Your University Is in Trouble

The views expressed here are those of the author and do not necessarily reflect the views of Morningstar.

How are U.S. colleges and universities financed? For the purposes of our discussion, we will focus on private nonprofit four-year undergraduate schools. University accounting has some differences from public companies, but both have revenues and costs. The P&L statement starts with operating revenues. They are tuition, associated fees such as dormitory rent and food services, plus alumni giving and endowment draws. In most countries, universities are run by the government, so tuition is a government appropriation and a professor is a government employee. Private schools exist overseas; in France, for example, there are some private colleges in engineering and business. In the U.S., students who go to private universities can get government support, such as Pell Grants, or borrow money from the Department of Education. But faculty and staff are employees of the university.

Sen. Bernie Sanders, I-Vt., and others have proposed to have government pay college costs for most students, at least at public universities. In Europe, the socialist model of funding higher education has meant that their universities have had to fight for appropriations. Just as in Game of Thrones, governments face three dragons. For governments, these dragons are pensions, healthcare, and interest on the national debt. In Europe, each dragon has priority over education. Because Europe’s university tuition is negligible, lots of kids show up at the university, but there are not enough classrooms or professors to do much teaching, and so the quality and reputation of European universities has declined.

Private U.S. universities are financed by their alumni. Every year, universities ask them for money, and donations flow in. This “voluntary tax” is spent on scholarships, new buildings, and increasing the endowment. The generosity of alumni has made U.S. universities the best in the world.

Scholarships, aka Price Cuts In the 1980s, U.S. universities started jacking up tuitions every year. This was tolerated by students' families for a while, but the system today has broken down. The sticker price of tuition is no longer increasing, and discounting, politely known as scholarships (but in reality, just a price cut), has reached very high levels. The causes of this discounting include demographics (birth rates in the United States have been flat for decades, so there is no growth in the number of potential students) and economics (the cost of educating a child is more than many families can handle, and the potential economic value of education for liberal arts students is perceived as not very high). In sum, higher costs and lower value.

Discounting took off when high school students were able to use their home computers to prepare many applications with little effort. Schools, faced with a shortage of students, sent out lots of acceptances and scholarship offers. A kid with four different offers now has the economic power and can start a recruitment bidding war. The discounts from list prices are now universal, even for kids from wealthy families, and the size of the discounts has been increasing every year. The drop in tuition revenue has sent universities into negative cash flows. Schools are now using their endowment draws to cover operating deficits.

Bigness Matters Therefore, universities with big endowments will do well. Those with small endowments will fail. How much do private colleges have in their endowments? The following data comes from College Raptor, a site that helps high school students find colleges.

Four really rich universities have endowments over $20 billion: Harvard tops at $36 billion, then Yale, Stanford, and Princeton. Ten universities have endowments between $20 billion and $5 billion, led by MIT and Penn at about $13 billion, and are rich enough. So are the 15 schools in the $2 billion to $5 billion range.

If Old U has an endowment of $2 billion, it can pay out 5% of it for a princely $100 million. Directing 10% of that payout to help offset tuition shortfalls would be $10 million. If Old U has 5,000 students and the tuition “list price” is $40,000, then that sounds as if it would create $200 million in tuition revenue. But everyone is discounting. A couple of years ago, discounts were about 50% of the tuition sticker price, and Old U struggled to manage on $100 million net. The discount percentage has been going up every year and now is in the 60% range. That means $20 million less revenue for Old U, and so now, 20% of the endowment draw must cover it.

How about the next level down? There are 28 schools between $1 billion and $2 billion, sort of upper middle class in Endowment town. At $1 billion, your annual 5% draw of $50 million cannot divert $10 million to additional scholarships. But your generous alumni are supporting the university, and if they are donating $50 million per year, you can use some of that to plug the tuition gap. Solidly middle class are the 46 schools between $500 million and $1 billion, and they have no choice about cost-cutting and postponing capital spending.

Smaller Endowments, Bigger Problems. At the poverty level, below $500 million down to $100 million, there are about 200 schools. Many of them have P&Ls showing break-even before depreciation. But depreciation, a powerful dragon, does not care if it is being recognized or not. A university is a heap of 50 buildings, including ancient dormitories (that would not be considered habitable by anyone over 21), and classroom structures with needy HVAC and leaking roofs. If you want to make a college president cry, utter the dreaded phrase "deferred maintenance."

Endowment statistics, like many other data sets, are power series, with a handful at the top, a fair number in the middle, and a crowd at the bottom. Other examples of power series are wealth of families, golf handicaps, and bridge masterpoints.

In sum, about 300 private schools have endowments over $100 million: four really rich universities, 25 rich enough, 74 middle class, 200 poor.

Many hundreds of institutions have negligible endowments and are in the destitute class. Alumni giving offsets part of the endowment draw, but endowments are just the sum of unspent gifts. And it is hard to talk alums into suddenly getting more generous.

Relying on the Kindness of Strangers Every successful business is made up of several segments. Some divisions may be growing but are not profitable yet. But there must be one that is profitable, the "cash cow" that makes enough profit to support the whole. That is true for universities, too. For a long time, the law school and the business school were great profit centers. Then, the 2008 recession sliced the demand for lawyers and MBAs. These schools, while they still exist, must now discount tuitions like the rest of the university, and the cash cow has run out of milk.

The great remaining profit center is educating foreign students. Chinese and Indian students came to the United States to study, paid full tuition, and their numbers grew every year. Those marvelous years are coming to an end. A key factor is the U.S. government’s decision to grant fewer visas, both for students and graduates, who can no longer get two years to work in the United States after graduation. So, fewer foreign students are applying to U.S. schools, and it is probable that tuition discounting will damage the last remaining profitable sector in higher education.

There is a new thing happening in Chinese universities, especially in STEM. Tsinghua University and Harbin Institute of Technology researchers are publishing as many good research papers as do Stanford and MIT, and another half-dozen Chinese universities are coming on strong. China wants to lead the world in high-tech research just as they do in manufacturing steel and electronics. Their best students will get educated at institutions at home.

When I started at MIT—in 1951, a long time ago—it had a requirement that to do Ph.D. work, you had to know German, which had been the language of physics and chemistry for 50 years. In 1918, the University of Berlin had the very best: Walther Nernst, Fritz Haber, Max Planck, and the young Albert Einstein. Hitler destroyed German science, and U.S. universities came to rule the world.

There is no divine law to forbid the Chinese from building top universities and attracting international students who now prefer the United States. Right now, the Mandarin language is a barrier to U.S. and European students, but it is quite likely that in less than 10 years, a student will be able to own a device that will translate languages fast enough to allow him or her to converse without learning Chinese.

What is to be done?

The problem is that students can use the Internet to find the lowest-price education and easily select the best deal. The economist calls this “price discovery.” Retailers call it “Amazon.” Retail stores tried to cut costs, but they are vanishing. Colleges are feeling the same pressure and are trying the same solutions of cost-cutting and productivity improvement, but that may not help Syracuse any more than it helped Sears.

Government money and regulation can do a lot. Changing the student loan rules would make a difference, too. In the meantime, increased alumni support will extend the time that your college will survive until trends change. So, send in some money.

This article originally appeared in the Spring 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.