2012 outlook - higher education

INDUSTRY OUTLOOK

U.S. PUBLIC FINANCE JANUARY 20, 2012

Table of Contents:

SUMMARY OPINION 1 CRITICAL CREDIT FACTOR #1: EVOLVING DEMAND TRENDS FOR UNDERGRADUATE AND GRADUATE PROGRAMS HIGHLIGHT FLIGHT TO QUALITY AND AFFORDABILITY 3 CRITICAL CREDIT FACTOR #2: RATTLED CONSUMER CONFIDENCE PUTS INTENSE SPOTLIGHT ON COLLEGE AFFORDABILITY 6 CRITICAL CREDIT FACTOR #3: PRESSURE ON NON-TUITION REVENUE STREAMS UNDERSCORES THE IMPORTANCE OF REVENUE DIVERSITY AND OPERATING EFFICIENCY 10 CRITICAL CREDIT FACTOR #4: LIQUIDITY AND DEBT STRUCTURE RISKS REDUCED BUT NOT ELIMINATED; UNIVERSITY CAPITAL SPENDING AND BORROWING CUT BACK 16 MOODY’S RELATED RESEARCH 20

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U.S. Higher Education Outlook Mixed in 2012 Revenue Pressure and Heightened Public Scrutiny Force Colleges and Universities to Demonstrate Better Operating Efficiency and Transparency

Summary Opinion

For 2012 Moody’s maintains a mixed outlook for U.S. not-for-profit private and public colleges and universities, mirroring our 2011 outlook. We have a stable outlook for the diversified market-leading colleges and universities, which have the strongest market positions and balance sheets and operate multiple revenue-generating business lines. These market leaders are typically rated in the Aaa and Aa categories, although not exclusively, and represent a minority of our rated higher education portfolio. We maintain a negative outlook for the remainder of the sector which covers the large majority of rated colleges and universities which are far more dependent on state appropriations and/or student tuition. This majority segment attracts students more regionally, retains less pricing power and maintains thinner balance sheets.

During the past year, public and political scrutiny of colleges and universities, both not-for-profit and for-profit, has escalated and we expect that the sector will remain under the microscope in 2012 and beyond. Prospective students and their families are increasingly price-sensitive, discerning consumers, and donors, research-granting organizations, and state governments have more limited resources to invest in higher education. Colleges and universities are under rising pressure to improve disclosure, increase operational efficiency, and limit tuition increases. They must work harder to distinguish themselves and clearly articulate their unique product values in a more competitive environment. We expect revenue growth to slow significantly in coming years, thereby raising the bar for management teams and boards to demonstrate long-range organizational sustainability without depending on regular net tuition increases that far exceed inflation.

The outlook expresses Moody’s expectations for the fundamental credit conditions in the industry over the next 12 to 18 months and does not speak to the expected balance of rating changes during this timeframe.

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2 JANUARY 20, 2012 INDUSTRY OUTLOOK: U.S. HIGHER EDUCATION OUTLOOK MIXED IN 2012

Despite stiffer headwinds, the large majority of rated colleges and universities have thus far fared well and demonstrated organizational nimbleness during the prolonged stressful economic period following the 2008-09 financial crisis. Although negative rating actions in the higher education sector have increased over the past three years, ratings have been relatively stable given that the majority of higher education rating reviews have resulted in rating affirmations. Colleges and universities led by experienced management teams with diverse backgrounds and overseen by strong boards will be best placed to navigate through ongoing future challenges. Across the rating spectrum, those organizations that are willing and able to adapt their business models to an era of “new normal” realities will be best poised for long-term success.

Key critical credit factors driving our outlook for U.S. higher education in 2012 are:

1. Evolving demand trends for undergraduate and graduate programs highlight flight to quality and affordability.

2. Rattled consumer confidence puts intense spotlight on college affordability.

3. Pressure on non-tuition revenue underscores the importance of revenue diversification and operating efficiency.

4. Liquidity and debt structure risks are reduced but not eliminated. University capital spending and borrowing have been cut back.

Mixed Outlook for U.S. Higher Education in 2012

Characteristics Associated with Stable Outlook Characteristics Associated with Negative Outlook

Market leaders with top-ranked academic programs and global reputations supporting pricing power

Typically small or medium-sized enrollments and lack of economies of scale

Highly selective and/or high net tuition per student reflecting consistently strong national demand from top quality students and faculty

Non-selective to moderately selective colleges and universities with average to low net tuition per student and a local/regional student draw

Multiple business lines generating revenue from diverse sources; comprehensive academic offerings and often multi-site operations

Undiversified business lines with heavy reliance on student charges and/or state appropriations

Generous philanthropic support, low dependence on state funding, and diversified research funding sources

Modest fundraising and/or limited or no research programs

Strong balance sheets and liquidity providing good support for debt and operations

Modest endowments or limited liquidity providing little support for debt and operations

Negative Outlook for Independent K-12 Schools and Other Not-for-Profit Sectors For 2012 we maintain a negative outlook on both the independent K-12 school and diversified not-for-profit organization sectors which share some credit characteristics with higher education. Many of the organizations in these sectors depend on gifts, endowment spending, government support, student tuition, and/or research grants. Moody’s publishes separate medians publications on these sectors, with medians broken out by not-for-profit subsector including cultural institutions, independent research organizations, service/advocacy entities, and philanthropic foundations. Although the unique risks vary by subsector, most will face increased pressure to improve operating efficiency and transparency as they confront continued challenges to grow revenue such as student tuition at K-12 schools and membership and admissions revenue at cultural institutions.

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Baseline Assumptions: Our 2012 outlook focuses on critical, near-term issues facing the U.S. higher education sector. Many baseline issues and fundamental assumptions underlie current credit strengths and challenges. In this publication we allude to the below listed baseline issues because they form the foundation for our 2012 outlook. Details on our views on many of these topics are available in previous Moody’s publications.

