Mergers and Affiliations

By Rick Beyer    //    Volume 27,  Number 3   //    May/June 2019

Increasing numbers of institutions are closing their doors in the face of financial difficulty. Some are finding ways to continue advancing their missions through innovation and objective decision making. What is the role of the board during these unsettled times?

The business model for higher education is under severe stress. There is more capacity than student demand. Consumer behaviors have changed, technology demands are increasing, and deflationary forces are diminishing tuition revenues. This has led Moody’s credit rating agency to downgrade the entire industry from stable to negative. Depending on an institution’s willingness and capacity to change, it is either a great time or a really bad time to be in higher education.

Within this new environment the financial model that propelled higher education for the past several decades is crumbling. A growing number of institutions are going out of business—victims of dwindling enrollments, declines in private and public funding, and in many cases a failure to come to grips with change. This is leaving boards with some major governance decisions to make, including maintaining independence, merging with other institutions, or developing affiliations that consolidate strengths.

For institutions that struggle to match revenues with expenses, it may be clear from a financial and operating perspective that new alternative strategies should be considered but difficult from an emotional perspective, particularly when viewed through the lens of a board composed of volunteers. Yet fiduciary responsibilities to intergenerational sustainability rest with the board and president, and it is impossible (if not impermissible) to defer decisions that will affect the institution’s future. It takes courage and leadership to navigate these uncharted waters. Passive boards will set the course for their institution with inaction, but strategic board leadership aligned with the president can position institutions for long-term prosperity.

SITUATIONAL ASSESSMENT OF HIGHER EDUCATION

The higher education student market has contracted over the past seven years from roughly 21 million to 18.5 million students. This and other factors have created significant turmoil for the sector: A recent Gallup poll on education found that 71 percent of chief business officers at colleges and universities say reports suggesting that higher education is in the midst of a financial crisis are accurate. That is underscored by the Moody’s credit rating downgrade for the sector, and the findings of AGB’s own Trustee Index (published annually in partnership with Gallup), which in 2018 found that 92 percent of respondents believe that moderate or drastic change is needed in the business model.

There is consensus by many constituents that higher education is not immune to the kinds of industry-changing currents that have swept other industries—and may in fact be the next industry to experience a hard fall, with many failures but hopefully just as many success stories. It is useful to look to other industries for clues. In health care, for example, more than half of the nation’s physicians no longer own their own practice, and there is a continuing  (albeit slowing) movement toward hospital- and health system-based physician employment. Over the next five years, we may see a similar movement in higher education with private institutions forming formal affiliations. We can also look to the retail sector, where e-commerce has led to the closing of more than 10,000 brick and mortar stores over the past two years; tellingly, one third of college students today have taken an online class, a portent that more landed and facility-rich colleges may be shuttered if resolute remedies are not brought to bear.

The higher education financial picture today is vastly different, the result of demographic shifts and changing consumer behaviors. The current tuition market is feeling deflationary pressure, and the more than 44 million students with $1.6 trillion of debt raises questions in the minds of stakeholders of the value of the investment. In a sector known for its deliberative pace, torpid operating rhythms prevent institutions from using speed and service to compete in the market. Furthermore, many institutions have outdated operating policies that prevent them from being competitive, including bloated general education curricula and barriers to more nimble processing of transfer students.

For the foreseeable future, institutional will and resolve will be greatly tested, and a premium will be placed on creativity and innovation. There is a great need for institutions to develop business models comprising comprehensive portfolios of major revenue sources. These will include the traditional brick and mortar model but that will no longer be the only one. The most prosperous institutions will use diversification to help offset the high-cost model of manual, human delivery of knowledge.

Given all of these trends and challenges, there remain three governance alternatives: go it alone, merge, or affiliate.

THE CASE FOR CLOSURES, MERGERS, AND AFFILIATIONS

Typically, institutions are not bought and sold as businesses are, but for the purposes of this article the term “sell side” is used to indicate a weaker institution seeking a long-term partner; “buy side” will rep-resent the stronger institution seeking to acquire desired resources and assets to strengthen its market position.

In the near future there will be more institutions on the sell side. The challenge for these at-risk institutions will be to recognize their opportunity in advance of serious problems. While there will be fewer institutions on the buy side, the opportunities should accrue to both large and small institutions.

At-Risk Institutions Institutions with U.S. Department of Education financial composite scores (an annual assessment of financial health calculated on three ratios: primary reserve, equity, and net income) below the department’s standard for fiscally responsible (1.5 on a scale of -1 to +3), are at risk, and those with 2.0 scores may also be vulnerable. Boards should carefully monitor the financial composite scores for trends; those that take a passive approach to the future may end up with the hard decision to close the doors, sacrificing historical mission, reputation, and good-will. In these situations, there typically ensues an 11th-hour entreaty to another institution, but the result is inevitably the same.

