Paul Wessel Final Assignment

Capital Markets and Development Finance - Alec Gershberg Milano Graduate School of Management and Urban Policy

New School University May 2003

Going Downstream: Capital Markets Accessing Non-Profit Organizations

(with apologies to Greg Stanton for the title)

Introduction Greg Stanton, a former Wall Street bond dealer, and his colleagues in “Going Mainsteam: NPOs Accessing the Capital Markets” exhort non-profit community and economic development organizations to take advantage of the efficiencies and opportunities of the capital markets. By pooling a number of cash flow streams, for instance small business loans, the originators

would be able to package these loans as a structured financing (perhaps with some form of credit enhancement provided by philanthropy or other socially motivated financial guarantor) and monetize them by selling them to an institutional investor(s). They would realize several immediate and quantifiable benefits such as lowering the cost of funds, lowering the transaction costs, reaching an institutional investor base that they never had access to before, and attracting a more consistent source of capital to their missions. …It takes several years to ready an organization for issuing in the markets because their systems and loan histories have to meet standard underwriting criteria. This cannot be achieved overnight. Nor can it be designed without direct involvement with Wall Street firms, investors, and underwriters that have developed and perfected these origination and issuing processes over the past 15 years.1

Connecticut’s health and educational facilities bonding authority, at the direction of the legislature, has sought to jump start such a process by acting as intermediary between the State, the bond markets, and Connecticut’s non-profit child care centers. This paper will examine a bond offering arising from this program and discuss it within the framework of Stanton’s thinking. Series D of the State of Connecticut Health and Educational Facilities Authority (“CHEFA”) Revenue Bond Child Care Facilities Program is a $3.94 million tax-exempt pooled offering providing loans for the construction of three non-profit daycare centers. It is the fourth in a series of $41.5 million bond offerings financing the construction of twenty-two non-profit child care facilities. CHEFA’s entry into child care facilities financing was authorized by Connecticut’s 1997 School Readiness legislation (Public Act 97-259) which sought through a variety of

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approaches to increase the quality and quantity of the state’s pre-school offerings. Its bond program is summarized in the Series D offering as follows:

The Authority's Child Care Facilities Program is one of the three loan programs established pursuant to School Readiness Act and is the only School Readiness Act loan program funded by the Authority's tax exempt bonds. Proceeds of such bonds are used to provide low-interest loans for the new construction or renovation of existing child care or child development centers, family resource centers or Head Start programs. The School Readiness Act provides that within appropriations available to the State Treasurer for child care facilities, not already allocated toward debt service for specific child care facilities, the Commissioner of Social Services may allow actual debt service, comprised of principal, interest and premium, if any, on such loans, a debt service reserve fund and a reasonable repair and replacement reserve to be paid provided such debt service terms are determined by the Commissioner to be reasonable.

Each of the Institutions is a contractor or subcontractor of the State Department of Social Services for its Child Day Care Center Program and/or a grantee or subgrantee of the State Department of Education for its School Readiness Program, and must agree that State grant funds received under either of the aforementioned programs will be intercepted by the State Department of Social Services to cover the portion of debt service not covered by the Debt Service Component and will be paid by the State Department of Social Services to the Trustee. If for any reason the ability of the Institution to continue to receive any of such grant funds is diminished, impaired, or interrupted, or if the State in any way curtails or adversely changes either of such programs, or the amounts which are otherwise available to be received by an Institution under such program, the ability of a Bondowner to receive payments on the Bonds may be adversely affected.2

