U.K.

Higher Education Reforms Pose University Challenge

Primary Credit Analyst: Hugo C Foxwood, London (44) 20-7176-3781; hugo.foxwood@standardandpoors.com Secondary Contact: Liesl Saldanha, London (44) 20-7176-3571; liesl_saldanha@standardandpoors.com Research Contributor: Robin Froggatt-Smith, London (44) 20-7176-3609; robin.froggatt-smith@standardandpoors.com

Table Of Contents
Higher Fees Lead to Marginal Net Financial Benefit Enrolment Reforms Make Revenues Less Predictable Student Demand May Change In An Era Of Higher Tuition Fees Creditworthiness Will Hinge On Management Demographic Challenges Ahead Related Criteria And Research

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U.K. Higher Education Reforms Pose University Challenge

Recent reforms have allowed many U.K. universities to nearly treble their tuition fees to 9,000 a year, and to enroll higher numbers of home and EU undergraduates. Following these changes, the first cycle of applications is now complete and the second is underway. Having analyzed the effects of the reforms to date, Standard & Poor's Ratings Services believes that they will widen the divergence between universities' credit profiles. In our view, universities charging the maximum 9,000 annual fee, and enrolling similar numbers of students, are likely to see a financial benefit, but this may prove marginal once the associated costs and grant reductions are taken into account. Universities charging closer to 6,000, meanwhile, are likely to face the challenge of adapting to a noticeable fall in revenues. More importantly, the funding reforms have increased universities' exposure to another major change: the reform of student number controls. In broad terms, this reform has removed some of the restrictions on undergraduate enrolment, allowing universities more freedom to expand their student bases. As a consequence, we believe the creditworthiness of many universities will continue to be affected, both positively and negatively, by an environment that is now less stable and predictable. As the recent reforms continue to affect not only funding and student number controls, but also student preferences, the credit quality of universities will increasingly depend on how readily they can adapt to change. Although the reforms to tuition fees mean that universities will have to manage a funding transition from grants to tuition fees, universities will in practice continue to benefit from the stability of public sector revenue sources. This is because the Student Loans Company (SLC), a non-profit organization owned by the U.K. government, generally pays regulated tuition fees directly to universities on students' behalf. The SLC then collects the repayments from the students. The universities themselves are not directly exposed to the level of repayments. Overview A rise in tuition fees, coupled with reforms to student number controls, has increased revenue volatility for U.K. universities. Even so, the likelihood of cash defaults at the universities remains remote because of government support for these institutions. We believe universities' creditworthiness will become increasingly dependent on the ability of management to adapt to changes in public policy and student demand.

More importantly, the new funding system will increase universities' exposure to another major reform: the relaxation of controls on student numbers. As some universities choose to expand their student bodies, others are likely to contract, leading to higher revenue volatility than the sector is used to managing. We therefore believe that management skill and expertise in setting fees, marketing the universities, and managing ongoing changes to student

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demand in the context of an evolving public policy framework will become increasingly crucial to universities' credit profiles. We believe that universities that fail to adapt effectively to the changing environment may see increasing volatility in their revenues, leading to a potential decline in credit quality. That said, in the event of impending financial failure, we generally believe there is a moderately high likelihood that the U.K. government, through the funding councils, would act so as to avoid a cash default, probably by brokering mergers or advancing grants where necessary.

