Volume V, #23
A few weeks ago I learned that my 96-year-old grandfather is charging his octogenarian roommate $5 per week to read his used newspaper. This was upsetting. Yes, the paper is The Globe & Mail, surely Canada’s finest newspaper. And yes, he’s only charging Canadian dollars. But I wondered whether a life of profligacy had reduced my grandfather to a state of penury requiring him to cadge money from his roommate.
My grandfather has lived a charmed life. A well-known Canadian watercolorist (actually watercolourist) with paintings in Canada’s National Gallery in Ottawa, John once wrote a manifesto titled “A 7-Minute Joy,” the point of which was that no watercolor should take more than seven minutes to complete. The license place on his car was A7M JOY. John served in World War II (painting in England and France) and now lives in a wonderful government-funded retirement home for veterans where he continues to paint regularly. John traveled widely, lived large and was extremely generous with family and friends. Everyone loved everything about John, except perhaps his awful puns. Every time my aunt passed around the mushrooms at Christmas dinner, like clockwork, John would announce from the head of the table: “they don’t leave mushroom for complaint!”
Upon investigation, John’s finances don’t leave mushroom for complaint. He’s the top seller in the retirement home gift shop and proudly told me he has $12k in his account. It turns out that charging his roommate $5 to read his Globe & Mail is just a weird thing that old people do.
While my grandfather may not have been overly profligate, let me tell you who has: colleges and universities. Lazy Rivers are a symptom of profligacy – the aquatic equivalent of my grandfather’s 7-Minute Joy. But we get a better sense of the magnitude by looking at college indebtedness. Bain & Company reported that between 2002 and 2008, schools increased long-term debt by an average of 12% per year – more than double the growth rate of spending on operations. And this year, colleges and universities successfully sold $32.7B in debt through September – almost 2x what they sold in the first three quarters of 2014.
Most of this additional borrowing is going into bricks and mortar. A recent Wall Street Journal article reported on two institutions that recently sold bonds to fund new facilities. Hawaii Pacific University borrowed $32.5M to pay for a major renovation and Nevada’s Roseman University of Health Sciences raised $67.5 million for a new office and research building. Despite the fact that municipal bond yields remain near record lows (~2%), Hawaii Pacific had to issue bonds at 4.48% and Roseman at 5.68%.
Bond rating agencies such as Moody’s have begun warning investors to steer clear of smaller schools, and the Journal quoted the head of the muni bond team at T. Rowe Price saying he’s avoiding small liberal arts colleges in favor of schools with “national brands.” But what’s amazing to me is that schools like Roseman and Hawaii Pacific are able to raise debt at rates this low. Perhaps one reason new debt has nearly doubled this year is that colleges and universities sense it won’t be long before the market catches on.
In other sectors, when insiders “cash out” to this extent, it’s fair to surmise that a peak has been reached. In 2015, in higher education, we’ve reached “Peak College.” In many respects, it’s all downhill from here.
The ball will start rolling downhill for public institutions when investors begin accounting for pension obligations. The University of California pension fund has a shortfall of between $8-16B. Increasingly, universities will be required to direct a greater percentage of operating budgets towards filling pension gaps. This is already happening in Texas, where community colleges are now being required to contribute 50% of annual pension obligations from general funds. And in some cases, state directives like this are contributing to additional borrowing. The University of California system has borrowed $2.7B since 2011 to help close the pension gap.
Then there’s the cost of health care for retired employees. 90% of private and public universities continue to offer this benefit (vs. 20% for the rest of the economy). Michigan State eliminated the benefit for all new employees after calculating that it was already a $1B bill that would double every 15 years. Still, this is the exception. Most institutions continue to either pay retiree premiums in full or split the cost.
But the major repricing of college and university debt will occur when ratings agencies begin to account for fundamental demand and systematic interdependencies in their ratings methodologies. Moody’s, for example, considers factors such as market position, operating performance, governance and management and strength of balance sheet to ascertain whether future revenue streams are likely to be sufficient to meet debt service obligations, but not whether degrees will continue to be the default currency of the labor market.
One would think that ratings agencies would have learned from the Great Recession, when ratings agencies failed to take into account fundamental questions of liquidity and demand for classes of securities and interdependencies therein. In higher education, while “just-in-time” providers like General Assembly and Galvanize are rushing in to fill the gap and online providers like Udacity and Coursera attempt to establish shorter, less expensive credentials that will have credibility with employers, ratings of college and university bonds continue to be bottomed on faith that demand for bachelor’s and master’s degrees will continue unabated.
As Mitch Daniels, President of Purdue has said, “Higher education has to get past the ‘take our word for it’ era. Increasingly, people aren’t.” At some point in the next few years, ratings agencies won’t either.
So if your institution issued bonds this year during “Peak College,” take pride in the wonderful new buildings. But keep in mind it’ll be a 7-Minute Joy in the context of higher education’s millennium-long history. Because when ratings agencies catch up, the resulting financial wreckage is likely to leave – as my grandfather would say – “mushroom for complaint.”
University Ventures (UV) is the premier investment firm focused exclusively on the global higher education sector. UV pursues a differentiated strategy of 'innovation from within'. By partnering with top-tier universities and colleges, and then strategically directing private capital to develop programs of exceptional quality that address major economic and social needs, UV is setting new standards for student outcomes and advancing the development of the next generation of colleges and universities on a global scale.