» Core student demand is likely to remain strong with postsecondary education fundamentally viewed as a “non-discretionary” long term investment for many families.

» Lack of threat from substitutes for the “college experience,” with traditional undergraduate colleges offering uniquely bundled services that tend to foster intensive personal development, intellectual growth, broad reasoning skills, career network building, political/community engagement, and general preparation for life and careers.

» Colleges and universities are important regional economic engines for their communities and are multifaceted in that they provide education, workforce training, employment, research activity, and health care.

» The future student body will become increasingly diverse, highlighting the importance of educational flexibility and the integration of technology to enhance instructional delivery.

» Regional demographic trends for traditional age students will influence student recruitment strategies and efforts to geographically diversify the student body.

» Private philanthropy, although pressured for some, will remain a key credit strength of the sector although perhaps at a new lower level, distinguishing higher education from the rest of the municipal market.

» Federal funding for research will not grow at the same robust pace as over the past 20 years. Top research programs will be the best positioned, and private research support will become increasingly important.

» The number of college mergers or closures will increase modestly and will be concentrated among the smallest institutions (typically under 1,500 students), particularly if macroeconomic conditions do not improve.

Critical Credit Factor #1: Evolving Demand Trends for Undergraduate and Graduate Programs Highlight Flight to Quality and Affordability

We expect that aggregate student demand for higher education will remain healthy, given projections for a growing number of U.S. high school graduates over the next decade, and the demonstrated economic benefits of attaining a higher education degree. International student demand also continues to escalate, with international enrollment in U.S. colleges increasing 5% in 2011, including particularly strong demand from China, India, and South Korea1

1 Open Doors Report, Institute of International Education

. Further, the Obama administration has set ambitious goals for improving college completion in the U.S. by 2020, including growth of non-traditional age, part-time, and at-risk student populations. Federal actions to improve access and

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affordability, including increased Pell grants and federal student loan relief measures2

We anticipate an ongoing bifurcation of student demand favoring the highest quality and most affordable higher education options. In January 2012, Moody’s published the results of its third annual tuition pricing and enrollment survey

, reinforce broader federal government spending and tax policies favoring higher education.

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Aggregate demand for higher education is further supported by positive data on the economic value of a college degree. Figure 1 displays the higher average yearly earnings (inflation adjusted figures) for people with college and advanced degrees compared to those without, highlighting the expected financial rewards of a college education.

to get an early gauge on fall 2011 student demand trends and FY 2012 tuition forecasts. Student demand and net tuition growth remain strongest for colleges and universities that are the most affordable, most programmatically diversified, and have the strongest reputations.

FIGURE 1

Return on Investment: Higher Average Annual Earnings for College Graduates

Source: US Census and Bureau of Labor Statistics

Undergraduate Demand: Strong Application Volume and Improved Selectivity Mask Underlying Challenges for Some

Growing undergraduate application volume has allowed many institutions to appear increasingly selective in recent years. This trend masks underlying challenges because it reflects students applying to a larger number of colleges. Based on preliminary results of our 2011/12 tuition and enrollment survey, public and private universities of all sizes and rating categories experienced growth in fall 2011 applications. However, median freshmen yield rates (percentage of accepted freshmen who chose to enroll) at both private and public universities have steadily declined over the past five years, highlighting increased competition. Median freshmen yield dropped to 27.6% in fall 2010 from 30.9% in fall 2006 for private colleges, and to 39.7% in fall 2010 from 44.1%% in fall 2006 for four-year public universities. The trend of declining yield is particularly notable for the lower rated private colleges which are increasingly competing with lower-cost public colleges and feeling the most pressure to slow tuition increases and offer more tuition discounting.

2 Moody’s: Proposed Federal Student Loan Relief Is Credit Positive for US Colleges and Universities, October 2011 (137024) 3 Moody’s: More U.S. Universities Expect Tuition Revenue Declines; Larger, Diversified Universities Favored in Tough Higher Education Market, January 2012

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Based on the 2011/12 enrollment survey, undergraduate full-time equivalent (FTE) enrollment growth for both publics and privates was strongest for the largest and highest rated institutions, which supports our stable outlook for the larger and wealthier, market-leading private and public universities. Market niche identity and brand reputation are now especially critical for colleges and universities that are not the low cost option.

Enrollment growth has also been particularly strong in recent years for lower-cost options, including community colleges. Two-year community colleges experienced explosive growth over the past four years, up nearly 22% between fall 2007 and 2011 as estimated by the American Association of Community Colleges. However, there was a 1% decline in enrollment estimated between fall 2010 and 20114

Graduate Demand: Signs of Pressure Despite Historically Countercyclical Demand with the Economy

. This slowed growth at community colleges could reflect ongoing economic hardships of prospective students who chose to work rather than enroll. Other causes include concern about job prospects after graduation, as well as physical capacity constraints at the colleges as a result of capital and infrastructure investments not keeping pace with enrollment growth.

In contrast with strong aggregate undergraduate demand, demand for some graduate programs and professional schools, including business and law schools, is softening. Historically, demand for these types of programs was countercyclical with the economy, but according to a study by the Council of Graduate Schools, enrollment of new students in graduate programs fell 1.1% in 2010, the first such drop since 2003.

Concern about student loan burden is much more prevalent among students at the graduate level. We expect that student cost/benefit analysis for certain degrees will escalate, with applicants increasingly concerned about graduating with high student loans and reduced job prospects. More specifically, 2011 marked the third year in a row for a decline in applications to two-year, full-time M.B.A. programs based on data from the Graduate Management Admission Council. We have anecdotally heard that recruitment for top students to these types of professional programs is fierce, with law and business schools increasingly using strategic financial aid offerings to attract top talent and secure entering class sizes. We expect that the graduate and professional schools with the strongest reputations and rankings and the highest demonstrated return on investment will retain the strongest student demand. Conversely, less reputable programs will need to reduce the scale of their programs and cut operating costs or face increased financial stress.

