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Robert Sedivy, Collegiate School's vice president of finance, says tax-exempt bonds give private schools a head start on critical construction.

photo by Mark Rhodes

But seven years ago the Richmond-area school discovered a new financial tool that speeds up the process and saves money to boot. Collegiate floated $5.7 million in tax-exempt bonds through the Henrico County Industrial Development Authority. The bond offering financed a new fine arts building plus renovation work on several other facilities. This year Collegiate is back in the bond market with a $22 million deal that is helping to pay for three new buildings and related renovations. The bonds also will allow the school to build an addition to a science building and refinance the remaining debt from the 1992 offering.

Collegiate was among the first wave of private secondary schools in Virginia to take advantage of a 1990 change in Virginia law that gives private schools access to tax-exempt financing through industrial development authorities. Colleges and universities have used tax-exempt bonds for many years, and now private schools are using them to improve aging buildings and keep up with technology. Private schools can use the bonds if they have tax-exempt status from the Internal Revenue Service and enough financial stability to satisfy the underwriters and the issuing authority.

Until recently "secondary schools haven't had the credit worthiness colleges have," says John O'Neill, a bond attorney and partner in the Richmond-based law firm of Hunton & Williams. "That has changed as schools get older and more established."

Meanwhile, on the supply side of this education equation, high-tax-bracket investors seem to have an insatiable appetite for tax-exempt securities. While some buyers are loyal alumni, most are institutional investors with no sentimental attachment to the schools. Their confidence in private schools' ability to repay debt is based primarily on growing enrollments and endowments.

With bond interest rates the lowest they've been in more than 18 years, "schools would be foolish if they didn't look at the availability of bonds," O'Neill says. "I think we will continue to see an increase in private schools using these bonds."

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For schools like Collegiate, bond financing is a sidekick to the traditional capital campaign. The school is in the middle of a $23 million capital campaign it started in 1997. Two-thirds of the funds raised from donors will be used to pay construction debt from the bonds. The remainder will enhance Collegiate's endowment, which currently is $22.5 million.

Tax-exempt bonds are an important new financial tool, but Collegiate and other private schools "will always also depend on tuition and fund raising," Sedivy says. Borrowing through bonds allows classrooms to go up faster, but donations from alumni and other sources are critical in covering day-to-day expenses and reducing debt. They also contribute to burgeoning endowments, which can qualify private schools for lower interest rates. In the past most private school bonds were unrated, but Collegiate's latest issue secured an A-rating from Standard & Poor's.

As a satisfied bond user, Sedivy had no qualms sharing Collegiate's story during a day-long seminar on capital financing strategies for private schools. The November session in Charlottesville was sponsored by Davenport & Co. of Richmond, the lead underwriter for Collegiate's recent offering.

Of the 20 representatives of private schools from Virginia, Maryland and the District of Columbia attending the conference, not all were ready to jump on the bond bandwagon. But they were at least interested enough to come and learn about financing options to use down the road. Envoys came from institutions such as North Cross School in Roanoke, whose roots extend back more than 30 years, and from schools such as Charlottesville Catholic, which opened just three years ago.

After inundating guests with talks on bond ratings, legal guidelines and financing options, the seminar raised their comfort level by presenting three case studies. In addition to Collegiate's Sedivy, representatives from schools in Maryland and Washington gave detailed accounts of their bond offerings. The conference gave Davenport's David Rose, senior vice president and manager of its public finance department, a chance to follow up with potential new customers. Rose counts about a dozen private secondary schools among his firm's clients. Some have completed public offerings, while others are just beginning to consider the possibility.

Within a few weeks of the seminar, Rose was at Covenant School in Charlottesville, which is exploring the best way to move from a rented facility to a permanent campus. With about 600 private schools in Virginia having nonprofit status, the field of bond financing in the commonwealth is a fertile one.

For some schools Davenport acts as an underwriter. For others it functions solely as an advisor "deciding who has the best financing option and negotiating that," Rose explains. As an advisor, Rose forges ongoing relationships with administrators as they reassess capital needs and plans every year or two.

"We typically are paid on an hourly project basis," Rose says. "We try to get away from being paid by the size of the offering. There is almost an identical amount of work for a $3 million project as a $13 million project."

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When the enabling legislation passed in 1990, Episcopal High School in Alexandria didn't waste any time getting into the tax-free bond market.

"We went to work two or three weeks after legislation became effective in Virginia on July 1," recalls Dick Yarborough, treasurer of the school that bills itself as Virginia's first high school. Established in 1839 as a boarding school for boys, Episcopal's directors made the monumental decision to go co-ed in 1990, and tax-exempt financing was an immediate way to pay for necessary renovations.

In June 1991, the school borrowed $13.7 million in tax-exempt bonds through the Alexandria Industrial Revenue Commission. By the fall of that year, dormitories were built and renovated for females and new athletic fields were ready for action on the 150-acre campus. Episcopal enrolled its first class of 48 females that fall, and today 150 of its 400 students are girls.

Four years later Episcopal did a bond refinancing and an advanced refunding that paid off half its debt. For the refinancing, Episcopal secured lower interest rates with the help of an A1 bond rating from Moody's Investors Services. Its previous offering had been unrated.

Having a rating "gave us a better interest rate and opened the bonds to a wider market," Yarborough says. When it comes to using tax-free bonds, "we would do this again in a minute. If you do it right, everybody benefits. We get money at a lower rate, and the people who buy the bonds get a good deal."

