Stories about the financial challenges faced by higher education institutions are common and point to the need for boards and administration to adopt an approach to financial planning that ensures long-term stability. In the March 24 edition of The Chronicle of Higher Education, Mark Keierleber writes about a number of smaller colleges that are adjusting to lower enrollments and the lagging economic recovery in “Financially Strapped Colleges Grow More Vulnerable.”
The article features a story about Ashland University, which borrowed money to build a recreation center, an education building, and an addition to its science center. After three years of declining enrollment, Moody’s downgraded the university’s bond rating due to its decreased liquidity. Keierleber also writes about Calvin College, another institution that borrowed money up front to construct projects while pledged gifts for the projects were paid over several years, and the cash received was invested for debt repayment. Lower investment returns on the pledged receipts pool, and the fact that gifts received and pledged did not meet the construction costs, created an operating deficit that will increase over the next few years without cost and expense adjustments.
Reading stories like these reminds me of the years I spent as a finance committee member and then treasurer on a nonprofit board. Early on, the institution had some operating challenges due to declining enrollment. Per customary practice, the CFO deferred maintenance expenditures wherever possible to defray the operating cash deficit and avoid spending cash reserves or borrowing from the endowment. Fortunately, the institution did not have any current debt, and our finance committee was able to work with the CFO and president to develop an operating model and budget that aligned annually with conservative enrollment projections. The deficits were ultimately eliminated, and maintenance deferrals were restored.
As I subsequently learned, institutions’ finances are more complex than simply managing the operating budget. Private nonprofits’ cash flows revolve around three components that I dub “the trinity”: institutional operations, the endowment, and fundraising/development.
Shortly after we stabilized our operations, the institution received a major bequest from an alumnus and—with that bequest in hand—the administration requested that the board approve the construction of two new buildings. Fortunately, our board chair requested that the finance committee develop a multi-year cash flow model showing all the sources and uses of cash before the board would approve the construction. The model indicated a need to raise an additional $2 million for the building funded by the alumnus’ bequest and a need to raise the entire sum for the other building.
Working with the institution’s development staff, the board was able to quickly obtain gifts and pledges exceeding the construction cost for the first building. The second building was more problematic as no major donors stepped forward to support the project. The administration insisted that both buildings should be built at the same time in order to satisfy student and faculty demands.
Since the campaign for the first building was oversubscribed, the development department was able to convince some of the donors to move their pledge to cover the cost of the second building. However, a substantial shortfall (70 percent of the construction costs) still existed.
Despite the mounting pressure from the administration to build both buildings, the board chair insisted that the institution first adopt guidelines for new building construction. We ultimately developed a 20/40/40 rule for constructing new buildings: of the total cost, 20 percent cash had to be on hand, 40 percent had to be received in binding pledges, and the remaining 40 percent of the project cost could be raised in a capital campaign. Included in the project cost requirements was the establishment and funding of an endowment for estimated building maintenance over the first 20 years and a requirement that the projected operating budget for the institution increase by the building’s expected operating costs (electricity, heating, cooling, cleaning, etc.).
The rule was a compromise. There were board members who wanted 60 percent of the costs to be cash on hand, some wanted 100 percent in cash and pledges, and others didn’t want any cash on hand requirement if pledges were available along with the development department’s promise to raise the remaining funds. Using this example, you can see the relationship between the “trinity” of operating budget, endowment, and fundraising.
Similar to the two schools mentioned in the Chronicle article, our institution borrowed the money to fund construction using a tax-exempt bond. The cash received from pledges was invested as received up to the date of the allowable pre-payment and, thanks to the non-profit tax exemptions, a higher rate of yield from the investments was achieved versus the interest rate on the tax exempt debt; this is not always the case because of market fluctuations. Thanks to prudent planning, establishment of construction guidelines, and successful fundraising to collect the cash to pay for the facilities, the debt was repaid and the impact on the operating budget was minimal. However, if the capital campaign had been unsuccessful, ultimately the repayment of the debt principal would have required a reduction of unrestricted funds from the endowment (if available) and would have reduced the annual draw from the endowment that was contributed to the operating budget. Imagine if these negative things occurred at the same time that enrollments were declining and the budget had to be adjusted for both items.
Clayton Christensen and Henry Eyring wrote about the high fixed-cost model utilized by traditional higher education institutions in their book, Innovative Universities. Institutions with large endowments and enrollments are generally able to weather a short-term disruption. Institutions with meager endowments, outstanding debt, and smaller enrollments are less able to weather disruptions, particularly if the decline in enrollments or endowment earnings extends over a number of years. Institutions’ boards and administrations should consider the potential for continued disruption and re-establish conservative planning that ensures longer-term financial stability rather than managing the process through a year-to-year approach.