* Investments in human capital, the present value of individuals’ future incomes, are currently fraught with legal risk due to uncertainties regarding the enforceability of income sharing agreements (ISAs).
* To date, efforts by Republican Congresspeople to enact legislation eliminating these uncertainties have failed. Enactment in near future is likely, however, due to Republican sweep of presidency and Congress.
* ISA legislation has been proposed primarily to provide an alternative to student loans, but its impact could be much more complex and far-reaching.
* Per IMF estimates, the total 2006 dollar value of U.S. human capital exceeded $700 trillion, roughly 27 times the total February 2016 value of all NYSE and NASDAQ stocks.
* If even a small percentage of U.S. human capital is securitized, valuations across a broad variety of asset classes will be significantly affected – especially financial services stocks.
Among the past few decades’ most consistent trends has been the securitizing of a growing variety of assets. Extrapolation of this trend suggests that human capital – the present value of individuals’ future earnings – may soon become an important investable asset class, following in the footsteps of home mortgage debt.
Though income share agreements (ISAs) have a variety of extremely useful characteristics that traditional forms of financing lack, they currently occupy shaky legal ground. Standing between ISAs and those who might benefit from participating in them are uncertainties regarding what conditions these agreements must meet in order to avoid being ruled unenforceable contracts of indenture.
The 13th Amendment outlaws slavery and other forms involuntary servitude, including the once commonplace practice of indentured servitude. Some courts have extended this prohibition to contracts involving the sale of individuals’ future incomes.
Republican Senator Marco Rubio of Florida has been thwarted twice, by two separate Congresses, in his efforts to enact legislation facilitating investment in human capital. Such investments would typically take the form of ISAs calling for investors to pay upfront for a percentage of investees’ personal income above a threshold amount for a specified number of years. The recent Republican sweep of the presidency and both houses of Congress is highly likely to result in adoption of similar legislation and widespread use of ISAs in the near future.
Though ISA legislation is ostensibly intended for the primary purpose of providing an alternative means of financing postsecondary education, there is reason to believe its impact could be unexpectedly complex and far-reaching. As I shall point out, the ISA-facilitating legislation proposed most recently is vague in specifying the purposes for which investees may use the ISA funding they receive.
Miguel Palacios Lleras’s 2004 book, Investing in Human Capital, envisioned: “A global market where the value of Human Capital can be traded, in different forms, either directly or through derivative securities.” Given that the total 2006 dollar value of U.S. human capital was estimated to be in excess of $700 trillion (roughly 27 times the total February 2016 value of all NYSE and NASDAQ stocks) by International Monetary Fund economists (di Giovanni and Matsumoto), the global market suggested by Lleras could be enormous, even if only a tiny percentage of it ever becomes securitized and tradable.
Clearly, the creation of an asset class that may ultimately attract trillions of investment dollars has the potential to generate huge opportunities for a wide variety of financial services firms, as well as for the broad range of businesses that would stand to benefit from the resultant redistribution of purchasing power. The other side of this coin, of course, is that ISA investment dollars would inevitably be siphoned away from other investable asset classes – particularly stocks - leading to downward pressure on their prices.
Though the emergence of ISAs will provide a bonanza for many providers of financial services, the most obvious beneficiary on my radar screen at this time is Silicon Valley Bank (NASDAQ: SIVB) aka SVB Financial Group. SIVB is particularly well positioned to benefit from use of ISAs due to its expertise in funding startups and prominence in the entrepreneurial community, as well as its geographical proximity to the heaviest concentration anywhere of venture capital firms, angel investors, and tech startups. SIVB has served tens of thousands of startup clients over the years.
Following In the Footsteps of Home Mortgages
Today’s vibrant market in mortgage-backed securities (MBS) would have been virtually impossible to envision prior to the Great Depression, when U.S. government interventions to address that era’s unprecedented numbers of foreclosures ultimately resulted in the creation of a nationwide secondary mortgage market.
Much as this market proved useful in alleviating the nation’s foreclosure crisis in the 1930’s, the monetizing and securitizing of human capital appears poised to provide significant relief for millions of Americans with uncomfortable student loan burdens. The present value of an individual’s future earnings can easily amount to millions of dollars, even for those with little or nothing in terms of tangible net worth. So it should come as no surprise that America’s human capital is a multi-hundred trillion dollar asset, accounting for roughly 75% of the nation’s economic wealth.
Nor should it surprise anyone that many Americans are interested in monetizing their own human capital. Unsecured credit card debt, for instance, can be thought of as a loan backed by a small percentage of the borrower’s human capital. Even when faced with onerous interest rates, many individuals not only maintain large debit balances on their credit cards, but would also be willing to increase these borrowings if given the opportunity.
