Illinois Finance Authority UNO Charter School Network; Charter Schools

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1 Illinois Finance Authority UNO Charter School Network; Charter Schools Primary Credit Analyst: Avani K Parikh, New York (1) ; avani.parikh@spglobal.com Secondary Contact: Laura A Kuffler-Macdonald, New York (1) ; laura.kuffler.macdonald@spglobal.com Table Of Contents Rationale Outlook Enterprise Profile Financial Profile JULY 28,

2 Illinois Finance Authority UNO Charter School Network; Charter Schools (Editor's Note: The version of this report originally published on July 25, 2017, had the incorrect table attached. A corrected version follows.) Credit Profile Illinois Finance Authority, Illinois UNO Charter Sch Network, Illinois Series 2011 A Long Term Rating BB+/Stable Affirmed Rationale S&P Global Ratings revised its outlook to stable from negative and affirmed its 'BB+' rating on the Illinois Finance Authority's series 2011A and taxable series 2011B charter school refunding and improvement revenue bonds, issued for the UNO Charter School Network (UCSN). The revised outlook reflects our view of UCSN's successful settlement with United Neighborhood Organization (UNO), the school's previous management company and guarantor on the bonds. Under the settlement agreement, finalized on Nov. 18, 2016, UCSN acquired the four school properties previously owned by UNO in exchange for a $4.5 million payment, settlement of all claims between UNO and UCSN, and forgiveness of all amounts owed to UCSN by UNO. On acquisition of the properties from UNO, UCSN now secures bondholders in the same manner as under the UNO guaranty but without the risk of UNO's insolvency. There was no other change to the debt structure or security for the series 2011 bonds. UCSN received 100% bondholder consent for this transaction. In addition, our outlook revision reflects UCSN's modestly improved cash position in fiscal 2016 and into fiscal 2017, as well as the school's successful implementation of its compliance plan associated with previously issued English Learner findings. On July 1, 2015, UCSN received notice from the Chicago Board of Education (CBOE) that its charter was subject to potential revocation due to these findings. We understand UCSN designed a program, consistent with applicable laws, trained over 100 staff members in a bilingual cohort program, and submitted a corrective action plan to the authorizer within the required timeframe. We expect that the school will be able to remediate these findings and discussions with the authorizer indicate UCSN has made progress, which mitigates previous concerns associated with potential charter revocation. UCSN is in the midst of its next renewal process, as the school's current charter expires June 30, At this time, both CBOE and UCSN management indicate no significant concerns, though the authorizer expects to continue to monitor performance. We assessed UCSN's enterprise profile as adequate characterized the school's large and fairly stable enrollment, sufficient waiting lists, solid retention, above-average academics, and a proactive management team. We assessed UCSN's financial profile as vulnerable characterized by a modest liquidity position and moderate debt burden, which JULY 28,

3 offset consistently positive operations and good lease adjusted maximum annual debt service (MADS) coverage. We believe that the track record of continued and timely payments to UCSN despite the political and financial challenges at Chicago Public Schools (CPS) and the state of Illinois, on which UCSN is reliant for funding, offsets the pressured funding environment. The school's network model also supports the rating since enrollment and operations are well diversified among several campuses, therefore providing the school with flexibility to address potential funding challenges over the next few years. We believe that combined, these credit factors lead to an indicative standalone credit profile of 'bb'. As our criteria indicate, the final rating can be within one notch of the indicative rating level. In our opinion, the 'BB+' rating on UCSN's bonds better reflects the school's sound market position when compared with peers and medians, with a unique curriculum and good academic results, supporting healthy demand. The rating also reflects our view of UCSN's: History of positive operations in recent years, with expectations of continued surpluses; Improving coverage of MADS at about 1.6x in fiscal 2016; our coverage calculations assume the operations, leases and debt associated with all of the UCSN schools; Three successful charter renewals, including the most recent one as of June 30, 2013, for five years; Wait lists at most of the schools and room to grow at many locations; and A restructured management team. Offsetting the above strengths, in our view, are the following factors: State budgetary pressures that could limit per-pupil funding; Only modest liquidity position for the rating level, though there has been recent improvement; Refinancing risk associated with the direct purchase loan maturing in November 2017, though we believe UCSN has a credible refinancing plan and has successfully extended this loan in the past; Potential for challenges associated with the continued transition to fully independent operations, though the team has handled the change successfully thus far, in our view; and The inherent uncertainty associated with the need for successive charter renewals from the competing CPS system through the life of the bonds. On July 7, 2017, lawmakers overrode a gubernatorial veto and Illinois passed a state budget for the first time since fiscal 2015, providing some stability after two consecutive years of uncertainty and limited funding to many public entities. Though there have been funding cuts over the past two years, K-12 education continued to be funded with timely payments during the state budget impasse. With the passing of a budget, we do not expect any significant delays in funding for UCSN for the next year. While there still could be some variance in frequency or timeliness of payments, we expect minimal disruption. In addition, UCSN receives funding through the city as part of a contractual agreement under its charter. In the event CPS is not able to fund UCSN per the charter agreement, the school may appeal to Illinois under the State Charter Law. However, given Illinois' and CPS' history of political gridlock, we will continue to monitor the funding situation at both the state and district level, and take rating actions as necessary. A gross revenue pledge of 11 of the 16 charter schools in the network secures the bonds. In addition, a custodial agreement has the trustee receiving quarterly payments from CPS for all UCSN schools and from the schools securing the 2011 bonds, making payment to the various bond funds, and forwarding the remaining funds to UCSN. According to the trust indenture, if CPS payments are not sufficient to cover debt service, UCSN may use other revenues, JULY 28,

