FEATURE STORY
Many schools have narrowly escaped debt defaults, but expect their fortunes to change.
by Jamie Mason
Moody’s Investors Service Inc. has never seen any of the colleges it rates default on their debt. Only two nonprofit colleges rated by Standard & Poor’s have defaulted in the past dozen years.
But a new normal is coming. Financial troubles are afflicting nonprofit colleges that have a liberal arts focus, have a single-sex student body, have outdated programs and facilities, or are in rural locations, according to Joseph D'Angelo, a partner at crisis management firm Carl Marks Advisors.
Nonprofit schools such as Sweet Briar College in Sweet Briar, Va., Dowling College in Oakdale, N.Y., Franklin Pierce University in Rindge, N.H., Ashland University in Ashland, Ohio, Alabama State University in Montgomery, Ala., Mills College in Oakland, Calif., and even the University of Puerto Rico all face an uncertain future when it comes to default. And they aren’t alone.
“Higher education institutions were almost shielded from reality,” said Greg Charleston, a senior managing director at crisis management firm Conway MacKenzie Inc. “I expect we will see more defaults in the next five years because of the change in what consumers are willing to pay for higher education.”
Major financial woes have already beset the for-profit college sector, of course. Two of them, Corinthian Colleges Inc. and ATI Enterprises Inc., have both filed for bankruptcy protection and liquidated. Others, such as Education Management Corp., have either restructured out-of-court or are currently doing so.
But nonprofit colleges have heretofore been pretty resilient.
According to S&P senior director, Jessica Matsumori, among the nonprofit colleges the firm has rated in the past dozen years, only Haverhill, Mass-based Bradford College defaulted and closed its doors in 2000 and San Diego-based Thomas Jefferson School of Law defaulted on its bonds in June 2014.
Thomas Jefferson School of Law revealed in October that its financial situation became untenable during the Great Recession when its new building was worth less than the money it borrowed to pay for it. At the same time, there was a national shrinking of the law school applicant pool, resulting in a decline in the school’s income.
The college had started earnest debt restructuring discussions in April 2014 but missed a payment over the summer. On Oct. 29, the school signed a restructuring support agreement with nearly 90% of its bondholders that reduced its debt by two-thirds and reduced its annual cash flow obligations by half. The agreement also ensured that Thomas Jefferson School of Law would be able to continue its operations at its campus in San Diego, according to a statement from the school.
Thomas Jefferson School of Law had raised $127 million by issuing bonds that were priced above 11% that it used to build its state-of-the-art building in San Diego in 2008. Through the restructuring, the bondholders took a big haircut, and the school was able to cut its debt by $87 million. The bondholders received $40 million in new bonds priced at 2% and became owners of the new building, and leased it back to the school for up to 10 years for $5 million in annual rent.
The Thomas Jefferson School of Law situation isn’t likely to be an aberration, either. Schools often take on debt to build new buildings or improve their campuses. And public ones can take on more because they get aid from the states they’re in.
According to Edith Behr, a Moody’s vice president and senior credit officer, the median of outstanding debt for public universities for fiscal year 2013 was $237 million, while the median of outstanding debt for private universities for fiscal year 2013 was $106 million. Compare that to fiscal 2002, when those figures were $101.2 million and $104.9 million, respectively.
Behr said that there is a small portion of Moody’s nonprofit college ratings portfolio - roughly 20% - that is weakening. These schools are having a hard time maintaining and increasing their revenues and enrollments. She said that these schools also have fixed costs that can’t be reduced, such as tenured faculty and debt service requirements.
But college enrollment trends are flat or down “at the same time that you have many institutions that incurred sizable debt over the last 10 to 15 years for new facilities in order to compete for students,” according to Jonathan D. Tarnow, a partner in Drinker Biddle & Reath LLP’s education law practice. “At the moment, everyone is competing for a smaller number of college students.”
As a result, the calculus no longer adds up.
“As with any budget, if your revenue stream isn’t what you predicted to service your debt obligations and you can’t lower expenses, you could end up having a liquidity problem,” he added.
Families and students are reconsidering the costs of higher education and more carefully considering the return on that investment, and where to make it, Tarnow said.
That mindset represents a sea change. Borrowing had become a given when it came to a college education, and school administrators got used to that thinking.
