School’s Out Forever: Protecting Students from College Closures

While headlines about higher education continue to be dominated by student protests and loan forgiveness, the bigger story is the rapid closure of small colleges. With COVID-19 relief funding in the rearview mirror, and as colleges hit their summer liquidity low point between the receipt of Spring and Fall tuition payments, small schools are closing at an unprecedented rate of one a week.

The forecast for the year ahead is even more grim since the Department of Education’s failed rollout of the updated federal financial aid process could turn this liquidity drought into a desert. Early measures show FAFSA completions are down approximately 10% this year, which means a 10% decline in freshman enrollment could be the baseline for the Fall — bad news for the many small schools that are currently 20-30% below new enrollment targets. And while the FAFSA fiasco will resolve over time, it doesn’t solve the bigger enrollment cliff facing higher education: long-term demographic pressures with a steady decline in high school graduates. 

Harvard Business School professor Clayton Christensen famously predicted that half of all colleges would close. His prediction could be on the cusp of coming true, albeit a decade late.

With all these challenges facing a system kept afloat by hundreds of billions in federal grants and loans, one might think the Department of Education (ED) would have devised a system to address the risks to students and taxpayers. Unfortunately, financial oversight of higher education is in need of significant reform.

To qualify for federal student grants and loans, colleges and universities must demonstrate financial responsibility to ED by passing a few basic financial tests. Some of them, like remaining current on debt payments and demonstrating sufficient cash reserves to make financial aid refunds, have little bearing on near-term liquidity. So the system relies on two primary metrics instead: annual audits and the so-called composite score. 

Audits are slow to produce; college fiscal years close June 30 and audits aren’t finalized until late fall. By the time they’re done, a new academic year will have begun, potentially with a significant enrollment shortfall. And the audit standard for a going concern opinion is a one-year forward look, thereby leaving the majority of students – especially new students – unprotected.

This leaves only one metric plausibly connected to an institution’s near-term ability to cover payroll or payments: the composite score, which combines different elements in an attempt to yield a single measure of a school’s overall financial health. But no element of the composite score deals with basic but crucial metrics like enrollment, or the gap between operating revenue vs. operating expenses. And the one metric that incorporates both revenue and expenses – net income ratio – is weighted at only 20% of the composite score (30% for for-profit schools). 

The premise seems to be that fundamental financial health is less important than the ability to beg, borrow, or steal from the endowment or other assets in order to cover operating deficits. While this may be possible for a limited time, it’s hard to see how it reflects a healthy operation. Putting aside that ED has only published composite scores through fiscal year 2021, one sign we haven’t been measuring the right things: only a handful of the institutions that have closed this year were on the ED’s watchlist. 

It’s also clear the system won’t police itself. Accreditors defer to ED. Creditors, which have a clear interest in ensuring colleges are able to repay debt, are focused on their own recovery, not protecting students and taxpayers. And boards of trustees are struggling to find solutions to macroeconomic pressures with the constraints of a shared governance structure and the power of multiple campus constituencies. This is one area where private company governance is clearly superior in ensuring financial viability. Do trustees represent current students? Alumni? The public? 

It’s clear that current financial guardrails are not working, and three reforms are needed. First, change the definition of financial responsibility: colleges and universities at risk of not making payments or payroll should not be able to make up for that fundamental weakness with another financial metric. At a minimum, the net income ratio should be weighted much higher than 20%. Better yet, add a new forward-looking ratio of sustainability by measuring operating deficits against unrestricted, liquid net assets for the duration it takes an average student to graduate.

Second, smooth the pathway for mergers between institutions. Mergers have grown more challenging due to an opaque patchwork of regulations between accrediting bodies and ED that have elongated the time to approval to over 3 years. given the long regulatory window to transaction close, institutions with declining liquidity often lack the runway to complete a strategic transaction.

Third, give institutions access to the provisions of the bankruptcy code which permit reorganization of liabilities in an orderly process. Under current rules, institutions entering bankruptcy proceedings lose all access to Title IV funding – a death knell for any college. As a result, troubled institutions lack the means to undertake an orderly restructuring.

Small schools account for the majority of institutions in the country: 40% of colleges enroll 1,000 or fewer students while another 40% enroll between 1,000 and 5,000. A step-function increase in the rate of closure will leave taxpayers with a failed investment in the tens of billions and seriously disrupt hundreds of thousands of lives. Research shows that when colleges close, half of affected students give up on pursuing higher education entirely. 

If Department of Education officials can’t figure out how to make these changes to safeguard our world-leading system of higher education, perhaps they should go back to school – that is, if they can find one that’s still open.