Weathering the storm Coping with financial challenge in the higher education sectora PwC Public Sector Research Centre publication

Contents

Introduction 2

Summary 3

The calm before the storm 4

The outlook 6

Operating in the storm 8

Conclusion 11

About PwC 12About the authorsContacts

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2

Introduction

The global economic downturn, the state of public finances, uncertainty around future funding levels and priorities, and the risk that the Higher Education (HE) sector will be targeted for spending cuts is increasing the possibility that some Higher Education Institutions (HEIs) will face greater financial challenges.

The HE sector has been the recipient of record levels of funding over the past decade and HEI total income has risen consistently. We reviewed the published financial data from the Higher Education Statistics Agency (HESA) and published financial statements for the sector for the four years ended 31st July 2008 (the most recent financial year end date for which data is available) and found that the financial position of the sector improved significantly during this time.

The financial year 2008/09 may well represent a high water mark in terms of the financial position of many HEIs. The sector’s annual financial cycle, combined with its diversified revenue base, will have delayed many of the effects of the economic downturn which are poised to hit over the next few years. Undoubtedly everyone will be impacted but some will be hit harder than others.

We are in no doubt that the downturn is already on the agenda of many in the HE sector and by now many HEIs will be preparing themselves for the full impact. While ‘success’ in the sector is clearly not measured solely by financial performance, a sound financial position is an essential element of HEI strategy. The risk of financial challenge in the sector is rising and the difference between those who struggle and those who do not will be the speed with which the issues are recognised, actions identified and implemented, as well as the financial position of each HEI going into the downturn.

In this Talking Points opinion piece we comment on the financial position of the overall sector going into the downturn, explore a potential scenario for the sector based on published forecast data, and consider applicable lessons from our work with other organisations that may benefit the HE sector.

The effects of the financial crisis may be coming later to the HE sector relative to other sectors; but one thing is certain, it is coming.

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While some HEIs will be more vulnerable than others, all HEIs will be impacted. Regardless of whether an HEI is in a relatively stronger or weaker financial position, difficult decisions are going to have to be made. We recommend looking at six key areas that our experience in other sectors has shown may be relevant to addressing the challenges ahead:

• Honesty and awareness of the size of the challenge

• Strong leadership

• Need to engage with the whole organisation and external stakeholders

• Realistic and detailed plans to resolve the situation

• Rigorous implementation (programme management arrangements)

• Financial control and discipline

Despite entering the downturn from a relatively strong financial position, the UK Higher Education sector currently faces a period of uncertainty. Impending tightening of public expenditure will impact the HE sector at a time when the cost base of many HEIs will rise. While the actual financial position of the sector at July 2009 is not yet available, forecast data suggests an overall weakening of the sector’s financial position.

Many Vice Chancellors and their finance departments are already considering how best to respond to the existing drive for efficiencies, announced via reductions in the teaching grant. We suspect that much of the easy savings will already have been achieved so that the ability of HEIs to respond to a prolonged second wave of revenue reduction arising from the re-assessment of public spending levels and priorities is likely to be more difficult. Forecasts for the next four years should include “downside” scenarios and challenge from zero based budgeting. In addition, there are lessons to be learned from other organisations that have already weathered financial challenge and crisis.

Summary

The likelihood of HEIs facing some degree of financial challenge over the next few years is increasing. Government encouragement to focus on income growth strategies is obviously part of the solution to the challenges that lie ahead for the sector. However, income growth strategies alone are unlikely to be sufficient and there will need to be focus on the cost of delivering services and operating models.

600

400

200

0

(200)

(400)

(600)

6000

4000

2000

0

(2000)

(4000)

(6000)

“Gro

ss”

cash

/ (d

ebt)

£m

UK

HE

Is n

et c

ash

/ (d

ebt)

pos

ition

£m

FYO5 FYO7FYO6 FYO8

(529)

(252)

30

426

Sector “gross” net cash (HEIs with net cash position)

Sector “gross” net debt (HEIs with net debt position)

Sector net cash/(debt)

2889

(3418) (3696)(3993)

(4660)

34444024

5086

80

70

60

50

40

30

20

10

0

(10)

(20)

(30)

(40)

800

600

400

200

0

(200)

(400)

No.