4 including revenues from the schools that are not pledged. We view this as equivalent to a general obligation of UCSN and base our rating on UCSN's operations. At June 30, 2016, the network had about $64.8 million of debt outstanding, including a new market tax credit issuance and a direct purchase with MB Financial Bank. To fund the settlement payment, UCSN refinanced its loan with MB Financial to borrow an additional $4.5 million. Pro forma debt is approximately $69.2 million, though we recognize that this figure is slightly overstated as it does not reflect amortization since June 30, All references to pro forma debt in this report reflect the additional $4.5 million borrowing, and associated debt service assuming amortization over a 12.5-year term. We rate the series 2011A and B debt ($36.2 million outstanding) that refunded previous loans. UNO was incorporated in 1984 as an Illinois nonprofit 501c3 organization to provide outreach and social services to Hispanics in Chicago. As part of its mission, it started to focus on education. In 1998, UCSN was incorporated as a closely affiliated organization to UNO to operate a charter school. The charter has been renewed three times and currently runs through June Technically, 15 schools operate under the charter, as the Rogers Park campus is reflected as one K-12 school. However, under the bond documents Rogers Park K-8 program and high school are considered separate schools; our article matches the references in the bond documents. There is no limit on the number of schools that UCSN may open, though there are no current plans to open additional schools. The Chicago Board of Education has to approve each school, but the network enrollment cap of 9,750 allows for flexibility in enrollment across schools. We understand UCSN plans to begin the upcoming school year under a new network name, ACERO Schools. Outlook The stable outlook reflects our expectation that over the one-year outlook period, UCSN will maintain relatively stable enrollment and demand. Despite the potential for funding cuts, we expect management will adjust operations accordingly to maintain surplus results supporting steady coverage and liquidity at a minimum near current levels. We also expect UCSN's charter will be renewed successfully. Downside scenario We could consider a negative rating action if funding from state is delayed or interrupted, there are significant funding cuts, or UCSN is unable to refinance its direct purchase loan, such that it significantly affects operating performance or liquidity. We would also consider a negative rating action if operations were to become negative on a full accrual basis, such that lease adjusted MADS coverage deteriorates or liquidity weakens from current levels. We would consider further negative rating action if UCSN falls behind in its remediation plan or there is any threat to charter renewal. Upside scenario A positive rating action is not likely during the outlook period, absent significant improvement in days' cash on hand and coverage, with further strengthening in UCSN's enrollment and demand profile. JULY 28,

