Recognizing the need for an efficient system to finance higher education, Felipe Vergara is introducing human capital contracts—a new set of financial products—to draw private capital toward the high education sector.
The New Idea
Felipe is applying a simple principle to the field of education finance: profit attracts capital. Through Lumni, Felipe is managing the first profitable education investment funds, and in the process is testing, refining, and demonstrating the tools that other groups will need to do the same. The cornerstone of Felipe’s innovation, the “human capital contract”, eliminates the risks to both students and investors that otherwise deter private investment. In exchange for education financing, these legally binding agreements require students to pay a fixed percentage of their income over a pre-determined number of months after graduation. For students, human capital contracts do away with both the need for collateral and the threat of burdensome debt associated with traditional loans. The effect makes unemployment and underemployment less ominous, but also allows students to pursue their dreams, whether drams of business success, entrepreneurial pursuit, or contribution to the social good. For investors, they essentially allow the purchase of equity shares in students’ post-college financial success. Lumni operates as a node, facilitating win-win financing opportunities between Universities, private investors, and students. To date, Lumni is the in the design or implementation phase for 10 funds in Chile, Colombia, Mexico, and the US. Through this global effort Felipe is working to demonstrate the potential for HCC-based funds to transform education financing around the world.
Human capital—the sum total of skills, abilities, and knowledge available in a society—drives economic growth, development, and individual potential. Yet each year, in the developing world, millions of promising students end their education for lack of funding to continue attending school. This problem is particularly striking at the University level, where costs rise sharply beyond those needed to sustain a student in the public education system. Most students have little recourse beyond their families’ contributions. Typically, only a small group of students receive government funding, and even fewer qualify for either merit or need based scholarships provided by Universities themselves. As a result, it is largely the economic elite, with the ability to pay school fees outright, who pursue higher education. This education funding hole traces to a market failure. A recent Inter-American Development Bank study showed that college graduates in Latin America earn 200 percent more than their non college-educated counterparts. Estimates in Chile have been as high as 400 percent for this same figure. While some of this disparity owes to other factors—students’ connections, position in society, or early schooling—the economic and development community widely accept that education yields net benefits for society and the individual, both economic and otherwise. But even where such benefits exist, capital markets are needed to bring them to fruition, with investors later compensated for the time value and risk of their contribution. Traditional mechanisms for financing higher education have failed to bridge this gap. Many countries have resolved the education funding dilemma through public channels. In the US, for example, a system of subsidized loans instituted in the 1960’s fills the space. But the business of subsidizing loans for education is expensive. In developing countries in particular, this strictly limits the supply of funding. Scholarships, either merit or need based, are even more expensive for the provider, whether public or private. Loans, the most common solution to this dilemma, present challenges for both lender and borrower. Education is a fairly risky investment—those who don’t make it through the education process are unlikely to be able to pay back their debts. As a result, private lenders require either collateral or exorbitantly high interest rates to render individual investments profitable. Similar risks deter poor families and students from borrowing funds. Any number of circumstances—sickness or poor performance, or, the endemic unemployment—would bring ruin to the borrowing student. Thus, even for the few families with access to collateral, higher education does not always make economic sense. A dearth of information exacerbates the risks of borrowing for families and students. Much of the world depends on anecdotes and observation to asses the likely outcomes of education. Families are misinformed about the likelihood of unemployment; stories of physicians driving taxies abound. Moreover, they are unable to compare educations across disciplines and schools to choose the best options. To date, most attempts at increasing universal education rely on mobilizing additional resources for scholarships or school funding through public or aid-base channels. Few creative, systemic solutions have arisen. Finance experts, beginning with Milton Friedman in 1955, have occasionally toyed with human capital contracts and other equity based instruments on a theoretical level, but like many academic notions, deemed the gap between theory and reality irredeemably broad. The practical challenges of implementation—information management, determining future and present income, gathering the information needed to price students, collection of funds, and legal questions—most daunted these economic thinkers.
