Higher Education Credit Analysis

Mary Peloquin-Dodd

Durham, NC

November 14, 2006

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The IndustryWhat the higher education analyst does

Public Colleges and Universities Private Colleges and Universities Independent Schools (primary and secondary) Not-for-Profit Corporations
Cultural Institutions Endowed and Charitable Organizations Membership Organizations Research Institutions

Social Service Providers (often more of a health care focus)

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Ratings Overview
Most public ratings in higher education are securities ratings (tied to the underlying security of a specific bond issue)

There is a growing demand for issuer credit ratings (a general rating for the institution) especially for use as counterparty ratings
Approximately 50% of the higher education market is sold with bond insurance AAA/AA/A There are a lot of LOCs, Standby Bond Purchase Agreements because there is a higher level of variable rate debt in this market than the municipal market as a whole The rated higher education market is a relatively small portion of the entire U.S. market.

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Rating Factors
Demand (higher education is a consumer product and therefore is fundamentally different from many other sectors in public finance) Management (this is a key factor in this sector) Finances (private institutions follow FASB standards and public institutions follow GASB standards) Debt (there is a lot of it and the amount is growing rapidly)
As a percentage of municipal issuance volume has increased over the last 10 years to about 7-8% of the sector Its hard to get your hands on issuance volume in this sector.

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Demand as a Rating Factor

Institutional niche/mission Enrollment trends Admissions flexibility (acceptance rates, matriculation rates, retention, student graduation rates, freshmen, transfers, and graduate/professional students)

Student Quality (standardized test scores, freshmen in top 1020% of high school class, retention rates, graduation rates)
Competitive profile (win/loss statistics, overlap pool, pricing compared with peers) Market responsiveness Ignore commercial rankingslike U.S. News

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Management as a Rating Factor

Top managers/administrators prior experience and longevity Are there vacancies in key positions? Ability to forecast and accurately budget Consistent record of planning/thinking ahead A lot of management and leadership comes from the corporate world Board composition and control
Look for standard committee structure

Local, regional, or national board

SOX type provisions Turnover

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Finances as a Rating Factor

Operating performance and revenue diversityincome statement performance

Balance sheet with a special focus on available or unrestricted resourcesendowment per student is a key indicator of ratings
Other sources of liquidity or endowment (foundations, assets held in trust by others) Debt relative to operating expenses and balance sheet resources Financial policies (biggest are endowment spending, surplus objectives, budgeting for contingencies, and budgeting for depreciation) Capital Campaigns history of each campaign, goal, and success.
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Debt as a Rating Factor

Amount of long-term debt compared to total liquid assets Unrestricted resources/ total debt Expendable resources/total debt Maximum annual debt service as a percent of annual operating expenses

Debt service coverage from operations (not quite as important in this sector as in some other industries)
Debt structure (fixed rate, variable rate, synthetically fixed rate debt, swap management policies, balloon debt versus amortizing debt) Revenue generating projects versus non-revenue generating debt.

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Red Flags: Watch for these things

Wide fluctuations in enrollment (greater than 10% per year) Enrollment of fewer than 500 students (unless specialized with a really good endowment) makes it hard to achieve economies of scale (not true for independent schools) Inaccurate budgeting (you will usually get actuals to budgets for any current fiscal year) Consistent operating deficits can eat up financial reserves very quickly Management turnover and vacancies in key positions

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Red Flags to Watch For

Poor transparency (information is not readily available) Material restatements of greater than 10% of net assets in financial restatements Auditors cite going concerns Significant change in investment policies and endowment spending rates Need to restructure debt (could be problems for an upcoming balloon payment) Prior debt covenants

Rate covenant violations (watch the definition of revenuesif it includes investment income, market drops could mean rate covenant violations)

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Ratings distribution by category: public colleges/universities

45 40 35 30 25 20 15 10 5 0 AAA AA+ AA AA3 5 22 30

43 40

25

1 BBB-

A+

A-

BBB+ BBB

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Ratings distribution by category: community colleges/districts

10 9 8 7 6 5 4 3 2 1 0 AAA AA+ AA AAA+ A ABBB+ BBB BBB0 0 3 2 1 4 4 6 6 5

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Ratings distribution by category: private colleges/universities

40 35 30 25 20 15 10 5 0 AAA AA+ AA AAA+ A 13 7 17 15 21 28 21 31

35 31

A- BBB+ BBB BBB- BB+ or lower

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Public University Rating Changes

Fewer public university downgrades and negative outlooks in 2005 and 2006but rating activity still mixed and some outlook changes;
Moderating tuition increases after several years of double digit ones; Improving state support for 2006 and 2007; 2008 also looking good; Not much recovery in state capital appropriations but more statewide bond issues for capital projects and deferred maintenance; Increases in debt. Demand picture varies-challenging in New England Recent Rating Changes
California State University Montana State University

