Charter Schools: A Good Credit Risk to Improve Communities

Scott Sporte, Managing Director, Community Investment Group, NCB Capital Impact

Charter schools offer banks a socially responsible investment opportunity that supports many struggling communities where they need it most. But they also offer a good credit risk, with lenders with large portfolios reporting strong performance over a period of many years. Fortunately for charter schools—which have a financing need conservatively estimated at $1.3 billion annually and growing—the New Markets Tax Credit (NMTC) Program has been a catalytic tool for some banks entering this emerging market. (See "Charter Schools Benefit From New Markets Tax Credit Financing.")

Bridging the Financial Gap

Charter schools are publicly funded but are allowed to operate largely independent of school districts in exchange for a high degree of accountability for their academic performance. Because they are typically structured as independent nonprofit organizations, however, charter schools do not have school districts’ ability to offer taxpayer-backed revenue bonds to finance facilities. Consequently, identifying and securing financing for their facilities is often one of charter schools’ greatest obstacles to growth.

Despite this challenge, the number of charter schools has grown quickly, which only heightens the need for substantial facilities financing. To meet the challenge, charter schools have turned to a variety of different financing options, and the role of banks is increasing as the market evolves. Organizations that have been involved in financing charter schools since the beginning of the movement in the early 1990s have been working actively as a bridge to bring traditional lenders into the market. Their experience shows that charter schools present a solid credit risk, and their access to financing structures and credit enhancement can help attract capital to the market. One such bridge organization is NCB Capital Impact, a nonprofit Community Development Financial Institution (CDFI) and an affiliate of NCB, which has been financing charter school facilities as part of its core mission since 1992. Because NCB Capital Impact is an organization dedicated to providing financing and technical assistance in underserved areas, we view charter schools as an important part of our work to provide choices to people living in neighborhoods where few options exist for quality health care, education, housing, and employment.

Since 1995, NCB Capital Impact has provided more than $475 million in financing to charter schools in underserved areas. Our investment has proven to be a solid one, with delinquencies averaging less than 2 percent and cumulative charge-offs of less than $2 million, or less than 0.4 percent. Charter schools have been able to achieve an excellent social impact while presenting good credit risk. Our peer organizations—such as the Low Income Investment Fund (LIIF), the Reinvestment Fund (TRF), IFF, the Raza Development Fund (RDF), Self-Help, and others—report similar outcomes.

Financing With Partners

NCB Capital Impact has built on its lending track record by partnering with banks and other investors to finance charter school facilities. We have leveraged our experience in underwriting and managing charter school transactions by structuring financing pools through the use of subordinate debt, equity from programs like NMTC, and grants from the U.S. Department of Education (DOE) to provide credit enhancement. (See "Addressing the Finance Gap" for information on the DOE’s credit enhancement program.)

For example, we have created financing pools such as the Charter School Capital Access Program, a $45 million project developed in partnership with TRF in Pennsylvania. Through this program, six banks came together to share senior debt representing nearly 80 percent of the pool. (NCB Capital Impact and TRF shared 20 percent subordinate debt, and the entire pool was supported by a 15 percent credit enhancement from a DOE grant.) With the credit enhancement providing a first loss guarantee, plus the subordinate debt, senior lenders were exposed to no more than 65 percent of each transaction, with debt service coverage averaging 1.5:1.0 and loan-to-value ratios of 50 percent or less. Through this pool structure, senior lenders were able to provide important capital to the charter school market while mitigating credit risk.

We have also made extensive use of the NMTC program to finance charter school facilities. Schools have been able to benefit from the below-market interest rates and the flexible financing criteria that the NMTC subsidy provides. In one recent transaction, NCB Capital Impact financed the Jack H. Skirball Middle School, a charter school affiliated with the Alliance for College-Ready Public Schools, a nonprofit charter management organization with 18 schools operating under its umbrella in Los Angeles, California. The Skirball school is located in Los Angeles’ Watts neighborhood, where more than 85 percent of enrolled students qualify for the federal free and reduced-price lunch program. The school has seen strong performance on standardized tests that exceeds the performance of area middle schools.