5 Enterprise Profile Economic Fundamentals UCSN is located in Cook County, which surrounds Chicago and is the second most populous county in the country. The county's minor population is very healthy at about 1.6 million. This partially offsets projections, which reflect an anticipated decline in the county's student population of about 2.6% through Industry risk Industry risk addresses the charter school sector's overall cyclicality and competitive risk and growth by applying various stress scenarios and evaluating barriers to entry, levels and trends of profitability, substitution risk, and growth trends observed in the industry. We believe the charter school sector represents a moderately high credit risk when compared with other industries and sectors. Market position Overall, we view UCSN's enrollment profile as relatively stable, supported by sound demand, above average academic performance and good student retention. Of the 16 UCSN schools, 13 offer grades K-8 and the remaining three are high schools. About one-third of students are English learners and UCSN employs a co-teaching model in line with Illinois law and statute to instruct English learners. Estimated enrollment at each school ranges from 280 to 736 for fall 2016, with total enrollment across the network of 7,861. Enrollment declined modestly from fall 2015, with reported 8,061 students. Management attributes this to some classes at certain campuses that were previously larger than expected, and those larger classes graduating. For this reason, management expects some modest shifts in enrollment in the near-term, with it leveling out at about 7,800 students for the near-term. UCSN's consolidated waiting list, which was 2,232 for fall 2016, provides support. More than 95% of students qualify for free lunch. The retention rate is very good, in our view, at an average of 94%, as is the daily attendance rate network-wide. CPS ranks schools from level '1' to '3', with a '1+' indicated the best assessment. For the school year, none of UCSN's schools were ranked in the lowest tier, at a '3'. Overall, 47% of UCSN's schools received a '1+' rank, 27% a '1', 20% a '2+', and 7% at '2'. In general, UCSN outperforms the district in terms of the percentage of schools ranked '1' to '3', and we view the network's academic results favorably and supportive of the school's demand. Despite UCSN's academic success, in July 2015, CPS' Office of Language and Cultural Education's monitoring report found UCSN deficient in identification of eligible English language learners, assessment, access to, and acquisition of services. Since that time, UCSN has provided quarterly updates to CPS on the remedial steps taken to address these findings and based on discussions with management, UCSN was on track to remediate them by the implementation deadline of July 15, Despite the English Learner findings, we view the school's standing with the authorizer as good. UCSN has continuously held its charter with the CBOE for 19 years and it has been renewed three times. Currently the charter contract is set to expire in June 2018, management indicates the review associated with the charter renewal just began. Management anticipates receiving an updated charter contract by the end of the school year. At this time, we are not aware of any significant concerns on the part of the authorizer. The statutory framework assessment reflects our opinion that, while there may be some areas of risk, the framework is JULY 28,

6 not likely to negatively affect UCSN's future ability to pay debt service. The majority of UCSN's operating revenue comes from per-pupil funding and governmental pass-through payments received from CPS, the revenues of which are primarily derived from state appropriations and local property taxes. The network receives funding from Title I, Title II, Title III, and supplemental general state aid, based on the number of eligible students. In addition, UCSN receives funding specific to special education services that it provides and are reimbursed to UCSN based on the cost of the services. We understand funding experienced about a 2.5% mid-year cut in fiscal 2017 and lower funding levels could occur during fiscal 2018 given state budget pressures. We will continue to monitor funding levels and management's ability to respond to potential funding cuts. Management and governance In 2013, UNO's state grant of $98 million was audited, and the SEC began its own investigation into possible securities violations. UNO and UCSN settled with the SEC the following June, with an independent monitoring period that ended on Dec. 31, Illinois specifically focused on whether UNO had violated its conflict of interest (COI) policies after the company of a relative of a senior administrator received construction contracts. Largely as a result of events that year, UNO and UCSN underwent a major reorganization, including the creation of new and separate boards of directors at both organizations. The then-ceo of UNO and UCSN stepped down. In 2014, UCSN made the determination not to renew the management contract with UNO, which expired in June In addition, in fiscal 2015, the IRS began conducting an audit of the series 2011 bonds the school issued. In August 2015, the IRS made a determination to close the audit. At this point, there are no further actions pending and the IRS audit was closed with no action. Following the termination of the contract with UNO and the major reorganization of senior leadership, former UCSN board chairman Richard Rodriguez became the CEO of the network. UCSN also added a chief of schools, chief of staff, chief financial officer, chief operating officer, general counsel, and compliance officer. With the settlement complete, there has been an absolute separation between UNO and UCSN, which we view positively. There has been some turnover in senior leadership in the past year, including the chief education officer and chief external affairs officer. We understand all open positions have been filled and there are no plans to add roles or additional transitions expected. In our view, the senior team possesses good depth and breadth, with experienced individuals in key roles at the organization. However, given that the team is still relatively new, a longer track record of steady oversight and successful operations would be viewed positively. UCSN has transitioned in fiscal 2016 to fully independent operations. Its fiscal 2015 budget included $2.5 million of transition costs as it built finance, human resource, and IT departments. During the transition period of fiscal 2015, UCSN contracted with Afton Partners LLC to facilitate the transition. UCSN has always managed the academic portion of its operations. We view the strengthening of conflicts of interest and compliance policies positively. Financial Profile Financial performance UCSN has reported positive operations consistently for the past several years, with healthy margins largely attributable to disciplined expense control, termination of the contract with UNO, and some enrollment growth. For fiscal 2016, JULY 28,