Online Education and Distance Learning: Avenues for Enrollment Expansion and Revenue Diversification

We expect that the expansion of online education and distance learning opportunities will continue particularly as the student body becomes more diverse and requires increased scheduling flexibility. Data indicate that close to 30% of students took at least one online course in 2009, up sharply from 10% in 2003, with this growth highlighted in Figure 2. The Sloan Consortium projects that this percentage may grow to 50% by 2016.

4 Collaborative analysis of the American Association of Community Colleges and the National Student Clearinghouse, 2011

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FIGURE 2

Online Education Continues to Blossom

Source: Going the Distance: Online Education in the US, 2011; Babson Survey Research Group; Sloan Consortium

The robust success of for-profit colleges in the online segment has at least temporarily ended, offering more opportunity for traditional colleges to expand their online capacity. We expect that distance or online education will be a central tool in advancing the global higher education environment and making higher education more economically viable and accessible across geographies and demographics. Although online education has opponents and educational outcomes data are closely scrutinized, advancements in technology, online curriculum and quality controls have made online education a more accepted and marketable tool to deliver education. We anticipate that for-profit, not-for-profit, and public universities will continue to invest in distance learning and online program development for financial and educational purposes. Successful adoption enables educators to expand and diversify their student bodies and tuition revenue streams and increase faculty scheduling flexibility and productivity.

Critical Credit Factor #2: Rattled Consumer Confidence Puts Intense Spotlight on College Affordability

College affordability is now in the spotlight more than ever due to fragile consumer confidence swayed by resumed stock market volatility during 2011, a persistently high unemployment rate hovering above 8%, and still depressed home equity. Social media attention, public protests, and political rhetoric during 2011 all contributed to elevating the discussion of the cost of higher education, with a particular focus on high graduating student debt levels, annual tuition increases that far exceed inflation, and skittishness about post-graduation job prospects. Rising student loan default rates have also drawn attention and pose a credit challenge for certain colleges, especially for-profit and graduate schools that risk exclusion from federal student aid programs due to high student default rates. High student default rates inevitably create reputation risks that can diminish student demand5

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5 Moody’s: Rising Student Loan Defaults Are Credit Negative for For-Profit Universities and Some Traditional Colleges, May 2011 (133456)

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Negative Outlook Persists on For-Profit Higher Education Providers Moody’s outlook for the U.S. for-profit post-secondary education sector is negative owing to continued pressure on revenue and earnings and selected pressure on enrollment levels. Weak consumer spending, the negative effects of extended high unemployment, and pressure on student loan funding have tempered demand for education. For companies that are highly reliant on Title IV student loans, the sector has also faced significant challenges related to government concerns over default rates and marketing practices. The DOE’s gainful employment regulations that were released in 2011 and other regulations passed in 2010 were intended to address these concerns. While the final gainful employment rules were far less stringent than originally proposed, they are still a credit negative to the extent that the industry faces more regulation than it did before. Moreover, companies are still feeling the residual impact of actions taken to conform to these regulations and combat the underlying issue of high default rates within the for-profit sector. In our opinion, these issues may continue to negatively affect enrollment trends near-term, although some large industry participants are starting to see gains in new student enrollments after sharp declines over the last 12-18 months. The U.S. based companies we follow in this space include The Washington Post Company (A3 negative) which operates Kaplan Higher Education (“KHE”), Education Management (B1 stable), Laureate Education (B2 stable), and ATI Acquisition (Ca negative).

Even if stabilization in enrollment is sustained, the full effect of the enrollment declines over the last year will sustain earnings pressure in 2012. In addition, we expect increased competition for students that are more likely to succeed in the programs and after graduation will create pressure on tuition rates, marketing costs, and the level of services offered. Despite challenges, we believe the enrollment gains at some for-profit schools are a favorable indicator that the intense pressure over the last two years is easing. The for-profit sector targets individuals that are not currently served well by more traditional non-profit institutions, and an improvement in the economy and labor market could allow some individuals greater comfort to pursue post-secondary education. Nevertheless, longer-term concerns remain, including the potential for increased competition from not-for-profit institutions as they expand online and non-traditional course offerings, and from funding pressures on student loans.

Tuition levels are at a tipping point, and the cost of college will be a critical credit factor for universities to manage long-term. Most colleges and universities, across the rating spectrum, are experiencing downward pressure on net tuition for different reasons and to varying degrees. We expect that the pace of future net tuition revenue growth, both on a total and a per student basis, will be much lower than the strong growth experienced over the past ten years.

As highlighted in Figure 3 below, although estimated household and not-for-profit net worth has increased since the 2008 downturn, it remains depressed compared to 2006 and it declined further during the second and third quarters of 2011. The U.S. economy remains fragile with forecasts for GDP remaining below historical averages. In its fourth quarter 2011update, Moody’s Macroeconomic Board noted that per the OECD Consumer Confidence Index, business and consumer confidence has weakened to levels that normally occur during a recession.

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FIGURE 3

Personal Net Worth Struggles to Rebound to 2007 Levels

Source: Federal Reserve Statistical Release, Flow of Funds Accounts of the U.S.

Increased student price sensitivity and government demand for transparency have forced private and public universities to re-evaluate future tuition increase assumptions, financial aid budgets, and the potential price ceiling for different types of institutions and degrees. While financial aid strategies have become increasingly complex and important for attracting and retaining students, the true net cost of college is obscure to many. The federal government’s regulatory response has been to require, as of October 2011, that all postsecondary institutions that participate in Title IV federal student aid programs post a “net price calculator” on their websites to enhance pricing transparency. Under the federal mandate, students and families will be able to use the net price calculator to calculate the difference between a college’s stated tuition price and an estimate of a student’s personalized net price.

