The trend toward converting nonprofit colleges and universities into for-profit institutions seemed to be accelerating over the past year, but suddenly the practice is under new scrutiny. The Higher Learning Commission of the North Central Association of Colleges and Schools recently refused to transfer the accreditation of Dana College to a group of investors who planned to purchase the institution, forcing the college to announce its closure, and Sen. Richard J. Durbin, Democrat of Illinois, has called for an outright ban on the acquisition of accreditation through such conversions. At the same time, some investors have made substantial amounts of money from converting nonprofit institutions, and many others are looking for similar opportunities.
My own institution has received at least a half-dozen unsolicited inquiries from investors in recent months. We have declined to pursue any of those (and have no plans to do so), but I have spent some time trying to understand the business model of for-profit conversions. The question of whether such transactions should be allowed, and, if so, what rules should apply, is shaping up to be a major issue for accreditors and legislators. Presidents and trustees who contemplate a conversion to stave off the financial collapse of their institutions also confront important ethical issues.
I have nothing against for-profit universities per se. Indeed, I worked for one for a while before assuming my current position at a nonprofit institution. Entrepreneurs who have created new and profitable institutions over the past two decades have performed some valuable services both to higher education and to the larger society. They have created opportunities for students whom traditional institutions were either ignoring or failing to serve effectively. They have pioneered new technologies and delivery methods, and they have revolutionized student recruitment.
But converting existing nonprofit colleges to for-profit ones is far different from building an institution from the ground up. In a conversion, investors receive substantial benefits from the accumulated financial and nonfinancial assets of the institution, which are often difficult to value. The people who created those assets, including current and former faculty and staff members, are seldom rewarded for their efforts. Furthermore, the mission of the institution is inevitably changed as a result of the conversion, raising questions about the fiduciary responsibilities of the board to both past and present stakeholders.
The conversion model is conceptually simple. An investor provides enough money to buy out the assets of the nonprofit institution. The value of those assets is placed in a foundation or other nonprofit organization to continue some charitable mission. That frees the operating part of the university—its accredited teaching operation—to continue as a profit-seeking venture. Investors then promise to invest in new programs like distance learning and other growth-oriented ventures.
In my experience, investors often promise to respect the history and mission of the institution and, in some cases, to retain its leadership with substantial equity and profit-sharing incentives. Investors characterize that as a win-win situation: The institution has new resources, students will continue to be served, and everyone involved stands to make a lot of money.
So what’s wrong with this picture? I see four areas of concern:
Institutional mission. The mission of the institution will change, no matter how much the investor promises to honor the educational standards and traditions of the nonprofit predecessor. Whatever the historic mission of the institution may be, an honest restatement of it after conversion would include the phrase "... to the extent that it increases shareholder value.”
For example, if the investors believe that commitments to, say, scholarship and diversity improve the bottom line, they may support efforts to encourage them. But if the business model depends more on enrollment growth and lowering costs, it is naïve to assume that those goals will not take priority. The board and management of the former nonprofit can do nothing to guarantee adherence to a particular educational mission, yet that is precisely what they were appointed to do. The conversion process requires trustees and officers to justify, on some grounds, abandonment of the core purposes of the institution.
Commitments to current constituents. The change in mission is not just theoretical; it will be played out directly in resource-allocation decisions. Investors typically seek returns on their capital of 20 to 30 percent or more. Traditional colleges do not generate surpluses anywhere close to that level, so the operations of the institution must change substantially.
A notion prevails that profit-seeking organizations are more efficient than nonprofits, and that margins increase just because commercial enterprises bring greater discipline to the operation. Those of us who trudge back to the coach section of every airplane we board know that that notion is false; they call those expensive seats up front “business class” for a reason. The for-profit world is not necessarily more efficient than the nonprofit one, where frugality is a way of life. It’s just that different kinds of inefficiencies are tolerated.
The way to increase margins in a for-profit setting is not by doing things more efficiently, but rather it is by doing different things altogether. As a percentage of the operating budget, for-profit institutions spend vastly more on marketing and recruitment than their nonprofit counterparts. They also pay taxes and distribute profits. Those funds have to come from somewhere, and most likely they come from reducing the portion of the budget devoted to instruction and academic and student support. Infusions of new capital in growth areas—for example in new distance-learning programs—can mask that trade-off to some extent, but the academic investment on a per-student basis is most likely going to be squeezed across the institution as a whole.
