“Compliance with debt covenants can be especially problematic if a market decline comes at the worst time of year and the institution doesn’t have a chance to mitigate the impact.”
In the short term, many institutions could have concerns about maintaining compliance with debt covenants. “Compliance with debt covenants can be especially problematic if a market decline comes at the worst time of year and the institution doesn’t have a chance to mitigate the impact,” said Grant Thornton Advisory Services Managing Director Brian Bonaviri. Institutions often have fiscal years that end in the spring or summer, and they only test covenants once a year. So, if financial covenants include unrealized losses on investment portfolios, there could be a significant impact on an institution’s ability to demonstrate compliance. Substantial unrealized losses in investment values, in the months leading up to covenant testing, might result in covenant violations for institutions.
What you can do:
Institutions need to understand the drivers of covenant inputs, and stress test their compliance models based on actual and projected operating performance. The testing should include investment market activity, when relevant to the respective covenant. This will allow institutions to get ahead of any potential instances of noncompliance. For example, the Debt Service Coverage Ratio is a widely known and used financial covenant, but there is not a uniform calculation. Institutions should carefully review loan documents and discuss with their counsel and advisors how such calculations should be prepared, to ensure alignment with the lender’s interpretation. Finally, if covenant noncompliance is anticipated, institutions should engage with lenders to proactively manage the impacts and understand what options exist. Options can include the receipt of waivers or covenant modifications.
In the longer term, many institutions that rely on their endowments to augment their operating budgets could face a reduction of associated cash flows. That’s because most endowment spending policies allow for the distribution of 4–6% of the fair value of the endowment. When all other factors are equal, a decline in the fair value of the endowment will result in less cash being made available to fund operations. As detailed below, there are several ways in which institutions can mitigate the potential longer-term cash flow constraints resulting from reduced endowment draws.
What you can do:
First, an institution needs to understand the realities of its financial position. Many institutions might be able to weather a short-term market downturn without over correcting. However, for other institutions, below is a list of potential considerations and actions to thwart or at least mitigate endowment losses and sustain a consistent level of endowment spending during a market downturn:
- Revisit Spending Policy – Most institutions spend a percentage of a moving average of their endowment’s fair value, such as the past three or five years (typically expressed in quarters). This can lessen and smooth out the impact of a sudden decline in the endowment’s value, but that impact might still be meaningful and affect the subsequent year’s disbursements. Spending policies are intended to preserve capital (inflation adjusted) over the long term while providing a reliable source of funding to support operating budgets. Now might be the time for institutions to reassess their spending policy percentage to adjust for any short-term declines in endowment values and maintain a consistent level of endowment funding designated for operations.
- Consider Supplemental Endowment Draws – Instead of adjusting the spending policy, institutions might consider nonrecurring supplemental draws from their quasi-endowment (otherwise unrestricted funds which have been designated by the institution’s board to function as if they were true endowments) to assist in addressing short-term cash needs. In particular, supplemental endowment draws can be tied to certain operating needs, such as debt service payments, funding postretirement plans, expanding student scholarships or specific capital purposes.
- Assess Investment Policy Statement (IPS) – Much like retirement planning on an individual level, it is beneficial for institutions to revisit their IPS with their Investment Committee and managers on a regular basis. While this is not always performed regularly in practice, an economic downturn can act as a good trigger to motivate a reassessment of an institution’s investment goals and strategies, as well as investment mix, with an emphasis on ensuring an adequate level of portfolio liquidity.
- Revisit Restrictions with Donors – Many contributions are restricted and are required to be maintained in perpetuity, pursuant to donor stipulation. Over time, donors might be more flexible with how their contributions might be used. Certain donors might be willing to repurpose previously restricted gifts to meet an institution’s current and perhaps profound operating needs. This will not increase an institution’s overall asset base, but it will potentially afford an institution some much-needed financial flexibility to address immediate cash-flow needs and strategic priorities.
Regardless of what actions an institution pursues, it is critical to analyze the short-term and long-term consequences. The recent market downturn has been swift and substantial, but there are other challenges still looming. Institutions need to focus on meeting immediate cash needs, while not overlooking their longer-term priorities. In recent years, institutions have become more focused on ensuring appropriate resource alignment with overall strategic priorities.
Take action now
Higher education is facing a range of challenges, including the lingering impacts of COVID-19, the looming enrollment cliff, substitutes for traditional class offerings and increasing labor costs. The market gains in 2020 and 2021 were a silver lining in a very challenging period. To weather a current and potential future market downturn, administrators need to know how to prepare and take action now.