Venture Capitalists Are Poised to ‘Disrupt’ Everything About the Education Market

Venture Capitalists Are Poised to ‘Disrupt’
Everything About the Education Market

by Lee Fang

Venture capitalists and for-profit firms are salivating over
the exploding $788.7 billion market in K-12 education. What
does this mean for public school students?

In his book, Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow, Michael Moe describes how carefully crafted business strategies have transformed markets to create huge profits in unlikely sectors. The title relates to how Starbucks became a global corporation of almost $15 billion in revenue by capturing and streamlining the café experience. Moe, a former director at Merrill Lynch, wrote that at one point in the United States, even healthcare was an undesirable and difficult industry for investment, and that bankers once worried if profit-making in such a realm was worth their effort. In 1970, healthcare spending comprised 8 percent of GDP, yet market capitalization in healthcare stood at less than 3 percent. That shifted quickly not only as the boomer generation aged, but as a wave of privatization hit hospitals, insurers, and other segments of the healthcare system. More than thirty years later, Moe wrote, healthcare companies are among the largest in the world, and represent more than 16 percent of US capital markets. “We see the education industry today as the healthcare industry of 30 years ago,” Moe predicted.

That book came out eight years ago, before the current wave of education investing, when the prospect for growth seemed dim. Unlike in healthcare, energy and other areas of the economy that have moved from public to private hands, K-through-12 education has stubbornly remained largely out of the control of investors.

Next year, the market size of K-12 education is projected to be $788.7 billion. And currently, much of that money is spent in the public sector. “It’s really the last honeypot for Wall Street,” says Donald Cohen, the executive director of In the Public Interest, a think tank that tracks the privatization of roads, prisons, schools and other parts of the economy.

That might be changing soon as barriers to investment are rapidly fading. As Eric Hippeau, a partner with Lerer Ventures, the venture capital firm behind viral entertainment company BuzzFeed and several education start-ups, has argued, despite the opposition of “unions, public school bureaucracies, and parents,” the “education market is ripe for disruption.”

Hippeau’s vision is the growing sentiment among investors. Education technology firms secured a record $1.25 billion in investments across 378 deals in 2013, while analysts predict that number will continue to surge this year. Since 2010, Moe has led what has been billed as the premiere education investment conference, which takes place annually in Scottsdale, Arizona. The first year attracted around 370 people and 55 presenting companies. This year, that number soared to over 2,000 with over 290 presenting companies and speeches by luminaries including former Governor Jeb Bush, Magic Johnson and Commerce Secretary Penny Pritzker. One of the largest start-ups, a Herndon, Virginia–based company called K12 Inc., a for-profit largely online charter chain, posted nearly $1 billion in annual revenue for its last fiscal year in August.

Many are attempting to duplicate that success. “There’s a dramatic shift in how investors are thinking about this industry,” Fahad Hassan, an education entrepreneur with his own venture-backed start-up, told a meeting of entrepreneurs earlier this year.

The explosion of investor interest in education raises a number of questions, among them: What kind of influence will the for-profit education sector attempt to exert over education policy? And if school reform is crafted to maximize the potential for investor profit, will students benefit, as boosters claim—or will they suffer?

There’s also the question of the effect of privatization on costs. And there, the healthcare example gives reason for concern. The privatization of health services has corresponded closely with skyrocketing costs, leaving millions of Americans without access to care or deeply in debt for seeking treatment for their illnesses. While new laws, including the Affordable Care Act, have extended insurance coverage to some 10 million Americans, many remain without coverage. The United States still spends $8,745 per capita on healthcare, far above the average for all other industrialized countries.

The tantalizing prospect of tapping into the K-12 market has drummed up new level of zeal from education reformers.

A good barometer of this passion is a document distributed by Moe, who now leads a firm called GSV Capital, which invests heavily in education start-ups including Knewton Inc. and Avenues, a New York–based private school with plans to expand into a global chain. Like any sweeping manifesto, his education reform blueprint sets the stage by listing massive social upheavals—the Arab Spring, the Fall of the Berlin Wall and the Spanish Civil War—and asks, for the “Second American Revolution,” one fought to decide the fate of education policy, “Which side of history will we be on?”