In contrast with student loan debtors, credit card borrowers accept their financial burdens in relative silence, largely due to the stigma associated with excessive credit card debt. Consequently, it is far more socially acceptable for student loan debtors, who borrowed money for the eminently laudable purpose of furthering their educations, to vocalize the travails associated with their resultant financial obligations.
Moreover, unlike credit card debt, student loan debt is not typically cancellable through bankruptcy. This strikes many Americans as unfair, particularly those who don’t believe that a misguided educational choice in one’s 20’s should result in garnishments of Social Security checks 50 years later.
These circumstances have led to widespread public sympathy for those whose expensive educations have failed to bear financial fruit, and Washington has taken notice. In April 2014, two Republicans, Florida Senator Marco Rubio and Representative Tom Petri of Wisconsin, introduced a bill entitled the Investing in Student Success Act of 2014 (ISSA 2014).
The stated purpose of ISSA 2014 was to make the nation’s student loan debt more manageable through the use of ISAs, shifting risk from the taxpayers to private investors.
ISSA 2014 died in committee and was replaced in the 114th Congress by the Investing in Student Success Act of 2015 (ISSA 2015), a similar bill sponsored by Rubio and Republican Representative Todd Young of Indiana that appears to be headed for a similar fate.
What ISSA 2015 Says
According to a summary provided at Congress.gov, ISSA 2015:
“authorizes an individual (i.e., a student) and another person (i.e., an investor) to enter an income-share agreement (ISA) in which the student agrees to pay a percentage of future income, for a specified period of time, in exchange for funds to pay for postsecondary education, workforce development, or other purposes.
An ISA that complies with specified terms and conditions and meets certain disclosure requirements is a valid, binding, and enforceable contract and is not subject to state laws that limit interest rates or regulate assignments of future income.
The bill amends the Internal Revenue Code to include an ISA as a qualified education loan (a qualified education loan is not dischargeable in bankruptcy), but it prohibits a tax deduction for interest paid on an ISA (interest paid on a qualified education loan is tax deductible).
Payments to a student under an ISA are not includible as: (1) gross income for tax purposes, or (2) income or assets for federal financial aid eligibility purposes under the Higher Education Act of 1965.
The bill amends the Investment Company Act of 1940 to exclude as an investment company any person whose business substantially consists of making ISAs.”
Income-Contingent Agreements: Past and Present
Agreements involving income-contingent payments have existed for years, most notably in the world of boxing, where it is the norm for fighters to be backed by wealthy patrons in exchange for a percentage of future purses. In addition, crowdfunding platform Lumni has begun serving as an intermediary between ISA investors and investees, while Fantex has been IPO-ing tradable interests in the future earnings of professional athletes.
Proposals consistent with the ISSA bills have been bandied about for quite a while. Milton Friedman’s 1962 book, Capitalism and Freedom, advocated “equity investment in human beings”, seeing this as a means of “strengthening competition, making incentives effective, and eliminating the causes of inequality.”
ISA proponents contend that human capital contracts should not be conflated with indentured servitude so long as the investees’ requirements do not include ongoing performance of specific services. In the minds of some, though, the phrase “human capital contract” evokes associations with forced labor, associations that are difficult to overcome, however great may be the potential value of ISAs to investees.
Income-contingent student loan payment arrangements are currently available, but they differ in several important respects from ISSA 2015 that are particularly unfavorable for low income individuals. As an alternative to debt that accumulates interest and continues to be payable for an indefinite period, ISSA 2015 proposes an equity-like arrangement prescribing income-contingent payments for a maximum of 30 years (albeit with payments suspended and the clock stopping during years with sub-$15,000 income). As a carrot for investors, it also allows for the possibility of deriving high returns when they fund individuals who are financially successful – though with investees’ payment obligations being capped at 15% of their annual income.
Unlike ISSA 2014, ISSA 2015 does not provide investors with unlimited upside in the event that their investees achieve extraordinary financial success. I suspect that the upside was limited in an unsuccessful attempt to attract support from Democrats. Once the Republican majority is seated in both houses, I expect that ISSA 2017 will maintain the 15% of annual income cap but do away with the annual limitation of obligation clause, which reads:
“The percentage of income required under the income-share agreement to be paid by the individual subject to the agreement may not exceed a percentage such that, when multiplied by $15,000 (as such amount is adjusted pursuant to paragraph (8)), the product exceeds the aggregate amount of periodic payments of principal and interest that would be required to be paid during a 12-month period under a comparable loan that bears interest at a fixed annual rate of 20 percent.”
