The ABC-Ds of Capital Financing

Until recently, the idea of carrying debt had such a stigma that the thought of proactively seeking long-term debt financing did not occur to most independent school trustees. However, in just over a decade, investor awareness of the fiscal soundness of independent schools, coupled with schools' increased openness to progressive capital financing programs, have made this sector one of the fastest growing in the $1.5 trillion tax-exempt bond marketplace.

"Once conservatively 'Yankee' in their thinking, independent schools and boards of trustees have become more sophisticated about financing in recent years," said Gary Nicksa, former chief financial officer of Buckingham Browne & Nichols School (MA).

The schools' more open stance to debt began in the late 1980s with administrators' pursuit of the lower all-in cost of tax-exempt debt over that of conventional bank loans. Several large independent schools were the first to follow colleges and universities, themselves 20-year veterans, into the tax-exempt marketplace. It took close to a decade for the new class of entrants to convince credit rating agencies and investors of their long-term stability; nonetheless schools began to benefit from stronger balance sheets and lower costs of capital associated with major building projects.

Still, Yankee tendencies endure, and not just in the northeast. Across the United States, schools routinely resist debt financing, regardless of whether or not there have been financial difficulties in their histories. The support and advocacy of board members, especially those with business ties and firsthand knowledge of the benefits of debt financing, have proven invaluable to school administrators, some of whom themselves take convincing along the way.

"You need a measure of predictability and stability with long-term financing," said Gary Hall, chief financial officer of Belmont Hill School (MA). "I worked previously for one 170-year-old institution that was past its glory days, and our real issue was how hamstrung we were from decisions made forty to fifty years ago. I needed to be convinced that whatever debt we took on [at Belmont Hill] would not hamstring my replacement twenty to thirty years down the road."

Today, more independent schools are finding that bond issuance is a predictable and stable means of long-term financing. According to Standard and Poors, these schools comprise one of the fastest growing issuing sectors. Certainly demographics are a principle reason. Enrollment in schools that are members of the National Association of Independent Schools is up 33 percent from 10 years ago, with elementary-school enrollment up 67 percent and middle-school enrollment up 27 percent. Demand has increased competition among institutions that simultaneously need to upgrade aging infrastructure. Perhaps not surprisingly, of the 100 or so independent schools that have issued bonds to date, 78 percent are northeastern establishments, with 80 percent of that number located in New England, the region with the oldest and largest concentration of independent schools in the country.

Early pioneers hew path to market

The first independent schools to issue bonds met with stiff resistance. Rating agencies felt such schooling was a discretionary expense for parents, and they doubted that market demand would support debt service for 30 years. Investors simply didn't know this borrower. Despite impressive reputations and large endowments, early pioneers lacked history in the capital markets, and schools -- including Albuquerque Academy (NM), Groton School (MA), Milton Academy (MA), and Phillips Exeter Academy (NH) -- had to painstakingly prove their case to rating agencies and investors alike.

An early example would be Groton, which, in 1989, found it easier to sell its bonds with third-party credit enhancement -- that is, obtaining a rated letter of credit from an international bank rather than issuing a bond based solely on its own credit rating. In 1992, despite its triple-A credit status, St. Paul's School (NH) appealed directly to an institutional investor and privately placed its bonds. For its second issue in 1996, St. Paul's obtained a letter of credit from a bank with a lower credit rating than its own.

Six years after St. Paul's initial private placement, the capital markets were informed enough so that the school could present a stand-alone issue on its own merits, and it did -- in the form of gilt-edged, Aaa/AAA bonds. On its second trip to the market in 1998, Groton School also released a stand-alone issue and found the process eye-opening.

"It certainly is a learning experience for the entire school community," said Hale Smith, Groton's chief financial officer. "A team made up of administrators and faculty from different disciplines have to describe the school in pretty distinct terms for rating agencies. The process makes you take off your rose-colored glasses and look at yourself honestly."

Over the past five years, the pool of "honest lookers" has included a steady influx of smaller, regional schools: Tabor Academy (MA), New Hampton School (NH), Derryfield School (NH), The Latin School of Chicago (IL), and Oakwood School (CA). Thirty-year, fixed-rate, stand-alone issues are now more commonplace; still, schools issuing debt for the first time, and/or applying for a first-time credit rating, often choose a third-party to back them with a letter of credit in order to issue variable-rate debt.

Sometimes, the entities that need the most convincing as to which direction to go remain schools themselves, even those that have been satisfied with this type of financing in the past. "Debt service reduces our flexibility because, clearly, it has first-call on our resources," said Hall. "As we talk about financing in the future, we'll have to take the time all over again to develop models and situations to convince new board members in new economic circumstances that we can carry debt in economic downturns."

