Taking the debt plunge

November 3, 1995

The market for lending to universities is buoyant, but finance directors must know how to negotiate the currents, argues Andrew Jordan.

To borrow or not to borrow, that is the question . . ." At least, it used to be. But for universities facing dual pressures to improve their facilities and to reduce their costs, the question is no longer if, but how. The 1988 Education Act opened up the private sector funding route for universities. Previously, few made use of debt-financing due to the extra risks attached to making debt repayments. Necessity is now forcing many universities to re-assess these risks, and for those who decide to take the plunge, a bewildering array of financing options is on offer.

The market for lending to universities is buoyant. They are seen as quasi-governmental organisations carrying a correspondingly low risk-rating in the eyes of lenders. Banks want to lend, and those which have not filled their sector limits are keen to get a slice of the action. As a result the margins on university lending are at historic lows - a good time for the borrowers.

But, given the cyclical nature of banking business, and the herd mentality of bankers (one in, all in; one out, all out), this situation cannot last. Were one university to default on its loan and not be bailed out by the Government, this could affect the whole sector. It would be seen to carry increased risk, and this would adversely affect both the amounts available and the rates on offer.

Income from students tends to be steady, predictable and long-term, which makes it suitable for debt-based financing (including leasing). Similarly, universities often have large sites in key locations which offer good security to lenders. Now that many universities have put aside their aversion to debt, it is hardly surprising that the bankers are rushing to supply the new market. But the increasing complexity of the products offered has made them increasingly hard to evaluate.

Many university finance directors have neither the time nor the experience to do this, and some financing packages have been accepted without a true appreciation of their effect or competitiveness, or of the risks.

The headline cost of borrowing is only one consideration. This must be competitive, but flexibility, term, repayment structure, and security required are equally important.

Stepping back and asking "What do we want to achieve?" is an essential exercise. Typical questions to address include "What debt or cash do we have now?", "How much flexibility should we retain for future projects?", "How much time and money should we spend finding the best package?", "What are the critical dates?" and "How much risk can we afford?"

It is surprising how rarely the terms of a financing offer are challenged prior to acceptance. Lenders will never start with their final offer, and there may be a considerable range between the margin they ask for and the margin they will accept. Experience is an essential asset: if you understand the lender's cost of obtaining funds, you can identify the size of their profit margin and negotiate it down to a level where it fairly reflects the level of risk.

After negotiating about rates, you can concentrate on the other aspects of the contract. Given a free hand, the lender will try to weight all the variable factors in their favour, taking a charge over all the university's assets, and insisting that the whole amount be repayable on demand.

Knowledge of the market (and particularly of what the same lenders have accepted on other transactions) is a powerful bargaining tool. By restricting the extent of the charge over assets to a reasonable level, the university will retain more flexibility for the future.

As for even offering to finance a 25-year development by a loan that is repayable on demand (which we have seen in practice), this seems little short of irresponsible. Yet some universities seem happy to accept total dependence on their bank's goodwill and good fortune, not seeming to realise the risks they are taking. Any sensible funding arrangement must match repayments and term to the underlying cashflows it finances, and should become repayable only if reasonable conditions are broken.

Debt-based finance is quick - if all the information is to hand, it can be arranged in a matter of weeks. But most major projects take months or years to plan, and this gives ample time for consideration of a wider range of more creative financing solutions including the Private Finance Initiative (PFI).

"Better services at a lower cost with lower risk" sounds too good to be true, but for some this may become a reality. With the PFI it is possible to turn the headache of a major redevelopment and property management into an opportunity. By offering it to experts, who can use the redevelopment to introduce state of the art techniques and efficiencies to provide cost-savings, a project can reduce costs as well as provide a satisfactory return.

By using the PFI, a university could acquire a package of support and services, financed and provided by the private sector (eg the provision, financing, construction and subsequent operation of a library).

While the cashflows of a property leasing arrangement closely resemble those of a loan, the property ownership structure will be different - typically the lender will acquire either the property or a lendlease at the start of the lease, and at the end the property (or use of it) will revert to the borrower in exchange for a nominal sum. Different options for eventual transfer of the property, for different amounts, allow greater flexibility than a simple loan in terms of the amount repaid.

For example, a high residual value would reduce the annual borrowing cost. Also, the amounts can be phased in a way that suits the borrower, being for example, constant, or rising with expected inflation, or stepped (possibly to match expected changes in the level of income).

Some universities now have the option of tapping the wider capital markets by way of a bond issue, or a securitisation. A bond issue offers the borrower similar terms and conditions to a loan but the debt is evidenced by a transferred security, which may or may not be listed on a stock exchange.

Securitisation issues are where the investors buy into either an asset or, more typically a reserve stream. There are a number of securitisation projects progressing. There has been a lot of smoke but as yet no fire.

Financially engineered schemes exist offering a reduced cost of borrowing, perhaps financed through a tax loophole rather than utilising genuine tax incentives which may be available under leasing. Borrowers should always be alert to such unusually cheap rates. The risk is that the scheme may be affected by future legislation. Independent professional advice is essential. Many borrowing schemes contain hidden costs and risks, arrangement fees, valuation and legal fees, so that the cost of evaluation can be trivial in comparison. But the reward for making the right choice is a more secure future - infinitely more desirable than the risk of a major crisis a few years down the line.

Andrew Jordan is the Coopers & Lybrand corporate finance partner responsible for financing advice in higher education.

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