College Buyers Widen Their Horizons: Consolidation takes in not-for-profit institutions

There has been significant consolidation in the career college industry in the past eight years largely involving roll-up style acquisitions of for-profit institutions. Several went public after attaining the size and scope demanded by investors. More recently, the acquisition trend has shifted to encompass not-for-profit professional colleges, as these schools put themselves up for sale to escape economic pressures and buyers are drawn to them due to a lack of good prospects in the for-profit sector. At least five acquisitions of non-profit colleges were completed in 2004 and 2005 (see sidebar) and more are expected because market conditions are causing schools to contemplate selling all of their assets or specific campuses. For most colleges, marketing costs have risen in the past year because of increased competition for students from well-funded post-secondary institutions. Competition also is leading to greater capital expenditures, with not-for-profit colleges being forced to update management information systems and implement online offerings. Some smaller traditional colleges face budget deficits and limited endowments. Managers of not-for-profit career colleges sometimes fear there is not enough money available to fund their retirement benefits. Consolidation has resulted in a limited number of platform companies available for acquisition while at the same time new entrants, primarily private equity funds, are eyeing the sector, attracted by the significant funding for student grants and loans available for qualified, accredited career colleges under Title IV of the U.S. Higher Education Act. This classic combination of more buyers and fewer quality targets has kept the market prices of post-secondary education companies that can serve as growth platforms at high levels, with EBITDA multiples that exceed the price-earnings ratios of publicly traded post-secondary education companies. Interestingly, a significant number of not-for-profit career colleges either were organized as not-for-profit corporations, or converted to that status, to acquire greater funding under Title IV and access state education grants. These companies often are both profitable and entrepreneurial, thus enhancing their appeal. As a relatively new sector of acquisition interest, these deals can be challenging to put together, and they face regulatory and other challenges. This article examines how these deals are structured and the primary issues that arise in completing them. The precedents for sales of not-for-profit colleges are sales of non-profit health care providers and insurers, which started in the late 1980s and resulted in major consolidation in the health care industry. Self-dealing with insiders in several of the earliest deals led to federal and state intervention and regulation of both the substance and procedure of these transactions. In 1996, the Internal Revenue Code was amended to add Section 4958, which imposes tax penalties on not-for-profit company “insiders” and directors who receive “excess benefits” in a sale or change-in-control transaction. Two years later, the IRS issued Revenue Ruling 98-13, which imposes restrictions on JVs with not-for-profit hospitals. That same year, the National Association of Attorneys General adopted model legislation with procedural and substantive safeguards for health care conversions, and most states subsequently adopted some form of this legislation. A number of deal structures can be used to acquire a not-for-profit college. One model involved National Technological University (NTU). A for-profit entity entered into a JV with NTU that provided for a division of academic and business functions between them. Each had a separate board of directors and officers that did not overlap. In the NTU structure, the for-profit firm derived compensation from the JV under a management agreement. NTU held all licenses and accreditation and received money under a Title IV program participation agreement. The JV structure was used to avoid requirements for obtaining a new program participation agreement, accreditation, and license approvals after a change in control. JVs have not been adopted generally for acquisitions. Investors worry that they won’t gain control over Title IV funds and that the structure will lead to regulatory problems and limitations on the operation of the business. In some health care transactions, the not-for-profit target converted to a for-profit corporation by amending its certificate of incorporation to authorize the issuance of stock, which then was sold to the acquirer. However, this format is not commonly used because a number of state corporation laws do not permit these conversions and the charitable purpose provisions in the certificate of incorporation may effectively prohibit them. The IRC does not provide for the conversion of a tax-exempt corporation to a taxable concern, although the not-for-profit corporation may achieve conversion on its own. It can amend its certificate of incorporation or merge into a for-profit corporation, if permitted by state corporation laws. Other transactions involving not-for-profit health care companies were structured as joint ventures between the company and an outside investor. A management agreement allowed the ostensible