While the board may find it emotionally difficult to close a college, it seems more difficult for boards to come to the realization they should pursue a merger or affiliation long before that point. Trustees should look beyond a balanced budget, which can engender a false sense of security because it does not necessarily signify that an institution is prosperous. Too many institutions with balanced budgets reach that objective through continued underinvestment in areas that are critical to their future, including new program development, technology, marketing, support services, headcount deficiencies, regular replacement of equipment, and paying market rates to attract and retain the most talented employees.

A better starting point for an institution is to perform a “quality of earnings” analysis on the current operating budget. The analysis can be completed in 30 days and will help to quantify an institution’s prosperity gap—essentially the distance between current financial performance and a prosperous future. This financial modeling exercise enables an institution to add back expenses in areas where underinvestment is present (for example, new programming, technology, people, marketing, support services, head count deficiencies, et cetera), and to quantify the amount of additional annual operating margin necessary to fully invest in critical areas.

It is not unusual for small- to medium-sized institutions to find prosperity gaps requiring $10 million of annual operating margin or more, and boards are usually surprised at the level of revenue growth required to close the prosperity gap. Knowing the distance of your journey to reach prosperity is critical, and board leadership should be an integral part of the discovery process with the president and chief financial officer. The board also needs to take a hard look at the institution—its resources and talent to execute on future goals, its capacity for innovation—and determine if it can, indeed, make it.

With the quality of earnings analysis completed, a board can use the prosperity gap to ask itself: Should we go it alone? Should we consider a long-term affiliate partner or merger? Or should we be on the “buy side” and seek to acquire other institutions for alignment?

College Mergers For those who have been through mergers, the challenges are enormous, ranging from redundancies in programs and personnel to the basic premise that there is never a merger of equals: There is always a weaker and a stronger partner.

For those institutions on both the buy side and the sell side, an assessment of what is complementary and what is overlapping is essential. With complementary programming there is a lower risk of revenue erosion; with overlap-ping programming, there is higher risk. In both cases there are opportunities for cost savings but anticipating such risk factors as revenue erosion is critical.

For those institutions seeking to develop a buy side strategy, developing a decision matrix that considers positive and negative attributes of potential candidates is important. A proper decision matrix will provide the process for institutions to explore many different opportunities.

Formal Affiliations The greatest opportunity for private institutions seeking long-term strategic partners may be through formal affiliations. Each entity retains its board, president, senior cabinet, faculty, accreditation, and degree-granting authority. An essential feature of an affiliation is reducing redundancy by establishing centralized resources for noneducational administrative functions (finance, purchasing, human resources, technology). Sometimes central resources can also include digital marketing, instructional designers, compliance, and academic support.An example of an affiliation system is TCS Education, which has created a nonprofit community system of colleges. Over the past 10 years, 5 independent colleges have become part of a unified system. Postaffiliation enrollment has grown from 3,000 to 9,000 students. Together they have successfully leveraged centralized services and each institution has gained access to higher quality resources.

With an affiliation, a system of private colleges is created. Each institution has control of its own budget, endowment, and strategic plan. Within this structure would be a support organization as well as a system board. The system board would have some reserve powers, but each institution remains its own legal entity. Affiliations provide the opportunity for institutions to keep their missions, identities, strategic planning, endowments, accreditations, and degree-granting powers.

An example of an affiliation system is TCS Education, which has created a nonprofit community system of colleges. Over the past 10 years, 5 independent colleges have become part of a unified system. Postaffiliation enrollment has grown from 3,000 to 9,000 students. Together they have successfully leveraged centralized services and each institution has gained access to higher quality resources.

THE ROLE OF THE BOARD

The unique nature of governance in American higher education has served the nation well in the past, and while the challenges facing the sector today are unprecedented in their scope and complexity, trustees must prepare for the era of significant change that has emerged in little more than a decade. If ever there was a time when board service was solely honorific, that day has passed. Today’s boards are critical leadership partners and advocates for their institutions, systems, or foundations and, indeed, for the entire sector, and they cannot afford to take a laissez-faire approach to the sustainability of mission.

New business models of the future will require diversified revenue sources, and institutions will need to become far more innovative. While closures will continue, formal alignments among discrete institutions should be considered, and strategic board leadership aligned with the president can position institutions for long-term prosperity.

AUTHOR: Rick Beyer is the senior lead consultant of AGB Consulting and the special advisor to the president of AGB.