings once they graduate.

This system would mitigate risk that graduates carry. Most students face risks to their earnings and employment early on in their careers. Student loans with either fixed payment schedules or which kick in at high rates soon after graduation lead to financial difficulty; lower home ownership, worse credit ratings and potentially defaults on loans. However, equity financing of student tuition should lead to the investors taking on a greater degree of the risk as their returns are also based on the income of the graduates. This system should lead to fewer defaults and graduates will maintain better financial health after they graduate.

A few US universities such as Yale and Purdue have offered equity financing for their students through a program called ‘income-share agreements’ to a small target population only, while most private sector schemes either have very low enrolment or have gone bankrupt. Why hasn’t this system taken off?

The key reason why equity financing hasn’t yet taken off is due to adverse selection between students and buyer (those buying some of the equity). Adverse selection, like the market for lemons, is a type of information asymmetry where a buyer has less information about the good or service they are buying than the seller. This leads to a buyer offering up lower prices to counteract for their inability to determine which goods are of better quality than others. However, as the sellers know about their products and can better evaluate its quality, those with the higher quality goods will leave the market as the terms offered by the buyer won’t be good enough. This process keeps on happening, unravelling the market by leading to most sellers withdrawing their products from sale as they won’t receive an acceptable price for their good or service, leaving only those with low quality products (which the buyer would overpay for) in the market.

If we now consider the mechanism for how an equity contract is agreed upon, we can realise how it becomes vulnerable to adverse selection and why no students are accepting a contract. An investor would approach a student with a contract with two parts, the amount they will pay the student now and the proportion of the student’s income they would expect to receive in the future. The investor would base this contract offer on their expectations of the students’ future earnings to cover their initial investment and make a return. On the other hand, a student would accept or reject the contract based on their income they receive to cover their tuition today against their expected future payments to the equity holder. In both cases, the expectations of future earnings for the student influence whether a contract is worthwhile or not and if there is any asymmetry in this evaluation then the market for equity financing becomes vulnerable to adverse selection.

A paper by Nathaniel Hendren and Daniel Herbst looked at this question of varying expectations and knowledge of future earnings potentials of students. By using panel data of 20,000 students from the Beginning Postsecondary Students study of 2012, they compared students’ expectations of future earnings, employment and future occupation with their actual earnings, employment and occupations five years later alongside a range of their observable characteristics such as age, gender, degree and university. This range of public information gives an estimation of what an investor could base the future expected earnings of a student on. Their research found that although, students were imperfect predictors of their future earnings, occupation and employment, they do a lot better at predicting this than any predictions based on the observable public information an investor could use.

This here is the information asymmetry which leads to adverse selection in this market. Only students who have lower expectations of their future earnings and employment would accept the equity contracts which offer a lot of funding upfront. This leads to investors not making returns and potentially going bankrupt, like My Rich Uncle in 2009. Due to equity financing currently not being profitable, Herbst and Hendren argue that the government should subsidise equity contracts, so it is profitable to bring more students onto equity financing schemes.

Like most solutions to funding student tuition, equity financing has a fundamental flaw. In this case, the information asymmetries between students and an investors’ knowledge of the students’ future earnings. Although, this problem suggests that equity financing is destined for the rubbish heap with many other ideas, if equity financing were to become more common it would help stop graduates getting into financial trouble. If governments decide to subsidise equity financing, then maybe we can move one step closer to making university more affordable for students in the US.

The views expressed in this article are the author’s own, and may not reflect the opinions of the St Andrews Economist.