Higher Education Focus: What to know about credit and debt capacity evaluations
If you manage a public or private higher education institution, you may be considering bond financing to fund projects for your campus and students, which means you need to understand the methodology used to establish debt capacity through the credit evaluation process. Key in any financing plan is to understand the credit impacts of new money borrowing, refunding for savings, restructuring to improve security, collateral and/or covenants, or a combination of these.
Revenue bond issuers are particularly discerning in the current market environment with clear motivations to optimize their debt portfolio. Credit evaluations, including trends, strengths, challenges and capacity, are consistently top of mind for both issuers and investors when structuring and offering revenue bonds. With the prior fiscal year end closed, audited financial statements complete, and enrollment largely established for the new academic year, fall is often a prime time to refresh your institution’s credit evaluation and debt capacity range or basis. Given the operating nature of higher education institutions and projects, the credit analysis is as closely aligned with corporate borrowers as any issuer-type in the municipal market (save for non-profit healthcare borrowers).
Not all debt capacity analysis is created equal due to the specific circumstances of each institution, its existing debt structure and covenants, and unique aspects of its capital and financial plan. Our approach is to try to encapsulate as many factors and comparative analyses as possible to establish a capacity range or test a specific amount(s) of new debt. For instance, existing bond (or bank) covenants, i.e. additional bonds test, minimum debt service coverage ratio, financial resources to debt, etc., must be tested to understand capacity under the existing legal structure.
Beyond testing covenants directly, rating agency medians and peer institution analysis provides tremendous insight regarding capacity at your institution’s current rating level or assuming rating change. Finally, it is a best practice for institutions to manage to certain financial performance outcomes and metrics that ensure financial health and inform capital investment decisions. This component is particularly valuable to set the path forward under prudent management and inform internal communications, especially within the senior management team and board of directors.
Read on to learn more about higher education credit, especially as it relates to the key measures and metrics designed to provide clear benchmarks and establish a range for debt capacity.
Wealth and liquidity
The following wealth and liquidity metrics are key areas when focusing on the assets side of a college or university’s balance sheet:
- Total cash and investments ($)
- Endowment ($) and restricted nature of endowment assets ($)
- Endowment portfolio investment allocation (%s)
- Spendable cash and investments ($)
- Spendable cash and investments to operating expenditures (%)
- Monthly days cash on hand (#)
These measures provide insights into the overall wealth of the institution, but also the ready access to liquidity (reserves) that have been needed or are available to support operations and capital expenditures as well as the repayment of debt service. Measuring the magnitude of operating reserves for an institution is done using the metric of spendable cash and investments compared to operating expenditures and monthly days of cash-on-hand.
As with any set of metrics, a reviewer may track trends across multiple historical fiscal years (typically looking back five years) and will work with the institution to understand forward-looking financial outcomes given expected operations and planned spending.
An institution’s overall operating size, pricing power and revenue diversity carefully factor into a credit review. Additionally, an institution’s ability to consistently operate at a surplus and generate solid cash flow are closely evaluated for a single fiscal year as well as establishing trends over time.
Key measurements include:
- Total operating revenue ($)
- Highest revenue category contributor (%)
- Annual change in operating revenue (%)
- Net tuition revenue ($, total and per student)
- Total tuition discount (%)
- Operating margin ($ and %)
- Operating cash flow ($)
- Operating cash flow margin (%)
As we discuss below, operating cash flow is a key measure when considering debt capacity and the ability of an institution to pay on its debt service obligations. The underwriting process will factor in changes in individual revenue and expense line items (ongoing or one-time charges) and the pressures the institution may face over time that will influence the ability to generate positive operating cash flow.
Leverage and debt affordability
Regarding financial leverage and affordability, a handful of metrics are predominately used to establish current and proforma capacity and balance sheet impact:
- Spendable cash and investments to total debt (x)
- Total debt to cash flow (x)
- Debt service burden (%)
- Annual debt service coverage (x)
- Maximum annual debt service coverage (x)
- Operating revenue to total debt (x)
These metrics are of particular significance as they are directly impacted by a new capital plan, refunding for savings, restructuring principal repayments, and/or defeasance strategies. When layering in the new capital plan, it is critical to establish clear assumptions and inputs and run live debt service schedules that overlay historical and pro forma financial analysis.
Colleges and universities are under significant competitive pressure to recruit and attract students to campus (matriculate), then ensure their growth and success through graduation. To understand how an institution is positioned within the marketplace amongst its peers, a credit evaluation looks at the following measures:
- Applications, acceptances and matriculations (number, by cohort)
- Selectivity for first-time freshmen and other cohorts (%)
- Matriculation for first-time freshmen and other cohorts (%)
- Total enrollment and enrollment by student-type, i.e. undergrad, grad, etc. (number)
- Retention (%)
- Graduation (%)
- In- vs. out-of-state students (%)
- Residential students, those living in university housing (%)
Strategic positioning and management
The competitive higher education landscape is rapidly changing and evolving, which only increases the importance for an institution to be thoughtful, nimble and well positioned for future success. The institution’s management and the board of directors’ approach to strategic planning and investment in personnel, programs, and facilities are critical to maintain market position, reputation and ensure the long-term viability of the institution. Too little investment over several years may diminish the attractiveness to students, donors and the community at large, as well as potentially reduce research or grant funding. However, too much investment, especially with the use of debt, may apply too much weight via high fixed costs and create an unsustainable business model.
Although this category of a credit evaluation is more qualitative in nature, these metrics provide awareness of the effectiveness and sophistication of an institution within its short- and long-term planning, ongoing self-assessment and benchmarking, policies, procedures, controls and accountability. Board turnover as well as senior administration/management and the potential impacts of change in leadership and vision can also be considerations in your institution’s credit review. The ability to set objectives and goals, measure them over time, and follow through with continuity amongst senior administration can be of great value.
Financial covenants and UMB’s approach
For purposes of structuring bond issues, UMB takes a multi-faceted approach to establishing financial covenants and additional bonds test, as applicable depending upon the credit strength of the institution. We must balance the credit strength of the institution and its future capital plans with the desire of the investor to monitor and maintain its investment to maturity or redemption. We seek to structure financial covenants such that they afford an investor good protection, but also with a margin of safety that allows the institution to satisfy its obligations going forward.
When appropriate within market circumstances, investor requirements and the credit strength of the borrower, we will structure covenants that ensure ongoing balance sheet strength, i.e. financial leverage, and the ability to generate cash flow and repay debt service, i.e. debt service coverage. When writing covenants, we use understood terminology and numbers that tie back to the audited financial statements or that management can prepare and present consistently.
Securing financing for your institution through bonds is a niche type of credit that requires careful analysis, planning and implementation.
As you begin the early stages of capital planning for your institution, connect with our higher education specialists to put their experience to work. Visit our website for more information.
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