How Boards and Presidents Influence Credit Ratings

By Karen Kedem    //    Volume 19,  Number 3   //    May/June 2011

Moody’s Investors Service provides credit ratings for hundreds of private and public colleges and universities—ratings that can strongly influence the interest rates higher-education institutions can obtain when they want to borrow money. How colleges are governed and managed are key determinants of those credit ratings, especially in an environment of limited resources.

It is clear that effective governance and strong management are crucial to the continued viability of institutions as they become increasingly global and compete for students, faculty members, research grants, and philanthropic and government support. In fact, at Moody’s we expect that the quality of a higher-education institution’s leadership team will be the main differentiating credit factor in light of reduced prospects for net tuition growth, the need for careful management of liquidity and debt-structure risks, and continuing financial pressures on the federal and state governments as well as private donors.

In our published ratings reports, we discuss our assessment of an institution’s governance and management to explain our rating opinions. Those assessments are a core part of the rating evaluation and often cause a final rating to be higher or lower than what would be indicated by a purely quantitative ratio analysis. Assessment of governance and management is especially likely to alter a rating outcome when the institution lacks great endowed wealth and is acutely dependent on competitive strategies to generate sufficient revenue from students, donors, and the government—conditions that apply to a large majority of colleges and universities in the United States.

The weight of governance and management assessments in our analysis is particularly important when a college or university is facing strategic change. We pay close attention when an institution is embarking on a major expansion of programs, initiating a significant new borrowing or fundraising campaign, undergoing financial stress, confronting a weakening market position, or experiencing high turnover in senior leadership.

We recognize that governance and management practices will vary significantly depending on the particular credit characteristics and strategies of individual colleges and universities. The depth of the discussion and points of emphasis in our credit assessments are based on the particular credit issues facing each institution. Our analysis of specific colleges and universities continues to evolve with changes in the economic and political environment in which they operate.

Governance and management are at the nexus of the credit factors used in Moody’s rating approach, as seen in the graphic on page 19. Although not an exhaustive list of best practices, this article provides a general framework for our analysis of governance and management. The five broad factors that we consider are:

(1) the composition of the board and senior administrative team;

(2) oversight and disclosure processes;

(3) short-term and long-term planning;

(4) self-assessmentand benchmarking; and

(5) government relations.

The Composition of the Board and Senior Administrative Team

Moody’s believes that the composition of a higher-education institution’s leadership team is the foundation for organizational effectiveness. Unlike boards of for-profit corporations, which derive their authority from the clear goals of equity holders, the boards of private, nonprofit colleges and universities retain the ultimate authority in setting their institutions’ strategic direction. They must also consider the multiple goals of many different constituencies—alumni, donors, students, and especially faculty members, who traditionally share in some aspects of governance. The concept of “shared governance” with employees is largely unknown outside of higher education. In addition, whereas corporate board members are often well compensated for their service, trustees of private, nonprofit colleges are often asked to give substantial donations to demonstrate leadership and commitment to the institution.

For public institutions, it is even more complex: In most states, elected officials continue to appoint board members, who may at times receive little preparation for the complex tasks facing them. Notable tensions can develop between the board’s fiduciary responsibilities and competing state interests on various fronts, including the ability to set tuition and fee prices, retain surpluses, and manage investments. While state financial support comes with certain conditions and expectations, a board’s ability to effectively govern the college or university is a credit strength.

Moody’s looks at a number of factors when assessing the board and senior administration of a college or university, including

• Board members who have expertise in the areas of financial statements, risk management, multiyear financial and capital plans, investment strategies, and philanthropic support;

• Board members who can provide material philanthropic support;

• A mix of long-serving and new board members with knowledge of the institution’s history and culture as well as external best practices and strategies—thereby ensuring continuity as well as the adoption of new perspectives;

• A board and senior administration with diverse experience both inside and outside the college or university, including some experience in business and government in addition to higher education;

• A president who shows clear understanding and leadership on financial and capital matters as well as the institution’s academic and research mission; and

• A strong chief financial officer and other vice presidents who demonstrate independent expertise and mastery of multiyear financial plans, budgets, and financial statements.

Moody’s reviews written materials that cover the professional backgrounds and years of tenure of each member of the board and the senior administrative team. We discuss the composition and structure of the board and its committees, the procedures for selection of new board members and the president, and the division of responsibilities. When warranted, we request a conversation with key board members.

An example of the impact of governance and management on an institution that Moody’s has rated involves a liberal arts college that experienced years of operating deficits, inattention to spending, and growing use of bank debt. After an extensive review, an outside consultant recommended that the executive committee of the board begin a search immediately for a new president with in-depth knowledge of the financial forces affecting liberal arts colleges. The consultant also told the board that it should reduce the number of board members to 30 trustees who could invest time and money in a turnaround. Three years later, under a streamlined board and new president, programs have expanded, revenues and enrollment are increasing, costs are lower, and operating surpluses have returned.

