For the past quarter of a century, the cost of a college education has grown at an exponential rate… The unsustainable growth in tuition prices is a phenomenon that has gripped the nation, raising generations who are in serious debt before they can even legally buy a drink, and who are often burdened with this debt for most of their adult lives.

Giovana Sarmiento, Medium

With this series, I hope to show you my view of higher education, split into four parts:

1. Costs: How out-of-control costs have fueled the industry’s financial disaster
2. Revenues: How university revenues are becoming more concentrated and why this is dangerous
3. Covid-19: How Covid-19 is affecting the industry and why schools are getting desperate
4. Solutions: What (limited) solutions exist to break out of this crisis

In this week’s post, we look at Part 2, revenues, in order to explore how university revenues are becoming more concentrated and why this is dangerous. In case you missed it, here is Part 1.

A Quick Refresher: The Super TLDR of the Problem

Universities are stuck in a vicious cycle that is deteriorating their financial health. Here’s what’s happening:

In its simplest form, the problem is that costs are being driven upward at a rate that revenues cannot match.

The Troubling State of Revenues

In Part 1, we found that costs in higher education are rising at an unsustainable rate. Let’s now take a look at the other side of the equation, revenues, and how universities may aim to raise revenues amidst rising costs.

While every school has different activities that make money (hospitals, sports, research, etc.), in general, all schools share three major revenue streams: tuition & fees, endowment & gifts, and government funding. Let’s take a deep dive into each of these, going from smallest to largest.

Stream 1: Government Funding

• Analysis: Contrary to popular belief, both public and private universities get funding from the government, albeit at different levels. In a study conducted by Bain & Company, researchers found that from 1985 – 2010, government support to schools remained relatively flat and actually shrank by a small margin.

• Opportunities for future growth: Limited. The recent polarization of higher education in the government (i.e. “the Radical Left is indoctrinating our youth”) has made government support for educational institutions a political issue. On July 10^th, President Trump tweeted asking the Treasury to re-examine the tax-exempt status of universities, a move, if implemented, that would seriously cripple the revenues of universities. While removing the tax-exempt status of universities would be a difficult hurdle for the administration, either way, no growth in government financial support combined with the recent politicization of higher education has made growth prospects for this revenue stream limited.

Stream 2: Endowment & Gifts

• Analysis: Universities make another stream of revenue through their endowment and the gifts that they receive from private and alumni donors. While you may hear about schools with massive endowments and wonder how they could ever have financial issues, most endowments are typically setup so that the university can only spend the interest that they make on the endowment. Thus, by comparison, the actual endowment revenue is much smaller than the endowment itself.
  • Additionally, most donor gifts are restricted, meaning that the university can only spend the interest generated by the donation specifically for the purpose specified by the donor. This type of gift stops the university from freely spending its endowment revenues on areas that need funding.

• Opportunities for future growth: Limited. Since endowment revenues are dependent on the performance of the larger economy, universities have relatively little control on this revenue stream.
  • Additionally, endowment revenues are extremely variable. Despite the 2010s seeing one of the largest economic bull markets in history, universities still saw three years of near-zero or negative returns from their endowments.

Stream 3: Tuition & Fees

• Analysis: Finally, the biggest revenue stream for universities. For universities targeting growth in their tuition revenue to compensate the rise in costs, there are two levers in which they can pull: volume and price.
  1. Volume: Growing the volume of students that attend your university is a tricky proposition. Universities are often physically constrained from taking more students because of building space, meaning that adding new students would also result in new costs, such as building classrooms and dorms.
     
     
  2. Price: Alas, in the face of limited alternatives across every other revenue stream, universities have turned to raising their tuition prices in order to raise revenues. The figure below shows that over the last 18 years, tuition prices have risen by 2.4% per year adjusted for inflation (4.6% non-adjusted) for private non-profit universities and 3.5% per year adjusted for inflation (5.7% non-adjusted) for public non-profit universities.
     • While that might seem relatively low, these numbers mean that in the 20^th century, private university tuition prices (not adjusted for inflation) have doubled while public university prices have nearly tripled.
       

• Opportunities for future growth: Mixed. Clearly, increasing prices without increasing value (as shown in Part 1) is an unsustainable growth pattern. Tier-1 Universities with pricing power, long waitlists, and low acceptance rates can do this because there will always be students (and parents) willing-to-pay for a top-notch education. However, the prospects are much worse for everyone else, as raising prices will come with a drop in enrollment and a limited incremental increase in revenue.

The 3 Consequences of Raising Prices

Consequence 1: Universities have a fundamentally riskier business model than they did 20 years ago.

• Analysis: As universities are raising prices and making a higher percentage of their money from tuition & fees, their revenue streams are becoming more concentrated and less diversified. The fundamentals of portfolio theory dictate that this is fundamentally riskier for universities, as one change in the overall model (Covid-19…) could disrupt a larger share of their revenues.

• Why This is Dangerous: While the industry-wide distribution of revenue streams for private non-profit universities looks relatively diversified (left side of chart), smaller private universities, such as Concordia University Texas in my hometown of Austin, Texas, are looking a lot like the right side of the chart. It’s easy to see how a small disruption, such as Covid-19 (covered in Part 3), could force Concordia University Texas and its 80% of revenues from tuition & fees into financial turmoil.

Consequence 2: As tuition prices rise, enrollment decreases.

• Analysis: The laws of supply and demand dictate that as price goes up, quantity demanded will go down. Even if universities are finding more revenue from this price-quantity trade-off, these increases are not sustainable. Eventually, universities will find that for every incremental increase in tuition prices, they will lose a number of students that will eventually result in lower overall revenue. The graph below shows how enrollment in US universities has dropped by 1% per year over the last six years.

• Why hasn’t enrollment dropped even further? A major component of the price-quantity trade-off is financial aid. In order to attract students in the midst of decreasing demand, universities have been increasing the amount of non-merit-based financial aid and effectively discounting the cost of their tuition in order to boost enrollment.
  • In a 2015 survey of university business officers, 49% of respondents selected that they either “strongly agree” (33%) or “agree” (16%) with the statement that their school’s tuition discount rates are unsustainable. Ultimately, this suggests that half(!) of the universities in the US are in a bad financial spot and may see enrollment significantly drop when they can no longer discount tuition at the levels they have been in the past.

• Result: This is the link in the vicious cycle between steps two and three. Tuition increases lead to less demand for a college degree.

Consequence 3: As universities face less demand, they are forced to increase spending to attract students.

• Analysis: Back in Part 1 on costs, I discussed how a contributing factor to the “Law of More” is that schools feel the need to spend more to attract students. This factor is compounded by the fact that enrollment is decreasing. In order to boost demand, schools are spending more on areas that they think will attract students, such as building renovations and support services.

• Result: This is the final link in the vicious cycle between steps three and one. In the midst of decreased demand, universities increase school spending to attract students.

Parting Thoughts

Universities are in a tough spot. They are stuck in a perpetuating cycle of increasing spending and tuition, seeing enrollment decrease, and compensating for decreased enrollment by spending more again.

And once again, these issues started before Covid-19! Stay tuned for next week’s issue on how Covid-19 has impacted higher education before we tackle potential solutions in Part 4.