Doing away with this clause will make ISA investing a lot more interesting, keeping hope alive for those investors who dream of making a Saverin-Zuckerberg-like deal that allows them to become billionaires from a $15,000 investment. Moreover, it will also provide additional incentive for investors to play an active role in mentoring their investees.
ISAs vs. Stock Ownership
The JOBS Act and its loosening of restrictions on the public solicitation of accredited investors are likely to accelerate the pace of crowdfunded investment in human capital. In the near term, the vast majority of equity capital raised via crowdfunding is likely to be directed toward businesses rather than individuals. Ultimately, however, many investors may well find ISAs with the entrepreneurs themselves to be a viable, if not preferable, alternative to owning stock in specific ventures.
Due diligence considerations - Whereas properly determining the investment merit of a private company seeking crowdfunding is typically difficult to cost-justify, it is far easier to assess individual entrepreneurs’ odds of achieving financial success. Think of investing in a startup as akin to a Lloyd’s syndicate underwriting insurance for a unique situation – and investing in entrepreneurs’ income potential as more similar to the underwriting activities of a life insurer.
Since situations entailing novel risks (including startups) don’t usually afford much useful historical data from which to calculate the odds of catastrophe or success, proper vetting demands that new data be generated and analyzed, often at great cost. Insuring or investing in the lives of people, on the other hand, avoids much of the need for additional data collection and analysis, especially if the sums at risk are relatively small.
The odds of making profitable investments in startup companies may be vastly improved through market research and a variety of other due diligence and analytical activities that tend to be time-consuming and expensive. Spending thousands of dollars to vet a single venture is certainly justifiable for venture capital professionals making six- and seven- figure bets, but it is totally out of the question for someone investing $10,000 at a time.
To a great extent, the due diligence on individual entrepreneurs has already been taken care of by others through standardized tests, university admissions committees, professors, past employers, and credit rating agencies. Though any given bet on a single entrepreneur’s financial success may still be quite likely to result in a significant loss, the returns on diversified portfolios of bets upon high-achieving individuals of solid character can be relatively predictable. Again, this is analogous to the underwriting activities of life insurers, who can’t say exactly which of their customers will die this year but can say with uncanny precision how many of them will.
Avoiding the perils of minority ownership - Minority investors in profitable privately held businesses often have difficulty deriving cash flow from their investments. It’s not unusual for the bulk of a successful business’s profits to be paid out as CEO compensation. Whereas stockholders typically require dividend declarations or a public market to generate cash flow, investors in ISAs could be paid when entrepreneurs’ tax returns indicate adjusted gross income (AGI) in excess of a designated threshold. (A reputable CPA firm, for example, can be given access to these tax returns through powers of attorney in order to monitor ISA deals on behalf of investors.)
Though there are no foolproof ways to avoid being cheated by a dishonest entrepreneur, the ISA model lowers this risk. Tying investees’ payment obligations to the AGI figures they report to the IRS makes the U.S. government, in effect, an ally in enforcing contract terms. In addition, owning shares in entrepreneurs’ AGI, rather than in their companies, ensures that ISA investors’ interests will not be diluted when entrepreneurs issue additional stock to themselves.
Note also that venture capital firms prefer not to fund businesses with fragmented ownership, due to potential difficulties with gadflies, cranks, and disclosures of sensitive information. Consequently, investing in the founder on a personal level rather than buying the company’s stock enhances its chances of securing additional funding on favorable terms in the future.
Monetizing investor mentorship - Were ISA-facilitating legislation to be passed, ISAs could afford investors the opportunity to enhance their returns by helping investees build their careers over the course of several decades. Traditional angel investments only incentivize investors to mentor company founders for as long as the company survives – and only to the extent that it makes the company more profitable. ISAs, on the other hand, can incentivize investors not only to help investees develop their businesses, but also to wield whatever influence they might have in securing desirable positions for investees with established companies.
Investors who have attained great success in their own careers or possess extensive personal networks of influential associates could undoubtedly negotiate favorable pricing of their ISAs, further increasing their returns. Senior executives of multi-billion dollar businesses, for instance, would be particularly well-positioned to accelerate the careers of those whom they fund, as well as to generate revenue-producing opportunities for investees’ businesses.
A potentially valuable tangential benefit of mentorship for business owners and corporate venture capitalists would be the opportunity to build relationships with extraordinary individuals whom they may want to employ at some point. Rather than relying on a few hours (at most) of interviewing in order to assess a candidate’s suitability, mentoring ISA investees can give them months, if not years, to get to know investees’ strengths and weaknesses, as well as to establish personal chemistry.