HE

Is in

defi

cit

FYO5 FYO7FYO6 FYO8

Gross operating surplus Gross operating deficit

No of HEIs in operating deficit

58

47 49

29250

(101)(128) (126)

(65)

303344

556

Source: PwC analysis of HESA data and statutory accounts

Source: PwC analysis of HESA data and statutory accounts

Sur

plu

s/d

efici

t (£

m)

4

Looking closely at the four years to July 2008 the number of HEIs with operating deficits halved, from 58 institutions to 29 (see Figure 1). More importantly, the aggregate total of operating deficits reduced while the aggregate total of operating surpluses increased significantly. Factors underlying this improving trend included:

• The introduction of student top up fees;

• An increase in student numbers in Higher Education, including an increase in foreign student numbers;

• Returns from financial markets and investments; and

• Increasing research grants and other income.

Cash and debt levels within the sector also show an improving trend (see Figure 2). Between July 2005 and July 2008 the net cash (debt) position of the sector improved dramatically from a net debt position of close to £(0.5) billion to a net cash position of close to £0.4 billion. Furthermore, a review of published accounts shows that the overall debt repayment profile of the sector was relatively long dated, suggesting that the sector as a whole was not facing significant re-financing risk.

The past decade has been one of expansion for the HE sector, with a doubling of its income as well as its expenditure. These have been the boom years for higher education and have reflected a period of economic growth in Britain. Even though income and expenditure are not measures of success in the HE sector, the long-term sustainability of any organisation is highly dependent upon its ability to cope during times of economic uncertainty.

We wanted to understand the overall financial picture of the HE sector at the end of the boom years and focused on the four years ended 31st July 2008, the most recent year for which financial data is currently available for the sector. While there are various financial measures that could be relative indicators of financial strength we have focused on the annual operating surplus or deficit. An operating surplus is an indicator that the cost base is being managed below income and, subject to movements in working capital and non-cash items, that an HEI is generating cash to fund investment and financing activity. We therefore see a track record of operating surpluses over the medium term as being a good indicator of financial strength.

The calm before the storm

Figure 2: UK HEI net cash/ (debt) FY05 to FY08

Figure 1: Aggregate operating surplus / (deficit) FY05 to FY08

80

60

40

20

0

(20)

(40)

(60)

(£m

)

HEIs

Source: PwC analysis

5

Figure 3: Cumulative operating surpluses / (deficits) FY05 to FY08 (before tax, JVs, MI and exceptionals)

These macro indicators suggest that the overall financial performance of the sector for the four years to July 2008 had been one of improvement.

However, even during this boom time, 41 HEIs – approximately 25% of the sector – generated cumulative aggregate operating deficits as seen in Figure 3. This chart is not a predictor of financial distress or an indicator of underperformance; we recognise that this would require a much more sophisticated review encompassing many non-financial measures. Furthermore, we recognise that HEIs may manage their activities to achieve a particular operating result, surplus or deficit, in any particular year. But a track record of recurring and significant operating deficits in such a favourable financial climate has to raise questions around how some of these HEIs will cope in more austere funding conditions. The challenges that lie ahead for the sector as a whole from increasingly tight fiscal constraints may be more significant for those HEIs close to or below the break-even point.

Nevertheless, while as a group these 41 HEIs tended to generate less operating cash flow relative to their incomes than the peer group, only four of the 41 had actual negative operating cash flow over the period. There may be several reasons for this but a key factor is likely to be around working capital management and the effect of non cash items. Sustaining positive working capital movements year-on-year is a challenge even in better economic conditions. It will be interesting to see the extent to which these positive cash effects from working capital management have been sustained or reversed in the July 2009 financial data.

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The statutory accounts for the HE sector year ended July 2009 and the analyses conducted by HESA are not yet available. However, in July 2009, the Higher Education Funding Council For England (HEFCE) published high level financial forecast information for each of the financial years 2009 through 2012.

While the key financial indicators show a downturn for the sector in 2009 with a recovery in the following years, HEFCE noted that:

“It is also not clear that the most recent forecasts fully reflect the increased level of financial risk facing the sector over the coming years.”1

This is a clear warning for the sector and highlights the difficult forecasting environment of late 2008 and 2009, particularly for those organisations that are funded in large part by the state. The implication may well be that some of the individual HEI forecasts submitted to HEFCE were too optimistic and may now be downgraded to a more conservative basis.

