Republished with permission from Discover Society.
A number of vice chancellors have claimed that they are constrained in how they can approach the financial impact of the COVID-19 pandemic by financial agreements. This means that they wouldn’t be able to cover losses using existing reserves because the University was prevented from doing so by legal agreements with its financiers to make a financial surplus each year.
The existence of these finance agreements and the restrictions they impose should not come as a surprise. I, among others, wrote during the 2018 strike of the increasing use of commercial bank financing by universities such as Portsmouth and UCL to fund capital expenditure on new buildings. Now, however, we see the consequences of credit drawn down during the days of plenty: significant restrictions on a borrower’s ability to govern itself.
This was quite predictable to anyone involved in the 2008 Global Financial Crisis (GFC). What we saw in 2008 was a shock in financial capitalism which had macroeconomic effects, effects which fed into the loan agreements of borrowers in the industrial circuit via what are known as financial covenants. COVID-19 may be a natural phenomenon, but its effects are manmade. A flash flood may have its origins in torrential rains, but the channelling of floodwaters off hills stripped of trees, into mudslides that devastate precariously-situated shanty towns, is the consequence of other actions.
Financial covenant – gearing
By way of example, a real estate rich borrower is bound by the following financial covenant stipulated in its loan agreement: to ensure that the value of its real estate is x times greater than the debt it has borrowed (sometimes called gearing). Now this covenant was intended to deal with a borrower that has made a poor real estate investment decision, or otherwise mismanaged that property. If the property falls in value – perhaps because of a fire or because borrower plans for the land fall through – then a gearing covenant could be breached.
Now what happened in the GFC was that the crash in the circuit of financial capital led to financiers seeking to offload real estate, or more particularly the instruments representing investments in them. This led to a downward asset price spiral and a sector-wide collapse in real estate prices. But what of our borrower? Well the net worth of the borrower’s real estate collapses in line with sector prices, something of no concern to anyone seeking to hold assets due to their use in production but a matter of great concern where the collapse in net worth inadvertently triggers the gearing covenant mentioned above. In 2009 industrial borrowers were astonished to learn that they had breached a contract – that paradigm of voluntary obligation – through no fault of their own but as a result of macroeconomic crisis caused by the very banks that benefited from the terms of the financial covenant.
A breach of covenant almost invariably permits the creditor banks to declare a special kind of breach of contract called an Event of Default. While it is normal for banks at this stage to negotiate a restructuring (with all that entails for employees), they go into that negotiation with a very big stick: acceleration. Acceleration means that the banks are entitled to stop all future borrowing, demand repayment of all existing borrowing, and where applicable enforce their rights against borrower assets.
Financial covenant – leverage
Another typical example is the leverage covenant , which can be drafted to say that the borrower must ensure that its total net borrowings must not exceed a multiple of x times its earnings before interest, tax, depreciation and amortisation (EBITDA). Here the borrower must ensure its core business activity generates sufficient income to repay its debt in a set number of financial periods. A simple way to think of this covenant is a requirement that if the borrower saved up all its earnings in every period, it would be able to repay its entire debt after, say, three such periods have elapsed. The ostensible purpose of this covenant is to measure the economic health of the borrower’s business, flagging to the banks just when a borrower suffers a reduction in sales for example.
Once again, in the GFC borrowers found themselves hammered because earnings fell as a result of macroeconomic distress brought about by finance capital. One of the early routes in which this distress was channelled into the industrial circuit was a credit crunch in the trade finance sector, which effectively meant industrial goods could not be shipped across borders, Likewise, consumers facing falling house prices reigned in spending. Industrial borrowers saw an immediate collapse in sales, triggering their leverage covenants. And once again the banks were able to negotiate a restructuring knowing that the borrower was at contractual fault and could be threatened with immediate insolvency by a demand for repayment of many millions.
Universities and Private Placements
Universities are likely to be subject to variations on financial covenants such as the simple ones outlined above. These clauses are arguably the most important element of any credit agreement, for they model how the borrower should perform, and given the multiples involved, the borrower is almost always expected to perform better than simply being able to repay a debt. What we observed in the GFC, and we are seeing again today, is that contractual stipulations, designed to monitor the microeconomic behaviour of the borrower, take on the role of transferring macroeconomic risk from creditor to borrower.
As if to compound matters, some universities will have to contend with the fashionable form of post-GFC financing which has spread its branches into the HE sector: private placements. A private placement is commonly structured as a kind of bond issuance in which the bonds are issued to a closed class of investors on an off-market basis (though in many respects it is closer to the kind of covenant-heavy bilateral financing one sees in a loan agreement). Indeed, it is not unknown for private placements to look much more like syndicated loans. A private placement is a hybrid between a bilateral loan agreement and a bond issuance. A borrower issues bonds to a pre-identified class of lenders (placees) on an off-market basis, but the terms of the bonds are fairly ‘heavy’ in that they are closer to those found in a negotiated bilateral credit facilities agreement. In particular, these private placement agreements may contain financial covenants (whereas a vanilla bond can be as simple as an obligation to pay, pay interest, and treat creditors equally).
