November 4, 1999

Investors Are Seeing Profits in Nation's Demand for Education

By EDWARD WYATT

When Arthur Levine, president of Teachers College at Columbia University, met last year with Michael Milken, the fallen junk bond king turned education entrepreneur, it was more than a case of the old school meeting the new.

"The message was, 'You guys are in trouble and we're going to eat your lunch,' " Dr. Levine said, recalling what he considered not a direct threat but a kind of predatory challenge.

Milken, whose Knowledge Universe companies range from preschool to corporate training, is not the only one who is hungry. Businessmen like Paul Allen, the co-founder of Microsoft, and Lamar Alexander, the former presidential hopeful and former governor of Tennessee, are flocking to education, bringing with them a flood of dollars. They say they will turn the $700 billion education sector into "the next health care" -- that is, transform large portions of a fragmented, cottage industry of independent, nonprofit institutions into a consolidated, professionally managed, money-making set of businesses that include all levels of education.

While the for-profit education business has been evolving for several years, with the establishment of Christopher C. Whittle's Edison Schools and the University of Phoenix's college for working adults, the transformation is now occurring on a far larger scale. The dissatisfaction with public schools of parents of school-age children and the demands of the economy are fueling a flow of billions of dollars from corporations, pension funds and the general public into for-profit educational ventures.

For-profit companies are setting up law schools and new elementary schools, training factory-floor employees to use computers and taking over the operations of existing junior high and high schools. Their motives, the companies say, are to wring the waste from a system built largely on public largess and nonprofit benevolence, turning it into an efficiently run and profitable machine -- using investors' money instead of tax dollars.

"Changes in education are coming as surely as the Berlin Wall went down," said William F. Weld, the former governor of Massachusetts who is part of a group that has raised $150 million to invest in for-profit education and training and which hopes to raise another $100 million by early next year.

Eight years ago, when he was governor, Weld encountered stiff opposition to the concept of schools managed by for-profit companies. This month, Edison Schools Inc., the Whittle brainchild that operates 79 new and existing elementary and secondary schools in 16 states, including Massachusetts, hopes to sell $170 million in stock to the public.

"These ideas would not have flown in 1991," Weld said. "People just couldn't wrap their minds around it. Now we can't put the genie back in the bottle."

Even institutions like New York University and the College Board have formed for-profit subsidiaries to produce and market online courses and other educational services, some of which might be the source of public stock offerings.

In many ways, the race to invest in education marks the triumph of a market mentality that has consumed the nation in the late 20th century. No longer is education, where institutions of learning grew out of religion, the route to spiritual enlightenment. For many students, it is the place to start a business or accelerate their movement up the career ladder.

Wall Street's interest is the result of big societal changes in the past generation. Nearly half of all students in higher education today are over age 25, up from 28 percent in 1970. Many of those students are seeking skills to change careers. Corporations, meanwhile, no longer view training as a cost to minimize but as a competitive advantage to exploit.

As in health care, entrepreneurs assume that they will be able to solve the intractable problems that have baffled government and nonprofit institutions.

"In the business world, we've seen a movement toward the hollowing out of the corporation to cut costs," said Guilbert C. Hentschke, dean of the Rossier School of Education at the University of Southern California. "Now, in a sense, you've got that same process in schools, where districts are entering agreements for outsourcing, contracting for services and chartering new schools."

But analysts warn that as Wall Street rushes in, investors might find that the education business does not open itself to the free market as willingly as did health care, utilities or other industries that operated under longtime government regulations that limited competition.

Where for-profit enterprises have been introduced in education, there is little evidence so far that students are performing better, that high school graduates are getting better jobs or that corporations are teaching skills that benefit the individual as well as the company.

"It's difficult to impossible to determine if a for-profit school is doing a better job than a comparable public school," said Henry M. Levin, a professor of economics and education who heads the National Center for the Study of Privatization in Education at Teachers College.

So far, at least, "private schools and those public schools that are run by for-profit management typically seek students that are not costly to educate," Dr. Levin said. "That's not cheating. They are playing by the rules of the game. They want to do a good job, but they also want to make a profit. But the result is that you can't really compare them with public schools."

