Ditch your shares...

November 21, 2003

...invest in a student instead and get yourself a percentage of future earnings, says Miguel Palacios

In the face of depleted public coffers and pressure to increase tuition fees, students and policy-makers alike are debating where to find funding for higher education.

"Human capital contracts" are an emerging private-market solution to this public-policy problem. Through this contract, a private investor provides funding to a pool of students in exchange for a percentage of their income for a specified period after graduation.

Like a venture capitalist who acquires a share of the future value of a portfolio of companies by financing their development, an investor in human capital contracts has a temporary equity position in the future income of a group of students. Unlike a venture capitalist, the investor has no direct influence on the "investment": students are free to choose a field of study or a career path.

From the government's perspective, human capital contracts offer a new complementary source of funds. Developed countries cannot expand access to higher education and maintain the excellence of university programmes from tax money alone. In emerging economies, where public funds are even more scarce, priority must be given to elementary education. In either context, private funding is the means of expanding access to higher education.

From the students' perspective such contracts are a means of financing education without debt. Because payments are a percentage of earnings, they adjust to students' capacity to pay. Human capital contracts level the playing field for students who are unwilling or unable to commit to fixed loan payments. They also allow students to share the risk of investments in education with an investor who, unlike them, can diversify this risk.

For investors, these contracts can offer attractive returns and be used as a hedge against variations in inflation-adjusted earnings.

The phrase "human capital contract" may sound new age, but the intellectual roots of the idea are not. Human capital contracts draw on the thinking of John Locke and Adam Smith, who explored the notion that knowledge and skills, though intangible, can create economic value, just like other types of assets. If there can be markets for oil, gold, automobiles and farm commodities, could we consider a market for a different kind of asset: intellectual capital? And if one can trade in the future value of various assets, why not let students do the same with their future earnings?

Some might fear that these contracts are a form of indentured servitude, but this is a misplaced concern. Because the investor has no say in any of the student's decisions - unlike, for example, other arrangements that require individuals to work for a particular employer - this arrangement is no more oppressive than taxes.

Indeed, students are already choosing human capital contracts. Lumni, a company that I co-founded, financed engineering and business students in Chile in 2002. MyRichUncle in the US and CareerConcept in Germany began financing students in 2001 and 2002 respectively. And those of us who have seen the potential of human capital contracts on a small scale envisage the socioeconomic impact that can be accomplished on a large scale.

But to achieve that scope we need to shape the legal and economic questions that are raised by any financial innovation: how will these contracts be treated under tax and bankruptcy law? Could a tax-collection agency provide information about students' earnings and help collect payments? What happens when a student emigrates?

Sounds challenging? Absolutely. But will establishing the proper context for human capital contracts be worthwhile? Again, absolutely. At stake is establishing an innovative means of using private capital to give talented students the opportunity to pay for higher education.

Miguel Palacios is a Batten fellow at the Batten Institute of the Darden Graduate School of Business Administration, University of Virginia, and author of Investing in Human Capital: A Capital Markets Approach to Higher Education Funding , Cambridge University Press, to be published in January, £30.00.

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