buyer to effectively control the not-for-profit company and receive the lion’s share of its net income. The IRS limited this arrangement in 1998 with Revenue Ruling 98-13, which imposes a number of restrictions on the JV, including a requirement that its board of directors or trustees is controlled by the not-for-profit corporation. But the majority of the deals involving not-for-profit health care companies were structured as asset acquisitions. Typically, the sale proceeds were paid to a newly formed “conversion” foundation and the not-for-profit corporation was dissolved. Rarely were these deals stock acquisitions because the buyer wanted to limit the liabilities it assumed, obtain a cost basis in the target for tax purposes, and avoid the legal limitations on changing the status of, or merging into, a for-profit corporation that were previously described. The transaction structures and principles developed in health care apply to transactions with not-for-profit colleges. Two key principles are that the not-for-profit seller receives fair market value for the assets to be transferred and that corporate insiders do not receive excess benefits from the deal. In the tax area, a critical question is whether the proceeds of the sale are taxable to the not-for-profit corporation. Federal income tax rules regarding “unrelated business income” underpin the analysis of that determination. The IRS does not review issues of fair market value and private benefits before a transaction closes but the attorneys general in most states will examine them before closing. Therefore, it’s desirable for a not-for-profit college to consider the procedures for selling its assets and how the proceeds will be managed and used for charitable purposes. These issues should be discussed with a representative of the state attorney general early in the deal process to determine: * How the legal officer will review the deal; * What standards will be applied; * Whether the review will be public or private; * Whether the attorney general will retain consultants; * How long the process and approval will take; and *When there will be a termination of real estate tax exemptions, if the not-for-profit corporation owns property. not-for-profit college may determine the fair market value of the business or assets to be sold by obtaining an appraisal from a certified valuation expert familiar with the post-secondary education business who can use two or more valuation methodologies. The state attorney general’s input should be obtained to eliminate the risk that the office will require its own appraisal at the college’s expense or require an auction process. Corporation laws in most states specify that directors of not-for-profit corporations have a fiduciary duty to maximize value in a sale. An auction process is not required in all deals because of the risk that some prospective buyers may balk at competitive bidding. However, an auction or modified auction that includes the most likely prospective buyers may be in target’s best interest. As noted below, sales of not-for-profit colleges take longer to complete than deals involving for-profit institutions, so the not-for profit college should be aware that a lengthier sale process can be a distraction to management before going into an auction. The issue of private inurement and excess benefits is generally more difficult to determine than fair market value. At the outset, it’s important to distinguish personal assets from corporate assets. An experienced college manager has a value in the marketplace, and payments under non-competition or consulting agreements are personal assets, unless they are in excess of market norms and diminish the sale proceeds to the not-for-profit corporation. It’s permissible for the not-for-profit corporation to compensate managers who will not remain with the college after closing. For example, the target’s projected EBITDA may be presented to prospective purchasers on an adjusted basis with an add-back for the compensation of departing executives. If the purchase price is based on a multiple of adjusted EBITDA, the college may have the funds to compensate managers who are resigning or being dismissed. IRS rulings interpreting the IRC’s Section 4958 create a safe harbor, i.e., a rebuttable presumption that the compensation is not an excess benefit, for appropriate management compensation arrangements. Several requirements must be met. The first is that the compensation arrangements be approved by the committee of independent directors prior to closing. Second, this committee must rely on appropriate data on how the compensation compares with money paid by other not-for-profit companies in similar circumstances. Committee members may engage several consulting firms with expertise in the compensation of non-profit management and search databases with information on payments in other sales involving not-for-profits. These firms often provide written opinions to the committee on the comparability of compensation, and obtaining these third-party opinions is recommended because directors who approve excess benefits may face personal liability. Finally, the committee must document the basis of its compensation decision at the same time it makes its determination. The state attorney general’s review of a transaction will consider compensation to insiders in light