When Investor Incentives and Consumer Interests Diverge: Private Equity in Higher Education

This paper studies the role of private equity in for-profit higher education.

Private equity and formerly private equity owned schools account for approximately 35 percent of total US for-profit enrollment, which in turn totals more than 2.5 million students per year. Relative to closely-held private firms or diffusely-held publicly traded firms, private equity owned firms have particularly high-powered incentives to maximize profits. In education, one reason such high-powered incentives might be poorly aligned with student interests is that education is heavily subsidized. Federal grants and federally guaranteed loans comprise around 90 percent of for-profit schools' revenue. This revenue has essentially no tie to student outcomes.

We find that student outcomes, including graduation rates, loan repayment rates, and subsequent labor market earnings deteriorate after a school is bought by a private equity firm.

Increased revenue from enrollment expansion and tuition increases lead profits to triple. The adverse effects of buyouts on student outcomes could derive from changes to the student body composition (i.e., the school attracts less well-prepared students). While composition changes likely occur, we find evidence that operational changes also come into play.

Education inputs, including the ratio of faculty to students, the absolute number of faculty, the share of spending devoted to instruction, and the absolute dollars spent on instruction, decline after the buyout. Private equity ownership leads to enrollment increases, which seems to reflect additional marketing and recruiting effort. Our results suggest that this effort is more aggressive at private equity owned for-profits than at independent for-profits, which have broadly been accused of deceptive, predatory marketing [1].

Law enforcement actions, most of which are related to misrepresentation and violation of recruiting rules, increase dramatically after private equity buyouts. The vulnerability of the target population may help explain how marketing could overcome the apparent disconnect between deteriorating outcomes and increasing enrollment. Students at for-profit schools tend to be socioeconomically disadvantaged, even relative to students at community colleges which are the closest comparison. Students at private equity backed for-profit colleges are disproportionately low income, women, African-American, Hispanic, and single parents.

A defining feature of the for-profit higher education industry is that the vast majority of revenue comes from government subsidies and guaranteed loans. Students pay tuition, which is financed by federal grants and loans, and schools are paid regardless of student outcomes. Even if students end up defaulting on their guaranteed loans, the schools are still paid via tuition revenue. The separation of revenue (from the government) from customers (the students) could create opportunities for rent-seeking behavior, helping to explain why high-powered incentives in this industry lead to adverse student outcomes. Buyouts lead to increases in per-student borrowing (the vast majority of which is federally guaranteed) and per-student federal grants. Also, the share of revenue from federal sources increases following a buyout.

We show using several complimentary strategies that private equity owned schools are better at capturing government aid. For example, we exploit an increase in student loan borrowing limits in 2007. Relative to other institutions, private equity owned schools responded to the increase by raising tuition faster than other for-profit schools did, which induced higher levels of borrowing. Superior capture of government aid, a purely rent-seeking phenomenon, appears to be an important channel through which high-powered incentives translate to higher profits. From a welfare perspective, this greater capture of federal aid that ensues after a buyout is unambiguously not in students' or the taxpayer's interest. It seems likely that subsidies to for-profit higher education could be improved to better align incentives between school owners and students.

Our conclusions contrast with recent research in other industries such as retail, food services, and manufacturing, and highlight the fact that the effects of private equity acquisitions may differ across industries. Much recent work in these sectors shows that operational changes induced by private equity ownership improve customer outcomes. One example is the May 18 post on this website, by Cesare Fracassi, Alessandro Previtero, and Albert Sheen. They study chain retail stores, a sector characterized by high competition, transparent product quality, and immediate market feedback. Incentives may be less well aligned with customer interests in sectors with intensive government subsidy, which typically also feature less competition, opaque product quality, and customer outcomes measurable only many years after payment. Sectors with these characteristics, such as healthcare, infrastructure, and defense, receive large amounts of private equity investment and are relatively understudied in the academic literature.

[1] E.g. https://www.gao.gov/products/GAO-10-370R, https://www.gao.gov/products/GAO-10-948T, https://eric.ed.gov/?id=ED538112.