“They had an everlasting ability to raise the tuition rate, as most students pay tuition through student loans,” asserted Conway’s Charleston, who noted that the formula where students borrow money, get a job and pay their student debt back worked for many years. “In the last five years, that formula doesn’t seem to be working as well.”
Charleston said people are weighing the cost of education against the kind of salary they can command upon graduation, putting pressure on schools when it comes to what they can now charge.
Many schools are already seeking ways to cut costs, taking steps such as freezing positions, offering early retirement incentives to reduce their workforces or by cutting their nonfaculty staff down.
“It’s not one size fits all,” noted S&P’s Matsumori about the various paths nonprofit colleges are taking.
Carl Marks’ D'Angelo suggests that those schools have also started to become more innovative in their restructurings-or have to begin to.
He said that some schools need to cut programs that aren’t sustainable anymore and noted that some schools have created joint ventures to consolidate their back office functions. He also said that schools have to differentiate themselves by doing things like having programs that let students study abroad or take classes at another school nearby, adding that it’s vital for colleges to embrace the Internet for education delivery to today’s millennials.
Schools have had to offer more scholarships to attract more and better students, but offering discounts to students means a decrease in revenues, and on top of already declining enrollments, operating deficits threaten to become unsustainable, D'Angelo said.
Historically black colleges and universities, known as HBCUs, are struggling, in part, because of federal reductions to Title IV, which is financial aid from the federal government in the form of Pell Grants and other programs. Pell Grant programs have been shortened to six years from eight years and Parent PLUS loans have also been reduced significantly, D'Angelo asserted.
But as for-profit colleges have already discovered, Title IV funds aren’t available for schools that file for bankruptcy. As a result, a vital debt restructuring tool is off-limits for nonprofit colleges.
“There are a number of nonprofit schools facing difficulty, for a host of reasons, that is causing them to look at different restructuring options,” according to Dennis Cariello, a shareholder at Chicago law firm Hogan Marren Babbo & Rose Ltd., who has been involved in various restructurings in the education space. “The lack of a bankruptcy remedy has greatly affected the capital markets in higher education, particularly as it relates to obtaining bank debt. With bankruptcy, there is an orderly process to resolve things when an institution can’t meet its obligations. Without that remedy, debtholders don’t have a clear exit strategy when things go bad.”
Most colleges and universities do have endowments, which are gifts from donors that are invested, to rely on. The earnings from the endowments can be used for various purposes, including operations.
“It can look like a school won’t be able to continue its operations, but then someone comes along and saves the school year, after year, after year, after year,” S&P’s Behr said.
The endowment at Sweet Briar figured prominently in what happened at the school and its prospects going forward. The women’s college faced closure this summer after the school’s board of directors voted so on Feb. 28 “as a result of insurmountable financial challenges,” it said in a March 4 statement.
According to the college’s new president, Phillip Stone, who was the former president of Bridgewater College in Bridgewater, Va., and a Virginia attorney, Sweet Briar’s previous administration cited persistent enrollment declines, despite deep tuition discounts requiring an unsustainable draw on the college’s endowment; significant liabilities in debt obligations and maintenance needs; and too few unrestricted funds available to meet operating costs in the coming year for its decision to close.
The board had decided to close the school while there was still enough in the endowment to help current students transfer to new institutions, pay its creditors, and try to provide faculty and staff with severance and outplacement services. In a June 18 report, S&P said that Sweet Briar was facing nonpayment on its roughly $26 million in debt due to a liquidity crisis and a potential covenant breach, which could have triggered a default. Sweet Briar has about $9 million in bank debt and $16.5 million in bond debt.
But Stone said via e-mail that the school will pay all of its obligations on time, including its bond debt.
“We will certainly explore possibilities for restructuring the bond debt to make repayment more comfortable to us,” Stone added.
On June 20, it was disclosed by both the college and the Attorney General in Virginia, Mark Herring, that a plan had been reached to keep the school open.
Judge James W. Updike Jr. of the Bedford Circuit Court in the 24th Judicial Circuit of Virginia approved the settlement to keep the school open and resolve the litigation surrounding its closure on June 22.
The settlement was reached between Amherst County Attorney Ellen Bowyer, Saving Sweet Briar Inc. (which was created by alumni who banded together in an attempt to save the school on March 3), Sweet Briar College and the Office of the Attorney General, after hundreds of hours of mediation.
