For-profit and undeterred

April 10, 2012: 5:00 AM ET

Despite recent scandals, the for-profit education sector is doing just fine and is likely to keep surging.

See clarification below.

By Katherine Ryder, contributor

FORTUNE -- At a recent conference at the marbled University Club in New York City, the caveat-filled headline said it all: "Private Equity Investing In For-Profit Education Companies: Despite grumbling from activists & politicians, the industry is getting good results."

For-profit education is indeed growing at a remarkable clip -- enrollment in for-profit schools grew by 235% from 2000 to 2010. This growth also seems to be coming at a particularly opportune time. President Obama recently set a goal of having the highest proportion of graduates in the world by 2020, yet cuts to community colleges and public universities, forced in part by fragile state finances, are undermining the ability of the public sector to support the president's mandate.

And yet, as implied by the "grumbling," free-market education is hardly a silver bullet. Indeed, while it may be an important part of the solution to America's education problems, detractors claim that for-profit education is also exacerbating one of the core frailties of the American economy—its indebtedness—by cashing in on cheap federal student loan money and pushing consumers into degrees they cannot afford.

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A series of recent reports have tarnished the industry's reputation. First, a report by the non-partisan Government Accountability Office in 2010 revealed deceptive recruiting tactics at fifteen for-profit schools, as well as a very real gap in the debt-to-income ratio of students. A second study by three Harvard researchers, published this year by the National Bureau of Economic Research, found that in a random sample of students at both for-profit and private universities, the for-profit students were less likely to be satisfied with their courses, were more likely to default on their loans, and were more likely to have poorer employment outcomes five years after starting the degree.

Regulators responded by forbidding predatory recruiting methods, and introducing a "gainful employment" requirement that stipulates that if a student borrows money, the earned degree should lead to salary that allows the student to pay back the loan. The industry's lobby group is currently fighting the regulation, saying it would adversely affect the low-income communities it attempts to serve. But even if this regulation does wind up passing, the structural issues of education costs and free-flowing government loans imply that the problem will persist.

Given ballooning student loan debt -- The Consumer Financial Protection Bureau came out with revised figures a few weeks ago that put total student debt outstanding at above $1 trillion -- it seems odd that the government hasn't better scrutinized the interplay between government loans and for-profit education. Answering three questions could help shed light on the matter.

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First, given increasing competition, why aren't tuition costs falling at for-profit universities? The gainful employment requirement remains highly contentious, raising the question of whether tuition should be lower across the board. Whereas almost all for-profit companies have been negatively affected by the federal and public scrutiny recently, one that is doing well, American Public Education, has succeeded because its 87 online courses are cheaper than those of its competitors. One would think the for-profit education sector, like any for-profit sector, would start competing on price.

The for-profits' response is to blame the government's 90/10 rule, which states that a company can't fund itself with more than 90% of federal debt. That means if schools drop their tuition too low, they would be in violation of the rule—given that students tend to get lump-sum loan payments from the government, regardless of what their schooling costs.

"The government inadvertently plays a role of price fixture in education," says Andy Rosen, the CEO of Kaplan, Inc, in an interview with Fortune. "The government should be encouraging price competition." Yet one of the recent regulations that the government has proposed is including military federal student funding in the 90/10 rule. If this eventually passes, it would make it even more difficult for for-profits to drop prices—and might have a particularly strong effect on American Public Education, which is able to keep its courses so cheap because it attracts so much military federal money.

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A second major question is why the government doesn't subsidize education more for the lower-income population, pushing some of the for-profit players out of business? President Obama has spoken about the need for more community college funding. But the reality is that government budget cuts are making this difficult. Santa Monica College, a community college in Southern California, recently announced that it would be charging students more for popular courses—infuriating students and leading to protests. But the college is in a tight spot—the most recent California education budget cuts announced another $564 million lost in state aid for Santa Monica College and its brethren.

Finally -- and perhaps most significantly -- one can ask why the government doesn't play a more active role denying loan applications for students if the programs they are entering seem unlikely to give them the ability to pay off their debt. This issue relates to both for-profits and more traditional education. It's a hard choice that requires significant political will—particularly given that it hits at the heart of the American Dream ideology of education. In the 1960s and 70s, college was cheaper, salaries were rising, and debt accrued didn't break the bank, even if you made some mistakes along the way. The financial, psychological, and systemic costs are much higher now. Should everyone be entitled to federal money for higher education?

What's most clear, in the near-term, is that so long as cheap tuition credit remains available, both the for-profit sector and traditional universities are likely to continue charging high prices to meet student demand—and that this demand will keep growth in the sector quite strong. Jeff Silber of BMO Capital Markets predicts that long-term, the for-profit-education sector's best performers will get up to the "mid to high single digits growth." The hope is that this growth will yield productive economic benefits, by helping a new generation into the workforce. Without government intervention to rationalize loan finance, however, education demand could also potentially push U.S. debt problems even closer to the brink.

This story refers to American Public Education's 87 online courses. In British English, this is analogous to degree programs. Fortune regrets any confusion.

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