Parents picking a charter school for their children want a school they can be confident will not close down. Bondholders want much the same thing.
Yaffa Rattner and the five-person high-yield analytics team at Piper Jaffray think investors willing to sift through the dross in this sector of weak and often unrated credits can find some alluring bargains.
A charter school is a tuition-free public school with a specified mission. Students may enroll in charter schools as alternatives to traditional public schools. The schools derive financing from state funds, charitable contributions, bank loans, and — sometimes — tax-exempt bonds.
Entering this school year, there were 4,900 charter schools with 1.5 million students in the U.S., according to the National Alliance for Public Charter Schools.
The first charter school opened its doors in Minnesota in 1991. About 280 charter schools have floated more than $2.3 billion in debt, according to Thomson Reuters, with the William Penn Charter School in Pennsylvania the first to test the market in 1997.
Make no mistake: the sector can be dangerous for investors, the Piper Jaffray team acknowledges. Charter schools close frequently and their bonds are low-investment-grade at best.
However, as more parents embrace charter schools and the sector matures, “carefully structured bonds in solidly performing charter schools can be attractive investments,” the team wrote in a report last week.
“There’s inherent risk in the sector,” Rattner said. “Therefore because there is risk in the sector it will be up to the investor to successfully decipher and extract the highest-quality school that meets their investing parameters.”
The reason charter schools are frequently considered junk investment is that state funding, much like for traditional public schools, is often apportioned per student. The drawback for a charter school is that enrollment is voluntary and can vacillate with the whims of students and parents. If a school has trouble maintaining enrollment, it could close down and default on its debts.
The government bodies that authorize these schools’ charters can also revoke them if the schools do not meet academic standards. That too would result in a school closing down.
Further, state funding for traditional public schools frequently covers capital projects, whereas for charter schools it does not.
As a result, charter schools receive an average of just $6,585 per student in state funds annually, compared with $10,771 per student in traditional public schools, according to a 2008 study by the Center for Education Reform.
The CER estimates that 12.5% of the 5,250 charter schools that have opened have failed, either because of low enrollment, financial mismanagement, or revocation of the charter from poor academic performance.
The Piper Jaffray team believes things may be changing.
Nearly 3% of public school students attend charter schools this year, according to the NAPCP, compared with 0.7% at the beginning of this decade.
Piper Jaffray notes certain areas such as New Orleans and the District of Columbia where more than a third of public school students attend charter schools.
Most important, fewer charter schools are closing, Piper Jaffray said.
“These trends are a product of market maturation, educational reform, and parent choice that taken together have eliminated significant risk in this sector,” according to the report.
The country’s growing embrace of charter schools does not mean investors should blindly buy their bonds. Distinguishing the strong from the weak is crucial, Piper Jaffray said.
While Rattner declined to discuss specific schools she considers stellar, the team outlined a number of metrics it uses to gauge charter schools’ creditworthiness.
Schools should be able to cover 30 days of operating expenses using cash on hand, have 15% of the following year’s operating expenses covered in the general fund balance, maintain a debt-service coverage ratio of at least 1.1 times, and maintain a working capital reserve of 3% of annual operating expenses.
State funds should filter through the bond trustee before they reach the school so that bondholders can be paid before the school spends any of the money, and the school’s property should serve as collateral for its bonds.
Investors can shield themselves from the sector’s harshest risks by unearthing “well-performing charter schools with seasoned management and enrollment,” Piper Jaffray said.
Schools with adequate liquidity and investor protections can “provide the fundamentals for an attractive investment.”