From:
A A

To:
A+ A+

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Private University Rating Changes

More private college and university rating changes than public universities in 2005 & 2006 Regional differences, demographics Variations in operating performance Substantial increase in debt and leverage; Competitive environment. Recent Rating Changes Rhodes College, TN Allegheny College, PA Old A BBB+ New A+ A-

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AAA Ratings

Amherst College, MA California Institute of Technology, CA Columbia University, NY Dartmouth College, NH

Harvard University, MA
Massachusetts Institute of Technology, MA Princeton University, NJ Stanford University, CA Yale University, CT

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AAA Ratings

Grinnell College, IA Pomona College, CA

Princeton Theological Seminary, NJ

Rice University, TX Rockefeller University, NY Washington University, Mo

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AA+ Private Universities

Brown University Cornell University Duke University Williams College Swarthmore AA+ AA+ AA+ AA+ positive AA+

Univ. of Southern California AA+ Northwestern Wellesley College, MA AA+ AA+

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Highest Rated Public Universities

University of Michigan University of Texas University of Virginia Texas A&M University University of Delaware UNC-Chapel Hill University of Washington AAA AAA AAA AA+ AA+ AA+ AA+ stable stable stable stable stable stable stable

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Trends Affecting Higher Education

Global marketplace for students; international students at a very low level but starting to rebound from lows;

Demographic picture of America is changinggeographic distribution of college-aged supply is shifting;

Aging population (fewer traditional aged students over time);

For-profit competitors (new legislation allows on-line providers to participate in federal financial aid programs);
Demand for continuing education as baby boomers age and jobs continue to change; Gender (female/male) and impact on program choice Harvards move to drop early decision admissions.

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Trends Affecting Higher Education

Focus on accountability (no college student left behind) recommendations watered downbut is it indicative of increased federal involvement in higher education? Weak state and federal funding of higher educationeven with recent increasesshare of state budgets devoted to higher education continues to fall; Rising costs of health care, insurance, technology, and utilities Increasing competitive pressures High growth states using community colleges for capacity

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Public Universities

Capital funding is picking up in many states (Oklahoma, New York). Many bond issues approved by voters in 2005; more issues were considered for November 2006. Some institutions are looking at new agreements with their states, possible mergers, and autonomy and flexibility legislation (Colorado and Virginia, South Carolina) States still regulating tuition increases or tying increasing funding to limited tuition increases.

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Private College & University Trends

Too much capacity in some markets (New England/Plains states;) and not enough capacity in others (South, Southwest, Western states). Overall demand growth through 2008-2012. Average four-year private tuition for 2005-2006 was $20,082. For publics, the average is $5,132. Weakest portion of the sector: tuition dependent, underendowed colleges and universities

Schools with established niches in programs with high demand doing okay.

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Other Industry Issues

Alternative Investments/Asset Allocation and Valuationwill we see opinions that are qualified or limited as to scope as fiscal year 2006 audits are prepared?
Do Boards and Investment Committees fully understand the risk profile and the monitoring requirements of their investment choices? Growing use of derivativesare they appropriate for every institution? Mismatch between growing costs of providing higher education and students ability to afford it?

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Other Industry Issues

Interest Rates: Higher interest rates and high levels of variable
rate debt--are institutions adequately prepared for a higher interest rate environment?

Pensions: Post employment benefits (pensions and unfunded

retirement health care costs).

Inflation: Rising inflation and energy costs in 2005 and 2006. Long-term Demographics--capacity requirements when some
regions begin to lose college-aged students

Financial Aid: can colleges afford to provide needed financial

aid?

Deferred Maintenance: How will it be funded?

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Other Industry Issues

Urban versus rural institutions (monetizing urban real estate assets)

Flight to quality (why are some institutions getting more and more applications every year) - a function of price?
NSF/NIH Research Fundingdrop in NIH funding; NSF is only a fraction of NIH funding Programmatic mixdo colleges want to offer only the programs that are most favorable to their bottom line Worldwide competitors growing in stature Weak persistence rates of students in American higher education

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Demographics
By the year 2007-2008, there will be an estimated 3.2 million high school graduates in the U.S.

This number is a peak for any year since the end of the post WW-II baby boom
The highest number of high school graduates in that year will be in the south (even though the western region will have grown faster) The fastest growing group of high school graduates over the next ten years, by race/ethnicity, will be Hispanic, rising from 295,850 in 2002 to 517,750 in 2012 (+75%)

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Mixed Outlook in Higher Education

Investment markets look good for now Other costs of doing business are rising (health care, insurance, utilities) Gift giving rose in 2005 and 2006more large gifts are being announced all the time Competition is fierce State budgets will always be under pressure especially as states face GASB 45

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