Saw this recently despite the age of the article:
Takinga gamble on human capital
Firms invest in students’ potential
The pitch goes something like this: Imagine investing in business superstars when they are just starting out, the way people do with athletes or music celebrities. What if a scout had spotted Bill Gates when he was 18 and given him money for books and college tuition, in exchange for a cut of his later earnings?
“Would you rather invest your money in the S&P 500 or would you rather invest in a whole class of Harvard College undergrads, a whole class of ex-McKinsey partners?” asked Patrick Chung, a graduate of Harvard business and law schools. “The rate of return on those people is much higher.”
As conceived by a handful of venture capitalists worldwide, human capital investments are an alternative to loans and grants in which students and young entrepreneurs apply for private funds to cover tuition or startup costs. Besides money, recipients tap into a network of well-placed investors who have a direct stake in their success. In exchange, they pay a percentage of their accumulated net worth for up to 15 years.
Think of it as a stock or mutual fund powered by the world’s best and brightest. So far investors have contributed over $30 million and the first graduates have returned around $800,000. Many are still in school and their funds have not reached maturity, but default rates have been low, entrepreneurs said.
While these “human capitalists” are touting the contracts as an intriguing evolution in education and venture financing, potential investors and students are wondering who benefits in the long term. Is this an ingenious new partnership – or a Faustian pact?
It is generally agreed that the idea was first floated by the Nobel laureate Milton Friedman in the 1950s, but after a brief test-run at Yale University, it was only in 2001 that the company My Rich Uncle successfully implemented the concept.
Companies offering human capital investments now include CareerConcept in Germany and Lumni, a fledgling program in Latin America. In the United States, My Rich Uncle funds students nationwide, and Direct Human Capital, run by Chung and two Harvard classmates, has received the support of several influential backers.
Private investment in education is nothing new in the United States, where pharmaceutical companies finance research and venture capitalists look for talent at top schools. But this is the first time future earnings, rather than present assets, have been considered as collateral for funding, entrepreneurs said. And it is the first time human capital has been treated as a financial security.
“What you’re seeing here is the emergence of an entirely new asset class,” said Chung, a venture capitalist with New Enterprise Associates, the largest early-stage venture capital firm in the United States. “This is not real estate, not equity. You’re investing in the productive capacity of humans. To be able to unlock that value and securitize it, it really is revolutionary.”
In a hypothetical case, Muffy is looking for funds to complete her MBA. She applies for a contract, going through a rigorous screening that includes a review of her academic transcripts, an essay and an interview. If she seems promising, the company will invest in her intellectual stock and mentor her, and she will pay between 1 percent and 4 percent of her accumulated net worth for every $10,000 she receives, for up to 15 years after graduation. If Muffy makes millions, her payments will be hefty. But if she earns nothing, she pays nothing. That’s the wager.
“We don’t know who is going to be the winner and who is going to be the loser,” said Miguel Palacios, a co-founder of Lumni and a doctoral candidate at the Haas School of Business at the University of California, Berkeley. “But we are telling the winners, ‘Hey, you lost a bet.’ Wouldn’t you rather lose a bet when you are rich than when you are poor?”
While part of the game is spotting winners, human capitalists say they are also motivated by the same ideas that inspire so-called angel investors, who put up their money without expecting a return. They say that talented people who are debt-free will be empowered, and that everybody with an idea should have access to a network of resources and mentors.
“Can you free up just a little bit of talent, and can you produce another Bill Gates? Another Steve Jobs? Our argument is yes you can,” Chung said. “You’ve created so much more for society than if that person were locked up in Goldman Sachs for 10 years.”
People too frequently make compromises in their career choices based on economic realities, said Tony Tjan, an investor in Direct Human Capital. Graduates who do not have to worry about earning enough to cover a flat loan repayment rate are free to take risks. They can start a company or work for one, or, as Tjan said, “follow a career path of being an equity versus a bond.”
Such metaphors have students and educators edgy.
“At first blush it seems the advantage is for investors, because they’re in it for a profit,” said Carl Buck, vice president of financial aid services for Thomson Peterson’s, a college counseling and financial services concern, and a former director of financial aid at several American universities.
Buck recommended that before signing up for such a program, students do their homework by comparing the criteria and expectations of a contract to a loan point by point. They should ask how easy it is to default under hardship or to accelerate payments, and what obligation they have to follow a certain career path.
For such programs to gain social and legal standing, they will have to prove a utility beyond the returns they bring to investors. “For this to really get a level of critical mass, at least within our culture of entrepreneurship and capitalism, you need to demonstrate a value beyond capital, a value that involves a relationship network and mentorship,” Tjan said.
The network, not just the money, attracted Allan Merrill, 29, who graduated from Harvard business and law schools in 2004 with heavy debt. He is working for a hedge fund in Wisconsin but would like to start his own investment firm. He was skeptical of a strange new program – and unsure of how he felt signing over part of his income for several years.
“Maybe these people would be trying to take advantage of me because they have more information about my future income potential than I do at this time,” he said. But the more Merrill listened, the more he liked the idea. “The people they are investing in you are people you like, admire, and have done things you respect,” he said. “They want to see their investment succeed.”
Ben Gilbert, a first-year graduate student in economics at the University of California, San Diego, said he considered a contract but opted for a loan, a decision he somewhat regrets now. “I think the newness of the idea is a little unsettling,” Gilbert said.
“But if you do one of these venture capital companies, you just have to pay a percentage, no matter what you do. So you could go work for a nonprofit for 10 years and pay virtually nothing.”
Of course, that is what investors hope will not happen. Palacios said the most challenging part of the process was persuading investors that it makes financial sense. “We think it works, but there are many unknowns,” he said. “There are many questions that only experience answers.”
CareerConcept in Germany, the broadest education investment program to date, offers the most promising test run. Since 2002, the Munich-based company has financed 1,500 students and is set to start a nationwide fund with 2,100 contracts. The fund should bring in an internal rate of return of about 6.5 percent, said its founder and chief executive, David Schmutzler. Graduates pay 3 percent to 8 percent of their earnings for three to eight years, depending on their field and how much money they received. Adding students lowers the fund’s risk.
“Universities play a big role in the marketing of the concept,” Schmutzler said. “That’s one of our biggest assets.” A lack of public funding and a cultural bias against loans has also made the contracts appealing.
In Chile and Colombia, Lumni has funded about 15 students and some investments are being doubled after early success stories, Palacios said.
In 2002, Marco Contreras was studying commercial engineering at the Universidad de Chile and working 35 hours a week in an office supply store to pay for one course per semester. Chile has no public loans and few scholarships.
He negotiated a contract of 1.05 million Chilean pesos, or $1,628 at the 2002 exchange rate, for which he has been paying 3.36 percent of his salary over a five-year term. He graduated in a year and used the program’s network to land a job as a strategic planner for a manufacturing company.
“They are still pilot programs, not grown to any large scale yet,” Palacios said. “But, of course, the goal is that they transform the way people think about financing education.”