6 minute read 5 Oct 2021
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How higher ed institutions can best leverage debt as a strategic tool

Authors
Kasia Lundy

EY-Parthenon Principal, US Higher Education, Ernst & Young LLP

Strategist. Education industry thought leader. Wife. Mother.

Haven Ladd

EY-Parthenon US Education Partner, Ernst & Young LLP

Innovative thinker. Practical advisor. Trusted navigator through stormy seas.

6 minute read 5 Oct 2021

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  • How higher education institutions can best leverage debt as a strategic tool (pdf)

Higher ed institutions may need to focus more on assessing the value of debt-financed investments rather than the capacity for more debt.

In brief:

  • Whether an investment can generate value often takes a back seat to whether an institution can take on more debt when considering future projects.
  • Different institutions have varying debt capacity and growth profiles. These can help guide future actions as higher ed models change.

Higher education institutions have continued to increase the amount of long-term debt they hold during a period when enrollment growth in the sector has slowed and is expected to decline. This raises a question about whether the sector is approaching a limit to the benefits of debt-financing. EY-Parthenon’s joint study with NACUBO found that decisions about debt are often made primarily on the basis of financial metrics that indicate if an institution can take on further debt without sufficient attention paid to whether it should.

Future debt levels are uncertain

The increase in long-term debt over time exceeds the growth of FTE enrollment at public and private not-for-profit four-year institutions, which has been below 1% per year from 2011 to 2019, according to the Integrated Postsecondary Education Data System (IPEDS). As a result, the debt burden per full-time student has increased substantially for many institutions and, as of 2019, was $24.3k overall. This varies significantly by institution type, with large privates having the greatest debt burden per FTE at $54.8k and small publics having the least at $13.3k. 

While most institutions said their debt issuance during the COVID-19 pandemic was in line with expectations, it remains to be seen how the overall sector and attitudes toward debt may change over a longer term. Fifteen percent of CBOs expressed uncertainty about future debt levels for higher education, and 55% indicated an expectation that debt levels will continue to rise over the next five years.  Sector leaders have emphasized the importance of focusing the post-COVID period on transformational change rather than a return to business as usual. For example, online learning is becoming a more viable choice for students seeking flexibility and affordability, which may disrupt higher education’s traditional residential model for a meaningful share of institutions. Sector leaders also acknowledge the difficulties of focusing on transformational change when students, families, faculty and staff are looking for some return to stability. 

How debt capacity is assessed

Whether institutions pursue a path of transformation or recommit to pre-pandemic priorities, the decision of how to finance strategic projects is an important one that will have implications for years to come, given that the debt maturities issued by higher education institutions are typically 30 years or longer, according to interviews with CBOs. 

Debt is the largest single source making up budgets for capital projects, at 42% across all institutions, according to the June 2021 NACUBO EY-P Institutional Debt Survey. About 71% of institutions have a formal policy or codified set of practices that are used to guide decisions about when debt is issued and for what purpose, and another 12% are in the process of developing these. Policies typically include:

  • Guidelines on capital projects eligible for debt financing 
  • Limits on the length of a long-term debt issuance
  • Methodology on how to assess debt capacity 
  • A set of financial ratios/metrics that can act as constraints on total debt levels
  • Requirement of a payment plan for debt service expense over the entire lifetime of the issuance 
  • Specification of specific stakeholder approvals needed

In fact, debt burden ratio and viability ratio emerged as the most frequently relied-upon metrics to assess levels of long-term debt. 

Institutions use these thresholds to assess the current state and project the impact of a future debt issuance. If forecasting suggests that a planned debt issuance would push the institution above its set threshold, it may delay the project until additional fundraising or cash reserves can be applied to reduce the overall debt burden required or until the debt can be restructured to achieve more favorable terms.  Therefore, one of the primary ways that institutions assess their level of debt is in relation to how much they can take on according to externally validated measures and lender terms.  This provides an incomplete picture, unless institutions also evaluate whether a particular debt-financed project is something they should take on.

How value is determined

The two most frequent ways that institutions define the value of  capital investment have both merits and limits:

Indirect assessments attempt to quantify the financial impact of a project funded by debt with a series of often qualitative assumptions. For example, a project may be expected to drive differentiation, which drives student interest and applications, which, in turn, may drive selectivity and, ultimately, net revenue per student. This can have a positive financial impact on the institution overall. But the logic may not fully factor in sector trends or effectively evaluate the level and impact of differentiation achieved. 

Direct assessments of cash flows can be performed when there is auxiliary revenue generated from an investment, such as the impact of a new dorm building that is expected to boost enrollment of residential students or boost room and board fees. However, this type of assessment may lead to too narrow a view of how the project affects the overall business model, by attributing benefits to the project only, and therefore create a more favorable view of project economics than exists in practice. 

Overall, strategic value can be measured in many ways because institutions have missions beyond financial viability. However, since a viable financial model is required so that the institution can continue operating and fulfilling its mission, we posit that revenue growth (as distinct from pure enrollment growth) can be used as a proxy to measure successful capital investments.

Looking at revenue growth over the past five years, there is a broad distribution of outcomes, suggesting that not all institutions are equally able to generate value from the debt-financed investments that they are making.

How can future decisions be made? 

Institutions can be divided into four different categories (illustrated in Figure 1), based on their level of debt capacity and their demonstrated ability to realize capital investment value. Each category can incorporate a set of considerations into their decision making.

Segmentation considerations for future debt issuances

Higher debt capacity and higher growth: These institutions can pursue “business as usual” if growth remains high. They may also want to consider whether investment opportunities to support growth are being “left on the table.”

Lower debt capacity and higher growth: These institutions could consider other funding sources, including partnerships, to continue to support growth.

Higher debt capacity and lower growth: These institutions can carefully contemplate how further investments in the current business model may impact financial health if growth remains stagnant. They can also consider investments in new models or removing excess capacity.

Lower debt capacity and lower growth: These institutions may need to consider both new models and funding sources. One consideration is whether they might better serve their mission through a range of partnership options. 

Focus on capacity and value 

As institutions face new and heightened challenges, from an acceleration of online learning to the looming “enrollment cliff” and heightened competition for students, decisions around taking on additional long-term debt will become even more critical. Innovative use of debt as a strategic tool may provide some institutions with a competitive edge, allowing them to further differentiate and solidify their positioning in the landscape. 

But debt can also become an undue anchor if institutions do not effectively assess their current capacity for debt and the expected value of prospective capital investments. In the absence of doing so, institutions risk allowing their debt burden to become just one more driver of the rising cost of higher education that is contributing to so many of the sector’s challenges. Institutions that understand their financial health within the broader context of the higher education sector, and make informed decisions based on this information, may be best equipped to meet the challenges ahead.

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Summary

Higher education institutions often focus their debt-financing decisions on whether they CAN take on more long-term debt. These institutions may also want to shift more of the focus to whether they SHOULD add more debt in order to fund strategic long-term projects, as these decisions will implications for years to come.

About this article

Authors
Kasia Lundy

EY-Parthenon Principal, US Higher Education, Ernst & Young LLP

Strategist. Education industry thought leader. Wife. Mother.

Haven Ladd

EY-Parthenon US Education Partner, Ernst & Young LLP

Innovative thinker. Practical advisor. Trusted navigator through stormy seas.