The outlook

Costs are forecast to increase by a compound annual growth rate of 4.9% which is slightly ahead of the compound annual growth rate in forecast income between 2007/08 and 2011/12. For some HEIs the growth in costs may be higher still because of the impact of future national pay awards and the burden of defined benefit pension obligations.

The relatively high fixed component of many HEIs’ cost base increases the degree of vulnerability from reductions in forecast income levels. This will add further financial risk to some HEIs. This point is acknowledged by HEFCE who concluded:

“There are undoubtedly going to be increased pressures on the sector, and the assumptions within the financial forecasts look optimistic, with HEIs’ anticipation of risks unclear. We are planning on the basis that the number of institutions at risk will increase over the forecast period, unless HEIs can mitigate some of the risks they are undoubtedly going to face.”2

HEFCE has stated that the number of HEIs at risk will increase unless mitigating actions can be taken. HEIs will come under pressure through a combination of:

• the application of efficiency savings to the current teaching grant;

• increased competition for research funding; a risk of reduced research grants and less income from the private sector / charities;

• increased competition for overseas students;

• lower investment income; and

• budget reductions at other public sector bodies (e.g. local authorities or the NHS) that have income relationships with some HEIs.

1 HEFCE, ‘Single conversation’ annual accountability returns – Outcomes for 2008 2 ibid

30

25

20

15

10

5

0

5

10

15

(£m

)

FY08 FY08 sensitised

HEIs

Source: PwC analysis

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The 2008/09 operating surplus forecast published by HEFCE already indicates a significant reduction of £267m relative to the 2007/08 total net surplus of £491m. As a percentage of total income this forecast operating surplus margin is 0.6% compared to an actual margin percentage of 2.0% in 2007/08. The data to assess how this £267m reduction will impact individual HEIs is not available so, by way of illustration, we have allocated the £267m forecast reduction across the sector pro rata to 2007/08 income (see Figure 4). This analysis is relatively simplistic but illustrates a potential impact on the sector if the forecast data were to materialise.

Financial forecasts are often updated, particularly during times of economic volatility, and different scenarios considered. Private sector management teams frequently engage in a range of ‘what if?’ planning scenarios as part of their normal planning and forecasting processes. If they are not already doing so, HEI management teams should be using such planning scenarios now in order to identify and evaluate potential risks and mitigating actions, and so be better enabled to address any challenges as they arise.

Figure 4: FY08 operating surplus / deficit with £267m sensitivity for England HEIs only

We believe that some institutions within the HE sector will face many of the same challenges that private sector companies have experienced and continue to face in an uncertain financial environment. A key distinction, however, between the higher education and private sectors is that HEIs tend not to fail; rather, they are turned around or forced to find another solution, such as a merger with another organisation. This is similar to the Health sector, where, over the last few years, many NHS Trusts have had to significantly reduce costs and increase efficiency in order to address substantial financial deficits.

Whether public or private sector, organisations that move quickly to recognise and adapt to the difficult market conditions and pressures will be those best placed coming out of the downturn. The HE sector will be no exception to this and many institutions will be well advanced in this approach. These organisations will naturally be better able to take advantage of the upturn as it emerges and to better fulfil their strategic ambitions.

Income growth strategies alone are unlikely to be sufficient to “weather the storm” and successful cost reduction strategies will need to be embarked upon. “Those HEIs that are unable to increase their income will need to consider restructuring their cost base to protect surpluses and cash flow.”3

For some organisations this is likely to require looking beyond the more traditional approaches to cost reduction and encouraging new ideas and thinking about how to deliver services more efficiently while retaining or improving quality. Those organisations that are slower to respond, or are in denial of the challenges ahead, are highly likely to face the “worst of the weather”.

With this in mind we explore below some of the lessons learned from our work across both private and public organisations that might be relevant to the HE sector:

1. Honesty and awareness of the size of the challengeManaging any organisation in a downturn will place additional demands on management. Organisations that move quickly to adapt to changed conditions are most likely to mitigate the effects of financial challenge. Before any financial turnaround can begin in earnest, it is crucial for any organisation (and other key stakeholders) to recognise that it has a serious issue and to translate this into a real understanding of the size and impact of the financial challenge it is facing. All too often the trap for many senior management teams facing financial pressure is denial of the issues, causing a lack of early action and slow decision-making, and often increasing tension with key

stakeholders. In our experience, the earlier that management acknowledges and addresses the challenge, the greater the likelihood that they will remain in control of the situation. Notably it is not unusual for stakeholders to have differing views on the scope and scale of a financial problem, as well as how the organisation seeks to address it.