Higher Fees Lead to Marginal Net Financial Benefit

In our opinion, even universities charging the maximum 9,000 annual tuition fee are likely to see only marginal net financial benefits from the new funding system. This is because of the other elements of the university reforms--namely, a reduction in teaching grants; increased mandatory spending on widening access to minorities; and a reduction in capital grants. And what financial gain there is may well be eroded by inflation over the years, because we believe that political sensitivities are bound to restrict the lifting of the 9,000 cap in line with the retail prices index. The U.K. government has already announced that it will not raise the cap for 2013/2014 or 2014/2015 (a slash between years denotes a period of one year). Furthermore, political pressure may well mean there are no announcements of increases in the cap before the general election due in May 2015. The more significant change for universities charging higher fees is not to the levels of funding, but to the change in funding sources. Standard & Poor's forecasts that by 2016, 59% of the sector's operating income will come from tuition fees, up from 29% in 2010. This includes revenues from overseas students, which we assume will continue to grow, although at less than the rate implied by the 11% average increase in enrolments over the past nine years (source for historical data: Higher Education Funding Council for England [HEFCE]). We estimate that the funding council grant, meanwhile, will decline to 8% in 2016 from 34% of operating revenues in 2010 (see chart), driven by real-term reductions in grants but overall growth in the operating revenue base. The decline in this funding source would be even more marked if we included the grant restricted for capital programs (capital grant; the chart below shows only operating revenues). We believe that the capital grant will decline to 1.7% from 4.2% of operating revenues over the same period, based on the future capital allocations that the government has indicated. (Source: Annual grant letters to HEFCE.)

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Nevertheless, there are some aspects of the funding shift that could be positive from a credit perspective. First, it could lead to greater revenue autonomy for those universities able to raise their fees without undermining demand. Second, universities wanting to spend less on capital investment and more on operating expenses may have more flexibility than under the old system, which had greater restrictions on use of the capital grant. And third, universities with stable demand may find that their revenue base is more predictable, and less dependent on ad hoc government policy decisions. However, these potential advantages should not be over-stated. Tuition fees are still capped at 9,000, and we do not see this limit rising in line with inflation in the context of the political sensitivities we describe above. And the more research-intensive universities are still materially exposed to government decisions affecting research funding, whether through funding council grants, research councils, or research contracts with other public sector entities. Although the shift to tuition fees from grants is a big conceptual change, universities will in practice continue to benefit from the stability of public sector revenue sources. This is because, for the most part, the SLC pays tuition fees directly to the universities on students' behalf. And importantly, it is the SLC, not the universities, which has direct exposure to the repayment rates on these loans. That said, we understand that the SLC will make advances to the universities in fewer installments over the year than funding council grants, causing some necessary adjustments to universities' working capital requirements.

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U.K. Higher Education Reforms Pose University Challenge

Another change that the new funding system has brought about is that universities will become more sensitive to volatility in student recruitment. Under the previous system, the HEFCE teaching grant was payable as long as universities recruited within 5% of their enrolment targets. Under the new system, if a typical university (with, say, annual undergraduate enrolment of 3,000 students and turnover of 250 million) recruits 5% less undergraduates than planned, it could face a budget shortfall of 0.5% of revenues. This would not be insignificant in a sector that typically posts low margins. HEFCE forecasts, for instance, that the higher education sector in England will average an operating surplus of less than 2% in financial 2013.

Enrolment Reforms Make Revenues Less Predictable

Our early indications are that these reforms--which give universities more flexibility to expand enrolment under certain conditions--have affected universities differently. Under the previous system, funding councils effectively limited the number of home and EU undergraduates a university could recruit, and in some cases, fined universities that over-recruited. Since then, the government has reduced the number of students funded by its block grant, and has reallocated the numbers in two ways. First, for the academic year 2013/2014, universities that offer courses that cost less than 7,500 a year have been allowed to bid to recruit approximately 13% more students, and those offering courses costing 7,500-8,250 have been allowed to bid for approximately 7% more students. This opportunity has proved of little interest to the stronger universities, which generally charge 9,000 for all their courses. Second, and more relevant to the stronger universities, is the removal of limits on the recruitment of students scoring above certain grades. Broadly speaking, universities were able to recruit unlimited numbers of students attaining at least AAB grades at A-level in 2012, and this threshold has been lowered to ABB for 2013. Some universities, such as the University of Bristol (Bristol) have aimed to expand their undergraduate enrolments within the delimited grade categories. Bristol targeted an increase in enrolments by 600 in 2012, and went beyond this goal by recruiting a total of 1,029 students (a 28% increase on 2011; source: The Universities and Colleges Admissions Service [UCAS]). Inevitably, however, the expansion of some universities has had a knock-on effect on others. In some cases, even universities with strong underlying demand profiles, such as the University of Sheffield, experienced an overall decline in their enrolments in 2012, as they were unable to recruit AAB+ grade students as planned, and had to reject applications from students with lower grades since they had already reached the relevant limit under the block grant. A lower-than-expected number of top A-level grades exacerbated this problem. The BBC reported that 2012 was the first time in two decades when the proportion of A and A* grades at A-level fell. Consequently, the number attaining AAB+ grades and above was about 15% less than many had expected. Many universities experiencing a shortfall in enrolments may have had a strong enough demand profile to potentially recruit more AAB+ grade students, but in retrospect may have made insufficient offers, failing to anticipate the decline in grades or the expansion of other universities.

