Over the last few years, many independent schools – along with the rest of the charity sector – have been driven to secure non-traditional sources of funding in order to compensate for dwindling state-backed and charitable resources, whether this be to accelerate capital investment or to free up existing resources for other needs. That drive, coupled with historically low rates of interest is causing the education sector to look at debt finance in a new light. This article examines some of the matters that independent schools will need to consider before embarking on these complex projects.
Why borrow from the Capital Markets? Schools will be familiar with more traditional forms of borrowing, such as direct lending by a bank under a facility agreement or similar. But the current financial landscape means both that banks may be less willing to lend on this basis, and that there may be advantages to institutions themselves in looking at alternative forms of funding:
- new capital rules for banks introduced in the wake of the financial crisis means that they are typically less willing than before to lend the substantial sums over long periods that schools may be looking for;
- interest rates are at the moment historically low. Even where banks are prepared to lend bilaterally under a facility agreement, they are unlikely to wish to provide long-term fixed interest rates, preferring to lend on shorter terms (which also provides an opportunity to reset margins) and/or to offer floating interest rates, potentially exposing a borrower institution to fluctuation;
- the ongoing obligations and financial covenants imposed in respect of borrowing from the capital markets are usually less onerous than those imposed by a bank lending bilaterally under a facility agreement, which are generally now much more stringent than they were prior to the financial crisis;
- the existence, in ever increasing numbers, of non-bank debt investors, typically pension providers, who have both long-term fixed liabilities for which they are seeking matching investments and who have the necessary free capital and internal infrastructure to enable them to make direct investments/loans;
- depending on the financial strength of the borrowing school, it may be possible to obtain unsecured funding. A bank lending bilaterally under a facility agreement will invariably seek formal security over the school's assets
A school looking at going to the capital markets for money faces an initial choice that will fundamentally shape the transaction – whether to pursue, on the one hand, a public, listed bond offering or, on the other, a private placement.
A public offer involves issuing a bond that is listed on a public market, such as the London Stock Exchange or a regulated overseas exchange such as the Irish Stock Exchange. This approach has a number of advantages:
- if a school is seeking public profile, the issuing of a public bond requires the drawing up of a formal public prospectus (Prospectus), and is typically accompanied by a good deal of commentary in the financial press;
- as set out below, and depending on the borrower school's financial strength, transaction sizes can reach into the hundreds of millions of pounds – there is depth in the private market to provide loans in the tens or hundreds of millions but the greater the size of the funding requirement the more likely that recourse to the public markets will be necessary;
- the liquidity offered by a listing on a public market may be attractive to some borrowers, resulting in a lower (and hence better from the Issuer's perspective) rate of interest;
- listed bonds may offer slightly stronger protection against withholding tax or gross-up requirements - although these can usually be quite adequately dealt with under unlisted issuances also.
However, there are certain disadvantages to a public offer which should be borne in mind:
- the Prospectus is required by applicable regulation to be an extremely comprehensive document, covering every aspect of the school's operation. As such, it generally requires a good deal of management time and cost to prepare;
- the members of the school's governing body (the Governors) will generally haveindividual personal civil and criminal liability for any claims by bondholders arising from any inaccuracies in the Prospectus, although part of the job of a school's professional advisors on any such transaction is to work with the Governors to ensure that these risks are minimised – it should be borne in mind that the necessary work, known as "verification", can be time-consuming;
- the Prospectus must be approved by the UK Listing Authority (UKLA), which can take time and result in an extended transaction timescale;
- legal and other costs may be higher due to the need to appoint a paying agent (who deals with payment to bondholders) and the need for both the banks which are arranging the issue and the issuing school itself to be independently advised
- it may be that the school in question does not wish publicity to attend its borrowing, which is clearly incompatible with a public offer.
The other option is for a school to seek a private placement, which is an issue of unlisted bonds pursuant to an agreement concluded with a lender or lenders, generally using one of the standard form "note purchase agreements" used in this market or a loan agreement. Advantages to this approach include:
- in contrast to a public bond issue, there is very little in the way of regulatory burden attending a private placement. The UK Listing Authority is not involved and no Prospectus is required to be prepared, resulting in potential cost savings and the avoidance of personal liability for the members of the Governors;
- the process of launching a private placement generally involves a school's financial adviser conducting a form of competitive tender amongst potential investors, which can result in more beneficial terms than a public offer to the market at large;
- the transaction timeline for a private placement is generally quicker than that for a public bond, simply because the transaction can be concluded as quickly as the parties can come to an agreement, rather than being at the mercy of public market conditions and the UKLA's workload.
In terms of drawbacks:
- the pool and depth of potential investor interest may generally be smaller in respect of a private placement;
- whilst a well-run transaction should minimise this risk, a lender may feel that it has more scope for negotiation on a private placement. If the school's financial and legal advisers fail to keep the transaction on track and close to the initial outline terms highlighted in the marketing phase, this can result in more onerous obligations being imposed on the school than in a public bond. Usually one firm is appointed to represent putative bondholders, initially in the aggregate, with such advice being relied upon by the note holders ultimately selected. The borrower – ie the school – pays these costs.
Planning and launching a bond is a major project even for financial institutions and other corporates who are regular capital market participants. The vast majority of schools contemplating a bond will be starting from scratch with little or no institutional knowledge. Accordingly, there are a number of fundamental questions that need to be answered by Governors at the start of the process as follows.
- How much is the school looking to raise?
- Are the school's finances, both in terms of income stream and balance sheet, robust enough to sustain payments of interest over the life of the bond as well as repayment of capital at the end of the bond's life?
- Are the Governors and management team prepared to devote sufficient time to the project over a period of up to a year to make the issue a success?
- Have the Governors and the management team been appropriately advised on the potential civil and criminal liability attendant on a bond issue, especially where a public issue is proposed, and are they prepared to accept that risk?
The terms of the bond will be crucial to ensuring a good uptake from the investment community and managing the Institution's risk. An experienced financial adviser will be able to advise on appropriate terms for the bond. Matters for Governors to consider will include:
- the repayment terms for the debt both as to the ultimate repayment date and potential amortisation;
- the rate of interest that the school is targeting, and how often it should be paid;
- whether the school is prepared to offer some form of security to bondholders. Is there an asset pool that could be secured? For charitable schools, particular care needs to be given to ascertaining whether their constitutional documents and the trusts over any endowment permit the granting of such security;
- the appropriate levels (and types) of financial covenants which might provide investors with comfort while protecting the Institution's flexibility to manage its day-to-day operations.
Most schools are relative newcomers to the capital markets, and also usually have charitable status. Therefore, schools considering borrowing in the capital markets need to ensure that they seek out and engage legal and financial advisers who are able to bring together expertise across the charitable, retail and wholesale capital markets and corporate sectors. Governors will need to consider:
- whether their existing legal advisers are able to bring together the requisite charities and regulatory expertise; and
- whether their financial advisers have sufficient profile to help the bond issue reach its target investment amount and are able to advise on appropriate terms.
If you require further information on anything covered in this briefing please contact Simon Graham (firstname.lastname@example.org; 020 3375 7141), or Andy Peterkin (email@example.com; 020 3375 7435) or your usual contact at the firm on 020 3375 7000. Further information can also be found on the Schools page on our website.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP,
Independent Schools and the Capital Markets.pdf