Leveraged New Markets Tax Credit Structure

The development of the Jack H. Skirball Middle School required approximately $5.8 million in debt to acquire a site and finance demolition and new construction for a building to accommodate 375 students in grades 6 through 8. The NMTC transaction used the leveraged A-B structure (see figure 3), where debt is used to leverage the tax credit equity, helping to maximize the subsidy to the school borrower. The leveraged A-B structure is common in NMTC transactions, where the tax credit is leveraged by a debt component to provide a stronger return to the tax credit investor. (See the OCC’s Insights report "New Markets Tax Credits: Unlocking Investment Potential" for more information about NMTCs.) In figure 3, Note A in the leveraged structure represents the debt and Note B represents the tax credit equity investor's portion. Since the tax credit investor receives its return in the form of federal tax credits, the investor may not require a return of its original principal investment. As a result, the B note commonly carries a put/call agreement where the note can be put to the borrower for a nominal sum, at maturity, leaving significant equity (20 percent to 25 percent of the transaction) with the borrower.

NCB Capital Impact provided the allocation of NMTCs, which were purchased by the U.S. Bancorp Community Development Corporation (USBCDC), providing more than $1.6 million in equity to the project (Note B, less the $300,000 debt service received). NCB Capital Impact partnered with NCB, FSB (an Ohio thrift and subsidiary of NCB, with national operations) to share equally in the $4.2 million leveraged debt portion of the transaction (Note A). The result of combining this A-B structure is $5.8 million made available to Alliance Skirball through NCB Capital Impact’s Community Development Entity (CDE) using the NMTC program.

Figure 3: Alliance Skirball Middle School NMTC Transaction
Leveraged A-B Structure

Figure 3: Alliance Skirball Middle School NMTC Transaction Leveraged A-B Structure.

Leveraged NMTC transactions are structured as conduit transactions, in which an investment fund LLC is capitalized with both debt and equity. In this transaction, NCB Capital Impact and NCB, FSB made leveraged loans to the investment fund, and USBCDC provided the equity investment to purchase the tax credits. The loans were priced at a market interest rate and were structured as seven-year interest-only transactions, as is common in leveraged NMTC deals, since lenders may not receive any return of principal. Loan-to-value on the loans from NCB Capital Impact and NCB, FSB was approximately 75 percent at closing, and the school was able to service the debt at approximately 1.35:1.0.

The investment fund then used its combined capital to take controlling interest in a CDE owned by NCB Capital Impact, which then used the investment proceeds to make a loan to the charter school. The structure is an effective way to leverage the tax credits, but it places some limitations on the lender.

The first limitation is on collateral. Because the lender’s loan is to the investment fund, the lender does not have a direct mortgage security interest in the charter school facility. Its security is an assignment of the investment fund’s ownership interest in the CDE and its collateral, which is the underlying charter school loan.

The second limitation is on foreclosure rights. Lenders to the investment fund are asked to agree to forbear from taking any action on the collateral during the seven-year NMTC compliance period, because under NMTC requirements, substantially all of the investment must be deployed to an eligible borrower, such as a charter school, or the investor runs the risk of recapture, having to repay the tax credits plus applicable penalties. If the investment fund lender forecloses on the collateral and uses the sale proceeds to repay its loan, recapture risk is triggered, so lender forbearance is the generally accepted method to protect against this risk.

We have made use of credit enhancement tools to help mitigate lender risks stemming from reduced access to the underlying collateral and the refinancing risk that comes from having a seven-year transaction structured with no principal amortization. NMTC transactions are often structured with a 5 percent debt service reserve to make sure that payments continue to flow to lenders, even if the school experiences an operating issue. The debt service reserve is typically enough to cover one full year of debt payments, providing a helpful cash cushion. We have also made use of our DOE credit enhancement grant to support the lenders, pledging 10 percent of the principal balance to help offset the risk of a large balloon payment at loan maturity. Together these enhancements significantly reduce lender exposure and help attract regulated lenders such as NCB, FSB to these charter school transactions.

Our experience with charter schools has resulted in an excellent combination of positive community impact and appropriate credit risk. We are eager to bring other lenders to the charter school market, and we believe that our track record and experience demonstrate the strength and attractiveness of this important market.

Scott Sporte can be reached at (510) 496-2233 or