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U.K. Higher Education Reforms Pose University Challenge

Looking ahead to financial 2014, we expect that enrolment may continue to be volatile. Given that most universities do not publicize their plans for enrolment, it can be difficult for them to accurately forecast what proportion of their offers will lead to enrolments. And universities will be reluctant to make too many offers beneath ABB that they are then obliged to honor, as they could risk penalization by HEFCE for recruiting above limits remaining under the block grant. That said, the further relaxation of the limit to include ABB grade students should enable mid-to-high-ranking universities to increase recruitment of students at that level, to compensate for reductions in their AAB+ grade enrolments. This, in turn, may of course depress the numbers of students that the less popular universities recruit, particularly universities that enroll ABB students but do not want to bid for the additional student places on courses costing less than 7,500 per year. We believe that expansion is likely to be limited to where existing infrastructure capacity allows it. Given the uncertainty over how this reform will develop over time, it's unlikely that many universities will be willing to increase investment in infrastructure to support a material expansion of home and EU undergraduates. Furthermore, many, but not all, of the universities with the strongest demand tend to be more interested in expanding their numbers of postgraduates (to help with research activities) and overseas students (because they pay higher fees), than home and EU undergraduates.

Student Demand May Change In An Era Of Higher Tuition Fees

Applications begin to recover from the fall in 2012
Standard & Poor's does not believe that the higher tuition fees will materially weaken underlying student demand, at least for the majority of universities that focus on school leavers. Although application levels for undergraduate entry in 2012, the first year of the new tuition fee regime, fell by 7.7%, the figures show applications creeping back up by 3.5% as of the January 2013 application deadline (see table 1). Perhaps more significantly, 2012 figures show that there was little decline (2.6%) in the largest and therefore single most important group of potential applicants: 18 year-olds. In 2013, applications from this demographic bounced back by almost 2%, and 19 year-old applicants, the second-most numerous group, recovered most of a 12% fall in the previous year (see table 1). The more marked decline is in applications from mature students. In year one of the new fee structure, there was a 12.2% fall, for instance, in applicants aged 25-29; and this trend has continued for older age groups this year. Such falls are likely to be at least partly due to the weak state of the U.K. economy, and the corresponding reluctance of businesses and mature individuals to invest in education. Universities that focus more on mature students, and that don't typically recruit overseas students (see "Overseas demand" section below), are therefore likely to feel the effects of this decline more strongly. More generally, precedent suggests that at least an element of the fall in application levels could be temporary, caused simply by the initial impact of higher tuition fees. In 2006, for instance, when tuition fees nearly trebled to 3,000, applications initially fell by 4.5%, but then rose by 7.1% and then 10.0% in the following years (source: UCAS). For these reasons, we don't believe that the fall in applications from the peak in 2011 marks the start of any underlying fall in student enrolments.

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Table 1

Total U.K. University Applicants By Age 2012-2013

Age 17 and under 18 19 20 21 22 23 24 25-29 30-39 40 and over Total 2012 7,808 280,229 103,652 38,950 21,285 14,265 10,383 8,278 23,422 21,486 10,315 540,073 2013 8,394 285,296 114,546 40,202 21,742 15,128 10,997 8,257 24,095 20,644 9,597 558,898 Difference (+/-) 586 5,067 10,894 1,252 457 863 614 (21) 673 (842) (718) 18825 Difference (%) 7.5% 1.8% 10.5% 3.2% 2.1% 6.0% 5.9% (0.3%) 2.9% (3.9%) (7%) 3.5%

Source: UCAS, as of the January application deadline. We note that some universities accept applications after this date.