Top performers can be many times more valuable to an organization than average performers. Therefore, the ability to identify who they are, get to know them, and develop an advantage in vying for their services can provide a game-changing competitive edge.
Diversification benefits - Given that entrepreneurs tend to benefit from creative destruction of the status quo and the disruption of business as usual, investors are likely to experience a low degree of correlation between ISA returns and the returns of stock in large cap, publicly traded companies with dominant market shares. Thus, ISAs may be useful in enhancing the risk-adjusted returns of conservatively managed equity portfolios.
Facilitating serendipity - The returns on ISA investment funds with multiple investors would stand to benefit as they attract growing numbers of investors, since each new investor would be in a position to add value through support of investees’ businesses and careers. The more investors that such vehicles attract, the greater will be the potential for investors’ serendipitous interactions with investees.
A window to future opportunity - Investors may choose to take advantage of the “window” provided by ISAs into the prospects of businesses founded by investees, potentially opting to make side deals involving investments of cash or sweat equity in these companies. Corporate investors, in particular, might conceivably have either employees who can be called upon to assist investees’ companies in areas of staffing weakness or idle assets that these companies could put to productive use (office space and equipment, for instance).
Psychological and societal benefits - Aside from financial reward, ISA investors may derive satisfaction from developing personal relationships with investees and helping them achieve success. The ISA model provides a basis for these relationships to last for at least as long as the agreed-upon contract term. Consequently, they are more likely to blossom into lifelong collaborations and friendships than are the typical dealings between angel investors and the entrepreneurs they fund.
The potential for societal benefit from ISA investments is likely to be significant, inasmuch as they will often entail the channeling of funds to promising entrepreneurs who might otherwise be financially pressured to scale down, delay or abandon their plans to create new businesses – especially those with significant student loan debt.
Why Wall Street Can Benefit From ISAs
Financial professionals stand to reap sizeable revenues from selling ISAs as a means of diversifying their clients’ holdings. A strong case may be made for the potential of properly vetted ISAs to enhance clients’ returns while lowering overall risk in their portfolios, while providing a variety of less quantifiable but often valuable benefits (e.g. opportunities for mentorship).
Wall Street’s growing need to justify its fees — Firms purporting to add value through the active management of clients’ stock portfolios are having an increasingly difficult time justifying their fees – which is to say justifying their existence. A growing body of historical performance data indicates that actively managed equity portfolios, on average, significantly underperform market indexes. Moreover, given revelations regarding high frequency traders’ ability to front-run other investors’ orders, passive strategies that involve buying exchange traded funds (ETFs) and holding them for many years – if not for the rest of one’s life – make more sense than ever.
Because an ETF can own thousands of stocks in some cases, while providing exposure to virtually every area of the economy, ETF buyers can assemble diversified portfolios without the assistance of a professional advisor. If they use discount brokers, the sales commission charged for buying unlimited numbers of ETF shares may be as little as $5.
Some might argue that Wall Street justifies its fees and commissions by providing financial planning services to retail investors. In many cases, though, relying upon a financial advisor with commission-based compensation to create one’s financial plan is akin to retaining a wolf to guard one’s henhouse. Rare indeed are advisors compensated in this manner who will counsel clients to buy and hold ETFs, since this group tends to be more interested in earning commissions than in making money for clients. Due to their day-to-day activities being more focused on prospecting and selling, they also tend to be less competent than financial planners whose income is solely derived from charging flat hourly rates for their analytical expertise.
Though some investment managers and commission-based advisors to retail clients actually are capable of beating market averages on a consistent basis, they are few and far between. Since the vast majority of them are not, Wall Street stands to eventually lose the lion’s share of its revenues from actively managed products (i.e. mutual funds, hedge funds, and the like) and from the commission-based advisors who actively manage clients’ portfolios.
Consequently, it is imperative that Wall Street develop new actively managed products that can compete effectively with ETFs for clients’ investment dollars. ISAs may well represent Wall Street’s best opportunity to accomplish this on a scale equaling or surpassing the revenue losses in its traditional products and services.
Analyzing the investment merits of individuals rather than companies will call for the development of new skill sets, as will sourcing ISAs and appropriately incorporating them in client portfolios. The effort involved in doing so provides credibility to these activities’ claims of value creation – and the fees that may be charged for them will be a function of the value investors perceive them to add.
ISAs as Door Openers — Financial services firms who originate and market ISAs are likely to find them to be effective door openers. Many retail investors would appreciate the opportunity to enhance their returns by playing meaningful roles in supporting ISA investees’ businesses and careers. Thus, the salesperson bringing this opportunity to prospects’ attention first is likely to open accounts with them and quite possibly sell them additional products in the future.