A key financial adviser in HE, QMPF, reports that it has acted on private placement transactions for Royal Holloway, York, Sussex, and Exeter. It is known that Bristol has secured financing through private placements funded by Pricoa Capital Group, a US outfit. Often private placements are used to fund specific capital projects, such as in the case of Exeter’s ‘382 high-quality student residences’ which were funded by a 47-year index-linked bond provided by the Pension Insurance Corporation.
It is of critical importance to understand how these capital project financings have been structured, and what a particular university’s financial obligations are as a consequence. A known example is Forth Valley College, which created a special purpose vehicle (SPV) for the purposes of developing its Stirling campus in partnership with a construction company. This is a form of Private Finance Initiative, beloved of public bodies because it moves liabilities for development off the national or local balance sheet. The SPV, however, is a mere shell and the construction company and banks will not agree to any project unless some asset rich party steps in and accepts the liabilities of the SPV. In many cases, this is a government body or university. Private placements can be linked to PFI projects, and the ultimate risk can be borne by a university.
A requirement to ‘run a surplus’ (which is where I began this article) is what we would term an interest cover covenant. Under such a covenant the University must ensure that either its cashflow or earnings are not less than a multiple of its obligated interest payments. In such a case, a vice chancellor would have limited room to manoeuvre. The covenant requires an excess, or surplus over what the University is required to pay in the form of interest, to simply be there on the books, unused, on every date that the interest cover ratio is tested. This ring-fences available financial headroom to the benefit of certain creditors and unduly restricts the University’s capacity to act in the face of the crisis.
And that assumes that the University will be able to satisfy the financial covenant. A breach, as noted above, is an Event of Default and entitles creditors to accelerate, that is, demand full repayment. To demand immediate repayment of the full loan, which is typically tied up in real estate, has the potential to force a debtor into insolvency.
In some cases, however, the threat of insolvency can be even more immediate. It is a question of how financial agreements are tied together. Many loan agreements contain a cross-default Event of Default, which is triggered if the borrower has defaulted under any financial agreement. Thus, if a university has a liquidity facility with another bank, it could breach that facility just by breaching a covenant in, say, a private placement structure it has set up to fund student accommodation or other capital project.
In some cases, universities have entered into liquidity facilities called revolving credit facilities (RCF). In simple terms, under such a facility a university may borrow cash for typically one to three months, repay this amount at the end of that period by putting it back in a metaphorical ‘pot’, then again withdraw funds from that pot for the next period. Legally the university must repay and reborrow every time, but in practice the banks allow a debtor to simply keep the cash – to roll it over – the bank making an accounting entry to reflect the notional repayment and reborrowing.
RCFs present a serious risk because roll over is only permitted to occur if no default is outstanding. If for example a financial covenant has been breached, even if the banks have deigned not to accelerate the loans, roll over will be automatically prevented – something called a ‘drawstop’. This drawstop often comes as a shock to finance directors, who fail to appreciate that legally the debtor was always liable to repay and that when the drawstop occurs they cannot roll over again in the coming months; rather, they must find and repay several million sterling as a matter of urgency or become insolvent as a matter of law.
In the years following 2008, banks used the drawstop as a repeated crisis tactic in negotiation. They would only permit borrowing under an RCF for a maximum of 3 months, threaten insolvency every three months to obtain concessions, and only waive the drawstop on a case by case basis. This allowed the banks to come back for more concessions unless the borrower could find alternative financing.
We can perhaps now understand the speed with which some universities have been forced to act to secure immediate savings in the face of a coming crisis of unknown scale.
These issues were foreseeable. The Financial Times as much as the Guardian has been at the forefront of reporting on Vice-Chancellor’s dalliances with finance capital. With yields falling in traditional sectors, higher education has proved an untapped vein of profit for those who continue the failed originate-to-distribute model – set up deals for quick fees and prestige, and damn the long term consequences for everyone else. University decision making is increasing determined not by the senate but by hastily agreed financial covenants. The result, to paraphrase Rudolf Hilferding, is a subordination of the interests of human knowledge to the interests of finance capital.
Our concern now is that extreme financial pressure will force even prudent universities into the hands of banks and, increasingly, offshore funds, who will offer easy credit on terms which will severely interfere with the governance of our academic institutions.
[STOP PRESS: This article can be usefully read in conjunction with the McGettigan Report on the University of Sussex’s finances, which was released subsequently.]
 Leverage has multiple meanings in finance; I use the Loan Market Association meaning here.
Stephen Connelly is Associate Professor at Warwick Law School. He teaches both corporate finance law, and the philosophy of law. His book Leibniz: A Contribution to the Archaeology of Power is out with Edinburgh UP in 2021.