Oversight and Disclosure Processes

Sound oversight and disclosure processes are necessary for an institution to maintain accreditation, eligibility for federal financial aid, and donor confidence. Moody’s believes that boards should review their institution’s internal controls to ensure they remain supportive of its mission and relevant to its financial operations. Effective internal controls can alert trustees and administrators to potential problems and help minimize any negative impact on the institution’s financial health. In addition, we believe that public disclosure of policies, budgeting practices, projections, and long-term plans help ensure accountability to key constituencies like students, alumni, donors, bondholders, community members, and accrediting agencies.

Indeed, effective internal controls and timely external disclosure about student outcomes, research productivity, financial performance, and organizational efficiency will increasingly become the hallmark of effective college and university leadership. They will also become crucial to avoiding and mitigating new risks to individual institutions and higher education overall.

Some of the factors that we review when assessing the internal controls and external disclosure of a college or university include:

• Board-approved policies on investments, debt, liquidity, and conflicts of interest;

• Use of an internal audit function that reports directly to the board;

• Clearly defined board committee structures and responsibilities;

• Term limits for board members;

• Frequent board oversight of the president, including annual performance assessments by multiple board members who rotate over time;

• Detailed disclosure on the college or university Web site of student outcomes, financial statements, research activity, budgets, compliance with bond covenants, and other material issues;

• The filing of financial statements within 90 days of the end of the fiscal year, including detailed management discussion and analysis;

• The availability of quarterly financial statements or interim operational information for large research and endowed universities, as well as those with healthcare operations;

• Appropriate staffing for effective implementation of policies; and

• A culture of disclosure and transparency for internal decision makers and external stakeholders.

Moody’s will review the board’s practices in key areas of oversight, including investments, debt, operating plans, and compliance-related issues. We read an institution’s written policies, assess presentations made by the administration to the board, and discuss staffing and processes for risk management with members of senior leadership. We examine information that the institution makes available to external stakeholders through Web sites, financial statements, and official statements associated with debt issuances. A large public university system has created a bondholder Web site, for example, that it continuously updates with information on its outstanding indebtedness, financial statements, liquidity, and material-events notices.

Clear and timely external disclosure is still a relatively rare practice in higher education, but it is common in other industries and expected to become more prevalent among colleges and universities. The ability and willingness to disclose key performance indicators, planning assumptions, and risk sensitivities to external stakeholders is a hallmark of a well-governed organization.

Short-Term and Long-Term Planning

Planning is vital today for a college or university, especially given the institutional imperative to fulfill a stated mission in an environment of changing student demographics and financial constraints. Highereducation institutions must also deal with increasing scrutiny from outside constituencies over issues involving community relations, tax-exempt status, and accreditation, among others.

Effective use of a college or university’s resources requires prudent short-term budgeting, a long-term financial plan, a long-term strategic plan, and the continuous alignment of all three. Plans that are based on detailed and realistic assumptions are much more credible than thinly documented plans. Budgets and plans that are, on the one hand, overly conservative and, on the other, overly optimistic do not indicate an institution’s real potential or its ability to achieve its goals without causing financial stress.

A case in point: After sustaining substantial investment losses due to market volatility, along with several years of elevated endowment spending, the board and senior leadership of a highly selective private college determined that the college’s investment assumptions and use of endowment spending were not sustainable. They lowered the assumptions for longterm investment returns and implemented a multiyear plan to reduce the institution’s dependence on endowment spending.

When we assess the plans and planning process of a college or university, we look for the following factors, among others:

• The integration of strategic, capital, and financial plans;

• The use of detailed, multiyear financial plans and budgets that tie to audited financial statements;

• Sound budgeting, producing consistent operating surpluses;

• The evaluation of differing financial and capital scenarios to determine the institution’s sensitivity to changing market conditions;

• Prudent endowment management and sustainable endowment-spending policies that are regularly reviewed by board members and senior administrators in the context of a multiyear financial plan and overall institutional risk assessment;

• A history of meeting or exceeding internal forecasts for budget performance, enrollment, and fund raising; and

• Recognition of the key risks in multiyear plans and the development of contingencies to address them.

Moody’s reviews an institution’s written strategic plan and master-facilities or capital plan, as well as its mid-range and long-range budget projections (five to 10 years). We analyze budget-to-actual results for operational performance, enrollment, fund raising, and investment returns. We examine the board’s and the senior administration’s assumptions used in projections as well as the use of sensitivity analysis (the evaluation of the impact of a change in any financial variable to the university’s budget or balance sheet).

Self-Assessment and Benchmarking

Moody’s believes that the most successful institutions follow best practices in selfassessment, such as closely and regularly monitoring a dashboard of key metrics to identify adverse trends quickly and make contingency plans or mid-year adjustments when needed. External benchmarking is particularly important in light of increasing competition for students, grants, and philanthropic support.

For instance, through the regular review of a key-metrics dashboard, the governance and management team of a selective liberal arts college in New England was able to easily identify variations in revenue and liquidity during the recession. Such oversight enabled the college to quickly put measures in place to ensure ample cash flow and secure back-up lines of credit as a precaution. The dashboard was also a planning tool and was integrated into the institution’s multiyear financial plan and annual budget. The administration was able to use the information to revise budget projections and alter spending plans quickly in targeted areas, instead of having to resort to disruptive across-the-board cuts.

