As most colleges and universities report their fall 2023 enrollment and fiscal 2023 financial data, S&P Global Ratings has observed institutions with weaker financial positions--often smaller, private colleges and universities--being disproportionately challenged by various operating pressures, specifically increased financial covenant violations.

Chart 1

Flagging Finances: Depleted Pandemic-Related Federal Funding Amid Rising Operating Expenses Leaves Some With A Revenue Gap

At the start of the pandemic, universities across the country went into crisis-control mode, and we saw hiring freezes, personnel reductions, and cuts to discretionary expenses. While there were widespread revenue reductions, universities' operations were supported by the federal government through Higher Education Emergency Relief Funds (HEERF). By fiscal 2023, most universities had already spent their HEERF dollars, but their expenses were rising due to increased salaries, a rebound in discretionary spending, and high inflation. Combined, these factors contributed to some institutions reporting significant operating deficits and weakened financial resources at fiscal year-end that ultimately triggered financial covenant violations.

Bond documents often contain financial and non-financial covenants that stipulate the terms of the agreement. Covenant calculations are typically measured either annually or semiannually. Around one-third of our rated colleges and universities carry a financial covenant. They're less common among higher-rated entities, while those with financial covenants are usually rated 'BBB+' or lower. While the nature and definition of financial covenants vary across the industry, the most common are related to debt service coverage (DSC) and liquidity ratios. Covenant violations are typically classified as an event of technical default, at which point the obligor may have a cure period (such as 30-60 days) during which it can engage a consultant to develop a financial plan to achieve covenant compliance. Each situation is unique due to each school's underlying credit characteristics, management's actions, and the bond document's specific legal definitions. A covenant violation can result in a rating action, but it is not mandated by our criteria.

In audited fiscal 2023, more than a dozen of colleges and universities that we rate experienced a financial covenant violation. Most of the schools reporting the violations are in the 'BBB' or speculative-grade rating categories and are characterized by a combination of weaker demand profiles (such as decreasing enrollment, low selectivity, and aggressive tuition discounting), poor operating performance, and softer balance sheets. Although some covenant violations were due to delayed audits, none of those resulted in a rating action.

How Covenant Violations Influence Our Ratings

A symptom, not the cause: Rating actions often reflect deterioration of financial metrics, not necessarily the covenant violation

S&P Global Ratings' first consideration in determining whether a rating action is warranted by a covenant violation is investigating the immediate legal ramifications. Depending on the bond documents, the violation may provide bondholders with:

• The option to provide a waiver and require issuers to hire an independent consultant to create a plan to achieve compliance, or
• A provision to accelerate all outstanding debt.

In most examples we observed during the past year, bondholders provided a waiver for the covenant violation, with institutions required to work on detailed plans to improve their financial position over a specified period. In the instances where the covenant violations resulted in rating actions, the rating action generally reflected our opinion of the institution's deteriorated fundamental credit quality, as opposed to the violation itself. We also saw institutions experiencing heightened liquidity pressure due to their weakened financial characteristics, which at times was exacerbated by the implications of the covenant violations.

A covenant violation's influence on our rating is dependent on several factors, such as:

• Whether the rating reflects a fundamental weakness in the institution's demand or financial profile;
• If the operational pressures are considered temporary;
• The institution's financial resources and liquidity;
• The time period given to make improvements; and
• The expectation for recurring covenant violations.

In instances where the bondholders have not provided a waiver and there is a debt acceleration provision, we have historical precedent of reflecting this with a lowered rating or negative outlook revision. Although we did not see this in rated institutions during the last year, if the bondholder does trigger this acceleration provision, it would likely result in our lowering the rating by multiple notches.

Covenant Violations In Higher Education

Table 1

Chart 2

Case Studies

We have highlighted a few examples of institutions that reported a covenant violation during the past year, including details of the specific circumstance and our rating action, if there was one.

Albion College, Michigan

Most recent rating action (May 2024): Rating lowered to 'BB' from 'BBB'. Outlook remains negative.  In December 2023, the college disclosed that it failed to meet the 1.1x DSC requirement associated with its series 2022 bonds. This covenant and a minimum liquidity ratio requirement of 1.0x also applied to a loan agreement it had with a bank on a line of credit. According to its draft fiscal 2023 financial statements (final audit not yet available), the college generated a material full-accrual operating deficit and we expected that additional appropriations from the endowment in fiscal 2023 would be used fill the budget deficit, depleting available liquidity. Albion engaged a consultant to assist with the creation of three-year plan and in early 2024 began negotiations with bondholders seeking a forbearance agreement. On May 15, 2024, we lowered our rating to 'BB' from 'BBB' due to the deterioration in several key credit factors; specifically, the college's liquidity weakened and its demand metrics softened. In this example, the multinotch rating action was driven by our view of a fundamental change in credit characteristics, not simply the covenant violation.