Investees who are either university students or recent graduates may well have affluent parents. Other things being equal, parents will want to do business with a firm that is involved in promoting their children’s careers.
Investors often have a keen interest in backing other students or alumni of their alma maters. This was confirmed through my conversations with Dan Macklin, Co-Founder and VP of Business Development at SoFi, a crowdfunding business that is able to make student loans at very low interest rates by focusing on students and alumni of schools whose graduates seldom default. According to Macklin, investors attach significant value to the personal relationships they develop with current and former students of their alma maters when lending to them through loans arranged by SoFi.
Consequently, many investors may prefer to buy ISAs that fund those with this connection and donate the ISAs to the school, rather than donating to the school directly. Aside from whatever commission might be earned on the transaction, this will get the salesperson involved in conversations regarding charitable gift and estate planning – conversations that often lead to five- and six-figure life insurance commissions.
As recipients of ISA funding progress in their careers and build their net worth, they will probably be inclined to direct their financial services business to those who helped them get their start. Albeit relatively few in number, the investees who become highly successful entrepreneurs and their companies will be in a position to generate significant fees, not only from wealth management and insurance, but also from investment banking and employee retirement plan business.
In addition, the administration of ISAs will create opportunities for investment salespeople to develop relationships with CPAs that may give rise to significant referral business. Investees may be required to execute powers of attorney authorizing the IRS to provide copies of their tax returns to third parties, such as reputable CPA firms, for the purpose of calculating their ISA payment obligations. Inasmuch as recently enacted SEC regulations require verification of accredited investor status, rather than merely taking investors’ word for it, requesting this authorization should not be viewed as an unreasonable demand. To the extent that salespeople are able to steer this business to CPAs who reciprocate in kind, these CPAs will become valuable referral sources.
Implications for Financial Services Stocks
In general, stocks in the financial services sector will benefit from the passage of ISA-enabling legislation while other sectors will face selling pressure.
Large Cap Financial Services - The financial services firms likely to benefit the most are those with:
- the requisite capital, infrastructure, risk tolerance, and vision to act as underwriters of ISAs on a significant scale,
- a salesforce capable of re-selling these ISAs to both retail and institutional investors, and
- the ability to exploit ISAs’ potential as door openers by cross-selling complementary products and services, such as traditional investments, insurance, lending, investment banking, and real estate.
I won’t attempt to judge risk tolerance and vision, but on the basis of the other attributes above, I believe this list to include (in alphabetical order):
Bank of America/Merrill Lynch (NYSE: BAC)
Berkshire Hathaway (NYSE: BRK/B)
Citigroup (NYSE: C)
Goldman Sachs (NYSE: GS)
JPMorgan Chase (NYSE: JPM)
MetLife (NYSE: MET)
Prudential (NYSE: PRU)
Wells Fargo (NYSE: WFC)
The impact of ISAs on the stocks of financial services firms unable or unwilling to participate in them will be unambiguously negative, due to the resultant competitive disadvantage, as well as inter-asset class cash flows out of stocks and into ISAs.
Small & Mid Cap Financial Services - Quite a few smaller providers of financial services are likely to find regional or other specialized niches in the sourcing and marketing of ISAs.
Most notably, Silicon Valley Bank (NASDAQ: SIVB), whose startup clients number in the tens of thousands, would have a unique ability to connect students possessing extraordinary tech skills and/or entrepreneurial abilities with ISA investors/mentors (especially those in the Northern California angel community) who could further promising individuals’ careers in a variety of ways. Moreover, SIVB has accumulated a wealth of data and specialized expertise over the years that would be invaluable in developing appropriate valuations and structures for ISA deals. Ultimately, I expect SIVB to partner with – or be acquired by – a much larger entity having the financial strength to underwrite ISAs on a significant scale.
As of the 11/25/16 close, SIVB was at $155.97, with a trailing 12 month P/E of 21.1. Its market cap of $7.8 billion was roughly 2.4 times book value. Ordinarily, I wouldn’t consider buying a stock this richly valued. But on closer examination, it’s not quite as expensive as it would seem at first glance.
Annualizing Q3 EPS of $2.12 gives us $8.48 and a forward 12 month P/E of 18.4 (assuming flat earnings ahead), a reasonable P/E for a business whose Q3 revenues were up 19.3% YOY, with YOY earnings growth of 9.7% for the first three quarters of 2016. Given prospects for rising interest rates in the year ahead and other things being equal, one would expect earnings to rise.
Bottom line: SIVB would be fairly valued even if the ISA opportunity were worth nothing. If one believes in the potential of human capital to become a significant asset class, as well as in SIVB’s potential to profit from this happening, then SIVB is a screaming buy.