Why independent schools enter the tax-exempt marketplace

A common misconception about schools that issue bonds is that they lack the ability to fund capital projects from available sources. This couldn't be further from the truth. Schools issue bonds because they have learned how debt can work for them, specifically how it can maximize the utility of endowment, budgetary cash flow, and fund raising. Along with minimizing their cost of capital, debt allows schools to build today rather than wait up to seven years for pledges to come in, and it gives them the means to leapfrog the slowly but steadily mounting maintenance, salary, and facilities expenses.

"We were being devoured by incrementalism," said Hap Ridgeway, head of Berwick Academy (ME), "and bond financing allowed us to jump that curve and build a high-quality facility while continuing to build endowment."

The Robert Louis Stevenson School (CA) wanted to build sooner, rather than later, to keep ahead of potential building permit issues. "In our case, we wanted to get the money fast," said its president, Joe Wandke. "It turned out that growing the balance sheet was a secondary benefit."

Some schools need cash in-hand to pay contractors who won't start or continue construction without it. With construction costs going up every five years, today's bid could wind up costing 20 percent to 25 percent more if financing is contingent on pledges coming in over time. Tax-exempt debt can only be used for the construction and renovation of facilities or the purchase of land or technology. Fund raising, cash flow, and endowment lose efficiency when applied to these particular needs.

Take, for example, a school with a $7.5 million endowment and the choice of borrowing $7.5 million and keeping endowment intact, or spending $7.5 million of endowment for the necessary "brick and mortar" projects. Over the life of a 30-year, 4.50 percent variable-rate issue, such a school would create more than $37.8 million of additional endowment funds assuming a full amortization of the debt service, equal endowment transfers to operations in both scenarios, $7.5 million in fund-raising receipts received over five years, annualized endowment returns of 10 percent and a level interest rate over the term of the bond. This example assumes that all debt service is paid for from endowment earnings.

Assuming that debt service is paid for from investment earnings, the level of arbitrage benefit depends on the level of investment returns. Figure 1 (not available online) shows the potential balance sheet benefit assuming different endowment returns. The school's endowment must average a return of approximately 5.15 percent in order to achieve a balance sheet benefit.

The following table Figure 2 (not available online) shows that initial fluctuations will not mitigate all of the long-term arbitrage benefits.

How to establish financing goals, make structural decisions

Successful bond issues complement a school's long-term financial strategy, as well as fulfill immediate needs. Though institutional goals may vary, here is a list of common themes:

1. Develop the bond issue within the framework of long-term planning. The finance plan must meet immediate needs and allow or create future flexibility as well as meet any existing bond covenants.
2. Borrow only for high-priority capital projects.
3. Coordinate the bond financing with fund-raising activities. Tax laws do prohibit using "restricted" development funds (as compared to unrestricted funds) and bond proceeds for the full amount of the same project; however, a careful review of campaign materials and pledge forms by your underwriter and bond counsel can mitigate this issue.
4. Increase long-term financial resources. Minimize your cost of capital by conserving high-yield investment funds and fund-raising receipts by using tax-exempt financing for capital projects.
5. Assess credit and debt capacity. Consider a plan to upgrade your credit rating. Rating agencies view demand as the leading indicator of a school's future financial viability. They see operating performance as the measure of a school's ability to repay debt service annually. Balance sheet liquidity would be the back-up resource for debt service in the event of financial difficulty.
6. Determine the optimal financing structure. The choice of a fixed-rate versus a variable-rate bond results from prioritizing interest rate level, annual budget certainty, prepayment flexibility, and flexible financial and security covenants.
7. Simplify the process. Minimize stress on resources. Select an investment banker with demonstrated capacity and willingness to serve as team leader, as necessary, and draft the disclosure document and ratings agency presentation.

When deciding the optimal course of action for a bond issuance, the first consideration is the current market interest rates. Recently, the spread between long-term, fixed rates, and seven-day variable rates has widened in favor of variable rates that have historically averaged 62 percent of the three-month LIBOR (taxable rate). The Revenue Bond Index (RBI), composed of the rates of 25 A-rated revenue bonds, is the measure for fixed rates. The Bond Market Association (BMA) index of over 2,000 variable rates that reset weekly measures the variable rate. Since June 1998, long-term interest rates have moved modestly upward (see Fig. 3, (not available online)). RBI was 5.12 percent in 1998 and 5.77 percent in June 2001. As of June 2001, the year-to-date BMA average was approximately 3.27 percent and rapidly heading lower.

