• Both universities and students are becoming increasingly more indebted
• Public and private universities have different exposure risks, with public schools more reliant on tuition fees and private schools reliant on market returns.
• Alternatives to traditional higher education are on the rise
• The higher education industry is long overdue for an operational overhaul

The Debt Crisis: How Higher Education Operates

Universities and colleges for a long time, have operated on a very successful business model. They provide an incredible resource to each generation of students, enabling development from both a personal and professional perspective. They operate as non-profits and essentially have control over their own universe of supply and demand.

With the advent of cheap credit, more and more students began to enter the university business model. To gain their credentials, students participate directly for 4 to 5 years, often taking out student loans to do so. The idea of the necessity of a college degree for life success perpetuates the increase in enrollment, as the college path is drilled into students from elementary school, despite the fact that it is not always the best path for some students.

Source: Bloomberg

The student loan debt crisis is several articles of information within itself. However, many universities are also experiencing their own debt crisis, increasing their own leverage to try and attract more and more students. As this “double-debt” issue grows, it becomes more apparent that something must give within the system. 

As average tuition as a percentage of median income continues to increase, despite stabilizing recently, more and more families are beginning to question the value of a hundred-thousand dollar degree plus interest payments. Federal funding has also been slashed in recent years, which exacerbates the debt problem for universities. Students are increasingly seeking out non-traditional routes, which exist primarily online, and some of which don’t require students to pay until after they secure a job. 

Source: Student Debt Crisis, FRED

Traditional universities require payment upfront for the goods that they provide. This model has been in practice for years and years, and it has worked. But the top universities are not as reliant on that up-front payment, as they are able to rely on their endowment return model, which compounds tax-free.

The Disconnect Between Private and Public Schools

Colleges and universities have four main revenue streams: “state appropriations, research funding, gifts and endowments, and student tuition”, tuition being the only one that can be freely utilized. As a business operation, universities want to maximize this unrestricted revenue, and that involves increasing the price of tuition. But there is a point of maximization, as once a product has reached past its maximal market value, no one will want to buy that product anymore.

Endowments are the treasure chests of top universities, with investment returns generating much more revenue than tuition. Princeton, for example, generates 911% more on their endowment as compared to their revenue from what they charge students for attendance. Harvard generates 529% more from their endowment. MIT is 118% more, Stanford is 115% more, Brown is 29% more, and so on, and so forth.

In order to keep those investment returns tax free, universities must maintain their non-profit status, which involves an educational purpose to students. The tax exemption is a benefit, enabling the schools to make the most out of the revenues that they have. However, there is a divide between the income generation of public and private universities, with private universities generating much more in terms of endowment, and public universities are more reliant on tuition income.

But the issue is different at private and public universities. The University of Michigan, regarded as a proxy for other public research universities, receives approximately 32% ofits overall revenue in the form of tuition and ~30% in the form of research funding, together comprising 2/3rds of it’s entire budget. Endowment, and the returns generated, makes up ~11% of it’s overall budget.

Source: The New Inquiry

On the other hand, a university like the Massachusetts Institute of Technology (MIT) only gets 10% of their revenue from tuition. They get much more from research, totaling 48% of their overall revenue. They get 22% from their endowment returns. Over 70% of their overall revenue amounts from research and endowments alone.

Source: Conrad Bastable 

Public universities are much more exposed to slashes in federal funding and tuition price freezes. Private universities, using MIT as a proxy, are able to fall back on research funding and endowment returns. However, the industry as a whole is expected to contract in growth in the coming years.

Moodys downgraded the growth of higher education from stable to negative this past year, expecting expenses to outpace the annual change in revenue. The public / private divide shows up again, with “less than 20% of public universities” that Moody’s rates achieving “total revenue growth above 3% while over 50% of private universities will achieve 3% growth“. More than half of private universities will experience revenue growth, and four-fifths of public universities will experience a reduction in revenues.

Source: Inside Higher Ed

As federal funding flattens out, universities will have to enter into the private sector in order to maintain research revenues, which will put further pressure on institutional funds. Public universities gather about ~25% of their revenues from governmental sources, so they will feel the squeeze more than their private counterparts. Private universities do have some reliance on federal funding, through loans and grants for students, tax preferences, and research subsidies, but public universities are more reliant in general on governmental funding. This puts a squeeze on many of the colleges and universities, requiring them to become overleveraged in order to maintain operations.

The University Debt Crisis 

The number of aid-eligible institutions fell by 5.6% from 2016 into 2017. Schools closed, and the number of closures each year is expected to grow. It’s getting more and more expensive to maintain a university, as equity, endowments, and growth are decreasing for most schools. Liabilities, debt services, and expenses are increasing. Back in 2012, 24% of universities saw a decrease in their equity ratio and a bump in their expense ratio. 