But most important for Yarborough, who has worked at the school for 31 years, is the chance to get away from "the days of pay as you go" for pressing needs. "Everything in those days meant waiting to receive a gift from someone. In the last 10 to 12 years, we find when we need to get something done, we can't afford to wait."

Episcopal continues to rely on donations and is in the midst of a $60 million capital campaign, but no longer do buildings and renovations hinge on individual gifts. And the money that comes in from donors can be invested to earn a much higher rate of return than the interest on the bonds.

As bullish as he is on bonds, however, Yarborough advises schools considering them to be prepared for "fairly substantive fixed costs." For its initial round of bonds -- underwritten by Wheat First Securities -- the school anted up nearly $80,000 to cover commissions, legal fees, printing costs and miscellaneous expenses. "If you're only borrowing a million dollars," Yarborough warns, "it may not be worth it."

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Despite its name, Episcopal High School is only loosely connected to the Episcopal church. That separation has led to what Yarborough calls "completely clean bond transactions."

In tax-exempt bond deals, the question of religious affiliation is a big one. The 1973 U.S. Supreme Court case of Hunt vs. McNair established that to secure government bonds, a church-related educational institution must not have the "primary effect" of promoting religion. Legislation authorizing bond financing also must have a secular purpose and not excessively entangle the government with a religious institution.

Virginia has its own landmark case that makes private schools here extra mindful of church-and-state issues. In 1991, the state Supreme Court ruled in a lawsuit brought against the Industrial Development Authority of the city of Lynchburg that issuing bonds for Liberty University would violate the U.S. and Virginia constitutions. The college's mandatory chapel attendance, service requirements at a specific church and other factors prevented Liberty from using tax-exempt bonds.

Further legal challenges also have cropped up in the past year in Wisconsin and Minnesota, where several private schools are facing the church-and-state question. Virginia law, meanwhile, provides for a specific validation proceeding that schools with any religious ties typically must undergo before seeking tax-exempt bonds. It was during this validation process in 1991 that Liberty's religious affiliation became an issue.

"Validation puts on the table, at the beginning of the process, issues that are likely to be controversial," says Hunton & Williams' O'Neill. A private school must issue a 60-day public notice of its intent to file for tax-exempt bonds. Then there's a public hearing and a 30-day appeal period. The entire process can be time-consuming, and it involves reams of paperwork.

Another potential pitfall of tax-exempt bonds involves government restrictions on the use of buildings financed. This issue usually arises when a school wants to use bonds to build a facility, such as a cafeteria, that will be operated under contract by a for-profit company. Government bonds can't subsidize for-profit ventures in any way.

"The price to be paid for the low cost of bonds is limitations, which some schools don't want to deal with," O'Neill says.

Another issue schools must address is their tolerance for debt. Tax-exempt bonds are "not for everybody," says Jim Johnson, a managing director of First Union Capital Markets in Richmond. "Sometimes it is easy to borrow money and hard to pay it back."

Johnson, however, has handled bond deals for several private schools, including Episcopal High School, and he finds "more schools becoming familiar and comfortable with bond financing." He notes that "Virginia is very blessed with sound organizations whose boards of trustees have been diligent. I don't see too many schools extending themselves too far."

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Construction at Norfolk Collegiate's 11-acre lower school campus is hard to miss. A few walls are all that remain of the building the Norfolk private school has used since 1972. Rising in its place is a 52,000-square-foot structure that will welcome students this fall.

Norfolk Collegiate raised about $2 million for the project through a capital campaign, but a $4 million, tax-exempt bond offering through the Norfolk Airport Authority gave the school the cash it needed to build and equip the new facility this year. As soon as the school year wound down in May, demolition crews went to work.

The tax-exempt bonds provided "a cheaper way to borrow," says Charles Robinson, a Virginia Beach banker and chairman of Norfolk Collegiate's finance committee. "The interest rate was 2 percent less than what we could get in the conventional market."

This year Norfolk Collegiate's 300 lower-school students are studying in two temporary facilities at a Norfolk church and a former nursing school. Despite the inconvenience, parents aren't complaining, says Headmaster William King. Science and computer labs, bigger classrooms and a new gym will be among the pluses in place next semester. And the larger building, which is twice the size of the one it replaces, will allow Norfolk Collegiate to expand its enrollment by about 60 students.

Money is always tight at private day schools like Norfolk Collegiate, but careful financial management is also important to prestigious boarding schools such as Woodberry Forest. Established in 1889, Woodberry Forest has elite alumni and a long history, but it didn't hesitate to take advantage of tax-exempt bonds.

The Madison County institution, which still uses a building designed by Thomas Jefferson, first employed tax-free bonds in 1995 to add buildings, install a fiber-optic network and expand classrooms. This year Woodberry Forest is seeking $5 million from the Madison County Industrial Authority to renovate and expand its fine arts center. The school goes into the deal with an Aa2 rating from Moody's, the highest bond rating of any private secondary school in Virginia.

Although the $21,200 in tuition paid by parents for each of the 381 boys attending the school seems hefty enough, "we spend more on each child than tuition," says Eric Chafin, the school's chief financial officer. Having tax-free bonds available to cover construction costs lets Woodberry Forest make sure its buildings and technology are always up-to-date.

"We are fortunate the General Assembly and the tax code allow this," Chafin says of tax-exempt financing. "The bonds are extremely valuable to the school. They are the most inexpensive way to borrow and let us do the best we can with limited resources."

© FEBRUARY 1999, VIRGINIA BUSINESS MAGAZINE