The Series D Bond CHEFA’s Series D Childcare Facilities bond is an intricately structured package of credit enhancements, guarantees, and insurance undergirding the revenue streams of three publicly-subsidized privately-operated child care programs. As a result, according to the insurer, “(t)hanks to the innovative bond offering structure – and financial guarantee insurance provided by Ambac Assurance – the loans cost significantly less than those operators could have obtained through a bank or other lending institution.”3 A third of the $3.40 million offering, issued August 1, 2000, is issued as serial bonds. This $1.21 million is carved up into fourteen bonds growing from $65,000 to $110,000 over a 2002 – 2015 maturity period with interest rates rising from 4.4% to 5.3% over that time. The balance is issued as a 20-year $680,000 bond at 5.5% and a 30-year 5.5% $2.05 million bond. These returns are all tax-exempt and interest is payable semiannually. It is assumed that the serial – term mix of the offering was based on the August, 2000 market conditions. The underwriter, First Union National Bank, purchased the Series D at par, less an original issue discount of $73,000 and underwriter’s discount of $52,000 (rounded.) First Union, now Wachovia Bank, was selected the underwriter for the first series of Child Care Facilities bonds, at which time the fees were negotiated. “Given the unique structure and the relatively small size of each bond issue,” explains CHEFA Managing

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Director/CFO Jeffery Asher, Wachovia continued to be the underwriter for each subsequent series. 4 These rates compared favorably with others offered at the time, though the benefits of their tax-exempt earnings must also be computed in the final analysis:

Comparative Yields (%)

Type of Bond 1-year 10-year 20-year 30-year

Series D 4.4 4.875 5.5 5.5

Treasury Constant Maturities 6.06 6.04 6.13 5.80

State & Local general obligation bonds, mixed-

quality 5.58

Source: Federal Reserve Statistical Release H.15 July 31, 2000

Series D as well as it predecessors, are payable from a Trust Estate established by the original Series A and B Trust Indenture. The Trust Estate includes the revenues from the bond sales*, a Debt Service Reserve Fund, loan agreements with the non-profit childcare operators (secured by mortgages in the case of the Series D bonds, of which more will be discussed later), and “a Memorandum of Understanding between the Authority and the State pursuant to which the State has committed, to the extent of available appropriations, to pay amounts equal to each Institution's allocable share of debt service on the Bonds and to replenish any deficiencies in the Debt Service Reserve Fund.”5 (This MOU will be discussed more fully below.) The offering underscores this “to the extent of available appropriations” clause by continuing: “In the opinion of Bond Counsel, such payment and such replenishment by the State are subject to annual appropriation.” It further makes clear that it is the Trust Estate, and not CHEFA or the State of Connecticut, which is the debtor here:

The Series D Bonds are not and shall not be deemed to constitute a debt or liability of, or a pledge of the faith and credit of, the State or any political subdivision thereof, including the Authority, but shall be payable solely from the Trust Estate. Neither the faith and credit nor the taxing power of the State nor any political subdivision thereof is pledged to the payment of the principal of or interest on the Series D Bonds. The Authority has no taxing power.6

* less funds for construction, bond issuance, and capitalized interest held by CHEFA

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The bond beneficiaries: non-profit childcare centers In a narrow sense, the public policy goal of this quasi-governmental bond offering is to secure the lowest cost source of funds for three child care center construction projects:

o The Waterbury Children’s Center is a child care provider and educational facility associated with the Waterbury Hospital. The Center, with an annual program budget of $590,000, is receiving $1.95 million in bond proceeds to construct an 120-child center. This funding will supplement a subordinated $212,000 loan, an equity contribution of $400,000 and an $80,000 city grant.

o The Southfield Children’s Center employs a staff of 8 and has an annual program

budget of $257,000. It receives $1.1 million toward the construction of a 60 child center on land owned by the Newington Interfaith Housing Corporation. An additional $240,000 contribution of CDGB funds will complete the sources for this project.

o The Manchester Early Learning Center will develop a 60 child center using

$890,000 in bond proceeds. From its base of an annual program budget of $470,000 and a staff of 18, Manchester fills out its financing with $125,000 in CDGB funds and $490,000 in contributions.

A CHEFA-supplied Staff Memo provides additional background on the Manchester project. Among the “Key Strengths” outlined are:

o The Early Learning Center is the only state-subsidized child care program in Manchester.

o The State of Connecticut Department of Social Services agrees to subsidize 80% of the $65,000 debt service, with the balance intercepted from DSS operating subsidies due to the Center.

