A beginner’s guide to debt in higher education

University borrowing, for the most part, is one of those “moral panic” stories that the higher education sector is beset with. Somewhere deep within the Calvinist soul of the nation there seems to be a conflation of debt with sin: any story splashing on “irresponsible” or “unsustainable” borrowing has the same effect on people as headlines about austerity or living within our means. Despite this, household debt continues to rise, as statistics regularly show.

Most people’s frame of reference is personal or household finance. Paying down debt, or borrowing the least amount of money for the shortest possible time, is seen as prudence, anything else is seen as profligacy. Just as a household might want to own the bricks and mortar they live in, or drive a newer, more reliable car, universities sometimes borrow to support growth, a change in strategic direction, or a new initiative. Borrowing, after all, can be a form of investment.

As Karel Thomas, Chief Executive of BUFDG, put it: “Borrowing is part of life, for individuals, governments and businesses. Debt is not always bad, as long as it is affordable and well-managed.”

Marc Finer, Director and Head of Higher Education Debt Advisory at KPMG, told me that, “There’s a perception that debt is in and of itself a risky thing, but lenders themselves are risk averse. Lenders will offer finance for a fixed period of time and fixed rate of return. Relatively low rates in the sector reflect that lenders don’t feel like they are taking a high risk bet. Lenders aren’t running around writing cheques – they are very selective.”

Types of funding

We need to start with an understanding of where institutional funding comes from. Most income, be it from student fees or funding councils, is directly linked to a particular segment of activity. Research grants are supposed to cover the cost of conducting and administering research. Student fees are generally expected to cover the cost of tuition.

All of this funding is recurrent rather than capital, almost all of it spent in year. But universities also incur one-off costs, most often linked to estates or equipment

Finer summarised: “A lot of the borrowing done by universities in recent years has been driven by estates investment. But this doesn’t just mean shiny new buildings. It may also be about clearing backlogged investment in the current estate, anything from repairing leaking flat roofs or removing asbestos through to retrofitting energy efficient windows.”

One-off costs are generally covered by capital. In the past a lot of this has come from funding council allocations linked to teaching or research. One of the great untold stories about recent university funding is the near disappearance of capital grants from funding councils. In England, for example, HEFCE allocated £738m of formula capital funding in 2008. Fast-forward to 2017 and this same allocation has shrunk to £104m from OfS and £183m from Research England, distributed across many more institutions.

But buildings still need to be developed, repaired, or replaced. Equipment still needs to be updated and maintained. So institutions now look to other sources of funding.

Types of borrowing

Generally, there are three sources of external finance available to institutions:

• Public bonds are primarily for access to very large (£200m+) amounts of money for long periods. They require an investment grade credit rating (from an agency like Moody’s). Institutions often work with banks to identify prospective pools of lenders. However, not all universities will be able to access the bond market – generally institutions of longer standing with income diversity (teaching, research, and industry) will be eligible.
• Bank finance sits at the other end of the scale. Borrowing is easier and finance is more flexible (a revolving credit facility being a common example). Institutions generally build up a relationship with their bank, which will often know a great deal about their finances and planning, and will be able to offer a facility that meets these specific needs.
• Private placements is the term used to describe non-bank borrowing that is not a public bond. Very liquid investors (often US pension schemes) seek reliable low-risk returns and will often approach individual institutions with offers directly. Some flexibility is available (though banks can be more flexible) and there is no requirement for an investment grade rating.

With each of these options, lenders are keen to see that institutions are able to service the loans they take. Due diligence and risk assessment ensure that there is little risk of lenders losing their money. As public-sector linked bodies, often with long histories, UK universities are currently attractive to investors during a period of high liquidity, with the cost and availability of finance generally reflecting this.

Ian Robinson, Director of Public Sector and Education at HSBC, explained how a bank might approach these decisions.

In making lending decisions we would start with a in-depth understanding of the institution, their strategy and their drivers as well as the robustness of their projections and viability of their plans. We look at both financial and non-financial metrics – including things like rankings, student number trends, operating cash flow, and surplus-deficits. All this helps us to understand the ongoing sustainability of an institution.

Thomas told a similar story from the perspective of a university financial director

Finance Directors are usually very prudent by nature, sometimes to the point where they could be accused of being over-cautious. To make sure that they are neither recklessly over-optimistic nor so cautious that they stand in the way of progress, there are checks and balances before decisions to borrow even reach the ultimate decision-making body, the governors.

