F i r s t S o u t h w e s t W h i t e P a p e r 1 A White Paper December 2012 By: Drew Masterson Managing Director FirstSouthwest (800) 922-9850
F i r s t S o u t h w e s t W h i t e P a p e r 1 The goal of this paper is to help answer the question: What is the right amount of debt for our investment grade charter management organization (CMO)? In setting forth specific figures for various credit ratios, we are recommending guidelines based on our best estimates of current market and rating agency benchmarks. Most of these financial and operational ratios are our benchmarks/medians and are not derived directly from published third-party criteria. Market participants and rating agencies adjust their criteria continuously. Accordingly, our current opinion of investment grade key criteria is subject to change rapidly. Further, given the somewhat small universe of rated institutions, the rating agencies rarely publish specific numbers. Any interested party utilizing the data contained in this white paper is encouraged to contact their FirstSouthwest banker to verify that the information contained herein is still believed to be reflective of current market criteria. Also, these parties emphasize different metrics in their credit reviews. Additionally, particular strength in one category, such as exceptionally strong liquidity, can temporarily offset an occasional weakness in another ratio, such as debt burden. Further, a rating agency or a particular institutional analyst may materially over-weight a particular ratio or performance metric disproportionate to the credit assessment of the broader market for charter school debt. Investment Grade Rating Essentials: We have observed that CMOs with investment grade ratings typically have the following characteristics: Established and growing CMO that is at least five years old. The median age of investment grade charter schools per the Local Initiatives Support Corporation ( LISC ) Charter School Bond Issuance: A Complete History, Volume 2 is nine years. It is a credit positive to have been through at least one charter renewal. The median enrollment of charter schools rated by S&P as of July 2012 was 880, up 17% from 2011; Superior academic track record as demonstrated by objective measures; Substantial waitlist purged annually with detail by campus and grade level. According to the LISC study, the median waitlist for investment grade rated charters was 52% of enrollment. The LISC study showed the following medians at the time of issuance for each of the following rating level: o BBB+ 149% o BBB 77% o BBB- 41% High performing and stable senior leadership team and board of directors; Relatively stable state/local funding mechanism and oversight; Legal provisions that, at the very least, provide a senior pledge of net available revenues, a mortgage on relevant real estate and a debt service reserve fund equal to maximum
F i r s t S o u t h w e s t W h i t e P a p e r 2 Key Metrics: annual debt service ( MADS ). A formalized renewal and replacement fund is also a credit positive; Solid design/construction team with proven experience; and Only in-hand, multi-year grants and modest local fund raising are used in financial proforma cash flows. We believe that each of these metrics must generally be met individually in order to achieve the targeted investment grade rating of BBB+, BBB or BBB-. Historical debt service coverage ratio ( DSCR ) of MADS: Net income available for debt service, including new bonds and all other debt such as leases and subordinate lien obligations, from most recent audit divided by MADS. Unfortunately, LISC s study did not include data on this critical measure. Five years ago, S&P would accept budgeted numbers for a school year where students are already in the seats. Recently the rating agency appears to have tightened its standards, going back to using audited financials. Estimated guidelines for this ratio based on our experience with S&P are as follows: o BBB+ > 1.50X o BBB > 1.35X o BBB- > 1.0X Projected DSCR: Projected net income available for debt service in future years divided by that year s debt service. According to the LISC study, the median DSCR of 102 investment grade charter schools is 1.53X in the final year of projections. The most important thing about projections is that they become reality. A growing trend among the agencies and investors is to test whether projections from previous years were achieved. Very rough estimates of guidelines for this ratio based on our experience with S&P are as follows: o BBB+ > 2.0X o BBB > 1.5X o BBB- > 1.2X Historical Debt Burden of MADS: S&P focuses on the pro forma MADS burden on the previous year s audited expenses. o BBB+ < 10% o BBB < 15% o BBB- < 20% Projected Debt Burden: The LISC study indicates that the median debt burden in the last year of projections for all three investment grade rating categories is approximately 11%. Of course, the burden of debt service on operations is generally significantly higher in the
F i r s t S o u t h w e s t W h i t e P a p e r 3 early years upon and after a bond issue, as facilities that were financed with bond proceeds absorb new students. The 11% figure represents a reasonable guideline for where a system should be when near full occupancy. Unrestricted Days Cash on Hand: Unrestricted cash and investments divided by audited operating expenditures divided by 365 days. The LISC study includes below investment grade schools in its median for all rated schools, which is 70 days. Some schools consider all state funds temporarily restricted until they are expended. This class of temporarily restricted funds should be included. Other Important Metrics: Unrestricted Cash & Investments as a Percent of Debt: Unrestricted cash and investments divided by total outstanding debt. LISC calculated the fiscal year 2011 median for all rated schools to be 11.9%. Trend in Growth of Net Assets: One, three and five year compound annual growth rate of total assets minus total liabilities. A positive trend is important. Debt Service per Student: Actual debt service divided by enrollment. LISC calculated a fiscal year 2011 median for rated schools of $927 per student. Debt per Student: Total outstanding debt divided by enrollment. LISC calculated a fiscal year 2011 median for rated schools of $14,648. Loan to Value Ratio: Total outstanding debt divided by unrestricted cash and investments plus the appraised value of all real estate and personal property. This ratio is not considered by rating agencies nor is it even disclosed in public bond documents. It is very important, however, when dealing with most banks on loans or direct placements of bonds. We have seen banks accept ratios anywhere from 75% to 100%. Credit Spreads and Bond Capacity by Rating: Municipal bond rates are typically compared based on their spread to the MMD AAA Benchmark yield curve. This is a way of comparing bond rates on different days while presumably normalizing for moves in the overall municipal bond market. So, if our CMO sold a 30 year bond for 5.44% and the 30 year MMD AAA rate for 12/18/12 is 2.86%, then this bond is said to have sold at a 2.58% or 258 basis point spread to MMD. This MMD AAA rate is near a 30 year record low. Ratings are not the only factor in setting a CMO s spread to MMD. Regular borrowers of $20 million or more per year issue at tighter spreads than do first time or smaller borrowers. The selection of an underwriter with significant experience in charter school bonds can make as much as 100 basis points or more difference in rates.
