What's Behind Our Sector View?

Our sector view remains stable, supported by healthy sector demand and continued operating stability

A majority of rated independent schools continue to experience enrollment growth, coupled with improving selectivity and matriculation rates, demonstrating healthy sector demand. While these demand trends have fueled solid operating performance, S&P Global Ratings notes that slowing economic growth could lead to challenges for independent schools in 2024, with potential for more modest investment returns or impacts on fundraising efforts. We expect independent schools will see moderated fiscal 2024 operating performance, given elevated costs related to salaries and benefits, despite easing inflation rates. However, given continued high demand in the sector, we believe many of these schools retain tuition-rate flexibility, which could offset increased operating costs. While the independent school sector is somewhat self-selecting, it does remain bifurcated, as longstanding schools with stronger demand and legacy endowments maintain greater financial flexibility in the face of rising operational headwinds, while smaller or less-selective schools with weaker endowment levels and financial resources could face greater credit risk. Although there is potential for slowing economic growth in 2024, we believe those schools with steady demand and elevated financial resources have cushion at the current ratings to withstand a moderate degree of financial pressure and mitigate credit risks.

Outlooks and rating actions indicate continued credit stability

As of the end of January 2024, 43 of the schools that we rate had a stable outlook and one school had a positive outlook. In addition, we added four new public ratings in the past year, at varying rating levels. Throughout the year we raised one rating to 'A-' from 'BBB+', and placed another rating on positive outlook, with stable ratings across the remainder of the sector. We expect this trend of stability will continue in 2024.

Sector Top Trends

Enrollment and demand hold steady, while long-term factors could shift the landscape

Demand continues to grow across the sector.  Demand remains healthy, in our view, with approximately 56% of our rated independent schools experiencing enrollment growth in fall 2023 and 14% of all schools increased enrollment by more than 3%. In our view, the increasingly diverse, high quality, and flexible programmatic offerings have bolstered these trends within the sector. The sector has been relatively inelastic to price changes historically, despite higher-than-typical tuition increases for a handful of schools to combat rising operational costs. We will continue to track any potential effects of slowing economic growth and rising tuition rates on demand over the next year. In our view, independent schools with less demand flexibility are likely to continue to face greater enrollment pressures relative to those of larger and more selective schools.

Chart 1

Changing landscape could affect international student enrollment.  International student enrollment levels have stabilized relative to early pandemic-related declines. However, heightened global conflicts, continued visa challenges, and global economic volatility could adversely affect independent schools that have historically enrolled a greater percentage of international students. Subsequently, net tuition revenues would likely weaken for schools that experience larger declines, as international student tuition is often not discounted. In response to some of these challenges, a few schools have considered reducing their recruitment of international students. However, the bulk of schools with international student populations remain invested and are aiming to diversify their international student base. Marketing to and recruiting students from a broader selection of countries could provide greater geographical diversity and help mitigate some of the aforementioned risks. We will continue to monitor the effects, if any, of the global uncertainties on the international student mix across the sector.

Demographic trends could lead to demand pressures in certain markets.  Given the trend of declining U.S. birth rates in recent years, we believe attracting students will become increasingly challenging, particularly in markets that are experiencing a disproportionate decline in the school-age population. We note that much of the Northeast region, where 61% of our rated schools are located, is projected to experience a decline in the minor population over the next five years. We will monitor how independent school demand is affected in this region, particularly in areas with increased competition from high-quality private and public school options. Ultimately, we believe independent schools in these environments will need to increase marketing efforts or reconsider their value proposition to maintain market share. On the other hand, certain states have benefited from expanding populations and economic growth, which will support demand trends in the near term.

Expanding voucher programs across the country are shifting the competitive landscape.  The popularity of school choice voucher programs continues to rise across the country, with more states passing bills in 2023 that provide state funds to students being homeschooled or attending independent schools. As a result, there could be a slight shift in students from public schools to independent schools over time. However, we do not expect to see a significant uptick in demand stemming from voucher programs, given current vouchers do not cover most independent school tuition costs. Alternatively, the impact on independent schools with a regional draw and lower costs of tuition could be mixed depending on the competitive landscape and the school's market position, since parochial schools and independent schools that accept vouchers could draw students away from these schools. While the impact is unclear, we will continue assessing how independent school demand trends evolve in response to the expansion of voucher programs nationwide.