That generally means a reduced role for faculty members in both teaching and governance, fewer student services, larger class sizes, or other significant changes. Academic traditions would normally call for discussions and debate about such important changes, but, in a conversion, all such decisions are in the hands of the investors. Current constituents of the institution, including students and faculty members, may find that the for-profit institution bears little resemblance to the college they joined prior to the conversion.
Valuation. The value of a college exceeds a mere accounting of its financial assets. Generations of faculty and staff members, students, trustees, alumni, and donors contributed to its accreditation, reputation, and traditions. Such nonfinancial assets—especially accreditation—are quite valuable to investors. Michael Clifford, an entrepreneur who invests in higher education, has been widely quoted as saying that accreditation alone is worth $10-million, even though it does not show up as an asset on the institution’s financial statements.
The price paid to convert a nonprofit institution is usually based on a business analysis of current and future revenue streams, assets, and liabilities. In many states, the state attorney general or some other office is the final arbiter of whether the price is fair and represents a reasonable amount to be set aside for public benefit. What makes the transaction unusual, however, is that it is frequently somewhat one-sided. Trustees who are negotiating the conversion have no clear incentive to maximize the price; indeed, they are sometimes under great pressure to keep the doors open and may feel the need to settle for whatever they can get. Nor is there usually a true market test for the value of the institution, because conversions are often negotiated with a single investor under strict rules of confidentiality and sometimes exclusivity. Thus, the attorney general or other public official who must approve the transaction may have little factual basis on which to evaluate the fairness of the transaction, much less to know whether another investor might have been willing to pay more.
Compensation. Some investors promise to give current senior managers a share of equity in the new for-profit venture to provide continuity and minimize disruption. Trustees must consider whether that creates an insurmountable conflict of interest and therefore should not leave the transaction primarily in the hands of those managers.
In addition, trustees should ask whether faculty and staff members should also have the opportunity to benefit from the new for-profit venture on terms that are comparable to those offered to senior management. In many situations, those employees will have sacrificed to sustain the institution for years prior to the conversion. Their dedication helped keep the doors open and the accreditation intact; they have “sweat equity” in the institution. (And, of course, even if faculty and staff members are able to gain financially from the new for-profit venture—which is unusual—it is impossible to compensate generations of predecessors who also contributed to the value of the institution.)
For-profit higher education is here to stay—we can’t turn back the clock. And in some limited number of cases, conversion of not-for-profits makes sense both for the institution and for the public. As some of their advocates have argued, the for-profits have greatly expanded the capacity of our higher-education system, adding opportunities and options for students who otherwise might have neither. With small nonprofit institutions under growing pressure, and states forced to reduce their support for public institutions, new models of capitalization should not be dismissed out of hand.
However, we do need new and stronger safeguards in the conversion process. Accreditors and regulators should consider the following:
- Before any conversion is made final, conduct a true market test to determine the value of the institution. Insist that more than one potential investor be invited to submit proposals and that an independent evaluation be conducted to determine which of the competing offers is best.
- For institutions under severe financial duress, create a receivership process that would allow alternatives to conversion to be explored. That could be similar to the process for failing banks, in which government regulators step in to broker a merger, sale, or distribution of assets—either to nonprofit or for-profit entities—in an orderly way, with the first priority being the protection of the interests of current students.
- In the event of a conversion, make the transfer of accreditation provisional for five years, during which time the investors would be required to demonstrate good-faith commitments to an agreed-upon educational mission with appropriate resources devoted to fulfilling it.
- Require public disclosure of financial incentives for any trustee or employee of the nonprofit institution who stands to gain personally from the conversion.
Ultimately, Congress should explore the idea of creating new hybrid structures that might allow nonprofits to raise funds from private investors without giving up control of the institution. That might take the form of tax-favored investment vehicles through which the institution could pay out a reasonable return on private capital that is used to support program expansions, distance-learning ventures, or other new efforts to increase access and educational opportunities. The precedent for such an idea already exists in tax-exempt bond markets. What we need is an equivalent vehicle for equity investors.
These proposals would not resolve all of the potential ethical problems associated with conversions, but they would go a good way toward assuring that trustees have a variety of options, that the public’s interest is better protected, and that investors pay fairly for the assets they acquire.