In that sense, if for-profit schools wish to expand they will have to take in less capable students and investors might find themselves on the same road as investors in H.M.O.'s several years ago. Those organizations were initially able to cut costs by offering services to groups of relatively healthy people -- employees of big corporations, for example. But as H.M.O.'s began supplementing their growth by recruiting less healthy individuals, costs rose, profitability sank and investors faced big losses.

Companies like Apollo Group, parent of the University of Phoenix, the country's largest private university, have been profiting from education and raising money from the public for several years. In addition, companies like DeVry Inc., ITT Educational Services, Sylvan Learning Systems and General Physics have long offered educational and training services to individuals and corporations, and venture capital investors and companies like Intel and Microsoft have been pouring money into educational start-ups.

Newer investors, however, are viewing a much broader span of learning as potential profit centers. An example is Knowledge Universe, the conglomerate assembled by Milken. Among its companies are Leapfrog Toys, a maker of reading and language products; Knowledge Learning, a day-care chain; Teacher Universe, which supports the use of technology in the classroom; MindQ Publishing, which develops multimedia learning systems; and Productivity Point International, which offers technology training for corporations.

"Ten years ago this industry did not exist," said Scott L. Soffen, a financial analyst at Legg Mason Wood Walker, an investment firm in Baltimore. The success of some of the early players -- Apollo, DeVry, the Learning Company -- was so exceptional that Wall Street was captivated, Soffen said. "Nothing attracts interest more than an industry group with momentum on Wall Street."

The opportunity to make money in education certainly looks good. The education and training industry accounts for 10 percent of the United States economy, as measured by gross domestic product, according to "The Book of Knowledge," a report issued last spring by Michael T. Moe, director of global growth research at Merrill Lynch. But education and training account for less than two-tenths of 1 percent of the value of the domestic stock market -- $16 billion out of $10 trillion, so there is plenty of room for growth and for companies to find profits in the education sector. Health care, by comparison, represents 14 percent of G.D.P. and a similar percentage of the value of the United States stock market.

There are plenty of private companies ready to soak up investors' dollars, said Michael R. Sandler, chief executive of EduVentures, an investment and consulting firm in Boston. Roughly $6 billion has been invested in private education companies by venture capital firms and other investors, he said, "an enormous amount of untapped market value."

Edison, the much-publicized effort by Whittle to build a better public school, is a long way from profitability. In the year ended June 30, the company lost $50.5 million on revenues of $132 million. Since its inception, Edison's losses total $113 million.

By taking on the elementary and secondary school market, Edison was somewhat unusual among for-profit education companies. Most efforts are focused on areas where others have already forged for-profit businesses and where it is likely to be far easier to make money -- the sale of textbooks and school supplies, for example, publication of learning materials, operation of preschools and delivery of classes and test preparation services over the Internet.

Those are the areas where the partnership including Weld hopes to succeed. The group, known as Leeds Equity Partners III, will be managed by Jeffrey T. Leeds and Robert A. Bernstein, two former investment bankers at Lazard Frères & Company who were among the early investors in Edison Schools. On the group's board of advisers are Thomas F. McLarty 3rd, the former chief of staff for President Clinton, and Lamar Alexander, the former governor of Tennessee.

"We really like the post-secondary part of the education business," Leeds said. He said he believed that schools providing professional training and certification -- in business, law, psychology, even medicine -- could be operated for-profit. If that training could take place over the Internet, serving students who cannot take time off from work or travel to a central campus, all the better, he said.

Lately, education stocks have badly trailed the market. The best investments have been in companies that offered computer-based training -- companies like CBT Group and Learning Tree International.

If primary and secondary school makes for a tough market, however, the need to constantly upgrade the skills of workers means that the most promising for-profit sectors are those where people need more education, after they have finished high school or college and entered the work force, said Dr. Levine, the president of Teachers College.

"I don't know whether these companies can do a better job of educating people," Dr. Levine said. "But they are the most aggressive and creative actors in higher education today. Some of them have shown they can make a profit. And that means that much of this industry is up for grabs."

Copyright 1999 The New York Times Company