Evolving financial aid offerings are affecting enrollment decisions.  As independent schools continue to become more focused on serving a socioeconomically diverse student body, we believe leadership teams should remain cognizant of the increased institutional financial aid and fundraising support required to achieve this goal. In light of this, many schools are shifting their approach to have a greater focus on providing increased financial aid distributions to economically disadvantaged students, including dedicated campaign funds for financial aid. Furthermore, given the progressively more competitive kindergarten-through-12th-grade market, we believe the presence of lower-cost and high-quality alternatives will require independent schools to continue to provide value and potentially reconsider their approach to financial aid distribution to maintain market share. If independent schools face difficulties delivering on this value proposition, they might need to shift their program or mission to sustain demand.

Rising costs create greater operational headwinds in 2024

Increasing operating expenses are fueling higher tuition rates.  Given the historically inelastic nature of the independent school market and the solid market positions for schools in our rated universe, many schools are increasing tuition at rates higher than pre-pandemic levels in the face of increasing operating expenditures related to salaries, benefits, and utilities. For the 2023-2024 school year, the average tuition increase was 5.2% across our rated schools, which is slightly higher than historical levels. These schools have not experienced demand impacts to this point, but there could be a potential inflection point if tuition rate increases are maintained at higher levels. Presently, we anticipate an annual increase of around 5% on average over the next year, based on conversations with our issuers.

Chart 2

Slow-growth economy could affect fundraising, market returns, and affordability for independent schools.  S&P Global Economics predicts economic growth will slow in 2024 (see "U.S. Economic Forecast Update: A Sturdy Job Market Keeps Growth Going," published Feb. 21, 2024, on RatingsDirect), which we believe could pose a challenge for the independent school sector as household budgets tighten, with potential effects on enrollment, demand, and fundraising. During the protracted 2007-2011 economic recession, we observed enrollment attrition across schools in the sector. And while independent school enrollment held steady during the most recent recession, which occurred briefly in 2020, many issuers noted this was partially due to families moving from urban areas during the pandemic. While most schools have experienced continued growth in annual fundraising in recent years, there is some risk that the slower-growth economy could weaken the willingness and ability to contribute to fundraising efforts alongside tuition increases. Also, market fluctuations could translate to heightened credit risk through operational pressures from decreased endowment draws or overall weakened financial resources over time.

Managing expenditure growth and long-term financial planning are key factors for schools.  While inflationary pressures have subsided from peak levels, costs of salaries, supplies, and even contracted services continue to rise. We believe this is partially mitigated by tuition increases and active cost-control measures by leadership teams. Some of our rated independent schools have begun to also consider expanded opportunities for revenue growth through increasing auxiliary programs, summer offerings, or other alternative revenue sources. Schools with less operating flexibility and historically lighter financial resources are likely to face greater operational pressures in 2024. We believe long-term financial planning, including potentially tightening expenditure assumptions and increasing reliance on revenue growth outside of annual tuition rate increases, will continue to play a significant role for independent schools.

Financial flexibility continues to support capital planning and mitigation of event risks, but management is key

Schools report positive endowment market performance.  Overall, schools across the rating spectrum reported growth in endowment market values for fiscal year 2023. Regarding the longer trend, endowment values have grown over time, withstanding short-term fluctuations in the market. We believe generally conservative investment practices within the sector have supported durability in moments of downturn. Because endowment income can materially add to operating revenues, increasing performance has been a point of focus for many schools who seek to support financial aid growth or to offset rising expenses. As a result, we see an increasing shift in the investment asset allocation toward private equity and other alternative investments. In our rated universe, we believe that leadership teams are highly skilled, with board-adopted policies that effectively set parameters for the management of investments. We expect effective risk management will support stability over the next year.

Chart 3

Capital planning continues with public debt market.  Fundraising resilience since the onset of the pandemic has aided the execution of capital planning despite pressures from market conditions. Likewise, in 2023, many schools continued spending for capital projects despite the increased cost of labor and capital. Historically, independent schools have benefitted from funding flexibility, and bank debt remains a popular form of financing for independent schools.

However, we started to see a shift in 2023 as economic conditions weakened and banks tightened lending standards, leading to higher debt costs. In response to the ongoing volatility in the regional banking sector, we have seen an uptick in public debt issuance for schools with weaker credit profiles, smaller endowments and balance sheets, and shorter operating histories, relative to our historically rated universe. For example, in 2022 and 2023 we added three schools between the 'BBB' and 'BB' rating categories. We believe this trend could persist if the uncertainty in the regional banking sector continues, bank options remain limited, and the relative value between interest rates on public and private debt is marginal.

Event risks remain at the forefront for management.  In our opinion, schools need strong controls around management and governance now more than ever as they navigate many forms of risk and their effects on the school community. Events related to Diversity Equity and Inclusion, cyber, litigation, and school safety (among others) have continued increasing, requiring greater financial investment from schools. We believe this has the potential to pressure lower-rated schools with limited funds or those without proper planning around risk mitigation and prevention strategies.