Robust Pricing Power at Premier Private Institutions Does Not Necessarily Translate into Strong Tuition Growth

Many top-tier private colleges and universities with the largest endowments have opted to expand their financial aid initiatives in order to draw a more socioeconomically diverse class as part of their public, non-profit mission. Many of these institutions have “need-blind” admissions policies and admit top students regardless of family income. Some have significantly reduced tuition for low and middle income families below certain income thresholds. This notion is exemplified by the FY 2010 median net tuition per student for Aaa-rated private universities of $20,653, which is a modest 3.2% increase over the FY 2007 median for the same subset of universities. Premier, highly selective colleges and universities are voluntarily not maximizing their pricing power and willingly accepting an absolute decrease in net tuition. These institutions are best positioned to absorb flat to declining net tuition revenue in coming years due to their inherent revenue diversification (and lower reliance on tuition), robust endowments and strong donor support for student financial aid.

Most Private Universities Confront Longer-Term Tuition Pressure

For private colleges and universities that have weaker market positions and are less selective, we are observing clear signs of deterioration of net tuition revenue and growth of tuition discounting. Figure 4 below illuminates the growing number of private colleges and universities rated A1 and below with declining net tuition per student, including estimates for FY 2011 and 2012. These institutions often have a more regional student draw, smaller enrollments, and budgets much more heavily dependent on tuition. Median net tuition per student for this segment of the market grew rapidly over the past decade and is especially high when compared to in-state public university tuition rates. The trend of

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increased tuition discounting to retain market share is clearly not sustainable over the long-term unless these colleges grow other revenue streams and implement offsetting expense cuts.

FIGURE 4

Tuition Tipping Point: Lower Rated Private Colleges Increase Tuition Discounting

Source: FY01-10 Moody's MFRA; FY11 & 12 estimates based on Moody's 3rd Annual Tuition Survey of US Higher Education

In a few select examples over the past year, private colleges have announced radical tuition pricing strategies, including steep cuts to their stated tuition prices. For example, University of Charleston in West Virginia (not rated by Moody’s) announced a 22% tuition cut for next year’s incoming students. Although this was an unusual decision, we expect that it will garner publicity and could improve near-term student demand. We do not expect this pricing strategy to become widespread among rated colleges, but it may be used in select cases, particularly by private institutions that lack a strong market niche and have weaker student demand6

Public Universities Retain Pricing Power for In-State Students

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The public higher education sector has received some of the sharpest public and political criticism against tuition increases in recent years, despite the fact that these schools remain a lower cost option and retain tuition pricing power in most cases. Further, universities in some states are hamstrung by state-imposed limitations on annual tuition increases or caps on recruitment of higher paying out-of-state students, particularly for the undergraduate student body. Although we believe that most public universities retain in-state pricing power, tuition pricing power for out-of-state students is much more limited, with out-of-state tuition approaching or exceeding the cost of attending private higher education in many states.

The pace of tuition increases spiked for public institutions during the past decade in direct response to pressure on state operating support. Between fall 2001 to 2011 the published tuition and fees, or “sticker price,” at public four-year institutions rose at an average annual rate of 5.6% higher than inflation7

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, much higher than the 2.6% rate of private non-profit universities. Nevertheless, in-state public higher education remains the lower cost option in most cases (as highlighted in Figure 5 below).

Moody’s: Radical Tuition Pricing Strategy is Credit Positive for U.S. Colleges with Weaker Market Positions, November 2011 (137391) 7 Trends in College Pricing 2011, College Board

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FIGURE 5

Publics Retain Pricing Power: Private Net Tuition Nearly Triple Public Net Tuition

Source: Moody's MFRA

Over the past few years, public universities, in particular, have benefited from rapid growth of Pell grants supporting low income students, as a result of increases in the maximum Pell award (currently $5,550 per year) with more students meeting eligibility requirements. The Budget Control Act of 2011 maintained this maximum per student award through fiscal year 2012 (9/30/12). However, the Pell grant program will continue to be pressured as Congress confronts competing priorities and mounting budget pressure. We expect that regional public universities and community colleges with more Pell-dependent student bodies will be the most challenged, with a growing gap between the Pell award and annual tuition as tuition increases are implemented. (For more detail on this topic, please refer to our special comment, “Supercommittee’s Failure Strains Pell-Grant Reliant Universities” published in December 2011).

A few state governments still hold the reins on tuition increases, either through statutory limitations on increases or through temporary compromises for low or no tuition increases at public universities in exchange for offsetting state funding in the past. However, the general trend is for public universities to become more independent in setting tuition while still being politically aware of risks of excessive increases. During the past year, we have observed examples of public universities garnering increased tuition-setting and budgetary flexibility. Most notably, in June 2011, New York State passed legislation allowing the State University of New York (SUNY) and City University of New York (CUNY) to implement $300 annual tuition increases over the next five years. Essentially, this legislation freed the state’s public university systems from their record of erratic and unpredictable tuition spikes, freezes and strong political control8

Critical Credit Factor #3: Pressure on Non-Tuition Revenue Streams Underscores The Importance of Revenue Diversity and Operating Efficiency

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In addition to slowed growth of net tuition revenue, colleges and universities are grappling with pressure on non-tuition revenue streams, including state appropriations, fundraising, endowment spending, research grants and contracts, and patient-care related revenue. Diversified market-leading institutions remain the best equipped to endure these pressures because they have good operational diversity. Their programs often include comprehensive and varied academic offerings, large research programs, and

8 Moody’s: New York Public Universities Gain Pricing Power in Reform Legislation, July 2011 (134201)

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robust fundraising that weathers economic cycles. Some have healthcare clinical operations in which they own or maintain tight relationships with academic medical centers and faculty practice plans.

