Co-authored by Andrew Laskey
A roof needs to be replaced. The heating or air conditioning is not working. The parking lot needs new blacktop. The football stadium field turf or stands need to be replaced or repaired. What options do Ohio school districts have to finance these relatively smaller capital improvement projects that come up from time to time in the course of running a school district? The first question may be, “What’s my legal authority to borrow to finance my project?” The next question may be, “Who will lend us the money?” In this article, we will address both questions.
Kent Cashell is Managing Director at RBC Capital Markets. 513.826.0551 | email@example.com.Andrew Laskey is Vice President, Public Finance at RBC Capital Markets. 513.826.0582 | firstname.lastname@example.org.
Ohio school districts have a very limited unvoted debt capacity. This typically means that, without voter approval, districts have limited options to finance and pay for capital improvements over time. While there are a few legal authorities to issue debt in the form of bonds, the most common method to borrow for these types of projects is a capital lease (also called a lease purchase or COPs). Since a capital lease is not technically debt, there are fewer limits and restrictions on their issuance. In fact, there is no explicit limitation on the size of a capital lease that can be entered into (unlike the numerous limitations on general obligation debt Ohio schools can issue). Many times, a capital lease is the only option a district might have to borrow for critical infrastructure needs. It should be noted that, while capital leases provide a legal avenue to borrow, the district usually must use existing resources to repay the lease over time. Once the legal authority to borrow has been determined, the question then becomes, who will lend us the money? There are two central methods to finance these capital facility needs. The district could pursue a security offering in the capital markets, with the assistance of an underwriter. The underwriter (along with the entire financing team) assists in the preparation of the offering, then the underwriter markets the district’s securities to a wide pool of interested investors. For larger projects this is the more typical method of issuance since the loan is syndicated to a pool of investors, each lending a portion of the total amount to the district. Additionally, the securities they purchase can be sold in the secondary market, which provides liquidity for their investments.
For smaller offerings, it has become increasingly common to solicit a direct loan from a single financial institution. Many times, this is called a “bank loan,” since many of these lenders are banks. Each method of issuance carries with it considerations, advantages, and disadvantages. Increasingly, financial institutions (mainly banks) have shown a desire and willingness to lend directly to public entities, including Ohio school districts. These direct loans have become more common for some key reasons. The process for originating a direct loan is relatively straightforward and can usually be completed more rapidly than a capital markets issue. Typically, no offering document (also called an Official Statement or Offering Circular) or credit rating is required for direct loans. Anyone who has issued debt in the capital markets knows that these two items are some of the most time-consuming aspects of preparing for a securities offering. This not only saves the district time but also typically saves on issuance costs, due to not incurring a credit rating fee and other fees which are typical with a capital markets issue. Another key benefit of a direct loan is that there are no ongoing continuing disclosure requirements (although, if you have other outstanding publicly-issued debt you will still have continuing disclosure requirements).
There are some key limitations with direct loans to consider. Typically, banks desire a loan repayment term that is relatively short (at least compared to the repayment of a typical bond issue). While each bank has its own lending guidelines which may change over time, the pool of lenders may be more limited for loans with a final maturity beyond 15 years. Additionally, banks tend to prefer general obligation loans over capital leases. This is not to say that a capital lease direct loan cannot be completed, but there could be an enhanced credit review and a smaller pool of potential lenders.
Obviously, a key consideration is which issuance method will produce the lowest interest cost? Unfortunately, there is no simple and straightforward answer. It depends on numerous factors including but not limited to: the size of the issuance, the security being offered (GO vs. capital lease), the length of repayment, capital market conditions, and banks’ willingness and ability to lend at any given time. It is possible to take a dual-track approach, where the board of education will authorize the treasurer to work with the financing team to explore both the capital markets and a direct loan to determine the most advantageous route for the district to take. This gives the financing team flexibility to solicit direct loan proposals and compare to a capital markets issuance and pursue the method of issuance that serves the particular needs of the district.
When exploring a direct loan, it can be beneficial to run a competitive process to solicit loan proposals from the financial institutions that are active in the direct loan market. The district can engage an “agent” to assist with this. In this role (“solicitation agent”), the solicitation agent assists in structuring the repayment term, as well as drafting a term sheet that lays out all of the applicable parameters of the loan including but not limited to: the borrowing amount, the security of the loan, the repayment schedule, optional redemption provisions, tax status, relevant financials, any fees the district may be responsible for, relevant proposal deadlines and transaction timelines. This process ensures the responding financial institutions understand the terms of the loan and provide proposals that can be compared on an “apples-to-apples” basis. These direct loan proposals can then be compared against each other and to a comparable capital markets issue before accepting a proposal or declining all and pursuing an issue in the capital markets.
Direct loans can be an excellent borrowing tool to finance critical district projects (and/or to refinance existing debt). By having a basic understanding of this financing option, school business officials will have another tool in their toolkit for when a need arises. Retaining the proper financing professionals early in the process can allow for smooth and successful financing. Entering into long term financial obligations should only be undertaken after careful consideration of all the options available to the district.