Felipe has taken up the challenge of turning theory to reality. In doing so, he recognizes that his most important task is also his most basic—to prove that HCC based funds can reliably return the appropriate risk-adjusted ROI to investors. With US$250,000 raised to date, he is demonstrating this fact with pilots in Chile and Colombia, two countries with relatively well developed financial and educational infrastructure. Ultimately, Felipe believes these funds can take innumerable forms, financing all areas of human capital development and creatively partnering with Universities and other institutions. For the pilot phase, however, he focuses on two distinct formations. The open funds in Chile, one for graduates and one for undergraduates, connect investments procured by Lumni directly to students. Through pending deals with Universities in both Chile and Colombia, University funds allow students to defer tuition payments through HCCs. Lumni, the fund manager, receives some compensation up-front from the University to cover the cost of operations. As Felipe builds these funds he has prioritized the tricky legal questions associated with their implementation. HCCs and the groups that manage them are novel legal entities, and their success is predicated on validity of a single legal agreement. In Chile, Felipe recruited a group of pro-bono attorneys to research and create a 32-page contract which establishes the legal basis for the HCC arrangement under Chilean law. In reality, legal action represents final recourse against non-paying students, while Chile’s relatively robust credit rating system serves as a more immediate stick. Lumni works closely with students to ensure complete understanding of the HCC obligations. To hedge against hidden income, the contract defines three forms of payment: formal-economy employees pay based on the income disclosed to federal authorities, family or small business employees use a minimum acceptable salary corresponding to 90 percent of the market average for their position, and self-employed entrepreneurs give Lumni an equity stake in their companies. Felipe knows that during Lumni’s early years, demonstrated success is particularly important but also especially precarious. As he pilots HCC-based funds, Felipe has minimized accompanying risks. This means selecting the right groups of students—those who are high performing, studying for careers that pay well, and likely to pursue high paying job. The organization employs a structured application and interview process to appropriately vet candidates. And to further improve the likelihood of success, Felipe has introduced mentoring, tutoring, and career counseling into the mix. Most importantly, Lumni must fund student’s whose economic outcomes can be accurately predicted, allowing them to structure payments for profitability without excess burden (payments never exceed 15 percent of income). Felipe has controlled this variable by launching funds for students already two years into their college education. But Lumni must use often spotty 3rd party information to predict salaries and employment trends for the post-University years. As Lumni grows, it will also amass accurate information on the financial benefits of particular education tracks at particular institutions. This information, vital for Lumni, will also be invaluable to the public, enabling students and families to make informed decisions about the opportunities conferred by higher education. This type of public information, along with the information systems to track it, represents one example of the broader set of tools that Lumni is creating for the good of the field. Felipe has begun conversations with poverty-focused public entities, such as the Inter-American Development Bank and the Andean Development Corporation to fund the development of such open access tools. Philanthropic and public dollars will only accelerate the development of information systems, fund-management training programs, and legal research. Today, Felipe is targeting socially minded investors. Given the risk inherent in this new venture, traditional investors might require a 20 or even 30 percent return on their investment, while Lumni can offer only eight or nine percent at the moment. Years down the road, when the actual risk inherent in these funds has been established, this criteria will disappear. Investors, both private and eventually institutional, will demand the appropriate risk adjusted return on their investment, without compensation for their contribution to the greater social good. It is these profits, and the groups that spring up to manage them, that will attract the capital needed to finance the world’s education needs.
Felipe quietly credits himself with an uncanny sense for the future, a premonition for what will become important, and an entrepreneurial drive to act on that sense. In his younger years, before the environmental movement had reached his native Colombia, Felipe felt a deep sorrow for the deforestation he observed in the hills around Bogota and the smog that increasingly hung over his city. Also sympathetic for the plight of the street recyclers, he organized a recycling program during high school, convincing local neighborhoods to sort their recyclables. Later, during his college years, Felipe complemented his studies of industrial engineering with a more sophisticated industrial recycling program, working with businesses around Bogota to improve their environmental practices. He also recognized early on that languages could someday bring him places that Spanish alone would not afford him entrance. Fascinated by this potential, he studied hard at the French day school he attended and began teaching himself other languages as well. Today he speaks six languages fluently. But languages were not Felipe’s only educational interest. As a young student, Felipe fell in love with the idea of education itself, the ability it gave him to expand his own mind, to see outside his world, to learn. When hardship struck his family, the education that had seemed his right for so many years, suddenly became a privilege for which he and his family had to struggle. Felipe was struck by the arbitrary nature of access to education in Colombia. In a period that remains with him today, the absurdity of his country’s social hierarchy stood in strong relief. In the years after college, Felipe worked in France and then Brazil before returning to Colombia to take a steady job with a prestigious national bank advising large corporations. His work engaged him, but he found himself drawn to small companies that fell outside the purview of his corporate work. On the side, Felipe began consulting for a small clothing designer on the verge of bankruptcy, but with dreams of exporting his wares. After six months, Felipe had stabilized the company and added a small bakery to his work-load. A few months later, it was a hydraulic press manufacturer. Against all advice, at 25 years old, Felipe left his position at the bank and launched Taller de Estrategia, or the Strategy Workshop, to consult to small and mid-sized organizations on Andean-wide strategies at a time when only large corporations were operating regionally. By mid 1997 Taller de Estrategia advised companies, institutions and municipal governments in Colombia, Ecuador and Venezuela. It had four partners, a total staff of 15 people, and had completed more than 50 projects in the fields of strategic and financial advising, and organizational training. Seeking an additional set of skills, Felipe applied to and attended the Wharton School of Business where he ultimately earned much more than his MBA; it was there that he met and fell in love with his wife, a Peruvian woman also at the business school. The following year he accepted a job with McKinsey & Company in New York, but again found himself drawn away from the corporate environment and toward the adventure of starting and growing a small enterprise. Two years later, he launched Lumni as well as Primera, a small language school with offices New York and Miami, his current home, to provide an income while he focused on Lumni. Today, Felipe remains driven by his love of creation. He believes that it will take a lifetime to transform the education finance industry and has dedicated his own to that end.