Although revenue diversity helps provide a partial safeguard against a downturn in any particular revenue stream, all higher education institutions across the board are increasingly focused on expense containment and improved operating efficiency. In fact, median educational expenses per student declined in FY 2010 for both public and private universities after a nearly unbroken string of increases stretching back decades. These expense measures not only reflect ongoing revenue pressures, but also increased political and public scrutiny of the profitability and transparency of these tax-favored organizations. Areas of expense containment are open-ended and diverse. These efforts include: more centralized control of budgets, salary freezes, furloughs, layoffs, early retirement options, increased cost-sharing for employee benefit plans, reduction of administrative budgets, streamlined procurement processes, elimination of under-enrolled academic programs, and proactive work to limit increases in utility and healthcare costs.

Is the Higher Education Model Broken or Just in Need of Some Fixing? Moody’s view is that the traditional higher education business model is generally sound and long-lasting. However, pressure on core revenue streams will require management and governance teams to be thoughtful, creative, and tougher in adapting their institutions and re-conceptualizing the sources and uses of available funds. Some innovative examples for change are likely to include:

» Evolution of more collaborative higher education partnerships and affiliations including clear cross-enrollment articulation agreements with other colleges and increased revenue and cost sharing across organizations.

» Movement away from a decentralized operating model, with a focus on centralization of processes and elimination of redundancies, even as more incentive-based budgeting processes are installed to grow revenue.

» Reassessing core university functions that are mission-centric and consideration of outsourcing certain administrative or auxiliary functions.

» Improved and more efficient use of facilities, including winter, summer, and weekend course offerings.

» Enrollment growth to reach a critical mass through multi-site operations, increased use of online course delivery, and outreach to non-traditional age students, including continuing education and degree completion programs.

» Reduced number of tenured faculty and increased use of adjunct faculty.

» Increased cost-sharing with employees for existing retirement and health benefits.

» Innovation in growth of research-related revenue streams, including technology commercialization.

» Increased number of mergers and acquisitions to create larger institutions with greater economies of scale.

State Appropriations: Public Universities Cope with Long Term Defunding as well as Loss of Stimulus Funding

Stagnant to declining state operating and capital support is a primary credit challenge confronting the vast majority of public colleges and universities. Over the next five years, this challenge will remain acute as many states face increased public service demands, reduced rainy day funds, and their own budgetary pressures, including Medicaid and K-12 education. Although the revenue picture for some state governments is improving, some large states have reported tax receipts falling short of FY 2012

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budgeted levels, partly reflecting persistently high unemployment and reduced income tax, lower sales and corporate tax collections, and continued weakness in the housing sector.9

We expect that the largest public universities that benefit from greater revenue diversification and economies of scale will be best equipped to adapt to the pressured state funding environment. Smaller regional public colleges and universities will face larger challenges because they are typically more reliant on state operating support, are less able to achieve operational efficiencies, and are more competitive with local community colleges.

In a rare number of cases, public universities could make the controversial decision to declare “financial exigency” in order to aggressively cut otherwise fixed costs, in response to declining government funding and weakening tuition pricing power10

While state funding has been declining as a share of public university revenue for three decades, the declines of the last few years have been the sharpest ever. Federal stimulus funding (ARRA) during FY 2009-2011 eased many public universities into this new reality of much lower government funding. Some universities were conservative in their use of ARRA funding and only spent the funds on non-recurring expenses, such as deferred maintenance projects or increased financial aid. With the end of ARRA in FY 2011, the public higher education sector faces a growing funding gap. According to the American Association of State Colleges and Universities (AASCU)

. This tactic was most recently employed by the main campus of Southern University System in Louisiana to address state funding reductions and enrollment declines. Although a declaration of financial exigency can improve near-term operational flexibility, it carries significant reputational risks and could harm student demand and faculty recruitment and retention.

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, thirty-five states expect a cut in state appropriations to four-year public universities in FY 2012, with thirteen states anticipating double-digit decreases. Reliance on government funding continues to dwindle, with state appropriations (including ARRA) comprising a median 29.1% of operating revenue for four-year public universities in FY 2010, contrasted with a 33.4% median contribution in FY 2006. Figure 6 below highlights the steady decline in state appropriations per student, and the counteracting growth of net tuition per student achieved through tuition increases and recruitment of higher-paying out-of-state students.

Moody’s: U.S. State Tax Revenues Continue to Grow but Some Fall Short of Forecast , November 2011 (136979) 10 Moody’s: Public Universities May Turn to Financial Exigency to Reduce Operating Costs, March 2011 (131460) 11 State Outlook, AASCU, July 2011



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Global Higher Education: Can State Funding Keep Up With Growing Student Demand ?

Higher education institutions outside of the United States are usually more directly funded by their national governments than are U.S. universities, but they benefit less from private philanthropic support. As macroeconomic growth varies widely across the world and many governments face difficult budgetary and policy tradeoffs, universities in some countries are facing the fundamental challenge of rising student demand and stagnant or declining government funding. While certain Asian countries are rapidly expanding their higher education sector, other countries, especially in Europe, are restricting government funding. In this sense, universities around the world, including those in the U.S., share a common challenge in striving to keep higher education as affordable as possible to meet public policy goals--even as public sector funds may be dwindling. In some countries, such as Brazil, a growing for-profit, private sector is helping to meet the rapidly growing demand for university degrees.

To the extent that government funding becomes more scarce, universities will likely have to become more creative in finding means to meet increased public pressure to fulfill economic development and social goals while maintaining access-oriented missions. One proven way to supplement state funding is to compete for non-resident students, who nearly always pay higher fees than resident students. Universities in Australia, Canada, the UK, and the U.S. are all well entrenched in this competition and are now being joined in this market by universities in many other countries. Another common strategy for navigating a constrained funding environment is to strive for greater operating efficiencies, driving down expenses and containing cost growth. In light of reduced operating and capital support, we would anticipate that non-U.S. universities would generally reduce capital expenditures in the short-term, but would need to seek alternate funding sources over the intermediate to longer-term- such as philanthropy or long-term debt.