7 the network posted an EBIDA margin of 12% of operating revenue and an operating surplus of $2.7 million, or a 2.8% operating margin, in line with trends over the past few years. Management expects fiscal 2017 to end with another operating surplus, though likely more modest than previous years due to the funding pressures described above. For fiscal 2018, management's current budget conservatively assumes a modest enrollment decline closer to just under 7,800 students and some degree of funding cuts. Management has developed a cost-reduction plan to address these pressures, and expects to maintain surplus operations though margins will likely be compressed relative to prior levels. MADS of all debt and leases is an inexact calculation due to the organization's growth, escalating leases, and changes in debt vehicles. We estimate lease adjusted MADS at $9.9 million (including lease payments) in 2017; this figure is lower than prior years as the transaction with UNO eliminated the lease expense associated with the four properties that were acquired by UCSN. All residual management fees due to UNO were booked in fiscal 2016; there will be no additional management fees going forward given the termination of the contract and final settlement with UNO. Although management fees are subordinate to both the 2011 bonds and the New Market Tax Credits (NMTC) financing, we include them in coverage ratios because these fees are a part of operations. Based on these calculations, coverage of pro forma lease adjusted MADS was good in fiscal 2016 at 1.6x. UCSN's debt structure is somewhat front-loaded, with declining debt service and the potential that the network's refinancing plans and paydown of NMTC in the near-term, could lower lease adjusted MADS further. Overall, we expect this should continue to support coverage in line with the rating level, despite the expectation of reduced operating surpluses. In March 2014, the school signed an agreement with the Chicago Alliance of Charter Teachers and Staff (Chicago ACTS Union) to allow the school's staff to be represented by the union. The majority, approximately 74%, of staff is currently represented by the union. A two-year agreement was reached in October 2016, and salaries are considered competitive with market. UCSN has demonstrated ability to manage expenses despite the limitations sometimes imposed by collective bargaining agreements. Liquidity and financial flexibility UCSN had more than 100 days' cash on hand in fiscal years 2010 and However, in fiscal 2012, cash dropped to 32 days due to higher receivables from CPS ($1.8 million), $37 million of self-funded projects, and some spend-down of grants received in fiscal Since then, the organization has built up reserves to between 50 and 60 days' cash on hand, with $13.7 million in unrestricted reserves as of June 30, 2016, equal to 57 days' cash on hand. Management's target is to maintain closer to 90 days' cash on hand, though we expect material improvement will likely take time given the organization's growing expense base. Debt burden At June 30, 2016, the network had about $64.8 million of debt outstanding, including a new market tax credit issuance and a direct purchase with MB Financial Bank. UCSN refinanced the loan with MB Financial and borrowed an additional $4.5 million in November 2016 to finance the settlement and pay residual management fees. The loan matures in November As of June 30, 2016, $14.8 million was outstanding on this loan. Factoring in the additional borrowing and debt amortization, UCSN plans to refinance the $17.5 million obligation upon maturity in a few months. In our view, management has a credible refinancing plan and could extend the loan with MB Financial if needed, as has been done previously. The loan is on parity with the 2011 bonds and issued under the same trust agreement as the bonds. It does include two additional covenants (maintenance of $7 million in unrestricted reserves JULY 28,