2. Strong leadershipA critical success factor for organisations seeking to achieve financial stability is the role of the senior management team, and, in particular, the leader of the organisation. In successful NHS turnarounds, the visible and sustained sponsorship of the executive management team – particularly the Chief Executive – has often been key to ensuring that the organisation is clear on the scale and importance of the challenge. From our experience, success depends on the whole team being aligned and taking collective responsibility for implementing cost reduction / restructuring plans. Addressing a financial challenge must not be the sole preserve of the Finance Director and the finance team, but requires engagement, commitment and action across the organisation. In a university setting strong governance structures will be vital, with the Board of Governors playing an active role. Strategic change requires leadership from the senior management team, particularly the Vice Chancellor.

Operating in the storm

3 HEFCE, ‘Single conversation’ annual accountability returns – Outcomes for 2008

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In some challenging situations both private or public sector organisations may seek to bolster the Board or senior management team for a period of time through the appointment of turnaround professionals. These individuals can fulfil executive or advisory roles. Within the private sector and some public sector organisations the role of the Turnaround Director or Chief Restructuring Officer (CRO) has become increasingly common. This type of approach can be important when management is under-resourced and does not have the capacity to manage key projects within a pressured situation. This type of approach has been proven to give management quick access to senior resources that bring a fresh perspective along with the right experience and skillsets to provide the necessary support and leadership in unfamiliar territory. It can also assist in managing external stakeholder relationships.

3. Need to engage with the whole organisation and external stakeholdersAlthough the senior management team needs to lead and drive the turnaround or major cost reduction, its success is typically dependent on the wider organisation being engaged and bought into the process.

Effective engagement throughout the organisation helps to ensure organisational ownership of restructuring plans and typically sees

the best results. A key aspect of that ownership is that any cost reduction initiatives should be about creating efficiency and productivity rather than simply cutting costs and risking service quality. For some organisations it can be relatively easy to cut costs, but much more difficult to improve efficiency and productivity while maintaining or improving the quality of services. For HEIs, buy-in from key stakeholder communities such as the academic community, unions and student population are key to successful cost reduction programmes. A clear communication strategy articulating the need for, and benefits of, a cost reduction programme is essential to success. Similarly, careful management and engagement with external stakeholders is key in order to rebuild or retain their confidence and support during a difficult and often emotional period.

4. Realistic and detailed plans to resolve the situationIn the case of the NHS, a common feature behind some organisations’ failure to address their deficits and take early action was that cost reduction plans were developed at a high level without wide consultation throughout the organisation. Although it can be perceived as a painful and time-consuming process, plans must have sufficient granularity and have been well thought through, reviewed and challenged if they are to be successful.

This requires bottom-up planning rather than top-down allocation of budget cuts. The output from such a process must then be modelled properly into a set of resource and financial projections which can withstand review, and, if necessary, satisfy external stakeholders.

A key learning from our experiences with the NHS is that ‘operators’ within an organisation often already have “good ideas” about where to reduce costs or eliminate inefficiency. However, the real challenge lies in developing plans that are realistic and achievable, and avoid the trap of over-optimism in either the value that can be achieved or the time-scale for implementation. Detailed plans must be robust and reflect detailed financial costings which are embedded in the organisation’s financial budgets, so that the financial impact of projects can be clearly measured.

The nature of many turnaround and restructuring plans is such that a degree of external challenge and independence is sometimes beneficial to the process. The fact that an organisation may be able to demonstrate that, relative to some benchmark of its peers, it operates in a satisfactory manner does not necessarily mean this should go unchallenged.

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5. Rigorous implementation (programme management arrangements)A number of organisations going through turnaround have successfully battled significant financial challenges over the last few years, using a programme office approach to help deliver substantial savings programmes within challenging time lines. Boards and senior management teams are naturally keen to ensure that key programmes are being delivered and to do this it is critical that they have visibility of a sufficient level of implementation detail, including milestones, financial implications and relevant key performance indictors.

The establishment of a Programme Management Office (PMO) can provide an organisation with a vital implementation and measurement structure, enhancing both the capacity and capability of the organisation to successfully deliver proposed plans and realise their benefits. Typically, the role of a PMO is to ensure clear accountability with a rigorous management and reporting process in place that enables performance to be scrutinised against implementation plans.