Overseas demand continues to rise

We believe that fee income from overseas students will continue to grow in real terms, as it has done over the past nine years. This is positive for the stronger universities, which tend to recruit more international students. That said, we believe the U.K.'s market share of this growth may be lower as a result of events in the summer of 2012, when the London Metropolitan University's license to accept students from outside the EU was revoked by the U.K. Borders Agency. This led to the sudden threat of deportation for many of the university's students. Given the personal impact for the students, this was widely covered by the media in China and India--the main recruiting countries for U.K. universities. Although the Home Office has now granted London Metropolitan a new license to recruit non-EU students, the university remains on probation and the number of non-EU students that it can accept will be limited until April 2014. We continue to monitor the extent to which these events may deter future applications from overseas students. That said, non-EU applications have continued to rise by 9.6% this year, according to figures from January 2013 (see table 2). Overseas fees can assume a particular financial importance for universities, as the fees for students from outside the EU are unregulated and so tend to generate higher margins than regulated fees. Overseas fees are also more likely to keep pace with inflation. Nevertheless, dependence on overseas tuition fees can expose a university to certain risks, such as currency movements or events in other countries. Furthermore, in order to maintain a competitive position for international students, ongoing spending on infrastructure can assume additional importance.
Table 2

Total U.K. University Applicants By Domicile 2012-2013

Domicile U.K. (including Scotland and Northern Ireland) Other EU Non EU Total 2012 462,507 36,205 41,361 540,073 2013 475,587 37,991 45,320 558,898 Difference (+/-) 13,080 1,786 3,959 18,825 Difference (%) 2.8% 4.9% 9.6% 3.5%

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Table 2

Total U.K. University Applicants By Domicile 2012-2013 (cont.)

Source: UCAS, as of the January application deadline. We note that some universities accept applications after this date.

Universities will need to adapt to changing demand and rising expectations

With students now paying substantially higher tuition fees, we believe that the relative popularity of certain universities and courses could change more swiftly than previously, as applicants question previously held assumptions about course quality. Many universities have noted increased attendance by U.K.-based students on open days since the government announced the tuition fee reform. We believe this may point to increased scrutiny of the potential value of different degrees, as higher tuition fees take effect. The state of the U.K. economy, and of the different industries within it, may also have more of an influence on the demand for courses. Our analysis of the 2012 application data, for instance, shows that one of the greatest falls in applications (negative 16.1%) was for courses in creative arts and design--an industry that we perceive as particularly sensitive to the state of the economy. In 2013, application rates have recovered somewhat across all subjects, especially for applied sciences that teach for vocations (such as medicine and dentistry, up 2.0%); we think this trend is unsurprising in the context of the U.K.'s difficult graduate job market. Exceptions are social sciences, where declining demand could make it harder for institutions specializing in this area to meet their recruitment targets. That said, there is no clear sign of any decreasing interest in the arts and humanities more generally. Applications for history and philosophy, for instance, are up by 2.3% in 2013, more or less in line with overall application levels. As well as following any changes in course preferences, universities wishing to maintain demand will also need to follow students' changing priorities and expectations regarding university life more generally. Rising expectations, particularly concerning the quality of student social spaces, sports facilities, and residential accommodation can be important considerations for universities to factor into their capital plans. Universities charging fees at the lower end of the spectrum may find it difficult to invest in their infrastructure, particularly in light of the major reductions in capital grants from the funding councils. The desire to invest in infrastructure, coupled with concerns about the reputational implications of charging fees at the lower end of the spectrum, may explain why so many universities have set their fees at the upper end of the 6,000-9,000 range.