FIGURE 6

State Appropriations per Student Declines as Net Tuition per Student Increases for Public Universities

Source: Moody’s MFRA

In addition to cuts in state funding, delays in cash funding of appropriations have challenged public universities in particular states, including Arizona and Illinois12

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. When state funding is delayed, our ratings and outlooks on the affected universities heavily focus on their market strength, management quality, and fiscal flexibility, including available internal and external liquidity to bridge the funding gap.

Moody’s: State Payments to Illinois Public Universities Continue to Lag, August 2011 (135161)

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Fundraising: After Several Tepid Years, Fundraising Regains Momentum in 2010 and 2011

Private gift giving to higher education picked up momentum in 2010 and 2011 following sharp declines in 2009. Fundraising tends to ebb and flow with the economic environment as it closely tracks fluctuations in the equity markets. Hence, volatile investment markets and depressed personal wealth have weakened many not-for-profit fundraising programs over the past five years, but the recent increase in philanthropic activity is a positive credit factor for the sector as a whole, signaling the recovery for an important revenue stream. Philanthropy remains a unique credit strength of not-for-profit sectors, distinguishing them from much of the rest of the municipal market and from universities outside the United States. According to Giving USA Foundation’s 2010 report13

Diversified market-leading institutions continue to amass the largest proportion of total gifts, as Aaa and Aa-rated universities dominated fundraising. To date, the fundraising rebound is most strongly evidenced by our more highly rated universities, supporting our mixed outlook. In FY 2010, Aaa- and Aa-rated private universities accounted for over 70% of total gift revenue to private higher education, even though they represent only 25% of all rated private universities. Despite ongoing macroeconomic challenges, colleges retain strong alumni, board, and other donor support, with many examples over the past year of announced “mega-gifts

, estimated charitable giving in the U.S. increased 2.1% (adjusted for inflation) in 2010, the first increase since 2007. Giving USA estimates that total charitable giving in the U.S. was very high at nearly $290.9 billion in 2010, and educational institutions received 14% of the total.

14.” For example, Cornell University recently announced a $350 million gift, the largest in its history, for the construction of a new applied sciences and engineering campus in New York City15

Not-for-Profits Face Sharpened Federal Scrutiny and Growing Tax Risk

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The wealthiest not-for-profit universities have been subject to increased federal examination in recent years and face growing risk that there could be future negative tax law changes. This scrutiny includes examination of the benefits of their tax-exempt status, including tax benefits granted to their donors as well as universities’ tax exemptions on investment income, property values, and revenue and tax-exempt debt. Recently, there have been changes to Form 990 in an attempt to improve transparency on financial health, operational efficiency, and the board’s financial responsibilities. The IRS has also conducted a formal study of a select number of colleges and universities, with a particular focus on the receipt of unrelated business income and the reasonableness of executive compensation agreements. We anticipate that there will be further scrutiny of tax-exempt not-for-profit organizations, including hospitals, but believe that the most severe federal tax changes which would have a material impact are remote16

Endowment Spending: Past Endowment Losses Still Affecting Multi-Year Endowment Draw Formulas

. For more on this topic, please refer to our recent publication, “Greater Efficiencies in Higher Education May Reduce Regulatory Risk” published in January 2012.

The wealthiest colleges and universities were most immediately disrupted by investment losses in recent years because a much larger proportion of their operating revenue is derived from the endowment draw. However, these top-rated private and public colleges and universities relied on compensating credit strengths to manage through the crisis and avoid serious financial weakening.

13 The Annual Report on Philanthropy for the Year 2010, Giving USA Foundation, The Center on Philanthropy at Indiana University 14 Moody’s: Large Gifts to Leading U.S. Universities Signal Credit Stability, Moody’s, May 2011 (133333) 15 Moody’s: Cornell University and The Technion Partner to Expand in New York City, December 2011 (138388) 16 Moody’s: Not for Profits Face Growing Tax Risk, extracted from “The Great Credit Shift: US Public Finance Post Crisis,” September 2011





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Many management teams moved swiftly and proactively to reduce expenses in anticipation of reduced future endowment draws.

Current year endowment-based revenue is typically derived from formulas based on multi-year lagged endowment valuations. For most universities, the FY 2012 endowment-based revenue is still weakened by the past nadir in endowment values, which was FY 2009 for most colleges with a June 30 fiscal year end (figure 7). According to the 2010 NACUBO-Commonfund Endowment Study, the average annual endowment spending rate (percentage of beginning of year endowment market value) was 5.6% for endowments over $1 billion, representing the highest annual spend rate over the past decade.

While strong endowment performance in FY 2010 and 2011 will potentially allow higher endowment draws in 2013 and 2014, most endowment-dependent universities are modeling low growth of future endowment draws to support their operating budgets. This conservative posture reflects diminished expectations for long term investment returns from endowment assets. Until recently, most universities incorporated an assumption of 9% or 10% average annual endowment returns, but many have lowered their assumptions to a figure closer to 7% or 8%, reflecting an expected era of more muted investment performance. In fact, the median annual endowment return was 3.2% for the 10-year period ending June 30, 2010 based on data from the NACUBO-Commonfund Endowment Study, compared to a 9.6% return median for the ten-year period ending June 30, 2002.