The revolution GSV goes on to describe is a battle to control the fate of America’s K-12 education system. Noting that this money is still controlled by public entities, or what’s referred in the document as “the old model,” the GSV paper calls for reformers to join the “education battlefield.” (A colorful diagram depicts “unions” and “status quo” forces equipped with muskets across businesses and other “change agents” equipped with a fighter jet and a howitzer.) The GSV manifesto declares, “we believe the opportunity to build numerous multi-billion dollar education enterprises is finally real.”

This opportunity exists in part because of major policy changes under the Obama administration. States moving to adopt the federal government’s Common Core standards, which include new standardized testing requirements, have incentivized the private sector to provide solutions to schools. According to Paul Irby, a market analyst with Onvia, states striving to implement the new standards could spend upwards of $12 billion, with much of the money going to updating IT, professional development for teachers, and testing technology.

Moreover, the Obama administration’s signature “Race to the Top” program, which provides states with large cash grants in exchange for changing how students and teachers are evaluated, is being viewed as a potential cash cow for education start-ups. In a blog post, Alex Hernandez, a partner with the Charter School Growth Fund, writes that school districts are “raising more money than you can shake a stick at” and the money granted to local school systems from Race to the Top may be used on the latest tech innovations. The most recent round of Race to the Top Funding, he adds, means districts “should be unwrapping new toys for a while.”

The Department of Education under Obama has seen a flow of revolving door hires from the education investment community. In May of this year, the Senate confirmed Ted Mitchell, the chief executive of the NewSchools Venture Fund, as the Under Secretary for the US Department of Education. Prior to his government position, Mitchell, a personal investor in an array of education start-ups, forged a partnership last year with the creators of Facebook app FarmVille to create new education game products. James Shelton, the Deputy Secretary, is a longtime education investor and the former co-founder of LearnNow, a charter chain that was sold to Edison Learning, a for-profit charter management company.

In an interview with EdSurge, a trade outlet, Shelton explained that the Common Core standards will allow education companies to produce products that “can scale across many markets,” overcoming the “fragmented procurement market” that has plagued investors seeking to enter the K-12 sector. Moreover, Shelton and his team manage an education innovation budget, awarding grants to charter schools and research centers to advance the next breakthrough in education technology. Increased research and development in education innovation, Shelton wrote in testimony to Congress, will spark the next “equivalent of Google or Microsoft to lead the global learning technology market.” He added, “I want it to be a US company.”

The other transformative changes come from the state and local level as a new class of politicians, including scores of Democratic mayors and Republican legislators and state officials, have ushered in new laws in recent years to divert taxpayer funding to charter schools, which are often run as for-profit companies and are more willing to embrace tech-centric classroom solutions than their public sector counterparts. In many states, including Florida, Pennsylvania, Tennessee, and Ohio, parents may opt to apply the amount the state would normally spend on their child’s education (between roughly $5,000 to $10,000) to send their children to a charter.

The opening up of the K-12 money for privately run schools, through charter schools or through vouchers applied to private schools, with restrictions on launching charter schools increasingly relaxed in many states, has created a boom in charter businesses hoping to persuade parents to trust their children, along with their money, with them. At present, more than 4 percent of students are enrolled at the more than 6,000 charter schools in operation. Few figures exist on how many of these students are taught by for-profit operators (in most states, charter schools must be registered as nonprofits, though they may outsource their operations to proprietary companies.)

The breakneck speed at which these schools have taken off, often with little oversight, has led to scandals. Since 2013, the FBI has investigated more than five charter schools in Illinois, Indiana, Ohio and beyond on suspicion that management has misplaced or stolen funds. In Florida, a state with famously lenient rules for operating charters and among the highest concentration for-profit K through 12 schools, the Miami Herald has reported on a continuing laundry list of poorly run charters: students going weeks without textbooks, class attendance sheets faked, and children charged illegal fees for standard courses. In a growing phenomenon, one Florida for-profit company, Academica, has earned over $19 million a year by charging leasing fees to public school land already owned by its charter schools.

