July 19 - Fitch Ratings has published an exposure draft of the charter school criteria outlining the agency’s changes to the way it analyzes charter schools. The draft includes a number of proposed amendments to existing criteria. If applied in the proposed form, the exposure draft would trigger a substantial number of downgrades to existing charter school ratings. Recent events in the charter school sector led Fitch to re-evaluate its assessment of the financial and operational downside risks facing these entities. Fundamentally, Fitch views charter schools as inherently non-investment grade because of their typically high leverage and lack of operational and financial flexibility. Those schools with significant credit strengths could reach investment grade, but will be capped in the ‘BBB’ rating category. Fitch invites feedback on the exposure draft during a four-week comment period ending Aug. 20, 2012. Please submit comments to firstname.lastname@example.org. The agency will continue to apply its current criteria until the finalization of the revised criteria, which Fitch expects to publish in September 2012, following the review of comments received during the comment period. The main proposals upon which feedback will be sought are: -- Increased Emphasis on External Risk Factors Fitch believes the operating model for charter schools exposes these entities to substantial external risks that are often outside of the direct control of management. These include political risk, regulatory risk, and competitive risk. Fitch proposes to place greater emphasis on these qualitative factors in assigning charter school credit ratings. -- School District Cap on Certain Charter School Ratings Fitch has observed at least one instance where a financially pressured school district withheld per-pupil funds legally due to a charter school, thereby significantly pressuring the school’s financial position. State intervention failed to solve the problem. In light of this risk, Fitch proposes to cap a school’s rating at the level of the school district that either authorizes it or serves as a pass-through for per pupil funding. -- Operating History and Renewal Threshold Charter renewal has always been a fundamental credit concern for the sector. Recent issues faced by rated schools highlighted the inherent risks of having basic operating authority controlled by an external party. Fitch proposes to rate as non-investment grade any schools that have less than five years of audited operating history and no charter renewals. This standard will also apply to transactions with multiple charter schools (pooled transactions) such that only those schools that meet the threshold will be included in Fitch’s assessment of historical pro forma maximum annual debt service (MADS) coverage (see below for more details). The only possible exceptions to this requirement will be when initial charter terms exceed five years and Fitch can sufficiently assess a school’s likelihood of renewal. -- Historical Financial Performance Expectations Most charter schools lack the history of audited financial performance to support an investment grade rating. The exposure draft identifies a set of baseline financial attributes Fitch would expect in order to consider a charter school for investment grade. They include sum sufficient pro forma MADS coverage, pro forma MADS burden (as a percentage of operating revenues) of 15% or less, and net debt-to-net income available for debt service of 10 times or less. Very few rated schools exhibit all of these attributes from audited financials, and this could be a primary driver of downgrades for existing ratings under the new criteria. -- Ratings Effect Fitch expects the proposed changes will affect ratings on nearly all charter schools. The agency currently rates 22 charter school transactions investment grade and expects most, if not all, of these ratings would be downgraded to non-investment grade under the proposed criteria. The five transactions currently rated non-investment grade could move one to two notches lower. This assessment is based on a preliminary review of Fitch’s charter school ratings. Further analysis will be performed when any final criteria are applied to all ratings, which could lead to a higher or lower number of rating actions. After the comment period and upon the publication of the new criteria, Fitch expects to place on Rating Watch Negative those schools it views at risk of downgrades, which could include all charter school ratings. Fitch would then conduct full rating reviews for those schools over the following six months, utilizing the new criteria. Fitch has also re-published its current charter school rating criteria alongside the exposure draft. The current charter school rating criteria remains unchanged, and in effect, with the exception of a specification that the criteria are currently under review and subject to comment. Feedback on the exposure draft should be sent to email@example.com by Aug. 20, 2012.