The factors we examine concerning an institution’s self-assessment and benchmarking processes include:

• Benchmarking relative to best practices and strategies across the institution’s peer group and higher-education sector;

• The existence of key performance indicators that are regularly monitored

• The development of well-considered contingency plans;

• Regular performance reviews and assessments of the college president and senior leadership; and

• In-depth institutional research and evaluation of the competitive landscape.

Moody’s reviews the metrics and set of peer organizations against which a college or university chooses to measure itself. Well-managed institutions compare themselves against a carefully selected set of peers rather than an “aspirant” group that is likely to reflect hope and image over substance. We discuss with board members and administrators the frequency and depth with which they review such information. We also gather examples of leadership actions based on an institution’s performance relative to key indicators, such as enrollment shortfalls or narrowing liquidity, to understand the board and administration’s willingness and ability to react to developing situations.

Government Relations

An institution’s relationship with its local, state, and federal government is crucial to securing continued financial support in the form of federal student aid, research awards, and tax-exempt status. Many government agencies and officials can directly affect the financial position of colleges and universities through their potential to restrict access to capital, reduce tax subsidies, or increase regulatory oversight. To help ensure a supportive relationship from such key stakeholders, colleges and universities increasingly must clearly articulate the economic benefits they provide to the region, state, and nation—including their roles as educators of informed citizens, trainers of the future workforce, large-scale employers, creators of new science and technology, generators of new business development and technology transfer, and providers of cultural enrichment.

Private colleges and universities—especially those with large research functions or substantial health-care operations, or those operating in states that offer significant student aid—risk loss of support from state and federal governments. Meanwhile, public universities are quickly becoming market-driven, public-mission institutions, much like their private, nonprofit peers. As public support continues to diminish as a percentage of their total budget, these rapidly evolving and complex institutions will require increased operating freedom and a more flexible oversight structure to fulfill their missions.

The transition to increased operating freedom is already occurring in some states. For instance, after years of declining state support, the trustees and the president of a leading public university located in an economically depressed state successfully convinced the legislature to allow board members to be appointed independently, not by the governor, and given full control over the setting of tuition and fees. Such reforms eventually allowed the university to attract more financial expertise and philanthropic capacity to its board. It also resulted in an enhanced ability to project long-term revenues based on more-reliable forecasts of net tuition. Despite the continuing loss of state support, the university is thriving and providing expanded enrollment for state residents, as well as attracting more non-residents to the state.

In most countries outside of the United States, colleges and universities are primarily supported and controlled by the government, so effective management of government relations is of utmost importance for an institution’s financial future. Our rating methodology for colleges and universities outside America reflects a government-directed model of higher education. In the United States, we generally view increased institutional autonomy as a credit positive because it tends to promote more efficient use of resources and more effective execution of long-term plans—both crucial for colleges and universities to succeed in the highly competitive higher-education market.

However, we recognize that financial support from the federal and state governments, which appropriately comes with certain conditions and expectations, can strengthen the credit quality of a college or university. Consistent funding for operations and capital, special financial contributions driven by unexpected events like natural disasters, and programs to support higher-education debt issuance can contribute to the fiscal health of an institution.

Moody’s considers the following when evaluating a college’s government relations:

• Political autonomy from the state in key areas, including the ability to set tuition and fees, regulate mix of instate and out-of-state students, retain surpluses, and manage investments;

• The consistency of state financial support for operations and capital projects, particularly during times that the state is experiencing economic challenges;

• Evidence of stable and supportive relationships with the local community, including a lack of contentious debate about local taxation;

• A significant institutional impact on the local and regional economy; and

• Special government programs that provide additional support for public higher education such as debt-service reimbursement from the state and funds established to support a specific college or university or higher education in the state at large.

Moody’s evaluates the political and regulatory environment in which an institution operates and looks for examples of limitations or flexibility in navigating particularly challenging situations. We review legislative and statutory changes as well as the political discourse that could affect colleges and universities. In addition to monitoring news coverage and evaluating the research of Moody’s state and local government analysts, we discuss the political landscape with board members and top administrators at colleges and universities.

In the final analysis, most of the colleges and universities that Moody’s has rated have weathered the economic crisis quite well, demonstrating agility under stressful circumstances. They continue to face significant pressures, but we expect that higher-education institutions with strong governance and management practices will be able to maintain or strengthen their credit profiles in the coming years.

College and university boards and administrative teams have been forced to question the underlying assumptions in their long-range models. To flourish and retain strong bond ratings, they can no longer accept the status quo as their institutions adjust to “new normal” realities, which include:

• Increased accountability for financial control over tuition increases and long-range operational sustainability;

• Growing demand for organizational transparency and data-driven decision making;

• More robust sensitivity analysis with a focus on assumptions and enterprise risk management;

• The need to clearly demonstrate the value of programs and services relative to peer institutions; and

• Heightened political and public scrutiny of tax-exempt organizations.

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