Borrowing Takes On a Different Hue
When Clarke University set its sights on a new science center, private debt placement was the best strategy on its project financing spectrum. Here's how the university built its 46,000-square-foot, state-of-the-art facility without breaking the bank.
By Deanna S. McCormick
Circa-1960 science facilities can't be expected to attract students who've been working in updated and fully equipped high school labs. That reality led campus leaders at Clarke University, Dubuque, Iowa, to recognize that a new science center would assist our small, private Catholic university with recruitment and retention.
The science building made sense for other reasons: With approximately 1,250 students, the university already offered a full array of undergraduate programs, several graduate programs, and doctorates in physical therapy and nursing practice. While our largest programs are nursing, education, and business, in recent years, we've placed more emphasis on preprofessional programs in the health sciences.
In the same time period—during 2008—we completed a comprehensive campus master plan, in conjunction with a feasibility study for a capital campaign. The strategic discussions indicated a strong need for a state-of-the-art science lab facility. The feasibility study confirmed the capacity and willingness of our current donor base to support the construction of such a facility.
With these factors in mind, and the approval of the board of trustees, the project was a go. It then became the job of the business office to figure out how to finance the venture.
Debt Management for the Dream Building
The university hired an award-winning architectural firm that specializes in higher education science buildings and started down the path of designing the new facility. The result was a plan for a 46,000-square-foot center, estimated to cost $13 million. Because of the timing of multiyear pledges to the capital campaign, the board approved a debt issue to support immediate construction. The debt issue would also refund the existing debt, because the loan agreement precludes the issuance of any additional debt.
Reviewing funding options. Clarke has very modest outstanding long-term debt of $4 million (which will be refunded with the new issue); an endowment approaching $30 million; and stable financial performance in past years. Enrollment has grown steadily since 2009, and annual operating surpluses have become the norm. The last debt issue occurred in 1998 to fund a student apartment building and encompassed a public debt offering secured by the County of Dubuque, with no requirement for a letter of credit (LOC) or bond insurance.
Because of issues with finances and enrollment in the late 1990s, Moody's rated the university's debt just below investment grade, a rating for a small college that might preclude another public issue of bonds—or mean a much higher interest rate should a bond issue be feasible—especially in the current economic climate.
Taking a private approach. We determined, along with our debt adviser, that a private placement with a financial institution would be the best method of securing funding. In fact, since the financial downturn of 2008-and the difficulty and expense of securing LOCs or bond insurance-many small private colleges that do not have the wealth of larger institutions are using private placements to secure funding for facility construction. We found that debt advisers can provide value to small institutions in that they help with the process of designing the request for proposal, evaluating the financial institutions that respond, and maneuvering the markets to make the best financing decision for the institution.
Private Funding Particulars
A private placement involves the financial institution holding the debt internally and not issuing public bonds. It does not require a letter of credit or bond insurance. And, it allows the university to expunge the current Moody's rating, which was quite positive given Clarke's position at the time the rating was given. Holding the debt internally also gave us the opportunity to structure the debt issue in a manner most advantageous to Clarke, without consideration of the needs and wishes of public bondholders.
All that said, a few quirks need to be considered with this type of debt placement, one being the issue of bank qualification. In our case, the bank qualification limited the debt issue to $10 million, which meant that in order to borrow the $13 million necessary for the science center, the university would need to find two conduits to support the debt issue—or issue the debt in two tranches over a two-year period. Based on the inability to find two such conduits and the additional cost of two issuances, Clarke requested an alternative to the bank-qualified option, in the request for proposals.
We received four very strong proposals, two of which did not have to be bank qualified. We chose one of the nonbank-qualified proposals, which also did not require us to move our entire banking relationship from a small, local bank. The proposal we did select offered a seven-year term; whereas the other nonbank-qualified option had a maximum of only a five-year term. The accepted proposal also had the smallest spread over LIBOR for the term of the loan, giving us an interest rate advantage.