of past abuses and will be concerned about the charitable use of the sale proceeds. There may be legal issues if the not-for-profit entity’s organic documents are drafted narrowly to only allow it to provide educational services and the proposed use of the sale proceeds includes grants, scholarships, and other charitable contributions. An English legal principle, “cy pres,” interprets the charitable purpose in organic documents narrowly and prohibits assets from being used for anything other than what was originally specified. For this reason, the sale proceeds often are received by a newly organized charitable foundation, known as a “conversion” foundation, under terms – especially managing and granting money – that are approved by the attorney general. The not-for-profit corporation is dissolved when the foundation comes to life. Buyers of not-for-profit colleges also may need approvals from the Department of Education, accrediting bodies, and state regulatory agencies. Some not-for-profit career colleges are accredited by regional, rather than national, accrediting commissions. Regional accrediting commissions generally accredit traditional colleges and universities, and their accreditations are perceived more favorably in the market. Credits obtained from attending regionally accredited institutions are more likely to be accepted when a student transfers to another institution. Some regional accrediting commissions have governance requirements for member institutions which mandate that directors or trustees serve in the public interest. In approving the sale of a not-for-profit corporation, the regional commission will focus on the preservation of academic integrity, including maintenance of faculty-to-student ratios and curriculum quality. Because Title IV funds may not be received by an institution that is not accredited, it’s important for a buyer to understand the accreditation requirements and meet with the regional commission early in the deal process. The Education Department does not approve the change in control of an institution receiving Title IV funds before a deal closes. However, the closing terminates the institution’s program participation agreement. So an interim, month-by-month temporary program participation agreement is entered into and remains in effect while the department considers a new more permanent agreement. Generally, Title IV’s financial requirements are more stringent for for-profit education companies than for not-for-profits, and the differences must be taken into account in preparing financial models for the target after closing. A major tip for new buyers is that within the last year the department has imposed additional restrictions on the program participation agreement for acquirers that have not previously participated in the Title IV program. One category of restrictions requires new college owners to issue larger letter-of-credit obligations to the department to ensure that the department will get Title IV funds that may have to be refunded. A second deals with the organic growth of the institution and includes restrictions on new campuses, branches, or programs, which may be important if there are immediate plans to grow the college. These restrictions generally continue until the department has received audited financial statements and a clean audit report for the first complete fiscal year after closing. The department provides nonbinding guidance on the character of restrictions in a new program participation agreement if the parties request a pre-acquisition review of the deal. The review is especially desirable if the target is a not-for-profit college, so the restrictions are understood and the risks and costs can be allocated in the purchase agreement. For example, a seller may agree to collateralize a portion of a required letter of credit in cash to assist a buyer in a leveraged acquisition. Most states license career colleges, and state approval of a change in control of any career college is necessary, generally after deal closing. Texas law, conversely, requires approval before the closing. State attorneys general do not usually cover licensing approvals in their examinations. Acquisitions of not-for-profit colleges generally take longer to complete than acquisitions of for-profit colleges. In the past year, acquisitions of not-for-profit education companies have taken, on average, one year to complete. From the buyer’s perspective, a “no material adverse change” condition to closing is desirable in a process that takes that long. Targeting Non-Profit Schools Early acquisitions of not-for-profit colleges have included: Grand Canyon University, Phoenix, Ariz. – Acquired by a group of individual investors who later obtained private equity funding, January 2004. Post University, Waterbury, Conn. – Acquired by Generation Partners, October 2004. Franciscan University of the Prairies, Clinton, Iowa – Acquired by Bridgeport Education with financing from Warburg Pincus, March 2005. Renamed Ashford University. Salem College, Winston-Salem, N.C. – Acquired by a group of individual investors, April 2005. Barat College, Chicago – Acquired by Best Associates, October 2005. Renamed American College of Education. Neil Lefkowitz is a Partner in the Washington office of Dickstein Shapiro Morin & Oshinsky. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com