Demand for student accommodation could change

One way in which many universities meet their infrastructure needs, particularly for residential accommodation, is by working with third parties. For instance, a private-sector project company might fund the construction of student accommodation by issuing debt under a project finance structure, based on the project's estimated cash flows and assets, while the university takes responsibility for nominating students to rent the rooms. Although the associated debt is typically off the universities' balance sheets, in our opinion the arrangements with the project companies generally expose universities to differing degrees of risk, which we assess as part of our credit analysis of individual universities. At present, the demand for high-quality student accommodation in many cases far exceeds supply, supporting high occupancy rates. But concerns about the higher cost of tuition fees, greater interest in part-time study, and advances in communications technology, could make living at home a more attractive option for some, particularly where their interest in a subject may be more vocational than academic. Although there is little evidence to date of any major

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trend towards students living with their parents, we will continue to follow any changes in this area, and any consequent pressure that this might place on universities' relationships with project companies.

Creditworthiness Will Hinge On Management

In this changing environment, we believe that the ability of management to pursue effective strategies, and adapt to change, will be increasingly important in determining a university's creditworthiness. With greater variation of fees across the sector, and with students placing the value of their studies under more scrutiny, the new context is likely to require new skills. We believe that managements' skills and expertise in setting the right level of fees, marketing their universities, and managing the risks associated with ongoing changes to student demand in the context of an evolving public policy framework, will become increasingly important. For universities charging fees at the lower end of the spectrum, the financial challenge is likely to be how to reduce operating costs, or find efficiencies, without implementing measures that undermine student demand. Most universities have little flexibility to simply reduce surpluses-the average operating margin forecast for 2012/2013 in England, for instance, is just 2% of revenues. Furthermore, such universities will also face difficulties in finding capital investment. Universities charging fees at the lower end of the spectrum are also likely to be those that focus much more on teaching rather than research. As such, they are likely to receive less capital grant than the more research-intensive universities. (HEFCE, for instance, distinguishes between capital grants for teaching and for research. Capital for teaching has declined from about 600 million in 2010, to about 60 million in the current year, whereas capital for research has only declined from 366 million in 2010 to 221 million in the current year. Source: Annual grant letters to HEFCE.) As well as a lack of capital grant, pressure on operating margins may mean that such teaching-intensive universities are reluctant to take on debt and the associated debt-service costs. For these reasons, such universities may look particularly to third-party financing of infrastructure. For universities able to charge fees at the higher end of the spectrum, one of the key decisions will be where to target any extra resources. In the short term, it may make strategic sense for the research-intensive universities to reduce capital expenditure so as to increase operating expenditure on the number and caliber of their research staff. This may help improve their submissions to the Research Excellence Framework survey, for which the deadline is November 2013. The scores this body awards not only have reputational consequences, but also determine the levels of recurrent research grant that the funding councils award.

Demographic Challenges Ahead

We think that these tandem reforms to fees and student enrolments will test management's ability to deal with increased volatility in student numbers and, consequently, tuition fee revenues. We will therefore continue to follow in particular changes to the student number control system, the market for different universities and courses, demand from overseas students, and the effect of U.K. demographic changes.

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The U.K. think tank Higher Education Policy Institute estimates that the 18-20 age group--which forms the majority of undergraduate applicants--will decline by 13% in the 10 years to 2020/2021, before rising again at least partially. In what we view as the most likely scenario, we believe that this decline will be largely offset by other factors, such as increasing participation rates in the U.K. and growth in overseas students. But if universities are unable to take advantage of such offsetting factors, then a demographic shift could lead to noticeable fall in demand, until the demographic trend reverses. In this light, the impetus for well-targeted recruitment and a clear management strategy is timely, and may even fortify credit strength over the long term.

Related Criteria And Research

Rating Government-Related Entities: Methodology And Assumptions, Dec. 9, 2010 Tuition Fee Reforms Set To Widen Gap In Creditworthiness Between Strongest And Weakest U.K. Universities, Dec. 8, 2010 Approaches to Rating U.K. Universities Amid Growing Credit Diversity, March 28, 2003
Additional Contact: International Public Finance Ratings Europe; PublicFinanceEurope@standardandpoors.com

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