A Question For Verne Sedlacek

How can institutions use financial stress testing to ensure their fiscal health?

By AGB    //    Volume 27,  Number 1   //    January/February 2019

This article is part of the Finance Committee Chair Toolkit, a resource that highlights a variety of perspectives, including how to assess disruptive scenarios and what types of actions to consider.

Potential federal budget cuts to higher education programs, along with uncertainty in the financial markets, are placing renewed demands on colleges and universities to safeguard their fiscal health. Trusteeship asked Verne Sedlacek, former president, CEO, and board member of institutional investment firm Commonfund, to explain how higher education institutions can use financial stress testing to gauge their fiscal condition and take appropriate risks for long-term viability. Sedlacek is a member of the Valparaiso University board of directors and a former member of the AGB Board of Directors. He will lead a seminar on financial stress testing at this year’s National Conference on Trusteeship, April 14–16, in Orlando, Fla.

Most people who have spent time in corporate America in the past 10 years understand the concept of financial stress testing, but how does that concept translate to college and university settings?

The concept of stress testing in the college and university environment is not very different from the one in the corporate and banking world. The overall goals of both are to understand where correlations of financial components may be aligned and to understand where key vulnerabilities may exist. Once those are identified, the stress testing can lead to shoring up those key components through hedging, insurance, or simply training and monitoring. The major difference is that the stress testing in corporations or banks looks to shareholder losses (or government losses in the case of banks) as the most important stress test outcome while the key value proposition with stress in the college and university environment is a significant reduction in the ability to fulfill the mission of the institution.

What does this look like in practice, and what kind of routine or cadence should boards adopt?

A college can take several different approaches to stress testing its institution. I believe the most straightforward place to start is to examine history and apply it to today’s institution. We all have good data from 10 years ago. The Great Recession exposed a significant number of vulnerabilities in the college and university financial structure. The industry was not prepared for the high correlation of certain revenue items, expense, liquidity, and cash flows associated with a severe recession. As such, many institutions went into crisis mode during that time. So, to start, take performance metrics from 2008 to 2012, the most difficult years of the recession. Understand where today’s critical points of failure are in the context of extremes of the early recession period. The institution’s board should conduct financial stress tests at least annually, and tweak and expand them through each annual iteration. The key with stress testing is not to make the “perfect be the enemy of good.”

How might boards identify the right balance between appropriate risk-taking and innovation versus the preservation of financial capacity and flexibility?

In today’s environment, boards of colleges and universities need to be prepared to take more risk than they have in the past. Taking risk in new ventures or programs should be done within the context of the stress test. Does the new program add to or decrease the enterprise risk? For instance, adding a new program may be a risky undertaking on a standalone basis, but if successful, may reduce the total enterprise risk. Any program that diversifies sources of revenue will tend to reduce the overall enterprise risk. If the college or university moves to a new market or demo-graphic, it could be beneficial in adjusting overall risk downward. The key to taking on new risks is to carefully examine the pro-gram with clear short-term and long-term objectives and be prepared to “fail quickly” if those objectives are not being met.

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