Under the settlement, Saving Sweet Briar committed to delivering donations of at least $12 million in new funding to the college for its continued operation. The Attorney General also agreed to release restrictions on $16 million in institutional funds in the college’s endowment, which combined with the donations will allow the school to operate for the 2015-16 academic year.
Stone said that Saving Sweet Briar has already made the first of three scheduled payments to the college, delivering twice as much as what was expected. The remaining installments of $3.5 million are due on Aug. 2 and Sept. 2.
He said the school is working on all fronts, including fundraising, academic planning and marketing, to grow enrollments and keep its alumni active because those involved don’t want a short-term fix but a sustainable one.
Stone said that the challenges that led to the former board’s decision to close won’t be overcome overnight, but that the school is tackling each one.
Through the settlement, at least 13 members of the college’s board will resign, and at least 18 new members will be elected.
Sweet Briar isn’t the only nonprofit college to go to the precipice of default. Franklin Pierce is facing a high probability of one, as well, according to a June 29 Moody’s report.
The report said that Franklin Pierce, which enrolled 2,200 students and generated $50 million in revenue in fiscal year 2014, has very weak liquidity and “continues to confront a highly competitive student market environment with thin operating cash flow insufficient to provide annual debt service coverage.”
The report said that the university’s weak liquidity gives it minimal room for error, as it has just $38,747 in an unrestricted board designated endowment and a $5 million line of credit, with $3 million drawn at the end of fiscal 2014. It also has $4.6 million in a donor-restricted endowment. The university has had trouble complying with covenants on its $11 million in series 2014 general revenue bonds due Oct. 1, 2034.
Franklin Pierce’s director of marketing and communications James Wolken didn’t return calls for comment.
Dowling, a liberal arts school on Long Island, has deep issues, too. According to an Oct. 7 S&P report, the school has been unable to stabilize enrollment and improve its operations. The report said that the college has a very small endowment of $2.1 million, compared with high debt of $54.9 million.
Besides getting a forbearance agreement from their bondholders through June 30, 2016, the college’s accreditation with the Middle States Commission on Higher Education has been in jeopardy since last summer.
A statement on Dowling’s accreditation status said that the school has a monitoring report due on Sept. 1 that has to provide evidence that it can sustain compliance with certain requirements, including “evidence of financial viability and sustainability with updated fall enrollments, student retention data, audited financial statements, multi-year budgets and a detailed enrollment management plan that supports the five-year financial plan.”
Dowling officials declined to comment.
Moody’s is also worried about Ashland, which has a high probability of default given its very thin liquidity and a complex debt structure, according to a Dec. 1 report by the ratings agency. The report said that the school is facing operational challenges and has a very high reliance on external bank facilities to fund its operations.
The university has balloon payments coming due on its debt in 2016 and 2017.
Ashland’s director of public relations, Steve Hannan, didn’t return calls.
With roughly $228 million in debt, Alabama State, too, has a leverage problem. The historically black university has had a “swift and significant erosion of already limited reserves that has pressured operating liquidity,” according to a Jan. 30 report from S&P.
“We believe adverse business, financial or economic conditions could impair ASU’s capacity to meet its financial commitment for its debt obligations on a timely basis,” the report warned. Alabama State’s spokesman declined to comment.
In Alabama State’s case, the school as of March 1 is on heightened cash monitoring 1, which is a step the Department of Education can take to provide additional oversight of cash management.
Hogan Marren’s Cariello explained that the DoE’s heightened cash monitoring 1 means a slight delay-generally three days-in when schools get financial aid.
The DoE can also put a school on heightened cash monitoring 2, which is a “significant sanction,” and can mean a substantial delay in getting financial aid, anywhere from 30 to 90 days, Cariello said. He noted that there are a lot of reasons why the federal government could decide to put a school on heightened cash monitoring 2 and it might not be for financial reasons.
Heightened cash monitoring 2 results in a cash flow problem because of the substantial delay in a college getting financial aid money, since the schools have to credit the money to the student, send the paperwork to the DoE for approval and then they get the money, Cariello explained.
Such a process, he noted, can make schools “cash poor, receivable rich.”
Cariello said that schools can come off of heightened cash monitoring 2, but that it can be difficult because there aren’t uniform standards for doing so. It’s all discretionary on DoE’s part.
“Most schools can’t survive on it for a long time,” he said.