The university is designing the debt issue to be 50 percent fixed (fund-of-funds and not a swap rate), to reflect an approach longer term in nature, and 50 percent variable. While there is interest rate risk with the variable portion, interest rates are currently the lowest in recent history. The Federal Reserve has indicated these rates will continue into 2014; and, should the rates turn north, the university could pull the trigger and secure a synthetic fixed rate via a swap. Our debt adviser is confident in the contingency plan.
The portion of the debt that is variable will allow Clarke to repay principal as campaign pledges are received, without having to pay a prepayment penalty. We also had the choice of (1) using a REIT (real estate investment trust), which required a mortgage on campus facilities, or (2) considering a nonREIT, which is basically unsecured with the exception of pledging liquid assets to the level of the interest payments on the variable portion.
Clarke selected the nonREIT option, which meant we were not required to provide any collateral other than the ability to meet cash flow, liquidity, and debt service covenants.
With all this in place, Clarke will formally break ground on the new building at the May meeting of the board of trustees, with the debt issue closing on or about May 24.
|Clarke University plans to formally break ground for the new science building at the May meeting of its board of trustees.|
While this approach to securing financing for a small college might seem easy and therefore attractive for your campus, we learned that a number of issues come into play when pursuing capital funding. Here are several recommendations:
- Understand the total debt capacity of the institution. Statistics from the NACUBO white paper "Perspectives—New Realities in the Bond Market" indicate that for small colleges without significant wealth, the national debt-to-endowment ratio averages 67 percent or less. Clarke's existing debt level to current endowment is approximately 12 percent; with the new debt the ratio is still below 50 percent. Benchmarking to peers and competitors indicates that Clarke's total new debt remains below the average and median of similar institutions.
- Understand implications of terms in the loan agreement. While Clarke's debt will be amortized over 20 years, a balloon payment will need to be refinanced at the end of 7 years (the maximum term that most financial institutions are willing to finance). Unfortunately, no one has a crystal ball that will predict where interest rates will go in the future. This issue may complicate the loan agreement with regard to the ability to refinance with your existing financial partner or finding a new partner. In all agreements involving the debt issue, Clarke is seeking language that would allow for refinancing at favorable rates in the future.
- Determine an acceptable level of risk and ways to mitigate that risk. While variable interest rates are currently in their "sweet spot," they have nowhere to go but up. Make sure your board understands this and is comfortable with seeking a swap—containing what might be considered exotic derivative implementation—to secure a synthetic fixed rate of interest for any variable portion of the debt.
- Budget for future years to ensure continued support for the quality of academic programs and service levels. Of extreme importance is the ability to forecast future budgets to ensure that the level of debt service fits into the overall picture of strategic resource allocation. An institution does not want debt service to be the tail that wags the dog. That situation can (1) preclude the institution's pursuit of other allocations of scarce resources to move strategic initiatives forward and (2) harm the ability to continue to allocate resources to sustain the quality of academic programs and student services.
- Understand thoroughly any financial covenants and pledging of liquid assets. We as business officers need to be relentless when understanding the implication of financial covenants and the ability of the institution to stay within those covenants. We need to be able to design the covenants with the future in mind so as not to put the institution in a position of being unable to meet the covenants and causing a knee-jerk reaction with the financial partner.
Also, in large part because of the current financial markets, increasing emphasis is being placed on liquidity. With this in mind, review in depth the pledging of endowment assets or future campaign pledges, and establish a satisfactory limit that benefits both the institution and the financial partner.
Clarke University is in a unique place to proceed with the issuance of debt to construct a much-needed facility on campus. Our current debt capacity will also not preclude the issuance of additional debt to fund other high-need facility projects in the future.
I'd offer this further advice to other institutions in the same position as Clarke: (1) Be willing to take risks to advance your mission; (2) employ a comprehensive master planning process that clearly indicates your institution's needs; and (3) conduct a thorough search for a financial partner that will provide terms that do not put the college in a negative position when pursuing future needs.
Taking such an approach has certainly given us the flexibility we needed to move forward with a facility that advances our competitiveness and will support our commitment to increased emphasis on the heath sciences.
DEANNA S. McCORMICK is vice president for business and finance, Clarke University, Dubuque, Iowa.