2023 Credit and Capital Markets Outlook for Higher Education

Earlier this month, our colleagues in Kaufman Hall's Treasury & Capital Markets practice published this Credit and Capital Markets Outlook for 2023. Their analysis was focused on healthcare, but many of their insights-based on their deep experience with capital markets and credit management-also are relevant to higher education. In this month's blog, we look at the credit and capital markets outlook for higher education, drawing on our colleagues' analysis and on the insights of the 2023 outlooks published in December and January by Fitch Ratings, Moody's Investors Service, and S&P Global Ratings. The higher education sector leads for the three rating agencies also will be joining us for a webinar on January 31; you can register here.

Stabilization's rocky road

Since the pandemic began in 2020, we have been tracking what we believe will be a three-phase path to full recovery. The first phase was crisis, which was largely a monetary event marked by stimulus funding and a loosening of the already accommodative monetary policy that the Federal Reserve has pursued since the Great Recession. The second phase is stabilization, which began in 2022 and will likely extend for several years, almost certainly through 2023.The stabilization phase is largely a credit event, a time of coming to terms with the financial and credit implications of the crisis phase. The third phase will be normalization, reached after inflationary pressures subside, interest rates stabilize, and market volatility eases.

As 2022 demonstrated, we are traveling a rocky road through the stabilization phase. A sense of increasing headwinds is clear in the rating agency outlooks for the higher education sector: Moody's has changed its sector outlook from stable to negative, Fitch describes the higher ed outlook as "deteriorating," and S&P, while maintaining a stable rating for the sector overall, notes that the sector is becoming increasingly bifurcated between highly selective, wealthier institutions and more regional institutions with weaker student demand.

The main headwinds we anticipate for higher education in 2023 include the following:

• An end to stimulus funding. Pandemic-related federal stimulus funds helped cover budget gaps at less financially stable institutions. With those funds now essentially depleted, these budget issues will come back to the fore.
• Uncertain government support. While state budgets did fairly well through the first years of the pandemic, the prospect of an economic slowdown or recession as the Fed cools markets and the economy means that state income and capital gains tax bases may constrict. This is a particular concern for state-funded public institutions. Moody's notes that many of the federal agencies that are significant funders of higher-ed research received significant appropriation increases in recent years, some of which should pass through to provide stable or increased research funding. At the same time, a now-divided Congress raises the prospect of limited near-term increases and potential budget cuts, although Republicans have voted to keep earmarks alive in the 118th Congress.
• Soft enrollment trends. Enrollment trends improved some last year, but remain below pre-pandemic levels; overall, public institutions have been more affected than private. International enrollment showed signs of recovery as well but as Fitch observes in its outlook, it remains 15% below its recent peak in 2015 - 2016. Geopolitical tensions and a strong dollar could undermine this nascent recovery.
• Higher operating expenses. Generally speaking, the Federal Reserve's efforts to rein in wage inflation with its blunt instrument of interest rate hikes seem to be having mixed results, due in part to persistent issues with labor participation. Higher education is most exposed to these pressures in areas where it competes for workers with other industries-environmental services, for example, or food services. Moody's also predicts increased faculty hiring and staff hiring as pandemic-driven hiring and salary freezes end, along with higher starting salaries and salary increases for current employees.
• Limited opportunities for tuition increases. All three rating agencies see limited opportunities for tuition increases. Fitch believes that inflation may provide some rationale for increases, but doubts that the increases will be sufficient to offset rising costs. S&P cites median fiscal 2021 tuition increases of 2.8% for rated private institutions and 1.7% for rated publics, compared to a 6.5% annual inflation rate for the U.S. Moody's notes that total tuition discount rates continue an upward trend, reaching 43% for private institutions and 38% for publics in fiscal 2023.
• Uncertain investment returns. A potential recession, continued tightening of the Federal Reserve's monetary policy, and inflation concerns may result in sideways or downward pressure on investment returns in 2023. This will likely result in reduced revenue gains from investment income and potentially dampen fundraising efforts.
• A higher interest rate environment. Markets anticipate that the Federal Reserve will continue to raise interest rates early in 2023 in its ongoing efforts to reduce inflation. While rates have risen materially from a year ago, it is also worth noting that they are not abnormal by historical standards.
• Persistent credit challenges. For institutions with lower- to mid-range credit ratings, these challenges will range across a spectrum of outcomes, from credit downgrades to bond covenant challenges to-at worst-closures. Financial challenges may push some institutions to find a more stable partner, contributing to a renewed focus on consolidation in higher education.
• A spillover impact from healthcare. Moody's notes that while only 16% of its rated higher ed institutions have academic medical centers, patient care generates 28% of revenue for the higher ed sector overall. Healthcare had a very difficult year in 2022, with median operating margins remaining in negative territory for most of the year. Moody's believes that patient care revenues will still be a positive factor for institutions with academic medical centers in 2023, but S&P cautions that these higher ed institutions associated with academic medical centers may be particularly susceptible to the higher wages and growing expenses with which academic medical centers have been grappling as they combat healthcare staffing shortages.

Balance sheets will continue to play a critical role in bridging institutions from the stabilization phase to the third phase of normalization, when operations return to some level of stability or institutions have learned to adapt to their operations running with higher expenses and lower revenues. How this is accomplished, however, will require a thoughtful and proactive response that balances protection of the institution against pursuit of potentially risky strategic initiatives and returns.

How colleges and universities should respond

We often describe not-for-profit healthcare systems as a combination of three companies: an operating company, finance company, and investment company that work together to, first, pursue the organization's mission; second, build organizational resiliency; and third, pursue returns. That same construct fully applies to higher education, although differences in organization structure and mission are well noted. Today, for many colleges and universities, all three companies are under pressure (Fig. 1).

Figure 1: Sustained Headwinds in 2023 Challenge Every Component of the Higher Ed Business Model

We believe that higher education leaders at financially challenged institutions will face some difficult decisions in the year ahead:

• One option will be to seek to grow revenue beyond traditional student populations, adding graduate and certification programs in areas of high demand (e.g., health sciences, technology) for older students or corporate employees, for example, or enhancing online programs. It will likely take several years to determine the success of these start-up efforts, which require resource input, so institutions must ensure they have adequate resources to fund program expansions until they begin to generate positive returns.
• Another option will be to delay significant capital expenditures. This should be viewed as a short-term solution, as deferred spending on programs and facilities will eventually erode the institution's competitive standing.
• A third option will be to monetize non-core assets, such as under-utilized facilities or real estate, to improve liquidity. These are "one time" opportunities but may help create a bridge as institutions seek to stabilize financial performance.
• A fourth option will be to tap into the institution's financial reserves to stay on course with strategic and capital spending needs, realizing that this will make the balance sheet less resilient and possibly shorten the time the organization has available to reach the normalization phase.
• A final option will be to seek a partner for a merger or acquisition. This should not be viewed as an option that is pursued when all else fails; indeed, institutions have a much greater opportunity to preserve their legacies and missions if they pursue a partnership when they are in a position of some strength, whether that be in program offerings, financial reserves, or other resources.

There is no single correct answer for all colleges and universities. There is, however, a common need to identify the path that leadership feels will best position the institution for long-term resiliency and growth. Our colleagues recently described the 2020s as "the era of great resource allocation." Thriving in this era will require excellent decision-making in both generating resources wherever possible in the institution and appropriately positioning those resources on the resiliency-to-return continuum.

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