Chart 1

Our Sector View Is Stable, As The Rated Universe Expands

In 2022, upgrades outpaced downgrades 2:1, given stable-to-increasing enrollment for charter schools, significant cushion provided by federal stimulus money, and higher per-pupil revenue in most states. Our rated universe has also continued to expand; S&P Global Ratings has assigned more than 50 new charter school ratings during the past two years, as the sector continues to mature with greater financing opportunities. Financial tailwinds from unprecedented federal emergency relief funds, much of which remain available for use through fiscal 2024, provide operating flexibility for most schools heading into 2023. At the same time, inflationary pressures tied to salaries, utilities, and supplies, coupled with labor shortages, will continue to be an economic challenge for most schools. Revenue growth, despite recent increases, is likely not enough to fully offset expense growth. However, in our view, operations will likely only be stressed sectorwide should state budgets meaningfully cut per-pupil funding levels--which is something we don't anticipate given states' record strong reserves entering 2023. (See "Outlook For U.S. States: Rainy Day Funds Will Support Credit In A Shallow Recession," published Jan. 5, 2023, on RatingsDirect.)

Despite these encouraging trends, the charter school sector continues to face inherent risks, in that charter schools require a charter contract to operate, and nonrenewal or revocation can swiftly affect credit quality. We continue to closely monitor all rated schools' charter contracts; none of our rated schools faced nonrenewal or revocation in 2022, despite state testing requirements being paused. As testing has resumed, authorizers and schools continue to navigate how best to evaluate academic outcomes and benchmarks, and most of our rated schools report a collaborative approach following the unprecedented learning loss caused by the pandemic.

Outlooks and rating actions point to stability in credit quality.  We enter 2023 with 22 schools (about 7% of ratings) on positive outlooks and an almost equal number (20, about 6%) on negative outlooks. Over the past year, while we've seen general stability in distribution of stable outlooks (87% as of Dec. 31, 2022, the same as a year ago) across the rated charter school sector we've also seen more rating upgrades (12) and fewer downgrades (6) given the aforementioned solid demand and growth in financial flexibility across the sector. We expect this trend will continue through 2023.

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Expectations for 2023

Based on our conversations with management teams, we expect fiscal 2023 performance will be similar to, or see some compression from, fiscal 2022 operating margins, given increasing costs of investments in salaries and academic support. Revenues remain strong and one-time emergency federal funds, which buoyed fiscal 2022 results and liquidity, are still available to be spent through fiscal 2024, offsetting some of the rising costs. While we see greater economic challenges in 2023, we expect steady creditworthiness for those schools with uninterrupted demand, good operations, and healthy cash flow, which in our opinion have cushion at their current ratings to withstand a moderate degree of pressure and mitigate credit risks.

Sector Top Trends In 2023

Demand is healthy.  Demand has increased across the sector, with enrollment up by 7.0% between fall 2019 and fall 2021, while traditional public school enrollment dropped by 3.5% over the same period, indicating charter schools have maintained enrollment gains while enrollment losses at traditional public schools continued. As families shifted to charter schools, private schools, and home school options during the pandemic, many wondered if this trend would sustain as in-person learning returned. The National Alliance for Charter Schools reports that the enrollment "adjustment," observed with charter sector gains and district public school enrollment losses, appears to be a "new normal," instead of a temporary reaction to turbulent times. The majority of our rated charter schools have seen enrollment stability or growth during the past year, supporting this view. We expect enrollment momentum to continue, even though increased competition from home schooling, online, traditional options—or private schools, given growing school choice voucher programs--remains a risk.

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Ample emergency federal support is still providing financial flexibility.  K-12 schools received significant emergency stimulus funds, which can be used for a wide range of purposes--from purchasing masks and shields, to building renovations and ventilation upgrades, to hiring teachers, tutors, and counselors. While schools have encountered some challenges with supply chain backlogs and staffing needs, limiting their ability to spend, this money has generally offset rising costs. The amount of emergency funding, coupled with the flexibility in timing and usage of the third and most recent round of federal funds, has bolstered our rated schools' unrestricted liquidity and operating margins, which we expect will continue into 2024, given the funds' September 2024 usage deadline.

Across our rated universe, the median unrestricted days' cash on hand has grown 40% in five years to 141 days in 2021 from 101 days in 2016, spurred not only by federal funding but also stronger operations from growing enrollment and favorable state funding. For schools with sound reserves, we expect capital spending will not be materially tempered, but most management teams are indicating that our rated schools remain focused on preserving reserves to maintain liquidity and flexibility in the current environment. Over the next year, liquidity strength will continue to play a key role in credit stability. And beyond our outlook period, and once the extraordinary federal money runs out, it will be critical for schools to plan accordingly to avoid any sharp drops in services and staffing.