Fixed interest rates. Fixed rates give a school budget certainty. They are locked in for the duration of the bond, so changing tax laws and interest rate movements don't impact the dollar amount of the annual debt service. Fixed rates generally give a school more future financial flexibility in the form of more liberal security provisions (i.e., no mortgage pledge) and more favorable financial covenants (such as lower debt service coverage ratio).

Variable interest rates. Over the last 10 years, variable rates have been lower than fixed rates (see Fig. 4, (not available online)) all but once (in September 1990). Schools choose variable-rate bonds for their lower rates or, as was the case with Buckingham Browne & Nichols, for "bridge financing," that is, borrowing short-term while awaiting restricted gifts, which, upon receipt, redeem the bonds without penalty with 30 days' notice.

Choosing your partners with care

Underwriters (also referred to as investment bankers) and lawyers support a school's bond issue. "One of the most important decisions you make is selecting the underwriter," said Hale Smith. "They are the team leader and usher you through the whole process. You have to have a lot of faith in them."

Underwriters can also help schools determine their debt capacity and financing goals through developing a long-term financial model that illustrates achievement with and without a bond issue. When it comes to executing the issue, underwriters can assist with scheduling and problem solving among the parties involved in the final plan of finance as well as among the rating agencies, bond insurers, and banks issuing letters of credit.

Robert Lewis Stevenson's Wandke advocates a serious front-end investment in the underwriter selection process. "I had no idea initially that issuing a bond was as sophisticated a process as it was," he said, "how time-consuming and complicated it was, and just how many players are involved. In the end, it worked because we spent time and money up front interviewing potential underwriters at their offices and finding the team whose personality fit best with ours. Doing this makes it a whole lot easier down the road."

Making things easy for a school is important, especially the first time around. "Our $10-million issue was the first in our 155 years of Miss Porter's history, which is always a wrenching experience," said Richard Eaton, the Connecticut school's chief financial officer. It took two years of discussion to decide to do the issue, he said, but once they decided, it took less than six months to get the bond to market. "The race belongs to the swift," Eaton noted, "and you have to do a number of things on faith, backed by numbers. You have to surround yourself with good people and let them go."

The choice of underwriter often comes down to its degree of willingness to shoulder most or all of the disclosure documentation necessary.

"Put it this way," said Gary Nicksa, "You have ten pieces of documentation for a car loan and forty when you purchase a house. For bond financing you're going to wind up with a book three to five inches thick with tabs!"

Most of the heft is found in Appendix A, which provides the rating agency with a thorough rendering of a school's vital statistics summarized in 30-40 pages at the outset of the document. Coverage includes:

• Student body (e.g., composition, SAT performance compared to the national mean, percentage that enters top-tier colleges);
• Financial resources (e.g., endowment, physical plant, fund-raising history);
• School history and mission;
• Curriculum and extracurricular programs ;
• Residential life;
• Recruitment approach, target communities; and
• Enrollment data (e.g., trends, projections, impact of bond on enrollment, revenues).

"Schools tend to be fairly casual about how they gauge their success," said Hap Ridgeway, "and prospective clients and families hear what they want to hear, so Appendix A was a real lesson in accountability. When we would want to talk philosophy and mission, our underwriters wanted to hear about enrollment and projections. By the end, we were better overall judges of our success."

Bond financing may not be for every school. However, it does come highly recommended by peer institutions that have the demonstrable demand to make this type of financing work to their advantage. "I wouldn't mind getting to the point where a bond issue for $10 million is so routine it wouldn't even make our board's agenda," Richard Eaton said.

Administrators interviewed for this article offer the following tips to colleagues:

• Encourage stakeholders to consider this option.
• Obtain and leverage the enthusiastic support of key trustees.
• Secure the cooperation of administrative staff.
• Put all aspects of the transaction out to competitive bid.
• Seek advice from investment bankers and lawyers who have done deals repeatedly in this niche sector of the capital markets.
• Double the amount of time you think it will take to complete this financing.
• Weigh the potential negatives, such as: restrictive financial covenants on school operations and the need to pay debt service each year.

Remember that the two key factors for a successful bond issue include designing a plan of finance that works for your institution and educating the investment community as to your school's credit strengths. Look for experts willing to do the work to help conceptualize that plan, prepare the required disclosure information, and assist in presentations to investors and rating agencies. This will ensure strong investor demand, the lowest possible interest rates, and a bond issue that works for your school.

Charles E. Procknow is senior vice president of public finance for State Street Capital Markets, LLC.