Source: The Sustainable University

When faced with this problem in the past, universities would simply hike tuition rates. But now, there is growing backlash as graduates find themselves underemployed or unemployed after graduation. The basic college degree no longer holds the same promise that it used to. 

Beyond that, universities still have to “keep up”. Build more. Do more. Spend more. In the face of budget cuts, institutions are taking out debt, growing at a clip of 12% per year, with interest expense on top of that. It’s expensive to maintain a campus, which can sometimes be the size of an entire town, as well as the administrative aspects of running a college or university.

Keeping Up With the Cost of Education

Total college US enrollment has increased almost 40% over the past 25 years. Median wages have increased by approximately 10%. The cost of education has 

 increased 300% in the same time period.

Source: FAS

It is important to note that GDP increased 182% over this same time period, so it would be impossible for the cost of education to have remained stagnant. But education outpaced production by 118%. A lot of that is due to the increased value placed on a college education, but top universities have also gotten more selective. When the supply of a good is constrained, that will make that good that much more valuable to the marketplace. 

The Disconnect: A Drain on the Student and the College

However, even the students at the top universities are not always safe from student debt. Over time, the number of searches looking for the term “student loan refinance” has increased quite dramatically. SoFi, an online lender, had a settlement with the Federal Trade Commission because they were misrepresenting how much borrowers were saving from refinancing.

Source: Google Trends

The FTC has sent out several “final warning” letters to other companies that are preying on student borrowers. The average graduate now leaves school with $30k in debt, which is a 3x increase from early 1990s. Refinancing federal loans with a private lender can sometimes result in less flexibility, restricting a student’s financial freedom down the road.

College is a cradle-to-grave process, in the most extreme of situations. Families usually set up college funds for their children, relying on interest and market returns to compound that into an actionable amount. The student then goes off to college, using that money, which might not be enough to cover the cost of attendance. The student then takes out loans. Those loans, and the interest they accrue, can follow that student well into adulthood. 

The Solutions: The Lambda School, Among Others

Several companies are looking for a way to dampen the effect of the student loan debt crisis. Education is an industry, and just like almost every other industry, there are disruptors. Austen Allred, the CEO of Lambda school, has been compared to disrupting education much like Elon Musk is in the process of disrupting the auto industry. 

Source: Austen Allred

Austen Allred recently tweeted that Lambda School would have more applications than Harvard. That means that there will be more than 40,000 applicants to this online program. Austen also said that the acceptance rate would be less than Harvard’s.

Lambda’s Philosophy: The Income Share Agreement Program

At the Lambda School, students go to school, for free. Upon graduation, and securing a well-paying job, they pay a percentage of their income to the university. The Lambda School is one of the leaders in implementing this ISA program, and now is backed by $30 million in VC funding, valuing the school at $150 million.

Right now, Lambda focuses on computer science, developing students into coders and software developers. But the room for growth could be in any direction, and that is what the investors are counting on. Upon securing a job that pays more than $50k, Lambda students pay 17% of their salary back to the school for two years. Payments are capped at $30k. If the students don’t get a job, they pay nothing.

It’s worked pretty well for Lambda thus far, with grads posting a salary increase of $47k after program completion resulting in an average post program income of $85k. As tech continues to change the career landscape for every field, the skillset that Lambda teaches becomes more and more invaluable.

Conclusion: College is Expensive 

If the market recognizes institutions like the Lambda School in the same light as a brick-and-mortar university, then the cost of an in-person classroom experience will have to decline. It would not make sense to pay more for a seat in a physical space when the same education credential can be received for a lower cost online. 

There are always caveats to every argument, with the concern of a change in the macroeconomic cycle potentially disrupting the success of Lambda. However, when the economy tanks, people tend to go back to school, especially the older generations. In 2007, 1.9 million students between the ages of 40 and 64 were enrolled in college or university, and in 2011, that number jumped to 2.3 million.

Public universities are more exposed to a loss of federal spending, whereas private institutions are able to benefit from endowment returns. Public colleges made up 74% of enrollments in 2016. As federal and state spending continues to

contract, public universities often have no choice but to attempt to raise their tuition prices. This further exacerbates the student debt crisis, as well as the university debt crisis.

Higher education is an industry that does a lot of good. As a personal anecdote, I have benefited tremendously from my education, and cannot imagine my life without it. But when discussing the university as an operational model, it is becoming more and more difficult for students to graduate debt free, which compounds into more problems down the road. The universities themselves cannot continue to operate on a debt-laden model.

Programs like the Lambda School are the beginning to alternatives to higher education. There are built-in challenges that the Millennials and Gen Z’s face. College graduates for the first time ever, have a negative net wealth. They don’t believe in or understand the stock market, with over 50% unable to define compound interest. This next generation is the most traditionally educated, the most indebted, and it is entirely necessary for them to have access to modes of wealth creation. It also entirely necessary to consider how dangerous it is to plunge an entire generation into a $1.5 trillion debt bubble.