Does free market competition ensure accountability in education by turning bad operators into economic losers? That’s what privatizers claim, but the record so far suggests otherwise.

K12 Inc., the for-profit charter behemoth that enrolls 123,259 students, went public in 2007 with the help of Moe’s previous investment firm, and has since been a darling of Wall Street. In January of this year, students from Newark Prep Charter School, which is K12 Inc.-operated, joined executives from the company to ring in the bell of the New York Stock Stock Exchange. In Moe’s revolutionary manifesto, K12 Inc. is listed as among the businesses he considers the “special forces” that will remake the education landscape.

The rising revenues of K12 Inc. have been matched by poor performance. In the 2010-2011 school year, only 27.7 percent of K12 Inc.-operated schools met the Adequate Yearly Progress (AYP) standard, far below the 52 percent average of brick and mortar public schools. An investigation in Colorado, where K12 Inc. has been ejected from several school districts, found that nearly half of online students left within a year, and when those students returned to brick and mortar schools, they were further behind academically than when they started. Similar investigations in Florida and Ohio found K12 Inc. teachers instructing classes without certification and instructing online classes of over 250 students.

In several states, K12 Inc.-operated virtual charter schools have faced a backlash because of poor performance and high drop-out rates. In July, Tennessee’s education commissioner announced the closure of the Tennessee Virtual Academy, K12 Inc.’s affiliate school, at the end of the 2014-2015 school year because of the charter’s failure to score above the state’s lowest level of academic achievement. Last month, Pennsylvania’s Agora Cyber Charter School, the largest school managed by K12 Inc., voted to consider ending its relationship with the company after revelations that the school allegedly manipulated attendance sheets and performance data in an attempt to conceal incredibly high rates of student turnover.

Still, despite wave after wave of negative press, K12 Inc. figures as a solid investment opportunity to many. Baird Equity Research, in a giddy note to investors this year about the potential growth of K12 Inc., noted, “capturing just two million (3.5%) of the addressable market yields a market opportunity of approximately $12 billion … Over the next three years, we believe that the company is capable of 7%+ organic revenue growth with modest margin expansion.” How will it achieve this growth? According to Baird, K12 Inc.’s “competency in lobbying in new states” is “another key point of differentiation.” The analyst note describes “K12’s success in working closely with state policymakers and school districts to enable the expansion of virtual schools into new states or districts” as a key asset. “The company has years of experience in successfully lobbying to get legislation passed to allow virtual schools to operate,” Baird concludes.

Indeed, K12 Inc.’s spectactular growth over the years stems largely from the extraordinary amount the company spends on lobbying, as well as on marketing and advertising, with promises in some areas that enrollment comes with a free computer. USA Today found that the company spent $21.5 million on advertising in the first eight months of 2012. The company sponsors billboards, radio advertisements, and spots on children’s cable television.

K12 Inc.’s lobbyists helped author model legislation to develop sweeping voucher laws through the American Legislative Exchange Council, a conservative group that provides state lawmakers with template legislation. Though state by state lobbying figures are difficult to come by, given the patchwork of varying laws, K12 Inc. has hired dozens of local officials to ensure that these voucher laws are quickly passed with few amendments. “We have incurred significant lobbying costs in several states,” K12 Inc. noted in a filing with the SEC.

“The stockholders benefit from those students’ enrollments, but the students get stuck with a lousy education that will follow them the rest of their lives,” says Jeff Bryant, the director of the Education Opportunity Network.

Nevertheless, Moe and his cohort have pledged to grow the industry by leaps and bounds in coming years. At the last two conference he organized, there was talk of organizing a bipartisan campaign to persuade 2016 presidential candidates to sign onto a statement of principles endorsing charters and other education innovations. The pledge also called for the federal government to create new tax incentives for spending on education companies akin to a health savings account.

At the last conference in April, Moe closed on an optimistic note. “How do you balance this whole idea between making a profit and helping kids?” he asked. “The way that we think we’re going to create the greatest returns for our investors is by investing in companies that have the greatest educational impact.”

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s