Private Schools/Public Money

How Independent Schools Have Used the Bond Market to Finance Expansion

By Mark Anderson

These are competitive days for schools, whether they're public, private or charter schools. They're competing for many things - from student achievement to top teachers - but fundamentally they're competing for families.

A factor growing in importance as families choose their child's school is its buildings and campus. Are they safe and comfortable? Functional for 21st century lessons? Do they provide an enriching environment?

And as the stakes rise for providing topnotch facilities, a difficult question emerges: How do you pay for them?

For public schools the answer almost always lies in the public finance market, where investors have long been happy to buy bonds backed by a school district's taxing authority - providing very long-term, low-cost loans.

Today, that market is slowly opening its doors wider to nonprofit private and charter schools, too.

Those new entrants to the public finance arena can't obtain the same favorable terms that taxpayer-backed school districts do.

But in many cases - thanks to the willingness of local and state agencies to issue tax-exempt bonds on behalf of private schools - the public finance markets are now providing what is often the only practical option for financing today's high-priced, but very valuable new buildings.

"We're seeing steadily more interest by schools in tax-exempt capital markets," said Ralph McGinley, an investment banker who specializes in working with nonprofit schools at Oppenheimer & Co.'s Minneapolis office. "It's growing partly because many schools just hadn't thought of this market before. They financed their growth by getting bank loans or through fundraising drives, but those sources can't provide enough capital now to build the kinds of facilities that keep schools competitive. And the school environment is competitive today. They're feeling the same pressure private colleges are to improve their facilities and their learning product."

That growing marketplace is getting a boost from the other side of the table, too. Bond investors - usually wealthy individuals, or institutions such as banks - are constantly searching for new, stable markets that aren't already jammed with investors, but that can deliver predictable results.

In the last several years they've invested much more in tax-exempt issues for private or charter schools, according to Richard Ward, a senior vice president at Dougherty & Co., another Minneapolis-based investment bank that specializes in nonprofit school financing. "Investors are accepting these as legitimate educational opportunities. And they've seen enough now to know that it's reasonable to expect these schools will do what they say."

That growing investor demand has helped drive down prices for private school borrowers. Interest rates on private and charter school bonds vary substantially, based on the type of bond and whether the school can provide equity or collateral on its loan - in the form of buildings and land, endowments or fundraising proceeds.

Many schools entering the market for the first time will be limited to non-rated, tax-exempt bonds, which are priced now in the vicinity of 7 percent, Ward said. "Those have come down in the last five years and are now in line with more traditional revenue-backed issues" for housing projects.

So the good news is that the bond markets are becoming more accessible and affordable, but Ward, McGinley and a handful of Montessori schools warn that it's still a challenge for first-time borrowers trying to get in the door.

First, the underwriting process - in which investment bankers like Ward and McGinley evaluate a school's ability to repay its loans - is an exhaustive, time-consuming ordeal. Borrowers fill out and accumulate bond documents that weigh many pounds and take up yards of file space. Securities rules and traditions require the participation of a small army of attorneys - representing the issuer (municipality or state development agency), underwriter (an investment bank, such as Oppenheimer or Dougherty) and the school - as well as the staffs for the issuer, underwriter and school, and various appraisers and accountants.

Princeton Montessori School founder Marsha Stencel provided a Dickensian image for the paperwork gauntlet that she encountered when she closed on her New Jersey school's first issue 20 years ago. "When we arrived it was like a scene out of the movies. You walked into a large room and there in front of you was a table that looked like it was 30 feet long, and all along the way there were lawyers, each with their papers to sign."

It's helpful to remember that all of that professional oversight unlocks the door to what is often the only affordable lending source for schools.

The high costs of land and construction make fundraising an impractical financing solution for most schools. And banks, because of the stringent regulations on how they use their depositors' money, generally require considerable equity contributions from borrowers - in the form of cash or property that most Montessori schools don't have.

Those bond-market opportunities come at a price, of course.

In addition to the stated interest costs, bond-related fees generally total from close to 6 percent of the issue's total value, Ward said - or close to $300,000 on a $5 million loan. Most of those bond-related fees can be rolled into the financing package and repaid with the bond. Schools also frequently run into other development-related expenses not directly related to the bond issue, which will require a separate source of funds.

So, are you eligible? Your school must be a nonprofit organization, and must find a public agency to issue the tax-exempt bond. City, county or state development agencies all have the capability to issue them on behalf of any effort that contributes to public good. Most do it frequently and will support a reputable school if it has room left in its annual capacity.

Are your financing needs large enough to turn to public financing? Because of the size of the fees involved, underwriters say the issue should reach a threshold size. Ward says he wants to see issues that are at least $2 million, but are generally between $4.5 million and $12 million or higher. McGinley starts a little higher at $5 million, and is more comfortable with issues between $7 million and $30 million.

Does the schedule work? In the best circumstances a bond could be issued in 45 days but in practical terms count on 90 to 120 days, and the school needs to be refining its needs and lining up its documentation well before that, McGinley said. Start planning at least a year before you hope to issue, Ward advised, recruiting school friends to serve on the building committee - friends with financial backgrounds or the willingness to do some studying.

What are your choices? Some schools may qualify for bonds that are risk-rated by Wall Street agencies such as Standard & Poors. Those rated bonds secure lower rates, but Standard & Poors needs to see security - in the form of cash or property, a long business track record, or a bank-issued letter of credit that adds the bank's guarantee to the loan.

Those advantages aren't available to many schools that are trying to expand or buy their first school buildings.

An alternative is available in non-rated bonds, McGinley and Ward's specialty. They evaluate a school's ability to repay the bonds, and if the risk looks good they'll give their underwriting imprimatur and bring the issue to market. Non-rated bonds carry interest rates that may be as much as 3 or 4 percentage points higher, but they lock in rates, fixing a school's financing costs while its operating income grows over the decades. Schools are also able to refinance if rates decline or their credit status improves.

But the underwriters need to be persuaded that the school will be able to repay its debts for the next 30 years, and they'll search for evidence of that in many places. They'll pore over a school's operating record - including its audited operating budget, budget forecasts and pro formas. They'll look for at least three years of stable and growing enrollment (at least 250 students to reach critical mass, Ward said).

They'll look for evidence of market demand for the school, reviewing waiting lists and student turnover data. McGinley said he meets with parents and school staff and expects to see that parents are very involved in the school. "We know that locks families in to a school and also creates an excellent learning environment."

Montessori schools come into the process with an inherent advantage, according to Ward. "Montessori has a very good, well-established track record around the country. It works in schools, and families choose it and are happy with it."

There are many other variables to consider as the underwriting process proceeds, from choosing fixed or variable rates, short or long term loans.

But as the process starts, Ward said, it's useful to keep a couple simple things in mind. "The bond market can provide a real benefit to nonprofit schools, providing access to all the capital they need. Just be aware that there's some work to get through to get to those opportunities. And it pays to start planning early."

Resources:

. Investment banks and law firms in your region can probably offer advice or refer you to specialists on private school financing. We consulted with two firms for this story: Dougherty & Co. in Minneapolis, (612) 376-4004; and Oppenheimer & Co., also in Minneapolis, (612) 337-2700.

. Most state development authorities will provide advice on tax-exempt financing opportunities for private or charter schools.