Future Earnings Agreements
Consumer finance (including student finance) in the UK is all debt based. Debt is based on a “principal” amount which is paid to the borrower in return for the lender receiving both the principal plus a compound interest charge at some agreed point in time in the future.
Finance for a qualification (“productive finance”) is like investment in the infrastructure of a business, future earning predictions will improve if the right qualification has been financed.
Debt is highly focussed on historical information to accurately assess a borrower’s ability to repay the principal and interest charges. As a result, this financial structure is highly restrictive for those who are likely to have adequate future earnings to justify the finance (if they have a qualification) but cannot evidence this with their credit history which is backwards looking. This exclusion has now been further enforced by the UK financial regulator (the FCA) through their implementation of “affordability” requirements. This means that lending decisions must be based on evidence of prior earnings and spending to ensure historic earnings are greater than historic expenses plus principal and interest repayments on the finance sought.
The structure of debt is also highly focussed on the downside of potential loss, or lack of repayment, as there is no potential “upside” beyond the repayment of the interest charge. Debt is suitable for borrowers for whom historical information is a good predictor of future earnings and hence their “ability to repay” the principal and interest charges. The “ability to repay” for prospective students is much more difficult to predict resulting in many under or over performing expectations. This again is highly restrictive as those who underperform will be unable to fulfil their obligation and “default” potentially repaying nothing. This “default” must be compensated for, which is achieved by the lender increasing the interest charge for those who are able to repay. This increased repayment burden will lead to higher defaults that must be compensated for by still higher interest charges for those who can repay. The structurally flawed nature of debt for this product is evident in the prohibitive cost of debt funded student finance today.
The unsuitable nature of debt for productive finance such as education has meant there is a significant market dislocation, with students who don’t already have wealth affectively locked out of “productive investment” into higher education.
Debt is unsuitable for “productive investment” when individuals are at the early stage of investing in their earnings trajectory – similar to companies. When companies are at an early stage they tend to receive equity investment rather than debt investment. StepEx is introducing an “equitylike” financing instrument for student finance, with institutional sophistication and regulation. The StepEx financial instrument or “Income Share Agreement” (ISA) provides lending that is based on the assessment of a range of future scenarios for each individual, effectively “de-coupling” the amount to be repaid from the amount borrowed. This model recognises the difficulty in predicting exactly how much a borrower can afford to repay when information on that borrower is scarce. Funding is instead provided in return for a fixed number of repayments of a percentage of future income. If the individual underperforms earnings expectations, they will repay less in total and if they outperform they will repay more in total. Across a portfolio, over and under performers will aggregate to a much more predictable return than the return provided by debt based alternative where under-performers pay nothing (default) and those who outperform repay only the interest rate.
Statistical and mathematical analyses, as well as product features approved by the FCA allow the risk to be effectively managed. StepEx will initially begin offering this product to lower risk student segments, where there is significant employer demand for the qualifications being pursued yet the structurally inappropriate nature of debt prevents funding of the “productive investment” of educational finance.