According to sources, who asked not to be named, other schools that could be troubled include Atlanta-based Morehouse College, a private, all-male and historically black college.
A spokeswoman at Morehouse College, Elise Durnham, couldn’t be reached for comment.
S&P director Ken Rodgers said that he is watching the University of Puerto Rico for potential trouble, since 68% of its revenues last year came from the Commonwealth of Puerto Rico. The University of Puerto Rico had $619 million in debt, according to an April 27 report from the ratings agency. But the commonwealth is facing its own liquidity crisis and is working to restructure its $72 billion in debt. Economic advisers to the commonwealth have criticized the amount of resources allocated to education, but Puerto Rico Gov. Alejandro García Padilla has stood firm on the issue.
A June 30 S&P report said that any delay or reduction in state appropriation payments to the school “could have a serious effect on its operations.”
The University of Puerto Rico is also on the DoE’s heightened cash monitoring 1 list.
“The UPR is the largest and most important institution of higher education in Puerto Rico,” said University of Puerto Rico spokeswoman Olga Lydia Velez via e-mail. “Efforts have been, and are being made, in collaboration with Industry and the Government to break the downward and/or stagnant cycle of financial strains. It is precisely at times like these that a strong university is needed to provide the human capital Puerto Rico needs to overcome the situation. This is our commitment.”
Some nonprofit colleges have already started getting creative. For example, Southern New Hampshire University in Hooksett, N.H., Hartwick College in Oneonta, N.Y., and various schools in Ohio are now offering three-year bachelor’s degree programs so that students can save money and start their careers early.
Cariello said that nonprofit colleges should also be able to file for bankruptcy protection. “You can come up with a good way of restructuring the school and get the benefits of a [Section] 363 sale without actually selling the school,” he asserted. “You can replace the board and management-which is similar to what happened with Sweet Briar-and let the school be absolved of past sins.”
Cariello has spoken with the House Committee on the Education and the Workforce and Senate Committee on Health Education Labor and Pension about the need for nonprofits to be able to file for bankruptcy protection. He is hopeful that his proposal will be passed as part of the reauthorization of the Higher Education Act, which is currently being discussed in committee.
Cariello noted that since nonprofit schools don’t have the benefit of bankruptcy protection because they will lose their Title IV funds, “schools have to be more creative.”
He said that some schools have done sale leasebacks to address their debt concerns, while some have converted from a nonprofit schools to a public benefit corporation. Others have looked at mergers to find more financially able institutions to take them over. Some schools have made changes to their business plans.
Some schools are even becoming “two plus two” colleges, Cariello explained, which allows students to earn an associate’s degree at a community college before transferring to a university to complete their bachelor’s degree.
Others are considering doing what Alliant International University did-become a public benefit corporation. The San Francisco school, which specializes in psychology, announced on Feb. 20 that it had converted from a nonprofit to a public benefit corporation, which is a class of a for-profit university.
According to Cariello, the advantage of becoming a public benefit corporation is that it can gain greater access to capital as a for-profit enterprise without abandoning its stated mission of being an education provider.
The conversion allowed the school to receive an investment from Arist Education System, a subsidiary of German media company Bertelsmann AG. Arist said it plans to create a network of universities in the health and human sciences sectors in the years ahead.
“We believe that world-class education programs will make a big contribution to solving global healthcare challenges,” said Bertelsmann CEO and chairman Thomas Rabe in a Feb. 20 statement.
Another route that smaller, more specialized colleges are taking is M&A. Being part of a larger institution that has multiple programs gives a college flexibility as the economy makes some programs more attractive than others, according to a source who asked not to be named. One example is Corcoran School of the Arts and Design in Washington, D.C., which merged with George Washington University last year.
Naturally, not all colleges will need to merge to solve their issues.
“You have to know the illness before you can find the prescription,” Cariello said, who noted that schools have to start making adjustments once they figure out what’s ailing them.
If a high amount of a school’s endowment, for instance, is going to attract students, maybe administrators need to consider online programs, he said. Or they have to figure out ways to make the school attractive to different demographics and forge relationships with community colleges.
“If an institution can look at their costs and get a handle on things, there are ways to manage financial problems before a default takes place,” said Drinker Biddle’s Tarnow. “It’s still likely to be the exception, not the norm, but it also may not be the extreme outlier that it has been before.”