8 and a limit on capital expenditures not to exceed $3.5 million), and as such we do consider this a contingent obligation, though manageable in our view given the refinancing plans and performance relative to covenants. Through a New Market Tax Credits NMTC initiative involving JPMorgan Chase Bank N.A. and Local Initiative Support Corp. (LISC), UCSN also borrowed $13.65 million in fiscal 2012, most of which matures in We expect the network will not need to repay a portion (about $2.8 million) of this debt, as with many NMTCs. In addition, management has established a sinking fund, which currently stands at approximately $2 million but is expected to grow to $3.1 million by maturity. S&P Global Ratings does not rate this transaction. Revenues of two schools that are not part of the series 2011 gross pledge secure this transaction, but we include the debt service on these bonds in our calculations. Overall, UCSN's pro forma lease adjusted MADS burden is manageable at 10.4% of revenues, with debt to capitalization hovering at about 90%. Our debt burden analysis also reflects potential exposure associated with the state's significantly underfunded pension plans. While currently 100% of employer contributions are made by the state for the Public School Teachers' Pension and Retirement Fund, we recognize there is potential that the state could shift obligations to the school. UCSN has also established an alternative 401(k) plan, which could reduce future pension exposure. Financial policies UCSN meet all standard annual disclosure requirements. The financial policies assessment reflects our opinion that, while there may be some areas of risk, the organization's overall financial policies are not likely to impair its future ability to pay debt service. Our analysis of financial policies includes a review of the organization's financial reporting and disclosure, debt profile, contingent liabilities, and legal structure and a comparison of these policies with comparable providers. Bond provisions There is a debt service reserve fund, and covenants include maintaining 1.1x annual debt service coverage; coverage below this level for two consecutive years could constitute an event of default. In addition, annual debt service coverage below 1x in any given year, combined with days' cash on hand below 70 days', also constitutes an event of default. There is an additional bonds test of 1.1x of existing debt and 1.2x of projected debt, as well as a covenant that UCSN will have 30 days' cash on hand at the end of every fiscal year. UNO Charter School Network, Illinois Financial And Enterprise Statistics --Fiscal year ended June 30-- Medians for 'BB+' rated charter schools Enrollment Total headcount 7,861 8,061 7,876 7, Total waiting list 2,232 1,824 2,171 3,014 MNR Waiting list as % of enrollment Financial performance Total revenues ($000s) N.A. 95,201 91,128 84,268 9,827 Total expenses ($000s) N.A. 92,551 88,701 80,944 MNR JULY 28,

9 UNO Charter School Network, Illinois Financial And Enterprise Statistics (cont.) --Fiscal year ended June 30-- Medians for 'BB+' rated charter schools EBIDA ($000s) N.A. 11,053 9,625 9,909 MNR EBIDA margin (%) N.A Excess revenues over expenses ($000s) N.A. 2,650 2,427 3,324 MNR Excess income margin (%) N.A Lease adjusted annual debt service coverage (x) Lease adjusted annual debt service burden (% total revenues) Lease adjusted annual debt service burden (% total expenses) N.A MNR N.A MNR N.A MNR MADS ($000s) N.A. 10,823 10,823 10,823 1,355 Lease adjusted MADS coverage (x) N.A Lease adjusted MADS burden (% total revenues) Lease adjusted MADS burden (% total expenses) N.A N.A MNR Pro forma MADS ($000s) N.A. 9,900 N.A. N.A. MNR Pro forma lease adjusted MADS coverage (x) N.A N.A. N.A. MNR Pro forma lease adjusted MADS burden (% total revenues) Pro forma lease adjusted MADS burden (% total expenses) N.A N.A. N.A. MNR N.A N.A. N.A. MNR Total revenue per student ($) N.A. 11,810 11,570 11,114 MNR Balance Sheet Metrics Days' cash on hand N.A Total long-term debt ($000s) N.A. 64,751 66,891 68,047 MNR Unrestricted reserves to debt (%) N.A Unrestricted net assets as % of expenses N.A Debt to capitalization (%) N.A Debt per student ($) N.A. 7,779 8,221 8,825 16,765 Pro forma Metrics Pro forma long-term debt ($000s) N.A. 69,251 66,891 68,047 MNR Pro forma debt to capitalization (%) N.A MNR Pro forma debt per student ($) N.A. 8,591 8,493 8,975 MNR N.A.--not available. N/A--not applicable. MNR--median not reported. MADS--maximum annual debt service. JULY 28,

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