Universities can be great generators of ideas and initiatives. Our experience has shown that those organisations which dedicate sufficient resource through mechanisms such as a PMO increase their chances of success.

6. Financial control and disciplineAny approach to delivering cost reduction has to be underpinned by increased financial control, discipline and austerity across the organisation. Organisations can fall foul of achieving discrete cost reduction targets but not achieving overall financial balance as a result of weak budgetary control. Successful and sustained turnaround requires the ability to deliver cost reduction programmes within the broader context of a greater focus on prudence and ‘value for money’ on expenditure across the board. While we recognise that HEIs do not have the same sort of economic drivers as the private sector, a culture where sound financial management might be seen as being less important than delivery in other performance areas is unlikely to bode well as the HE sector grapples with the full effects of the economic downturn.

Finally, in the context of financial pressure, organisations need to take a more proactive view of cash management and cash forecasting – remember “cash is king”. In some cases organisations are looking at asset realisations and / or alliances or consolidation to generate further cash flow.

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Now, more than ever, HEI management needs the right reliable information. The likelihood that the HE sector will face some degree of financial challenge over the next few years is increasing. Government encouragement to focus on income growth strategies is only part of the solution to the challenges that lie ahead. HEIs should be asking themselves what lessons can be learned from other sectors during these challenging times and implementing best practice. Now is the time for HEIs to plan for the coming storm.

Conclusion

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About PwC

About the authors

Contacts

Philip Bloomfield is a partner in PwC’s Transaction Services practice and in 2009 became a member of the PwC Higher Education leadership team. Within our Transaction Services practice Philip has responsibility for our work in the Government and Public sector as well as continuing responsibilities for a number of private sector client relationships. He has an interest in the Higher Education and Education sectors and has led a number of related assignments. Philip has worked exclusively on transaction related projects since 1996 and prior to that was a member of our Audit practice in London. He has some 24 years experience of advising clients, in the UK and internationally.

Quentin is a director and the Education sector lead in PwC’s Business Recovery Services team. Over the past 8 years Quentin has specialised in turnaround and restructuring, working with organisations (and their stakeholders) facing financial challenge and distress. He has a broad range of private sector experience in restructurings and turnaround, and has applied this experience to work across the public sector, including the NHS. Quentin has significant experience in developing cost reduction and turnaround plans, as well as the rapid ‘hands-on’ implementation of programme management solutions.

PricewaterhouseCoopers’ Government & Public Sector practice has been helping government and public sector organisations locally, regionally, nationally and internationally for many years. We work with organisations across sectors as diverse as health, education, transport, home affairs, criminal justice, local government, housing, social welfare, defence and international development. Our people combine deep specialist expertise with a genuine understanding of the public sector. Our Government and Public sector practice now comprises of approximately 1,300 people, who work across advisory, assurance, and tax. We bring specialist expertise from both our private and public sector practices to advise the higher education sector.

Higher Education Practice LeaderJohn Berriman020 7213 4656john.berriman@uk.pwc.com

Business Recovery ServicesQuentin Cole020 7212 6784quentin.r.cole@uk.pwc.com

Finance and AccountingRachel Taylor020 7212 3698rachel.z.taylor@uk.pwc.com

ConsultingDr. Tammy Long0191 269 3358tammy.long@uk.pwc.com

Corporate FinanceRay Mills0191 269 4284ray.mills@uk.pwc.com

Audit and AssuranceGreg Wilson0161 245 2916 greg.wilson@uk.pwc.com

TaxDavid Phelps0121 232 2092david.phelps@uk.pwc.com

Risk Assurance and Internal AuditPeter Smithson020 7212 5693peter.smithson@uk.pwc.com

Transaction Services and Due DiligencePhilip Bloomfield020 7804 4904philip.bloomfield@uk.pwc.com

Forensic ServicesEdwin Harland020 7804 5843edwin.harland@uk.pwc.com

StrategyDuncan Lampard020 7213 3390duncan.lampard@uk.pwc.com

Human Resource ServicesIan Tomlinson-Roe020 7213 1644ian.tomlinson-roe@uk.pwc.com

Quentin Cole 020 7212 6784 quentin.r.cole@uk.pwc.com

Philip Bloomfield 020 7804 4904 philip.bloomfield@uk.pwc.com

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without performing appropriate due diligence and/or obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on this information contained or for any decision based on it.

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