Q: How did ISAs come about? What is their history?
Although income share agreements have become more popular in recent years, the idea dates back to the 1950s. Milton Friedman originally proposed the concept of income share agreements in his essay “The Role of Government in Education.” In the essay, he outlines an “equity investment” in which investors can buy a share in an individual’s future earning prospects.
In 1971, Yale University became one of the first colleges to offer ISAs, based on a modified version of Friedman’s idea. However, the “Tuition Postponement Option” proved less than ideal. Reflecting on the program’s end, Yale President Richard Levin says that “it was an experiment that had good intentions but several design flaws.” According to the Yale Daily News “One of that program’s major design flaws was that its participants were set up in groups called ‘cohorts,’ meaning that all members would keep paying until the entire group’s debt was paid off. As inflation mounted, tax laws changed, and some participants defaulted, the cohort’s debt burden persisted.” The latest iteration of ISAs eliminate many of the problematic features of such programs, and provide more protection for students. See the article on “What is an income share agreement,” to learn more about these features.
The Purdue University Back a Boiler Program, is a recent and by some measures the most successful iteration of an ISA program providing students close to $10 Million of funding for over 700 students as of this writing.
Q: What type of schools are choosing ISA programs?
Recently, many coding schools, also known as boot camps, that have established ISA programs. The initial attempts in this space were based on using balance sheet dollars to fund ISAs. Although some schools are doing this, it can get prohibitively expensive in the medium to long-term, particularly when schools have fixed costs of shorter duration.
Now, we are seeing some accredited schools following the example of Purdue University and starting ISA programs with donor or private investor dollars. In some cases, these are structured deals, designed to reduce risk and increase returns for investors, by having the school take a lower layer or lower advance rate.
We anticipate that more schools and boot camps will seriously consider ISA programs, either on their own balance sheet or from third party providers like MentorWorks. To stay competitive, an educational institution has fixed investment needs, and having a capital source that appeals to incoming students as a flexible financing option can make a significant difference in enrollment and retention.
In our partnership with at least one boot camp, we have seen increases in enrollment by students who would not otherwise be able to take such a program. Many students are averse to loans, worrying that they will end up with obligations they cannot afford. Others find that federal student loans are unavailable for certain certificate programs like coding schools, many of which have strong employment outcomes. So it makes economic sense for schools to invite outside capital in ISA programs.
Q: What type of schools are raising ISA capital? What types of schools are ISA investors investing in?
There is a diverse set of schools now with ISA programs or interested in setting up ISA programs. As of this writing, MentorWorks is working with both accredited programs and coding boot camps to set up ISA programs.
We have seen investors investing in relatively early stage schools all the way to schools that can provide prior outcomes data which allows for ISA pricing based on more justifiable assumptions. The latter approach seems to be a favored one, since it has lower risk.
Major investors in this space are concerned about school outcomes, particularly completion rates, placement rates, and graduation income. While some investors require credit or delinquency screening, the underwriting and pricing process for ISAs is primarily dependent on program outcomes.
Q: What types of investors are investing in this space? What are their motivations?
We have talked to various types of investors that are interested in ISAs, including impact investment groups, angels, venture capital and private equity groups, asset managers, and large institutional groups.
The reason for this diversity is that ISA investments can be tailored for investor preference. One impact group we are working with is interested in supporting low income students in vocational programs. Another investor group we are working with is interested in strong career outcome pathways programs.
All investors have some combination of return and impact in mind. ISAs are investments in education, and tend to attract impact-oriented investors. Even among this group, there is a diversity of motivations, the extremes of which are impact-return tradeoff seekers vs. impact plus return seekers.
Portfolio diversification is another important reason that investors might consider ISAs. ISAs can provide a range of returns with a very different risk profile than public or private equity or corporate debt investments. ISAs can provide risk-return tradeoff options somewhere between public securities and angel/venture type investments. The different correlation structure with the market can create an interesting diversification play for investors. In effect, ISAs make the market less incomplete by providing a new asset class to invest in.
Here are some things to consider while thinking about ISA investment:
Motive: What combination of impact vs. financial returns are you seeking? Many investors seek both, in which case the set of ISA programs they prefer is different than those investors that focus more on impact. Note that the latter model can support a larger range of programs, particularly for underserved students. A clear understanding of what return expectation and impact metrics investors want will make the choice of investment much easier.
