Midwest's universities scramble for a shrinking high school graduate pool

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The Midwest's public and private universities are straining to deal with enrollment losses, a challenge that is driving credit erosion and forcing the sector to look in new directions for solutions, market participants and school officials say.

In August, the University of Akron, a mid-tier public university In Ohio, said it would cut the number of degrees it offers by 20% to adjust to dropping enrollment. The decision came after the university saw ratings on roughly $449 million of outstanding bonds downgraded to A-plus from AA-minus by Fitch Ratings.

Akron illustrates the quest to right-size a business model and scale down. The higher education sector on a whole has struggled with shifting demographic trends that in many states means fewer high school graduates to draw from. While it's a national issue, the Midwest has been especially hard hit.

In Michigan, for example, schools are fighting for a pool of high school graduates that has declined by 15% in the last twelve years, according to Eastern Michigan University Chief Financial Officer Michael Valdes. “The forecast absent some great inward migration of people with children, is that we are going to have a similar erosion of the next twelve years,” he said.

“State universities and colleges are vulnerable at down times and the public school area is almost always the first area that states cut when they have troubles balancing their own budget,” said Howard Cure, director of municipal bond research at Evercore Wealth Management. Cure said that many schools in the Midwest have suffered severe cuts in state appropriations from the last recession.

In Illinois, public universities were hard hit by the state's two-year budget impasse at times having to go without any state funding. That led to a majority of the regional state universities being cut to junk. Many cut programs and staff and are still dealing with enrollment losses.

“For the University of Akron, cutting back on some of their courses is probably a good idea,” said Cure. “These more regional schools can’t be all things to all students. So getting rid of things they don’t have a real strength in is a good idea.” Akron has seen enrollment decline to 17,563 in fall 2017 from 22,430 in fall 2012.

Tipper Austin, director at Fitch Ratings, said that Akron isn’t likely to be alone in its decision to cut degree programs.

“They are ahead of the curve in taking this sort of action at that scale, mostly because they have faced tougher enrollment challenges. But we will see others having to make similar decisions,” he said.

The academic program review is expected to lead to about $6 million in savings in the coming years.

“The university has faced a difficult enrollment environment for several years, stemming from pressured demographics within Ohio and heightened competition from both in and out of state,” said Edison Castaneda, Moody’s lead analyst on the school. “UA has done a good job coming to terms with this lower enrollment reality and has reduced its expense base considerably over the last few years to counteract declines in revenue.”

The move, Castaneda said, should allow the school to re-invest in programs that are seeing higher demand or are academic areas of comparative strength.

Demographically Akron is tied to a small regional market that draws from a few surrounding counties. Those counties are producing fewer high school graduates.

Austin said that despite the challenges the university faces, its rating outlook is stable. That is because the school has a healthy reserve and cash flow over the last three years has been good as a result of aggressive management on the expense side.

“I think cutting some of these programs and rethinking what they offer is part of that larger effort,” said Austin. “Managing their expense base to live within their declining revenues has kept the university from having to spend down its reserves.”

Schools struggling with enrollment issues are also bolstering marketing, recruiting, and fundraising efforts. Valdes said that public schools are offering discounting in the form of financial aid in terms of lowering the overall costs for students but declining enrollment trends continue to be pretty persistent.

Eastern Michigan University recently completed a parking public-private partnership with concessionaire Preston Hollow Capital. Under the agreement, EMU transfers all parking operations in exchange for a $55 million upfront payment, which will help fund long-term investments in academic facilities and programs.

The university sought to achieve three objectives with the arrangement, said Valdes.

“First and foremost for us was enhancing the financial position of the university," Valdes said. “We were not in the position that we wanted to be relative to our ratios and that translates to our borrowing costs and how a crediting body looks at us.”

Moody’s rates the mid-sized public school A2 and in May revised the outlook to negative from stable, citing continued enrollment challenges expected through 2019 which are expected to limit future revenue growth and potential improvement in operating performance despite expense reductions.

Valdes said that beyond improving the university’s financial position, the parking P3 also helped EMU de-risk its operations around future changes in transportation and allowed the school to direct more of its capital to its core mission of academics.

Preston Hollow Capital LLC’s partnership with EMU is the first it’s done in the education space. Ramiro Albarran, a managing director at the firm, said these types of deals can allow universities to take assets that it is not an expert in, like parking garages, and use those assets to generate liquidity and cash and fulfill its educational mission. The firm is currently working on two housing related P3 transactions and expects to close on one in the next 30 days.

Schools like Akron and EMU with a regional student population that don’t have big endowment balance sheets are reliant on student fees and are particularly vulnerable to the decline in state appropriations.

Valdes said that in Michigan, state funding for public universities has dropped to about 25% compared to 75% in the late 1980s. For the current fiscal year Eastern Michigan will receive less in nominal dollars than it received in 2009.

“That makes us more tuition dependent which makes us more aggressive around student recruitment and those factors coupled with the fact you have very organized employee base that has contractual increases built into it puts pressure on the margins,” Valdes said. “If it happens over time then there is pressure on reserves.”

Valdes said Michigan put caps on tuition increases.

Usually the smaller state schools get a larger proportion of their budget from state appropriations so that heightens vulnerability,” Cure said. “The flagship schools get other monies coming in. They have endowments, they usually get a large body of money coming from the federal government in terms of research grants and they may have a broader geographic draw which also includes out of state students.”

Cure said there are extreme cases were public universities have taken real hits in ratings because of a lack of state support.

“From an investor perspective you have to look at the relationship with the state and what’s the potential of more cuts coming,” Cure said.

Those institutions are particularly vulnerable in the face of another recession. “I don’t know what is going to happen in Illinois, for example, which is struggling to balance its budget with all of its pension needs in a relatively robust overall economy,” Cure said. “How prepared are they for the next recession?”

The challenges are taking a toll on sector ratings with downgrades outpacing upgrades over the last decade. For the second quarter, the higher education sector saw the number of downgrades outpace upgrades for the 16th time in the last 17 quarters, according to Moody’s. The amount of downgraded debt outpaced upgraded debt, $2.1 billion to $840 million.

Still Moody’s said that the sector maintains an overall high median credit quality – A1 for public universities and A2 for private – even as the sector grapples with this period of transformation.

“We currently maintain stable outlooks on 85% of private colleges and universities and 75% of public universities,” Moody’s said. “Pockets of pressure remain, notably among less selective or less well-endowed small private colleges and regional public universities in areas with demographic challenges or state budget pressures.”

According to S&P, enrollment for A-rated public schools remained flat in fiscal 2017. Conversely, lower-rated public colleges and universities, specifically in the 'BBB' and speculative-grade categories, experienced significant 7.3% and 9.6% declines, respectively, in enrollment during fiscal 2017.

At private schools, enrollment challenges are similar -- Beloit College in Wisconsin recently lost its investment grade rating with enrollment struggles cited as a primary factor -- but according to Austin there is a faster widening gap between the top-tier name brand universities and all others. Private schools also have the affordability issue to tackle.

"We expect certain regional public universities will be more challenged by demographic declines than public flagship institutions that have a much broader market and student draw. Many small, tuition-dependent private institutions serving local/regional markets with declining demographics also continue to face enrollment pressures and increasing discounting levels,” said Emily Wadhwani, a Fitch Ratings director.

According to S&P downgrades have outnumbered upgrades in the private university sector at a rate of three-to-one but the majority of ratings remain in the 'A' and 'BBB' categories and approximately 91% of ratings maintaining a stable outlook.

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