FIGURE 7

Budgets of Endowment-Dependent Universities Most Impacted by Past Investment Losses


Research Funding: Federal Research Funding Cuts On the Horizon

Given looming federal funding cuts for sponsored research, the largest, top-tier research institutions, including both public and private universities as well as highly-rated independent research organizations, will likely maintain stable credit profiles and will successfully navigate an increasingly competitive research environment. Federal government funding represents more than half of research grants awarded to research universities in the U.S., and future growth of federal funding is expected to slow dramatically compared to a period of rapid growth which began in the late 1990s. Federal stimulus funding (ARRA) created an increase of federal grants in 2009-2011, but the best managed research universities recognized this as a temporary infusion and did not model future budgets or invest heavily in facilities or infrastructure based on these short-lived higher levels of federal support. For a more detailed discussion of the credit challenges facing U.S. research universities, please refer to

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our recent special report, “U.S. Research Universities Face Looming Federal Funding Cuts, but Remain Well Positioned to Withstand Credit Challenges” published in December 2011 (138109).

Patient Care: Teaching Hospitals Face Uncertain Fate of Graduate Medical Education Funding; Declining Revenue Growth and Patient Volumes Challenge All Hospitals

Universities which own or have tight affiliations with hospitals or faculty practice plans will face additional challenges as the healthcare sector reacts to falling top-line revenue growth, reimbursement pressures from all payers, healthcare reform, and declining patient volumes. Medicare and Medicaid rate reductions are inevitable, and private commercial health insurers face their own financial challenges and increased regulation. In response to these pressures, most hospitals, like universities, are increasingly focused on expense containment and operating efficiency, although there is more merger and acquisition activity in the hospital sector compared to higher education. For more detail on the revenue challenges facing not-for-profit hospitals, please read our August 2011 publication, “Hospital Revenues in Critical Condition; Downgrades May Follow.” (134473) Moody’s currently maintains a negative outlook on the not-for-profit healthcare sector.

We expect that the leading academic medical centers will typically be well positioned because they often offer high-end tertiary and quaternary services not offered by community hospitals, and more diversified revenue bases, including gifts and research grants. However, teaching hospitals, which serve as important training grounds for medical school residents, face an uncertain future for graduate medical education (GME) funding from Medicare. One proposal achieves federal savings by limiting GME payments to 120% of the national average resident salary, which would disproportionately negatively impact teaching hospitals located in urban areas with higher costs of living. This type of proposed reduction to GME would have a negative credit impact on universities that own hospitals serving as a primary venue for medical resident education.

Critical Credit Factor #4: Liquidity and Debt Structure Risks Reduced but Not Eliminated; University Capital Spending and Borrowing Have Been Cut Back

Many university capital programs and liquidity positions are now much more conservatively positioned than they were three years ago. Though most endowments achieved strong positive investment returns during FY 2010 and 2011 which allowed them to regain much of the value lost during the FY 2008 and 2009 stock market downturn, most management teams will remain cautious. They are unlikely to soon return to past levels of thin liquidity and robust capital spending until economic conditions are more favorable. Boards are working carefully with management teams to assess balance sheet risks under cautious expectations for future investment gains, gift proceeds, and operating performance.

Liquidity and Investment Management: Strong Investment Returns in FY 2010 and 2011 and Increased Focus on Liquidity

FY 2010 public and private university median data highlight growth of cash and investments during 2010 at universities and their supporting foundations. These data will again show improvement when FY 2011 medians are calculated, reflecting another year of strong investment performance. The NACUBO-Commonfund Study of Endowments indicates an average annual return of 19.8% in FY 2011 (ending June 30, 2011) based on preliminary data.



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FIGURE 8

Balance Sheets Bounce Back from 2008-2009 Downturn

Moody’s Private University Medians FY 2006 FY 2007 FY 2008 FY 2009 FY 2010

Expendable Financial Resources ($000) $138,524 $162,991 $154,347 $99,396 $118,812

Total Financial Resources ($000) $218,926 $253,360 $245,421 $185,246 $205,026

Moody’s Public University Medians FY 2006 FY 2007 FY 2008 FY 2009 FY 2010

Expendable Financial Resources ($000) $114,283 $134,404 $142,604 $121,660 $146,137

Total Financial Resources ($000) $188,920 $214,089 $211,864 $201,830 $226,826

Notably, these financial resource calculations incorporate growth of pension and post-retirement health benefits (OPEB), which have depressed net assets. Although large defined benefit pensions are rare in the higher education sector, lowered discount rates and past investment losses have significantly increased those liabilities in recent years for a select few. OPEB liabilities are quite large for public universities in certain states, and for many they are being amortized and recognized on the balance sheet over a long time horizon (30 years). As the size of these postemployment liabilities grow over time, our credit analysis of universities will evaluate development of long-range funding strategies and/or the institution’s ability and willingness to curtail the benefit plans.

University-wide assessment of sources and uses of liquidity remains a key credit challenge for the sector, particularly for universities with the largest endowments which may have endowment offices which in the past operated more independently from the treasury office or academic unit of the university. During FY 2010, median unrestricted monthly liquidity improved across the private higher education sector, over FY 2009 (figure 9), except Aaa-rated private universities.

FIGURE 9

Liquidity Improved in FY 2010 for Most Private Universities; Highest Rated Institutions with Greatest Liquidity


As highlighted in figure 10, the largest endowments actively invest in less liquid alternative asset classes. Even so, Moody’s collection of fiscal year-end liquidity data highlights that despite significant investments in less liquid and illiquid assets, the Aaa- and Aa-rated universities still maintain strong levels of monthly liquidity on hand. In FY 2010, the median monthly days cash on hand was a very strong 737 days for Aaa-rated private universities and 396 days for Aa-rated private universities.

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Largest Endowments Remain Active Users of Alternative Investment Strategies

Source: 2010 NACUBO-Commonfund Endowment Study

In certain cases there have been notable shifts in liquidity management and improved levels of communication between university financial management teams and the endowment offices, which is a credit positive. To improve liquidity, universities have taken measures such as adding operating lines of credit, selling private equity commitments in the secondary market, and reducing unfunded capital commitments. Although several highly rated universities issued taxable debt to bolster liquidity during the credit crunch, we do not anticipate continued reliance on liquidity borrowing. In fact, during 2011 Duke University and Harvard University paid down portions of their taxable bonds by utilizing the bonds’ make whole call options. For more details on Moody’s liquidity ratios and analysis, please refer to our publication “U.S. Colleges and Universities Increase Liquidity as Credit Pressures Continue” May 2011 (132922).

