Talking about Financing Options for Nonprofits

April 13, 2011

We spoke with Kevin Quinn of the Wye River Group about financing options for nonprofits. Based in Annapolis, Maryland, Wye River provides financial advisory, capital financing and investment advisory services to not-for-profit institutions, and state and local governments and agencies ( Our questions and answers with Kevin are below:

1. Are regular bank loans and tax exempt financing (for 501 C 3’s) generally the only types of financing you see for nonprofits, or are there other popular financing vehicles?

Bank based financing, structured either as a taxable loan or a bank purchased tax-exempt bond, is the most prevalent form of debt financing for nonprofit organizations. However, for nonprofit borrowers with any of the following objectives or constraints, a public offering of fixed rate bonds may be an appropriate alternative:

  • True fixed rate financing with a term of 15 years or longer,
  • Amortization structure of up to 40 years,
  • More liberal financial covenants,
  • Lower fixed rates than available from banks due to strong, investment grade rated, credit quality, or
  • Bank loan-to-value (LTV) or other bank risk considerations that cannot be satisfied (i.e. relatively large project and/or small equity contribution).

2. Other than purchasing or refinancing a building, what other types of major loan purposes do you see?

Under Federal tax law, tax-exempt financing can only be used for tangible assets, such as equipment, land, or buildings. Typically such financing is used for the acquisition, development, construction, or renovation of facilities used by a nonprofit in its mission. There are no eligibility constraints for taxable debt financing. Consequently, taxable financing is sometimes used by nonprofit borrowers for “tax-law ineligible” costs such as the following:

  • Working capital
  • Rental property
  • Facilities in which religious services will be conducted
  • Facilities in which a commercial enterprise will be conducted

3. For 501 C 3 entities that can qualify to issue tax exempt bonds, what is generally the cut-off in terms of the size the loan needs to be for cost effectiveness as far as issue costs are concerned?

The major advantage of tax-exempt financing is that the interest cost is lower than that of taxable debt financing. The relative interest cost advantage can range from 20% to 33% lower, depending on the size and credit quality of the borrowing and the borrower. However, transaction costs for a tax-exempt financing are generally higher. Consequently, in order for a tax-exempt financing to be “cost justifiable,” in our experience, the minimum borrowing amounts should usually be at least $2.5 million for a bank-based financing and $5 million for a public offering.

4. What kinds of interest rate spreads from traditional bank financing do you see for tax-exempt bonds?

Banks provide financing to nonprofits in one of two ways: (1) through a direct loan or purchase of tax-exempt bonds, or (2) by “lending their credit” through a letter or line of credit. In the latter case, a letter-of-credit (LC) is used to secure the issuance of tax-exempt variable rate demand bonds (VRDBs) which are sold primarily to institutional investors. Although the VRDB structure is considerably more complicated than a direct bank financing, it has historically been the most popular financing alternative among nonprofit borrowers. This has been the case largely for two reasons:

  • First, absent a specific exemption under Federal tax law (for instance “bank qualified” financing or the “2 percent de minimis exception”), banks are limited in their ability to fully enjoy the “after tax” benefit of owning a tax-exempt obligation.
  • Second, until recently, banks could “leverage” their capital much more with a LC than a direct loan, thereby securing a better return on the capital exposed in a financing. The combination of changing tax laws, changes in bank capital, and accounting requirements and the currently low interest rate climate have had the collective effect of reducing the relative benefit to banks of LC based financing over direct financing.

With that background information, let’s get to answering your question. In general, under current market conditions, we are not seeing a meaningful difference in the “credit spreads” offered by banks for LCs and direct loans. Because LC spreads are not as advantageous, relatively speaking, as they once were, we are seeing increased participation in, and competition for, nonprofit financings from community and regional banks, which are not investment grade rated and do not have rated LC capability. That greater competition is good for nonprofit borrowers and has served to bring credit spreads down from the horrendous levels that prevailed in late 2008 and 2009 as a result of the credit crisis. In general, through the regular competitive solicitations that we conduct for nonprofit borrowers, we are seeing credit spreads that range from 85 up to 250 basis points (generally over LIBOR) depending on factors, such as the borrower’s credit quality, the borrower’s industry sector (i.e., education, healthcare and association) and size of financing.

Taking into effect the relative credit spreads and adjustments for the tax-exemption, we are seeing interest rate benefits on tax-exempt transactions (compared to taxable debt financings) ranging from 35-50 basis points for variable rate deals to up to 300 basis points for true fixed rate transactions.

5. What are your thoughts and advice with respect to interest rate swaps?

We approach interest rate swaps and similar derivatives based transactions with great care and skepticism. There are several problems with derivatives: complexity, accounting treatment and lack of pricing transparency. In general, if our client wants a fixed rate borrowing, we strive in our solicitation to secure “true” fixed rate financing proposals from the banks. However, many banks remain, by virtue of structure and strategy, “variable rate” lenders. Consequently, in our solicitations, we typically secure alternate bidding for the variable rate modality and then compute a “synthetic” fixed rate borrowing cost based on prevailing swap levels. When acquiring a swap for a client, we prefer to conduct a competitive bid process. Sometimes, because of size or credit circumstances, that is not practical and so we “negotiate” the swap terms with the same bank that is providing the financing. In recent years, we have found the banks to be more cooperative in negotiating up front their “markup” in the swap, so that our clients can be assured of market competitive pricing on the swap in advance of making a commitment.

6. What advice would you have for borrowers?

We think borrowers should consult an independent financial advisor, such as our firm, if they are considering or pursuing a debt financing. The capital markets are complex and bank pricing strategies and market conditions are constantly evolving. We specialize in this area and because of our regular involvement in financing solicitations, negotiations and implementations, are very current on prevailing rates, credit spread ranges, and “market” terms and covenants. Consequently, a borrower would benefit appreciably from the type of analysis, market reach and stewardship that a firm like ours can provide in first determining what type and structure of financing is most appropriate to its need and then securing its preferred type of financing on the best combination of price and terms through a competitive solicitation process. We have developed a very time and cost efficient process using a combination of web-based tools and information dissemination techniques to solicit upwards of 25 pre-qualified financial institutions for each transaction. Our process insures the following:

  • The most market competitive pricing and terms
  • The most cost efficient way to canvas the market for the best deal
  • Fairness among all of the competing banks
  • Informed decision-making, considerable time and cost savings, and peace of mind for the borrower

Got questions? Connect with an experienced Aprio Tax Exempt and Nonprofit CPA Services advisor today. 
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