F i r s t S o u t h w e s t W h i t e P a p e r 4 The chart following illustrates what one would expect; namely, that the higher the rating the lower the spread to MMD. This data comes from the LISC study for 2011 and 2012. Note that the table shows only the spread for the longest maturity of each issue. Spread to MMD by Rating, 2011 and 2012 # of Par MMD+ Term Rating Issues Millions $ Yield (bps) (Years) A+/Aa3 1 17.7 6.12% 142 29.3 A/A2 1 2.5 6.50% 170 31.9 BBB+/Baa1 1 26.5 6.00% 221 29.7 BBB/Baa2 8 179.7 6.44% 258 29.7 BBB-/Baa3 32 462.0 7.26% 333 29.5 BB+/Ba1 10 180.2 7.61% 350 30.3 BB/Ba2 3 46.6 7.29% 381 30.0 Rated 1 55 915.2 7.15% 319 29.8 Unrated 20 225.3 7.46% 408 25.6 All 75 1,140.5 7.23% 341 28.7 1 One offering had two series with different ratings due to partial guarantee by Colorado. So, what does this mean in dollars? Let us look at a $10 million issue of bonds for each of BBB+, BBB, BBB- and BB+ (below investment grade) issues. We assume all bonds are sold at the 30-year rate and that spreads remain at the above levels despite current near record lows in the MMD index. The 30-year MMD AAA index for 12/18/12 is 2.86%. Hence the BBB+ rate would be 5.07%, the BBB rate would be 5.44%, the BBB- rate would be 6.19% and the BB+ rate would be 6.36%. Annual debt service would be approximately $656k, $684k, $741k and $755k respectively. The savings from moving from BB+, below investment grade, to BBB-, investment grade, is surprising low at only $14k per year. The savings from moving from BBB- to BBB is an additional $57k per year. And, the savings from moving from BBB to BBB+ is an additional $28k. One might assume that a higher rating and lower interest rate is always better. But, with higher ratings come the expectations of higher coverage, lower debt burden and greater liquidity. Let us examine the additional bonds capacity from an incremental $1 million of net available revenue for debt service at each rating level. We will use just the historical DSCR of MADS as the limiting factor and will incorporate the different interest rates for each rating that were estimated above. This presumes that other key criteria are within the acceptable ranges. As presented above, this coverage factor is 1.50X, 1.35X and 1.00X for BBB+, BBB and BBB-, respectively. The resulting debt capacity is $10.2 million, $10.8 million and $13.5 million for BBB+, BBB and BBB-, respectively. So, even at higher interest rates, the lower coverage associated with a lower rating can provide increased capacity to fund the vital projects for a rapidly growing CMO. Another way of putting it is that a higher rating can constrict a CMO s capacity to
F i r s t S o u t h w e s t W h i t e P a p e r 5 fund growth. Each CMO must weigh the costs and benefits of different rating levels to make an informed decision about its plan of finance for growth. Sources: In addition to direct experience advising Charter CMOs through the rating and issuance process, external sources of information upon which we relied were Standard & Poor s publications: U.S. Charter Schools Continue To Grow But The Sector Outlook Remains Mixed (June 18, 2012); Public Finance Criteria: Charter Schools (June 14, 2007); and LISC s Charter School Bond Issuance: A Complete History, Volume 2 (October 2012), at: http://www.lisc.org/section/ourwork/national/education/publications/bondhistoryv2. This White Paper ( Paper ) is based upon information supplied to us and reflects prevailing market conditions and our views as of the date of this Paper, all of which are subject to change without notice. We have no obligation to update this Paper or any assumptions or estimates made herein. We utilized information obtained from outside sources and while we believe such information is reliable, we have not performed an analysis or independent verification of such information. Certain assumptions have been made in preparing this Paper and changes in facts or market conditions may be material and may change the recommendations provided. The guidelines expressed in this Paper are based on existing facts, information and market conditions and are an expression of judgment only and not a guarantee of results or market access. FirstSouthwest does not represent that this Paper or any information derived from this Paper is accurate or complete and accepts no liability in relation thereto. The information, analyses and estimates set out herein are for general information purposes only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal, tax, or accounting advice. You should consult your own attorney, accountant, financial or tax advisor or other consultant with regard to your specific situation. FirstSouthwest is a diversified investment bank focused on one mission: to provide superior financial advisory and related services to public entities nationwide. To learn more about how FirstSouthwest can assist you, please call or visit us online: 713.654.8654 800.922.9850 www.firstsw.com