Digest No. 03 - August 2017

Troubling Changes in Capital Structures at Small Private Colleges

Ward, J.D. 2016. “Troubling Changes in Capital Structures at Small Private Colleges.” Journal of Higher Education Management, 31, 57–74.

Summary of the Article

This article focuses on problems associated with long-term debt at smaller private colleges and universities used to fund large capital projects, such as the construction of new academic buildings or residence halls and the renovation of existing facilities. James Dean Ward explains that colleges and universities use various methods to fund capital projects such as major gifts, grants, reallocation of currently available money, withdrawals from endowment, borrowing, and issuing bonds. The choice of how institutions fund their projects, depends on the debt adversity each college sets for itself. Some institutions elect to use debt to fund capital projects. Ward issues a caveat to smaller private colleges, stating, “tuition-reliant, less wealthy and highly leveraged institutions are in danger of being overcome by financial deficits” (p. 58).

The author offers two frameworks, static trade-off theory and pecking order theory, originally derived from for-profit sector financial management. Broadly explained, “The static trade-off theory proposes that nonprofit managers balance the costs and benefits of debt to reach an optimal leverage level, while the pecking order theory suggests that managers simply prefer internal funds to external borrowing” (Calabrese 2011 as cited by Ward 2016, p. 62). For example, institutions with diverse revenue streams (e.g., stable enrollment, auxiliary income, consistent donors, varied sources of grant funding) are more likely to use static trade-off approaches. Smaller institutions without diverse revenue streams or larger endowments adhere more closely to strategies described by pecking order theory. However, Ward argues that in the case of some recent institutional closures, smaller colleges and universities were more likely to adopt the static trade-off than the pecking order approaches.

Problems with Long-Term Borrowing

Ward describes problems for small private colleges with increasing dependence on long-term borrowing. He states that colleges must assess their financial health and expected ability to repay the debt. Ward admonishes that an institution still must repay the debt even if projected future income fails to occur. Debt-servicing expenses include payments on both the interest on the loan and on the principal and are greater for loans obtained for an extended period of time. He views this warning as especially important for smaller private colleges with smaller endowments and student enrollment challenges. These institutions may struggle to meet their debt obligations because of unmet revenue projections.

Institutions may issue bonds as one form of long-term borrowing. Institutional collateral and creditworthiness determine an institution’s ability to borrow funds through bonds. The value of the institution’s physical plant, expected tuition revenue, and available cash function as collateral for the loan. The reputation of the institution, projected demand for specific programs, and a continued expectation for tuition revenues contribute to the creditworthiness of a given college or university.

Ward references research by Lyken-Segosebe and Shepherd (2013) conducted for the Tennessee Independent Colleges and Universities Association. In that study of 57 smaller private colleges that closed, these authors found that the debt-serving expenses of these institutions were approximately five times those of other colleges and universities. (Unfortunately, Ward does not include the amount of the debt servicing expenses for the closed colleges.) Lyken-Segosebe and Shepherd also noted that these 57 smaller private colleges were very dependent on tuition revenue to the point that over half of their revenues came from tuition, especially from part-time students. Based on these particulars, Ward urges smaller private colleges that fit the profile of these 57 closed institutions to be “particularly wary of long-term debt” (p. 68).

Moreover, the creditworthiness of smaller private colleges that fit the profile of the 57 closed institutions may also be problematic. The bond ratings of similar colleges may suffer because of their lack of institutional collateral. Ward states that bond ratings signal to the potential loaner risks associated with lending money. Loan risks also translate to higher interest rates. Ward notes that the bond ratings of many smaller private colleges are declining.

Implications for Action by Campus Leaders

New presidents and presidents with nonfinancial backgrounds should find this article of particular value as it provides an overview of the bond issuing process, case studies associated with long-term institutional borrowing, and theoretical frameworks for borrowing and spending. Institutional expenses for debt service constitute a marker for vigilance by the presidents of private colleges and universities. Presidents of colleges that are highly tuition-dependent, have small endowments, and enroll large numbers of part-time students should espouse a high value on institutional debt adversity. The acquisition of high levels of debt accompanied by burdensome debt-servicing expenses can result in rapid institutional financial decline and perhaps closure. CIC presidents should consider use of resources available to CIC member institutions to benchmark the debt levels. These resources include CIC’s annual Key Indicators Tool (KIT) and the Financial Indicators Tool (FIT) benchmarking reports.

To maintain institutional viability, some capital projects may need to be undertaken without delay. Presidents should use caution when approving capital projects unless the funds for the project have been secured through means other than incurring the bond repayment debt.

About the Author

James Dean Ward is a doctoral candidate at University of Southern California and a research assistant in the Pullias Center for Higher Education.

Literature Readers May Wish to Consult

References from this article that readers may wish to consult:

Blustain, H., S.T. Cobine, E.S. Gore, J.A. Palmucci, M.K. Townsley, and J. Van Gordon. 2008. Strategic Debt Management. In National Association of College and University Business Officers, Seventh Edition. College and University Business Administration. Washington, DC: NACUBO.

Lyken-Segosebe, D. and J.C. Shephard. 2013. Learning from Closed Institutions: Indicators of Risk for Small Private Colleges and Universities. Nashville, TN: Tennessee Independent Colleges and Universities Association.

Teece, D.J. 2007. “Explicating Dynamic Capabilities: The Nature and Microfoundations of (Sustainable) Enterprise Performance.” Strategic Management Journal, 28, 1319–1350.