One-Third of Colleges Are on Financially 'Unsustainable' Path, Bain Study Finds

An analysis of nearly 1,700 public and private nonprofit colleges being unveiled this week by Bain & Company finds that one-third of the institutions have been on an "unsustainable financial path" in recent years, and an additional 28 percent are "at risk of slipping into an unsustainable condition."

At a surprising number of colleges, "operating expenses are getting higher" and "they're running out of cash to cover it," says Jeff Denneen, a Bain partner who heads the consulting firm's American higher-education practice.

Bain and Sterling Partners, a private-equity firm, collaborated on the project. They have published their findings on a publicly available interactive Web site that allows users to type in the name of a college and see where it falls on the analysts' nine-part matrix.

The methodology is based on just two financial ratios, and they produce some findings that may seem incongruous with conventional views on colleges' financial standing. The tool classifies wealthy institutions such as Cornell, Harvard, and Princeton Universities as being on an "unsustainable path" alongside tuition-dependent institutions like Central Bible College, in Missouri. But the very public nature of the findings is sure to bring some attention to the analysis. Bain and Sterling provided advance copies of the analysis and the tool to The Wall Street Journal and The Chronicle.

Overly Alarmist?

Mr. Denneen allows that the analysis may be skewed, particularly for the wealthiest institutions, because the period studied, 2005 through 2010, concludes with a fiscal year in which endowments were hit with record losses. One of the two ratios used in the analysis, called the "equity ratio," is based on the change in value of an institution's assets, including its endowment, relative to its liabilities. Since 2010 the value of many endowments has rebounded. The other, the "expense ratio," looks at changes in expenses as a percentage of revenue.

Still, Bain and Sterling maintain the analysis sends a sobering signal, even if some might see the findings as overly alarmist and self-serving. "Financial statements have gotten significantly weaker in a very short period of time," says Tom Dretler, an executive in residence at Sterling, a firm that is a major investor in Laureate Education Inc. and other educational companies.

Besides the credit ratings and reports produced by bond-rating agencies and the Education Department's controversial annual listing of colleges' financial-responsibility scores, there are few public sources of information on colleges' financial health.

The new analytic tool classifies colleges based on whether their expense ratios increased or their equity ratios decreased, giving the harshest rankings to those with changes of more than 5 percent, moderate rankings to those with changes of 0 to 5 percent, and good rankings to those where expense ratios didn't increase and equity ratios didn't decrease.

For example, it lists Bennington and Rollins Colleges along with California State University-Channel Islands and Georgia Southwestern State University as being on an unsustainable financial path for several years because their ratios of expenses relative to revenues spiked up while their equity ratios fell. (For all four, the expense ratio increased by 25 percent or more.) Hundreds of other colleges were classified with that same designation if only one of the ratios changed by more than 5 percent.

Higher-education leaders who say the Education Department's scores can be a flawed way of measuring a college's health say the Bain-Sterling analysis may suffer the same weaknesses.

"Places that are viewed by some as having an unsustainable way of operating may not be," says Richard H. Ekman, president of the Council of Independent Colleges. Analyses like this, which rely on data from a particular period of time, he says, "may not tell the full story."

Susan M. Menditto, an expert on accounting matters at the National Association of College and University Business Officers, notes that even the way colleges account for their endowments—in some cases counting restricted gifts, in other cases not—might not be reflected in the analysis.

Mr. Denneen says the simple tool serves a different purpose than does a report on the creditworthiness of an institution from Moody's Investors Service, which uses 36 criteria to formulate its ratings. "This does provide a useful lens," he says. "This is really a guidepost for how hard you ought to be thinking about pushing on your financial model."

Disconcerting Trends

Along with the tool, Bain and Sterling are publishing a paper, "The Financially Sustainable University." It is their take on what they view as several disconcerting trends in spending, and it puts the two firms among an ever-growing list of analysts, pundits, and policy makers who have been calling on higher-education leaders to rethink how colleges are administered. (Jeffrey J. Selingo, The Chronicle's vice president and editorial director, contributed to the paper.)

The paper covers familiar ground, although some of the fresher recommendations and findings could resonate with the college administrators, campus leaders, and trustees who are its intended audience. Most notably, it suggests that colleges tap into their real estate, energy plants, and other capital assets more creatively to generate revenue for new academic investments, and it concludes that colleges have too many middle managers.

While it fails to make distinctions between different kinds of colleges, as do other respected analyses such as those of the Delta Project on College Costs, the Bain-Sterling paper shows that, over all, the growth in colleges' debt and the rate of spending on interest payments and on plant, property, and equipment rose far faster than did spending on instruction from 2002 to 2008 for the colleges studied.

It says long-term debt increased by 11.7 percent, interest expenses by 9.2 percent, and property, plant, and equipment expenses by 6.6 percent. Meanwhile, instruction expenses increased by just 4.8 percent.

"Boards of trustees and presidents need to put their collective foot down on the growth of support and administrative costs," the paper urges. "In no other industry would overhead costs be allowed to grow at this rate—executives would lose their jobs."

Nothing on Faculty

Unlike Bain's proposals for the University of North Texas at Dallas, which, controversially, extended into curricular and faculty matters, the paper focuses primarily on colleges from an administrative and management point of view.

Still, Mr. Ekman says he found it "interesting that Bain would do this at this time." He says he wonders whether the report could provide insights into how Mitt Romney, the presumptive Republican nominee for president who once was a partner at Bain, might regard current issues in higher education.

Both Mr. Denneen and Mr. Dretler say they see the report and the analysis as ways to encourage colleges to take steps that would allow them to spend less on things that aren't central to their missions and spend more on academic programs that could help them attract new students and remain affordable.

They also acknowledge that their firms stand to benefit from some of the recommendations. The group Mr. Denneen heads at Bain has consulted on administrative restructuring at Cornell, the State University of New York at Stony Brook, and the Universities of California at Berkeley and North Carolina at Chapel Hill, and it's eager for additional engagements. Mr. Dretler has been talking to dozens of college presidents about financing deals related to the billions of dollars in real estate they carry on their balance sheets.

The paper also argues that colleges, with their extensive research programs, could be realizing more than the 2 percent financial return they now collectively earn from licensing the results of that work. One of Sterling's portfolio companies specializes in licensing intellectual property and is looking to expand into the academic market. Even taking into account that the mission of academic technology transfer isn't supposed to put profits above all else, Mr. Dretler says, "we think there probably is a way to do better than $2-billion on a $92-billion investment."