Independent School Rating Performance And Sectorwide Medians

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Fiscal 2023 medians

Medians By Rating Category

The small sample size of the independent school portfolio results in some variable trends at each rating level. However, in general, medians tend to strengthen in line with higher-rating categories (see table 1).

As historically seen, medians generally trend according to the rating category, except for enrollment, which varies across the portfolio. At the 'AAA' rating level, median enrollment is smaller compared with that of some lower-rating categories, although the smaller student base is offset by other very healthy demand metrics, such as new student selectivity and matriculation rates. Schools in the 'AAA' rating level also have very sizable endowments, robust fundraising support, and less dependence on tuition-generated revenues, with a greater proportion of revenues supported by investment and endowment income. Tuition discount rates are usually higher for 'AAA' rated schools because these schools have larger financial resources to support higher discounting needs. Furthermore, given the strength of demand metrics at higher-rating levels, these schools have greater flexibility in increasing net tuition rates. Conversely, at the 'BBB' and 'BB' categories, issuers have a much higher dependence on tuition-generated revenue, with less support from endowment and fundraising income, reflecting the increased reliance these schools have on enrollment and demand. In addition, the 'BBB' and 'BB' rated schools can often have a reduced ability to raise tuition discount rates compared with that of higher-rated schools due to increased tuition dependence and higher competition.

Other key financial ratios, particularly endowment market values and financial resource ratios, track according to rating category. During fiscal 2023, endowment market values trended positively after rebounding from market volatility in the previous fiscal year, with the higher-rated issuers having the largest endowment values and lower-rated issuers having much smaller endowments, relatively. Medians for the financial resource metrics are much stronger at the 'AAA' level, with cash and investments at 9.9x of operational expenses and at 10.8x of debt. Conversely, medians for 'BBB' schools show cash and investment levels of 1.3x to operations and 1.7x to debt. Medians across the portfolio indicate manageable debt burdens, in our view, with a range of 4.1% to 5.7% (excluding the speculative-grade rating category). Although higher-rated schools typically have more debt outstanding, their operating budgets also tend to be larger, which reflects in maximum annual debt service (MADS) burdens that are manageable.

Table 1

Sectorwide Medians

Propelled by a surge in market performance for fiscal 2023, endowment and financial resource ratios rebounded, partially due to weaker market performance in fiscal 2022, improving to levels closer to fiscal 2021 high points (see table 2). However, despite improved market returns, our sectorwide universe indicates an overall decrease in investment income, but this is primarily due to the addition of newly rated schools with relatively lower endowment levels when compared with previous years. We note many higher-rated schools benefited from increased endowment draws for operations due to stronger investment gains, providing some operational relief from expense pressures in fiscal 2023, as demonstrated by the decreased concentration of net tuition revenues for higher-rated schools. The addition of newly rated schools with somewhat lighter liquidity positions also has led to a decrease in sectorwide cash and investments relative to operations, but most schools did experience improved nominal cash and investment balances in fiscal 2023.

Tuition discounting and financial aid offerings have decreased in fiscal 2023, indicating a shift by some schools in their approach to financial aid offerings in this current inflationary environment. Annual tuition rate increases, decreases in financial aid offerings, and lower tuition discounting have led to an overall increase in net tuition revenue per student. And finally, despite continued rising operating expenses, our rated schools experienced improved net operating margins in fiscal 2023. We note that our fiscal 2023 net operating income margins include adjustments related to net assets released from restriction for capital purposes, as outlined in our updated "Global Not-For-Profit Education Providers" criteria, published April 24, 2023. Compared with fiscal 2023, median operating margins in previous years were somewhat inflated, as net assets released from restriction for capital purposes would have been included in total adjusted operating revenues.

Table 2

Medians Over Time By Category

Table 3 compares medians over the past three years by rating category, reflecting relatively stable demand and financial metrics overall. We note that median headcount levels have demonstrated stability across all rating categories, with the exception of the 'A' category, which was primarily due to new ratings with relatively smaller enrollment levels. Other demand metrics, including selectivity and matriculation rates, have remained relatively stable across rating categories, at levels above pre-pandemic trends. Given the rebound in market performance in fiscal 2023, higher-rated schools, with larger endowment levels, have a decreased dependence on tuition revenues, benefitting from greater revenue diversity overall. However, we note this has been less apparent for lower-rated medians, given the relatively smaller endowment values. Cash and investment to operations has followed suit with improved endowment market values, rebounding from the dip in the previous year relative to the historically high investment returns in fiscal 2021. Finally, debt levels and metrics across the sector have remained relatively stable.

Table 3

Table 4

Table 5