Executive Summary

 Executive Summary as pdf

Red Flags: Overleveraged Debt is the Grand Canyon Institute’s (GCI) third policy paper in a series analyzing the financial and governance practices of Arizona’s charter schools. In this paper, GCI finds that Arizona charter school debt has increased to a level that means that many charter schools are failing financially, and many others are at great risk of failing financially.

 

From FY 2014 to FY 2018, the long-term, lease-adjusted debt[1] held by Arizona’s charter sector consistently exceeded the current depreciated value of its property and assets. On the whole, the sector owes more than it is worth. A business property or homeowner in this position is deemed to be underwater on their debt. Like any business, an overleveraged charter is financially vulnerable and could fail if it then suffers an income loss.

 

Ten percent of charter sites are in significant financial distress with closure a near certainty due to excessive debt and poor underlying financials. Another 10 percent are at risk of closure. Charter school sudden closures during the school year from FY 2016 through the Fall of 2018 have resulted from financial issues related to charter long-term, lease-adjusted debt on those properties. Unfortunately, many charter operators were allowed to borrow based on projected student enrollment growth, i.e., using future educational revenues from students as a guarantee for their bond debts.

 

Increasingly, charter schools appear to be competing amongst themselves for students as the charter industry is consolidating. From FY 2014 – FY 2017, 60 percent of growth in student enrollment, known as Average Daily Membership (ADM), was captured by 10 charter companies, while 35 percent of charter companies experienced losses in their ADM[2] during the same time period.

 

Government tax-free bonds and federal charter credit enhancements, which were designed to allow charter holders to acquire educational assets have enabled this overleveraging. A similar over-leveraging of debt was partially caused by the excessive lending policies of Fannie Mae and Freddie Mac in the last mortgage industry failure (2007). GCI identifies the overleveraging of charter properties and assets as the underlying reason for financial failures.

 

Proactive action is critical to avoid future charter closures during the school year. Last January the sudden closure of Creemos Discovery charter school stunned many, but not if you had traced their finances for the prior years. GCI demonstrates that financial data can be used to prevent school year closings, which can be most harmful to a child’s education. Of 426 charter closures since 1994, an unacceptable 67 charters between October 1 and April 30.

 

Charters can be educational and financial innovators. It is not in the charter market’s best interest to continue to allow financial practices that are destructive to other charters and to districts. The children in schools that close during the school year place new demands on other charters in the area and to school districts trying to absorb those students mid-year.

 

Increasing charter school financial transparency and accountability will further competition among schools. GCI’s research shows that a charter school financial failure can be predicted two years in advance. This gives ample time to either assist the charter in solving its financial problems or plan for the closure in a way that does not disrupt a child’s education.

 

In 2018, the Arizona legislature passed HB 2663 granting the ASBCS the authority to close or deny renewal of a charter school for financial reasons (previously, the ASBCS could only close a school for poor academic performance). Subsequently, the ASBCS appointed a subcommittee charged with updating its current financial framework and adopting rules and policies to be used for accountability purposes in fulfilling its new obligations. GCI was invited to participate in this process and has worked with the ASBCS’ subcommittee to identify benchmarks for assessing the financial performance of charter schools.

 

GCI hopes that charter holders see this as an opportunity to use financial data to deleverage their businesses. Borrowing based on projected ADM is a cause for concern as GCI believes that academically performing charters are being financially disrupted, leading to closures at sites that should be thriving both academically and financially. Relying on a mindset that only focuses on academic performance is misguided.

 

In addition, the legislature needs to reconsider the extent to which public tax money should be used to pay for privately-held charter school property. Charter schools currently receive about $1,600 more per student than district schools, primarily to pay for private property.  That amount is the same regardless of academic performance, whether it is a physical or virtual school, and how long the charter has received the extra payments.

 

Overview of Recommendations: Rule and legislative changes

 

1. ASBCS should follow through on forthcoming recommendations from their financial subcommittee to add a “Falls Far Below” criteria to a modified net income measure and lease-adjusted debt service coverage ratio (rule).
2. Charter companies should not be permitted to incur new debt beyond property value[3] unless they have well-documented ADM growth history and approval by the ASBCS is granted (legislation).
3. Charter companies should be required to get a loan quote from a commercial lender or show their bonds would be investment grade when seeking new financing, and that this information be reported along with their chosen means of debt-finance to the ASBCS to improve transparency (legislation).
4. Charter companies that have taken out debt based on projected ADM growth be required to report whether or not they are meeting that growth in their audits (rule).
5. The current state loan guarantee system be modified to require that charter companies meet investment grade (at least BBB or NAIC category 2) on their own or for smaller operators that they meet the highest speculative grade (BB or NAIC category 3) and meet ASBCS financial dashboard criteria sufficiently for the last three years, especially their lease-adjusted debt service coverage ratio (legislation).
6. Charter Additional Assistance be modified to be contingent on satisfactory academic performance and be limited to facility funding at no more than fair market value to provide early support for schools and then gradually phase down so after 15 years it equals District Additional Assistance for a given level of ADM (legislation).
7. Charter Additional Assistance be replaced by limited start-up support for online charter schools and any additional funding beyond base student amounts be limited to covering costs associated with providing students computers in their homes or subsidizing their home internet service (legislation).

[1] Long-term, lease-adjusted debt is defined as all of the committed long-term debt payments and all of the amounts of contractually-committed lease agreements. This information is sourced from charter school audits.

[2] Charter ADM was evaluated over 4 years 53% of 427 charters saw either a net loss of ADM or a loss greater that 0.5% of ADM during this time period. The figure of 0.5% is a bare minimum.

[3] Including construction in progress’ property values, which allows for expansion and growth in the market.