Horizon of returns: ISA investments that we have seen can range from 3 years to 9 years. Clearly understanding the maturity structure of the underlying program and tailoring it to the payback period requirements of the investor will help with ISA investment choice.
Program choice: The outcomes of a program are the fundamental determinants of ISA value, so program choice is a key decision. As an example, a new coding boot camp can have much higher risk than a more established one. Accredited programs can be a safer choice (though not always), but there may not be as many options currently available. Some investors we are working with have a very clear preference – for instance, impact-oriented investors who want to fund vocational schools and community colleges.
Program outcomes: Naturally, fields like programming, cyber security, etc., tend to have stronger outcomes. In our opinion, however, the income share rate can easily be adjusted to reflect mean outcomes. It is as important, if not more, to understand the variance of outcomes. Programs having a lot of variance in salary outcomes, for example, due to a lot of lower paid job placements, can be much worse for ISA returns, even if they have a lot of higher paid job outcomes. This is because the upside in ISAs is capped. This asymmetry requires investors to consider the spread in outcomes very carefully.
ISA design: Paying attention to the ISA design features like the salary floor, payment cap, income share rate, deferral period, and payment term is important. Beyond the obvious economic reasons, some investors have told us that they care about income share rates not being too high. Other investors mention having a high enough salary floor to make the ISA more student-centric and reduce adverse selection by having students who expect to do well find the ISA financing option attractive. There is some merit to this notion – students from top colleges, including those we have funded, have told us that they prefer higher salary floor levels.
Valuation models: Given enough data on outcomes, it is relatively straightforward to price ISAs using a discounted cash flow model. At MentorWorks, we prefer to use the Monte Carlo valuation method, when possible, because it explicitly accounts for salary variance and distribution in pricing ISAs. This method explicitly prices each salary path that has happened in the past, and considers the average outcome in returns. This methodto can allow a lot of modeling flexibility – for instance, it allows us to build in selection effects of ISAs by a certain set of students into these models, to explicitly account for different times to employment, and combine different types of risks for certain subsets of students.
Q: Can ISAs be a part of Angel or PE investors’ portfolios?
We have been getting investor interest in ISAs from impact groups, PE groups, and from accredited investors including angels.
The two major market frictions in this space are:
Information Asymmetry: The lack of information about ISA offerings and deals is one of the factors holding the market back. This issue spans two distinct frictions:
ISA program knowledge: Many investors are learning about ISAs as an asset class, and need information to assess this opportunity. This series of articles is one effort address this information gap.
ISA deal activity information: Most deals are currently conducted as private transactions, and there is no standardized information source for existing ISA deals. We are addressing this problem through our ISA Investor Information Portal, which we are making available to accredited and institutional investors. This free tool allows accredited and institutional investors to view schools that have ISA programs and those that are actively working on raising ISA capital from outside investors.
Transaction Costs: The legal and accounting costs of an ISA fund can be prohibitive below a certain fund size, as is true for any private investment fund. This makes standalone angel investing in ISAs much harder. However, this can be addressed by participating in a larger deal with other investors. Again, our ISA Investor Information portal can make this process simpler.
Q: How can investors find out about ISA opportunities?
MentorWorks now has an ISA Investor Information Platform, as described above, to allow investors to find out about potential ISA deals or schools interested in setting up ISA programs. This is a purely informational portal which allows investors to directly connect to schools. We are not currently supporting transactions through the platform. In some cases, however, where we are managing ISA programs, we can connect investors to the lead investor for interest in participating in a deal to create a deal syndicate.
Q: What are the regulatory risks of ISA investment?
ISAs do not currently have their own federal regulatory frameworks, though a few states have some structure for them. In 2017, the Investing in Student Success Act was introduced in the U.S. Senate and the ISA act was introduced in the U.S. House of Representatives, to put formal regulations around ISAs, but both are currently in committee.
MentorWorks has done substantial diligence on federal laws through a prominent law firm with a strong focus in the Fintech space. We did not find any prohibitions around ISAs, in general. All our contracts are compliant with loan compliance requirements, to the extent relevant in the context of ISAs.
There is still some risk that judicial intervention could invalidate ISAs and related obligations. Given the strong push by schools and lawmakers to establish ISAs as a valid financing option, we believe this to be unlikely.