State stability supports funding stability, for now.  While federal sources have provided meaningful flexibility, state funding growth remains critical for charter schools given their high reliance on these revenues. Per-pupil funding levels differ by state; however, in most states where we maintain ratings, per-pupil funding growth remains healthy, despite lagging inflation, as indicated in table 1.

Table 1

While per-pupil funding has been growing, history shows that, should state budgets be squeezed, reductions to K-12 funding could follow. But state rainy day funds have reached an all-time high and many states continue to outpace fiscal 2023 revenue forecasts, with no meaningful drawdowns currently planned, mitigating the potential for near-term per-pupil funding cuts. The map (chart 4) shows the strength of reserves across the country, after applying a modest stress scenario. In pulling this together, S&P Global Ratings subtracted the theorized revenue declines associated with a potential shallow recession from the forecast reserves in fiscal 2023. Even with this, every state would still have a positive reserve balance. It has not been uncommon that some states would have nothing in reserves heading into a recession, so to be able to show that all could have a remaining balance after this forecast shallow recession speaks to the preparedness of states heading into 2023 and bodes well for K-12 funding constancy (see "Outlook For U.S. States: Rainy Day Funds Will Support Credit In A Shallow Recession," Jan. 5, 2023).

Chart 4

What would be the impact of a potential recession?  Our chief U.S. economist has indicated that the economy is likely to fall into a shallow recession in 2023, tempered by moderate initial jobless claims and unemployment rates (see "Economic Outlook Sees The U.S. Tipping Toward Recession," Nov. 28, 2022). Rising consumer prices and interest rates are whittling consumers' discretionary income, which could affect parents' school choices and, in fact, could increase demand for public schools. At the same time, operating costs are rising, including for supplies and labor (in particular, wages), all of which could challenge schools' budgets if they continue to grow. However, we believe that strengthened liquidity positions and expected stable-to-growing enrollments will allow the charter school sector to remain stable in the face of continuing economic uncertainties.

The midterm elections: Some wins, some losses.  School choice remains an important political issue nationwide. At the federal level, a divided government is likely to provide a significant bulwark to any potential challenges to federal support for charter schools through the Federal Charter School Program. However, charter school regulations are predominantly dictated by state legislators. At the state level, election outcomes in Michigan and Massachusetts could signal some stress for charter schools, in our opinion. In Michigan, a state which saw sectorwide enrollment growth through the pandemic, new Democratic majorities in both the state house and senate have caused charter school advocates to raise concerns about potential funding reductions or regulations related to limiting charter school growth. In Massachusetts, the new governor previously filed a legal brief defending a state cap on charter schools, and replaces a pro-charter school governor. At the same time, the popularity of school choice voucher programs continues to increase across the country, with Iowa the most recent state to pass a bill (HF 68) that will provide state funds to students attending private schools. In our opinion, over time, these statewide voucher programs could affect public school demand in certain areas depending on how these programs are operationalized.

While there were some election outcomes that may not be favorable to charter schools, the operating environment in some states could improve, including in Pennsylvania, Florida, Nevada, and Texas--states which are each home to 10 or more charter schools that we rate. In Pennsylvania and Nevada, governors that signaled opposition to charter schools have been replaced by new governors who supported school choice during their campaigns. In Florida, a state considered one of the most charter-friendly in the nation, school choice has been a focus of the administration and likely will remain so, aided by newly formed supportive supermajorities in the state house and senate.

Labor shortages and relations present challenges for the sector.  The national teacher shortage has been especially profound for K-12 schools, as teacher burnout and attrition throughout the pandemic remains a trending topic. While charter schools are in no way immune to these challenges and typically have less flexibility than traditional public schools do in regard to teacher compensation, most of our rated schools report relatively high teacher satisfaction and retention. However, acute labor shortages across the country present operational challenges, and we expect 2023 will see an increasing focus on teacher wages, benefits, and working conditions, especially in regions where teacher shortages are creating pressures. Only about 11% of charter schools nationwide are unionized, but unionization efforts in charter schools have increased during the past few years, and we expect this activity will likely continue given the successes achieved by charter school teachers thus far. At the same time, there are initiatives in some areas to raise teacher salaries, which can offset a need for unionization. For example, in Utah, the governor is proposing a $6,000 raise for all teachers in the state on top of a 5% cost-of-living adjustment; this is expected to be voted on as part of the state budget by March.