“Credit Concerns” listed include:

o the Center’s “strong dependence on public funding.”

o 78% of its income is dependent on continued State subsidies, similar to other projects financed under this bond program, though this risk is mitigated by the DSS debt service subsidy.

o The Center’s financial performance over the past five years was weak to poor, with losses in two of those years.

The memo also reports that projected Debt Service Coverage Ratio, inclusive of both operating and debt subsidies, drops from 1.36 to 1.20 over the first five years. (Revenue

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available for debt service appears reduced by increased subsidy, but no explanation is provided.) Clearly, Manchester and its sister projects require heavy subsidies of both debt service and operating budget. It is not surprising that multiple layers of credit enhancement are necessary to produce cost-effective bonds.

Credit Enhancement Stanton et al in “Going Mainstream: NPOs Accessing the Capital Markets,” pronounce “Credit enhancement is potentially the greatest equalizer between for profit and nonprofit capital market transactions.”7 Unquestionably, the credit enhancement in the Child Care Facilities Bonds allow the institutions described above to overcome the three hurdles, described by Stanton, that make the capital markets both desirable but, at the same time, inaccessible:

o Non-profits need for capital exceeds the availability from conventional sources. o Current funding sources are often unpredictable

o Long-term projects are often inhibited by short time horizons of typical funding sources.8

Credit enhancement fulfills Stanton’s promise here: The Series D Bonds have sold very well, according to CHEFA’s Asher “partly because the State of Connecticut was paying all of the debt service and mostly because of the AMBAC insurance.” All of CHEFA’s Child Care Facilities Bonds, now in their fifth series, are insured by Ambac. “We decided to do this,” Asher explains, “because it is much more cost effective and simpler to sell one credit rather than trying to educate the market on the individual child care credits. In addition to the simplicity, using Ambac gave the bond issues a AAA rating and the lowest possible tax-exempt interest rate.” A unique debt service payment process stands in front of this credit insurance. While the borrowers of the bond proceeds are the three non-profit child care corporations, the debt service is paid by the far more credit-worthy State of Connecticut. 80% of the debt service is an explicit debt service payment by the Department of Social Service (“DSS”). The remaining 20% is supplied through the “intercept” of DSS fees that would have normally been paid to these centers for the provision of child care services.* Commitments to payment of the “Debt Service Component” and the “Contract Intercept Component,” as well as provisions for a payment schedule are stipulated in a separate Memorandum of Understanding between DSS and CHEFA.

* This bifurcated payment approach may well be a maneuver to insure a more secure total debt payment flow while not directly violating a legislative prohibition on state funding of more than 80% of the project costs.

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Ultimately, then, while the CHEFA staff prepares and presents extensive financial analyses of the cash flow of each borrowing child care institution, 80% of the loan payments are guaranteed – albeit subject to annual appropriation – by the state of Connecticut. The remaining 20% of the payments are secure as long as (1) the operating subsidy program continues and (2) the childcare centers operate and enroll children eligible for the subsidies. Both of these areas have been problematic for certain borrowers under this program, more of which will be discussed below. A Debt Service Reserve Fund also strengthens the credit of this pooled bond issue. A pre-existing fund from prior issues, consisting of $500,000 from CHEFA and $1.5 million in state debt service appropriations (plus earnings), is increased by $454,000 from DSS to accommodate the increased needs imposed by this offering.

Redemption Provisions

Series D contains both optional and mandatory redemption provisions, or “calls.” Optional redemption rights by the CHEFA may be invoked for bonds maturing 10 or more years after the issuance date. These, presumably, would be invoked in the case of significant interest rate drops. Mandatory sinking fund redemptions begin to be triggered four years prior to the maturity of the 20 year bonds and nine years prior to the maturity of the 30 year bonds. The Trust handling the bond offering redeems the total 20 and 30 year term bonds in phases as the bonds mature. Among other things, sinking fund redemptions tend to stabilize a bond’s price by creating a market as they approach maturity. A special mandatory redemption feature appears necessary given the nature of the three non-profit child care borrowers, but somewhat troubling to CHEFA:

An unusual factor affecting overall pricing of the Child Care Facilities bonds is a special mandatory redemption feature, which my cost five basis points across maturities. The pricing achieved was reasonable, and the resulting scale of 5.7% was in line with the Authority’s goal to price this issue at equivalent or better yields than the previous two child care issues.9

This redemption takes place if (a) certain anticipated governmental approvals are not received, (b) a surplus beyond $25,000 remains after the completion of construction, (c) early retirement of the loan debt by one of the child care operators, or (d) the State determines the structure financed by the bond proceeds is no longer needed and retires the debt. Mandatory redemptions totaling $1,030,000 had been triggered by unexpended bond proceeds in two of the three earlier child care facilities bond series.

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Mortgage Leasehold New to this third series of the Child Care Facilities Program bonds is a mortgage leasehold provision. An examination of the introduction of this provision leads us quickly into a discussion of the public policy dimension of CHEFA’s Child Care Facilities bonds program. Each of the non-profit child care borrowers in Series D is required to execute a mortgage agreement allowing CHEFA to foreclose and take possession of the bond-funded center upon failure of a borrower to make requirement payments, or other “event of default” under its agreement with CHEFA. The reason for this new provision, explains CHEFA’s Jeffrey Asher, is that, “We wanted to improve our collateral and protect our rights to take over the child care facility when there was an event of default such as loss of license to operate as a child care center. We wanted to be able to bring someone else in to run the facility as a child care center.” Asher, in a CHEFA Board review of the Child Care Facilities program, argues the preferability of the “Illinois” model of financing, in which the state owns the bond-funded facility and the non-profit manages.10 In response to an emailed question for background on this, he replied:

If the state had direct ownership of all the buildings that were financed via this program, it would be much easier to replace the provider if it became necessary; we wouldn’t be faced with a transfer of ownership, we could simply hire a new child care provider. We had one provider that owned two facilities and they surrendered their child care licenses and got out of the business. We went through a very long, protracted legal process to transfer the ownership to another provider and we were limited to transferring the ownership to another child care provider that had financed in one of our pooled bond issues.

This movement of CHEFA from simply, as their homepage explains, helping “Connecticut's eligible health, educational and cultural nonprofits gain access to low-cost, tax-exempt debt financing so they can continue to meet the needs of their clients,” to potential manager of child care centers is very intriguing one. This possibility leads back to the discussion with which we began this paper, this notion of capital markets – and their disciplining institutions – accessing non-profit institutions.

Market Opportunities and Market Discipline CHEFA, to its credit, appears to take its quasi-governmental status and the broad mission of Public Act 97-259 to heart. From its base of Yale and Wesleyan Universities, Connecticut’s hospitals, large public institutions like UCONN, and likes of Miss Porter’s School, it is earnestly seeking to participate in the growth and development of smaller down-market child care centers, as well as charter schools.* Commendably, it is

* In 1997, CHEFA allocated $1.5 million from its operating reserves to make five-year term loans (interest only the first year) for renovations, equipment acquisition, working capital, and other start-up costs.

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venturing out into riskier markets in its striving to “invest in the health and education of Connecticut’s citizens.” CHEFA is playing a leadership role in Connecticut in developing the pooling mechanism that Stanton exhorts Community Development Financial Institutions to create. The Authority, under legislative mandate, is taking a top-down approach to the problem Stanton’s piece addresses from the bottom up. Here, we see the supply-side push to the dilemma/opportunity Stanton explores from the demand-side. The problem – and opportunity – of accessing the capital markets is that fundamental to the process is the imposition of organizational and financial discipline on the borrower. Long-term, low-cost financing is available to support the goals of a non-profit with cash flows (even if somewhat contrived, as is the case here) provided the non-profit is capable of performing – and willing to accept the consequences if it does not. When one of the earlier-funded non-profits lost its Head Start license, CHEFA joined with DSS in saving the real estate deal by bringing in new management and ownership .11 Where another financial institution might have simply foreclosed and liquidated the asset, CHEFA acted in accordance with its double bottom-line. A CHEFA board member even inquired about the fate of the teaching staff when discussing the board resolution on the transfer, a question unlikely to be considered at the board level of a JPMorgan Chase or Fleet. The mission-driven capital market institution then incorporated this experience into the later round of funding examined here. In addition to execution of the mortgage discussed above, CHEFA also imposed the following as a condition of access to the capital it could raise:

In the event an Institution breaches one or more covenants of its Loan Agreement the Authority may, in addition to other remedies, require the Institution to retain a Management Consultant for the purpose of making recommendations, which recommendations shall be adopted by the Institution, except to the extent limited by law. The Management Consultant may recommend replacement of management of a Facility. Pursuant to an agreement with an Institution entered into on June 1, 2000, the Authority has temporarily replaced management at two Facilities that were funded with a portion of the proceeds of the Series A and Series B Bonds and, in conjunction with the Department of Social Services, is in the process of selecting a permanent replacement manager for such Facilities.12

CHEFA is quite explicit that the access it provides to the capital markets brings with it a degree of management oversight that is more typical of venture capital than bond financing. In its board meeting “Child Care Sector Analysis,” CHEFA discussed problems with enrollment reporting required under the bond documents, low enrollments at a center which potentially puts a provider in default, and site visits by CHEFA staff. The CHEFA Executive Director comments that “part of the goal of the CHEFA child care program was to build management and financing expertise on the facility level. As CHEFA staff visits the providers, the level of capacity and compliance should increase.”13

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As CHEFA involvement in the child care facilities field deepens, it is even looking to take a more active role in the design of the facilities. Durability of construction, lack of indoor play space, and concern about “strip mall”-style design are all issues now on CHEFA’s plate.

Conclusion CHEFA’s attempt to squeeze the round peg of heavily subsidized child care into the square hole of the capital markets is fascinating process of squaring the peg and rounding the hole. It’s a sort of state-sponsored “creative destruction.” Ambac celebrates that it helped create day care for 700 children. The Chief Financial Officer of a bonding authority worries about the size of indoor play spaces. Heavily subsidized child care centers are pushed to think beyond the fiscal year cycle to 20 and 30 year cycles. While none of this really affects the serious and growing problem of the distribution of wealth in the country, it does impose a discipline on some of the ameliorative efforts to respond to that very troubling fact. In these times when “sustainable” and “measurable” are all the buzz in the community development field, it is good to see a process that imposes these standards in the way that markets do so well. If the “end of government as we know it” forces us to head for the capital markets because, to paraphrase bank robber Willie Sutton, that’s where the money is, CHEFA’s Child Care Facilities bonds program provides us with some very good lessons on how to get there. 1 Gregory Stanton, Jed Emerson, and Marcus Weiss, Work in Progress: “Going Mainstream: NPOs Accessing the Capital Markets,” p. 12. 2 State of Connecticut Health and Educational Facilities Authority Revenue Bonds, Child Care Facilities Program, Series D, August 1, 2000, pp I- 26. (Hereinafter referred to as “Series D Offering.” 3 Ambac, “Not-for-Profit Child Care Facilities Find Valuable Financing Through Insured Bond Proceeds,” http://www.ambac.com/pdfs/deals/child%20care.pdf 4 This comment and all others attributed to Jeffrey Asher are from a May, 2003 email from Asher to the author. 5 “Series D Offering,” p. 2 6 ibid. 7 Stanton et al, p. 8 8 Ibid, p. 3.

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9 Connecticut Housing Finance Authority, CHEFA – Investing in the Health and Education of Connecticut’s Citizens, Steps to CHEFA Financing, p. 13. Available at http://www.chefa.com/financials/CHEFA_00_web.pdf 10 CHEFA Board of Directors Minutes for the meeting of July 23, 2002, found at http://www.chefa.com/minutes/BrdMin_07.23.02.pdf. 11 For discussion of this, see CHEFA Board of Directors Minutes for the meeting of April 23, 2002, found at http://www.chefa.com/minutes/BrdMin_04.23.02.pdf . 12 “Series D Offering,” p. 31. 13 CHEFA Board of Directors Minutes, July 23, 2002