The financial challenges facing the university sector are well-known. The Office for Students’ report on the financial sustainability of the sector indicates that 40 per cent of HE providers were expecting to be in deficit in the financial year ending 31 July 2024 and an increasing number were showing low net cashflow. As the old financial year draws to a close, it’s worth reflecting on how those expectations are panning out in practice and what this is likely to mean for the new financial year.
Debt service covenants are under pressure
Financial covenants are the ratios which lenders use to assess the financial health of their borrower. For higher education providers, the anticipated deficits in the income and expenditure statement and low net cashflow are putting particular pressure on debt service covenants. These ratios show banks and other lenders whether a borrower has enough available cash flow or operating surplus to pay principal and interest owed to the lender.
Universities are under particular pressure because they often have term debt that runs for decades, and this means that they may well have debt service covenants which were set in a very different financial environment.
In particular, at one stage, the Higher Education Funding Council for England (HEFCE), the OFS’s predecessor as regulator for HE in England, required universities to “annualise” its debt service. In other words, even if the principal of a loan was only repayable at the end of the loan term (which is true of much university debt), the university was required to spread the payments of principal evenly across the term when calculating its covenant. While, in some senses, that was very prudent, in other senses it is misleading because that annualisation does not reflect the cash payments the university has to make in a given year. It also does not take into account the impact of inflation on the repayment. A “bullet” repayment in 30 years’ time is likely to have much of its real value eroded by inflation over that period. Many bank and private placement agreements entered into in the HEFCE era copied across those “annualised” covenants with the result that many universities are compelled to comply with covenants which do not reflect the economic reality of the borrowings they have entered into.
Should universities repay early?
In an environment where cash is in short supply, it perhaps sounds counterintuitive to suggest that universities use what cash they have to pay down debt. However, if covenants are tight and cash is at hand, that may be an option.
Universities borrowed significantly from the private placement market during the period of low interest rates following the Global Financial Crisis. However, as the OFS has noted, some university governors and trustees have had a preference to maintain cash reserves in response to financial pressures, rather than investing in capital projects. For some institutions, it may make sense to use those cash reserves to pay off debt that is no longer needed, rather than keep it for projects that are no longer going ahead. For borrowing that was entered into during the era of low interest rates, the “make-whole” payment to compensate lenders for the early repayment may well be low or zero (fundamentally because, in the present environment, lenders can likely lend out the repaid sums at higher rates).
For those universities that entered into borrowing with foreign investors (e.g. US pension funds or life assurance companies) early repayment might also result in a payment to the university if, as a result of the prepayment, the foreign investors have to unwind any cross-currency swaps they may have entered into to provide the university with sterling. That payment may reduce the overall amount the university is obliged to pay back. This only applies if the unwinding results in a gain which the investors are contractually obliged to pay over to the university. It could operate the other way depending on the market circumstances at the time of the prepayment (i.e. the unwinding of the swap may result in the university having to compensate the investors for a loss).
The borrowing entered into by the sector in the era of low interest rates was cheap by today’s standards so, for many universities, early repayment may not be a practical or desirable option. As ever, universities should take financial and legal advice before contemplating such a significant step.
What will the new financial year bring?
It’s likely that the new financial year, and the new student recruitment cycle, will bring its own headwinds and challenges. For those institutions that are forecasting a financial covenant breach in the 2024/25 financial year, early engagement with lenders is vital. For more guidance on what a university needs to know in this situation see Breaching a financial covenant: what a university needs to know - Mills & Reeve (mills-reeve.com)
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