Making an acquisition in a highly regulated industry like postsecondary education means following required procedures and obtaining approvals from multiple agencies. Often, the most significant approval comes from the U.S. Department of Education (ED) because the approval can include a requirement to post a letter of credit with ED as the beneficiary for as much as 50% of the Title IV awarded to a school for its most recently completed fiscal year. Depending on how the new entity is able to secure the letter of credit, this can tie up significantly more capital than anticipated when evaluating a deal.
This article will outline ED’s primary considerations when determining if a letter of credit will be required after a change in ownership, and, if so, how much is required.
Two Years of Audited Financial Statements
As part of the application process, the ongoing entity must provide audited financial statements for the two most recent fiscal years. The audits must be prepared in accordance with Generally Accepted Accounting Principles (GAAP) and audited in accordance with Generally Accepted Government Auditing Standards (GAGAS). For a simple stock purchase, this requirement is met by the school’s two most recent fiscal years’ audits, which are required to follow the same standards. However, for an asset purchase or a stock purchase where the assets or shares are being acquired by another entity, this requirement can be more difficult to meet. While the acquiring entity might have two years of audited financials, unless it owns a school, most likely the audits were not performed in accordance with GAGAS. It is possible to have additional procedures performed and reissue the prior year reports to meet this standard. A newly formed entity created specifically for the acquisition cannot meet the standard.
There are competing considerations when deciding how to acquire a school. Acquiring the school by an existing school or by an entity that already owns other schools enables the ongoing entity to have two years of financial statements that meet the requirement. However, acquiring a new school this way most often means that ED will request consolidated financial statements going forward. This means that profitability issues at one school that might negatively impact the composite score will now impact all the schools owned within the same entity. While purchasing the school with a newly formed entity means that two years of financials can’t be provided, it does isolate the risks to just that school.
Opening Balance Sheet and the Ratios Considered
After a change in ownership, the ongoing entity is required to submit a same day balance sheet showing the company’s financial position the day ownership changed. This is typically called the Opening Balance Sheet (OBS). Just like the previous two years of audited financial statements, the OBS must be prepared in accordance with GAAP and audited in accordance with GAGAS. The OBS is required to be submitted to ED the last day of the month following the month when the transaction closes. For example, if the deal closes April 1, then the OBS must be submitted by May 31. However, if the deal closes April 20, then the OBS is still due May 31. Because of this requirement, and the fact that it is easier to prepare and audit the month-end close balance sheet, most deals close on the first of the month.
Financial Responsibility Ratios
During its review process, ED uses the OBS to evaluate the company’s financial position. While neither the Title IV regulations nor the FSA handbook outline specific metrics related to a change in ownership, ED has long utilized two dated ratios that are included in the regulations, though they no longer apply when considering the stability of ongoing institutions. These are the Acid Test (34 CFR 668.15(b)(7)(i)(A)) and the Tangible Net Worth Test (34 CFR 668.15(b)(7)(i)(C)).
The Acid Test attempts to measure a company’s liquidity by comparing its most liquid current assets, cash and accounts receivable, to current liabilities. The ratio specifically excludes inventory, prepaid expenses and other current assets. ED further excludes all unsecured related party receivables. For the ongoing entity to pass the Acid Test, the ratio must be at least 1:1.
If the ongoing entity is projected to fail the Acid Test, there are a couple of methods to improve the ratio. The most straight forward method is to contribute additional equity into the company. If related party receivables do exist, formally securing the receivables with assets outside of the company can also improve the score. Finally, long-term debt can improve the score by either keeping cash in the company or infusing cash. One way to accomplish this is to negotiate to have a portion of the sale proceeds paid to the seller 13 months or later after the OBS date. It is important that the terms of the note do not require a restricted cash balance. If required, then the restricted cash balance is no longer considered to be a current asset and is not included in the Acid Test calculation. Similarly, the new owners could provide capital in the form of a note payable that matures at least 13 months after the OBS date.
Tangible Net Worth Test
The Tangible Net Worth test compares the company’s tangible assets, measured as total assets less any intangible assets, to its total liabilities. To pass, the tangible assets must exceed liabilities by at least $1. Leveraged transactions with significant debt to finance the purchase typically fail this test. One strategy that can help this test is to have a valuation performed for the fixed assets to write them up to fair market value. Doing this increases tangible assets, therefore reducing intangible assets, most likely goodwill, created as part of the transaction. As a side note, from our experience, transactions which have utilized debt for 40-50% or more of the purchase price normally fail the tangible net worth test.
Letter of Credit Considerations
ED’s School Participation Division (SPD) is responsible for approving changes in ownership. We advise working with an attorney who specializes in postsecondary education to help guide you through this process. We work with many attorneys and can provide recommendations upon request.
It is possible to gain insight into SPD’s thoughts regarding a potential acquisition by submitting an E-App marked “pre-acquisition review”. If the acquisition incorporates multiple levels of companies, then the attorney will work with the acquirer and SPD to identify the level of consolidation expected to be submitted for the OBS. This enables the buyer to project the OBS and determine whether they expect to pass the Acid Test and the Tangible Net Worth Test.
While no specific guidance is provided by SPD to determine a letter of credit, we have seen consistency in what they consider. The three primary criteria we see being reviewed have been outlined earlier: being able to submit audited financial statements for the two prior years for the ongoing entity, the Acid Test, and the Tangible Net Worth Test. Historically a new owner who doesn’t have two years of audited financial statements is required to post a 25% letter of credit. Failure of the either the Acid Test or the Tangible Net Worth Test will increase the letter of credit to 35% and failure of both tests increases the letter of credit to 50%. After the new owner submits audited financial statements for one complete fiscal year post-closing to the SPD, the letter of credit may be reduced to 10-20%.
Based on the many deals we’ve worked on, SPD also considers other factors, such as:
- Do the acquirers have experience in postsecondary education?
- Metrics related to the school (cohort default rates, Gainful Employment data, etc.)
- The school’s capability for processing Title IV aid, approximated by results of most recent Title IV compliance audits and recent Program Reviews performed by ED, if applicable.
The E-app for preacquisition review must be submitted at least 45 days prior to the expected date of the transaction. While this process does not provide a definitive yes or no regarding approval of the transaction, SPD will share results of this original review. If the three primary criteria are all met, then it is possible the school will not be required to post a letter of credit. If a letter of credit will be required post-transaction, SPD will provide an estimate for the percentage expected as part of this process.
The key to any acquisition is complete and thoroughly planning as to the new entity’s structure to minimize the regulatory impacts on the new owners. Our firm can provide advice and guidance throughout this process. If you’re interested in speaking more on this subject, please do not hesitate to contact me.
Find out more about Dave McClintock, and the rest of our staff, on our bio page.