Debt Structure: Reduced Issuance of Variable Rate Bonds Counterbalanced by Increased Use of Direct Bank Loans

Following the credit crisis, universities have issued less variable-rate demand debt and entered into fewer interest rate swap agreements due to increased concern about counterparty exposure and terms of loan and swap agreements. In 2011, universities successfully navigated the wave of expiring letters of credit and standby bond purchase agreements, as many extended or substituted their liquidity agreements well in advance of the expiration date. Swap valuations remain negative for the majority, swinging even deeper into negative territory during the first few months of FY 2012, which forced some to increase collateral posting since the close of their FY 2011. These negative derivative valuations continue to influence decision-making about refunding variable rate debt. Many boards and management teams are reluctant to pay high swap termination values that might turn much more positive if interest rates start rising.

There has been an increase in the use of direct bank loans or direct purchases across the municipal market, but there has not been an overwhelming amount of activity in the higher education sector. In many ways, these direct bank loans carry credit risks similar to variable rate demand bonds, such as interest rate variability (for variable rate loans), repayment acceleration risks, and market access and renewal risks. However, they do not expose the university to risks associated with short-term bond

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remarketing or credit deterioration of the bank. We continue to incorporate these new transactions into our underlying credit analysis for universities, with timely disclosure by the university essential17

During 2011, an increased number of universities took advantage of the taxable bond market, expanding their potential investor base and in some cases issuing very long-dated debt, including four recent examples of premier U.S. universities issuing century bonds (100 year maturity). We view universities’ increased access of the taxable bond market as a credit positive for the higher education sector because it provides access to long-term capital that can be spent more flexibly and with less burdensome compliance that accompanies tax-exempt debt

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Capital Spending: Anticipated Slowed Capital Investment

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We expect a continued slowdown in capital spending and a slower pace of debt issuance by universities during 2012, in response to economic uncertainty and shifting student demand trends. This scaling back of capital spending since the 2008-2009 recession allows universities some breathing room to assess critical capital needs and gain more certainty on the sources of funding facilities, including the ability to fundraise for key projects.

Per Moody’s private university medians, capital spending (as measured by the capital spending ratio19 ) declined in both FY 2009 and 2010, highlighting a slowdown in cash spent on capital projects. Correspondingly, the median age of plant20

We do not expect all universities to act uniformly in their pace of future borrowing. We expect growing universities, in particular public universities which must absorb reduced state capital support, will continue to expand their facilities footprint in order to build physical capacity and infrastructure to support a larger student body. Public university bond issuance was particularly strong during 2010, spurred by debt issuance associated with the federal stimulus program known as Build America Bonds (BABs). With the conclusion of the BABs program in December 2010, debt issuance in 2011 was lower, and is expected to stay relatively low in 2012.

for private universities has increased over the past five years (FY 2006-2010), a red flag that slowed capital investment could lead to a backlog of deferred maintenance and borrowing needs.

At a comparatively small number public universities, there has been growing use of public private partnerships for construction and management of auxiliary facilities, including student housing and dining facilities. This tactic has not been more widely used across the higher education sector because student housing and other auxiliary functions are typically profitable and fundamentally important to the university’s competitive position and reputation. In a recent case, University of Kentucky announced that it is negotiating with a private developer to expand and manage all of the student housing on one of its campuses21

17

. In assessing the credit impact of a privatized student housing project on the university’s underlying credit profile, we analyze not only the university’s legal requirements to support the project but also the project’s strategic ties to the university and the university’s role in the project.

Moody’s: Direct Bank Loans Carry Credit Risks Similar to Variable Rate Demand Bonds for Public Finance Issuers, September 2011(135849) 18 Moody’s: Universities' Access of Taxable Bond Market Is Credit Positive, October 2011(136864) 19 Capital spending ratio is calculated as purchases of property, plant and equipment (PP&E) from the statement of cash flows divided by annual depreciation expense. 20 Age of plant is calculated as accumulated depreciation divided by depreciation expense. 21 Moody’s: University of Kentucky Explores Outsourcing All Student Housing, December 2011 (138322)




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Moody’s Related Research

Special Comments:

» Strong Student Demand, Ongoing Tuition Increases, and Cost Containment Enable Public Universities to Mitigate State Funding Cuts, July 2011 (134342)

» Private College and University Medians Highlight Divergent Credit Trends, Supporting Moody’s Mixed Outlook for Higher Education, July 2011 (134286)

» Market Position: Key Credit Factor of U.S. Higher Education Ratings, June 2011 (132849)

» Top 10 Factors Driving U.S. Higher Education Upgrades and Downgrades, September 2011 (136029)

» More U.S. Universities Expect Tuition Revenue Declines; Larger, Diversified Universities Favored in Tough Higher Education Market, January 2012 (138401)

» Independent K-12 School Medians for FY 2010 Indicate Resilience Despite Revenue Pressure, January 2012 (138703)

Rating Methodology:

» U.S. Not-for-Profit and Public Higher Education, August 2011 (134044)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.













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» contacts continued from page 1

Analyst Contacts:

NEW YORK 1.212.553.1653

Michael Gusta 1.212.553.3792 Associate Analyst [email protected]

Paul Corcoran 1.212.553.4418 Associate Analyst [email protected]

Report Number: 139177

Author Kimberly S. Tuby

Editors Edith Behr Karen Kedem John Nelson

Senior Production Associate Diana Brimson

© 2012 Moody’s Investors Service, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved.

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