Since CoVenture makes investments in “new asset classes,” we get asked about Income Share Agreements all of the time.
My quick one-liner on the topic is:
· It feels like you are taking equity-like risk, for debt-like returns.
Why are you taking equity risk?
The reason you’re taking equity risk is that you are investing in the future outcome of the student’s career — but without any of the governance, cash controls or fixed return of a debt instrument.
In many cases, the investor is actually SECOND lien to the employee for the initial amount of income they are receiving. Example: the investor only gets x% of the income so long as the student’s income is about $X.
There is no fixed payment in most cases, and there are not really any covenants you can put on an individual’s life (not to mention governance). You can’t tell the student where they can work — and it might actually negatively incentivize them to do something less high earning since they don’t have a fixed amount they must repay.
And fraud is easy; a student could just say: “I make $X when really they make $Y and finding that out, and then acting on it would be expensive relative to the size of the loan. Collecting on these ISA’s could cost so much it’s not worth it.
So it’s really an equity investment, not debt.
Why are you getting debt-like returns?
Most of what we have seen in the market has been 11–15% returns… which is closer to a reasonably good debt investment. If I were making an equity investment in something as risky as a young individual with a slim working history, I’d need something in the 20%+ range.
Other negative deal features:
· Unlike consumer lending, auto lending, or mortgage lending… there is limited data to tell how coding schools are going to do (or other vocational schools will do). The less data, the looser the confidence interval, the more I need to get paid for the debt.
· The investment is highly cyclical — meaning that if the economy goes south, so do jobs, and so does the income of these students
· Difficult to monitor mid-cycle — it is hard to tell how a loan is doing until fully repaid
So When Does an ISA Actually Make Sense?
(1) ISA’s make sense, when some of the economics that the originating school is earning gets passed through to the ISA holder.
Example: Let’s imagine a coding school costs $10k. But it costs $3k to “acquire customers” aka recruit students to pay the full $10k cost.
But if an ISA was offered, the school would only spend $500 recruiting students, because the offering would be way more affordable.
That is $2,500 of savings. If $2k of that got passed on to the entity funding the ISA’s, that would be 20% of spread incrementally added to the yield of the deal, which may be a 3 year term. AKA ~7% per year. 7% on top of a 15% yield, suddenly makes the return a 22% earning deal, putting it back in the “equity-like return” range, and therefore making the investment more palatable.
(2) ISA’s could also make sense for schools who were willing to take “year 1” risk — meaning they could wait until the student got a job at a reputable place before selling the paper to ISA investors.
At this point, the deal would feel more like it had debt-like risk since the investor is now just underwriting churn data as opposed to the equity risk of the career of the student. Plus, the term of the agreement would be shorter, making the effective annualized yield higher, depending on the terms of the sale.
So Where are We Now?
At this point… we’re all still learning. What I’ve been surprised by, though, is that investors aren’t yet getting paid like we’re learning — we’re getting paid like this is already a “proven thing, that is going to work,” and the returns don’t look much better than more predictable asset classes.
This might be because of how intellectually stimulating the asset class is, which is attracting dollars. It could also be driven by impact investing dollars over time — which would price out most investors allocating in a purely capitalistic basis.
We hope to see the asset class develop, but for now… we’re out.