On May 24, 2024, the college and master trustee entered into a forbearance agreement, which granted a waiver of the covenant calculations for fiscal years 2023 and 2024, unless a forbearance termination event occurs. The college does not expect to meet the minimum DSC ratio until fiscal 2027. In addition, the agreement provides that the college can borrow up to $20.6 million from the endowment to address liquidity needs and grants the master trustee mortgages on the college's core campus and additional properties as further security for the bonds.

Champlain College, Vermont

Most recent rating action (March 2024): Outlook revised to negative from stable. Rating affirmed at 'BBB-'.  Champlain's enrollment has fallen annually since fall 2016 due to local demographic pressures and a highly competitive regional market. Although the college's financial performance was at least breakeven until fiscal 2020, the pandemic exacerbated the operating pressures facing Champlain and it reported deficit net operating results for the past three years. With its HEERF money depleted, Champlain's fiscal 2023 operations generated a material deficit, resulting in a violation of its 1.1x DSC covenant, with its actual coverage at 0.43x. The college paid debt service on time and in full.

The legal remedy for this covenant violation was to hire a consultant. It did not present any debt acceleration risk. Of importance, repeated violations of this covenant would present the college with the same repercussions and would not add acceleration risk. Despite this, on March 5, 2024, we revised the outlook to negative from stable and affirmed our 'BBB-' rating on the college's outstanding debt because management's expectation is for enrollment declines and operating pressures to continue in fall 2024.

Bradley University, Illinois

Most recent rating action (March 2024): Rating affirmed at 'BBB+'. Outlook is stable.  After Bradley reported a significant and steeper-than-expected deficit, its DSC ratio fell below the minimum covenant threshold of 1.25x in fiscal 2023. The DSC covenant was associated with the university's series 2021B direct placement debt and a $5 million line of credit. In fiscal 2023, the university had no balance outstanding on the line of credit.

Bradley received waivers on the covenant violation from bondholders and the bank associated with the line of credit. On March 27, 2024, we assigned our 'BBB+' long-term rating to Bradley's series 2024 bonds, which refunded the series 2021B direct placement bonds, and affirmed our 'BBB+' rating on the university's outstanding debt. Although the university anticipates full-accrual deficits will continue in the near term, management expects fiscal 2024 operating results will improve from fiscal 2023 levels as it pursues cost-reduction initiatives.

While the DSC covenant violation signaled that the university's financial performance is weaker than expected, we do not believe its credit fundamentals significantly changed, as they remain supported by solid financial resource ratios and ample liquidity. Following the university's series 2024 bond issuance and refunding the series 2021B direct placement, Bradley's long-term debt is no longer subject to financial covenants. Although this removes the risk of covenant violations, we will monitor the university's financial performance to assess whether fundamentals remain consistent with the rating.

We Expect Heightened Covenant Violation Risk To Continue For Weaker Colleges And Universities

Looking ahead, we anticipate financial covenant violations will continue, but we do not expect for them to be widespread. Similar to recent examples, we expect future covenant violations are most likely to occur with 'BBB' category and below rated credits. More specifically, schools that are highly dependent on student-generated revenues and experiencing continued enrollment declines are most susceptible, in our view, while those that are able to retain their market position and maintain sufficient financial flexibility face less risk.

Based on our conversations with management teams, fall 2024 enrollment projections are particularly challenging due to regional demographic trends and delays with the Free Application for Federal Student Aid (FAFSA). Additionally, we expect fiscal 2024 operating margins will generally be weaker than margins in fiscal 2023, given limited revenue recovery, net tuition revenue pressure, and increasing costs. These factors combined could lead to more variable outcomes in the near term. While some of these pressures (FAFSA delays, for example) are expected to be short-term in nature, other factors, like the looming demographic cliff and generally increasing financial aid, stand to impact institutions longer term and, perhaps, on a broader scale.

Ultimately, we believe the credit impact for any college or university facing a covenant violation will be determined on an individual basis given the underlying characteristics of the institution, the extent to which credit fundamentals have materially weakened, and our forward-looking expectations.