Those checks involve robust business cases, independent evaluation of proposals by lawyers and debt advisers, scrutiny of figures by lenders and auditors and sign-off by internal committees. At every stage, questions are asked and asked again, so if a university borrows money, the community of the university has to be convinced that it is a good idea and lenders have to be convinced they will be repaid. Neither party sets out to fail.

That said, not every HE provider is the same. All lenders will make an assessment of an institution as a part of this– but every financial relationship proceeds on the basis of a business plan. Increasingly, lenders will question assumptions of perpetual growth as the outlook for HE – given demographic pressures, pensions liabilities, Brexit, Augar – looks less rosy.

“We’ve seen changes in institutional behaviour – terms have shortened to provide flexibility and reduce costs, and changes in the educational landscape in terms of numbers has had an impact on the way that universities borrow,” said Robinson.

Strangely one message that doesn’t appear to have cut through is the apocalyptic warning from Michael Barber that the OfS will not “bail out” institutions. Banks and other lenders are savvy enough to see this message as being aimed at institutional planners rather than the financial markets – there remains an assumption that some institutions are too important to lose, and that other mitigations short of a bailout (mergers for instance) will play a part.

But really, no lender would offer finance to an institution based only on the idea that it would not be permitted to fail. This idea gives the information-rich decisions that underpin finance little credit.

How is borrowing changing?

Finer described the way the wider marketplace is shifting.

 There’s lots of liquidity in capital markets, so these days private placements are similarly priced to bonds. Direct conversation with private placement lenders makes it easier for HE institutions to tell their story. For this reason the balance of long-term borrowing has shifted to private placements in the last two years.

The demise of student number controls and capital grants happened pretty much simultaneously in the early part of this decade. The combination made borrowing more necessary and more available – institutions had both the capacity and the will for student number growth. Higher fees meant that, for the first time in a long time, the majority of teaching could be financially self-sustaining.

The visible evidence of borrowing – new campuses, new buildings, and new facilities – is all around us. But a big part of borrowing-supported activity has been less visible – campus maintenance and refurbishment, IT infrastructure upgrades, and software underpinning new teaching methods and research processes.

But this era is in the past. With a gloomier outlook, many HEIs are actively planning to shrink – with lower student numbers prompting retrenchment and restructure. The loss of a subject area is at the extreme end of such planning but many institutions are considering specialisation, or refining their course portfolio. Others are looking at raising entry grades. Such is the logic of marketisation – clearly not every institution can grow, and not every institution can be fully comprehensive.

As Robinson explained:

 Some universities are planning to shrink – some have expanded very rapidly when caps were removed, others are reducing student numbers strategically to ensure they bring in a higher level of acceptance grade.

Finer said that:

Lenders are asking more questions these days – about student growth projections, about what could go wrong, about how universities will find additional cash to cover risks. There’s more due diligence.

Last summer we saw concern over university access to bridging loans under former HEFCE rules. Now that these are forbidden, we might have expected to see a rise in the demand for such support from banks. But this has not happened.

Bridging loans differ from other forms of finance by having a very short term. You could compare them to a payday loan. But the general quality of institutional financial planning is good, so this state of affairs is a rarity.

An institution would only have approached HEFCE for such a loan if a bank couldn’t offer one – another very unlikely scenario.

The outlook

Finer said that institutions shouldn’t worry unduly, but should plan realistically.

I’m not convinced that there’s a credit crunch coming for universities. Some institutions may have taken on debt when it was available even where there wasn’t an immediate need for the cash, because their long-term sustainability and ability to service the debt was never thought to be in any doubt. But in a market where conditions could get tougher and plans could change, the institutions with more flexibility in their debt arrangements are likely to be more resilient. Capital structure needs to be planned properly and appropriate to each institution’s own situation.

Robinson expected this period of change to continue.

The landscape of borrowing has changed significantly in HE and will continue to change as the sector evolves. We’ve seen significant changes in recent years – an appetite for shorter terms and more flexibility is linked to the uncertainties that the sector faces.

But every provider is different, as Robinson reminded us.

For a university to find the most appropriate form of borrowing, careful assessment is needed to get best value debt and to reducing risk in refinancing debt. We prefer to build a strategic relationship with universities to help best meet their needs