Academic testing has resumed amid varying rates of learning loss.   K-12 students have experienced many challenges over the past few years, creating significant learning gaps, although charter schools overall have reported better results from more in-person instruction compared with their traditional school counterparts. A recent NWEA study pointed to significant investments of federal emergency funding for summer learning and after-school programs that have helped academic recovery; however, it also stated that full academic rebound is likely five or more years away. Students are showing strong signs of academic rebound, but not all student groups are pacing at the same rates. Many of our rated schools have used federal money to invest in intervention programs to mitigate learning loss and to enhance efforts around emotional and social health. If needs persist, they could be a funding challenge as federal money phases out. While charter nonrenewal or revocation risk was muted, in our view, when testing requirements were paused--and to date we have not seen any charter renewal challenges as a result of testing scores--this will be something to watch.

Management response is key to disruptions caused by event risk.  Beyond charter nonrenewal or revocation, a growing number of additional event risks continue to emerge across the sector. As discussed earlier, we expect 2023 will see an increasing focus on teacher wages and working environments, especially in regions where teacher shortages are creating pressures. In addition, cyber breaches, significant management turnover, governance scandals, or weather events can also constrain schools' operating flexibility. While some organizations have broad tools to address environmental, social, and governance risks, charter schools do not always have the financial resources or expertise to implement comprehensive risk management strategies to insulate operations from these evolving risks. We expect the focus on management's planning around these risks to continue to heighten in 2023.

Changing demographics intensify competition.  While demand for charter schools continues to grow, changing demographics continue to ratchet up competition for students between traditional public schools and charter schools in certain states, such as Pennsylvania and Michigan. City competition has also increased in places such as New York City and Washington, D.C., given more-transient populations. Enrollment in public elementary and secondary schools is projected to increase very modestly during the next few years, but the disparity in growth rates between states, and cities, is striking. Also, in cases where charter schools are authorized by the school district, and as competition for students intensifies, the relationship between the charter school and the authorizer can be restrictive, given the inherent conflict of competing for the same students and the related per-pupil revenue.

How Will Credit Quality Be Affected?

What could change the sector view?  Most charter schools enter 2023 with good financial flexibility and liquidity levels; 87% of our rated universe maintains a stable outlook. Unless we see unanticipated and significant state budget pressure and cuts to K-12 funding, we expect the credit position for charter schools to remain stable.

Which credits could experience operating stress?  Our rated universe increasingly reflects more established charter schools, which generally have completed several successful charter renewals, maintain steady academics, and experience less credit volatility than newer schools. However, while we anticipate general stability across the sector, there could be credit stress among lower-rated issuers, especially among schools that enter 2023 weaker from an enrollment, academic, or financial standpoint. For some of these schools, operating pressures could mount as inflationary and staffing pressures heat up throughout the year, which could cause liquidity and bond covenant challenges, particularly if breached covenants lead to collateral postings or acceleration of debt.

Will there be a rise in technical defaults?  While material emergency funding has been a credit positive, federal funding recognition and reimbursement delays could, in some cases, create challenges for schools relating to budgeting or timing of receipts. We are actively monitoring this. Some schools expected receipt of certain funds that have been delayed or recognized differently in fiscal 2022 audits, which could lead to technical covenant violations constituting events of default. To date, only two of our rated schools have reported a breach in debt service coverage covenant resulting in a technical event of default. Both schools are single-site operators with fewer than 600 students enrolled in fall 2022, which experienced significant transitions in senior leadership prior to the violations and have since implemented corrective action plans to avoid covenant breaches. While we could see more covenant breaches, particularly for smaller schools and those experiencing leadership transitions, we believe networks and other large operators are better positioned due to greater oversight from management teams and other benefits that come from scale.

Charter Schools Rating Performance

As of Dec. 31, 2022, S&P Global Ratings had 336 public ratings on charter schools in 26 states plus the District of Columbia. Certain states such as California and Texas have large charter school networks with multiple schools supporting a single rating; therefore, our rated universe covers approximately 1,400 schools. Charts 5-8 reflect the number of obligated groups issuing rated debt, and not the number of schools or networks. In 2022, we assigned 27 new public ratings, compared with 28 in 2021.

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While the majority of rated schools, which continue to mature, are stable, the charter school sector remains susceptible to some unexpected credit profile changes, which could relate to failure to meet authorizer standards, or academic or enrollment shortfalls. During 2022, we did not see any payment defaults (failure to make payment of principal and interest as scheduled, per S&P Global Ratings' definition) within our rated universe. Our rating on Plymouth Educational Center Charter School, Mich. remains at 'D', as the school is operating under a forbearance agreement through June 2024. We enter 2023 with 13 ratings at 'B+' or lower, indicating extreme vulnerability to nonpayment.

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