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Dear CFO Hartmann,
We read with interest your comments appearing in the Aug. 30th Lantern article https://www.thelantern.com/2017/08/how-ohio-state-energy-partners-could-impact-university-in-coming-years/
Of particular note was the paragraph in which you responded to issues of transparency:
"When asked about transparency concerns, Hartmann said she wasn’t sure of their validity because she said Engie (sic) had engaged with Ohio State for more than two years and 'lots of input has come into this.' ”
For the record: "transparent" would be about the last word one might use to describe the reviewing process of this deal that reached completion during the previous academic year; it was anything but.
And one should probably not interpret the University Senate vote on 4/4/2017 of 44-22 in favor of approving the deal as in any way representing broader faculty opinion on this matter. If fact, a multi-college survey taken immediately following the Senate debate, in which faculty had access to both i) the Senate resolution and ii) the Full Concession Agreement (a document not made publicly available by OSU until the day after the Senate vote, and only then in response to legal action), recorded a faculty "vote" on the same Senate resolution of 89.1% against to 10.9% for (432 responding). Details of that survey may be found at https://ascfacultysurvey.wordpress.com.
The purpose of this letter, however, is not to relitigate the recent past, but rather - moving forward - to bring to your attention various financial concerns which have become more pronounced as a consequence of our review of documents i) recently recorded with the Franklin County Recorder's Office; ii) released by OSU via Public Records request within the past two months; iii) describing the agreement and currently posted on the osu energy management website. For ease of reference as well as access, following are the items in question (with permalinks to copies in our document repository):
D1. First Lien Open-Ended Leasehold Mortgage (OSEP as Mortgagor, MUFG Bank NA as Mortgagee), for the amount of $460M (recorded 7/6/2017; linked here)
D2. Second Lien Open-Ended Leasehold Mortgage (OSEP as Mortgagor, MUFG Bank NA as Mortgagee), for the amount of $390M (recorded 7/6/2017; linked here)
D3. OSEP Investment Model Structure (internal OSU/OSEP 50-year projection of OSEP costs and income; linked here)
D4. CEMP Fact Sheet (osu.edu energy management posting; linked here)
D5. Concession Agreement Summary (osu.edu energy management posting: linked here)
D6. Concession Agreement and Sch. 1 (osu.edu energy management posting; linked here) (Note: This seems to correspond to the first 205 pages of the 2655-page FCA date 4/10/2017)
This is a somewhat preliminary list of concerns; undoubtedly others will arise upon further investigation into the particulars of the OSEP partnership.
Item 1. Anticipated Capital Expenditures (including non-utility). Referring to D3, we see listed the estimated Capital Expenditure (Capex) costs beginning in FY 2018. There are some unexplained big-ticket items, such as the $155.6M expenditure scheduled for FY 2021, and $203.4M planned for FY 2051. More to the point, the 50-yr total (FY2018 - FY2067) for the projected costs - as listed on this IMS spreadsheet - is $1.7764 Billion Dollars. This expenditure, which OSU will be repaying to OSEP at an effective interest rate of over 7%, is completely separate from the O&M and Debt-repayment costs for which OSU is also responsible.
In OSU's presentations regarding the estimated costs to be incurred for capital improvements, the number used repeatedly was $250M - see, for example, the Fact Sheet D4 (Sustainability Costs, estimated). The D3 spreadsheet indicates these estimated 50-yr Capex costs to be roughly 7 times those advertised by the OSU administration during the course of their "transparent" discussions of the financials associated with this deal. And if one restricts just to the first 5-yr period FY2018 - FY2022 (that presumably will fall under the first 5-yr plan to be approved), OSU is already scheduled to incur Capex debt totaling $313M.
Q1. What OSU projects, if any, will the additional $1.5B+ in planned capital expenditures pay for that are not related to utilities, energy, and sustainability?
Q2. Given that the Capex estimates appearing in D3 were certainly known (at least roughly) to ENGIE as well as the OSU administration months before its July release due to a Public Records request, and certainly before the April 4th Senate vote on the CEMP agreement, why weren't these estimated costs publicly acknowledged earlier?
Q3. Is the $1.7764B 50-yr estimate an accurate approximation of what OSU's Capex costs will be, or could they grow even further? And if so, what is a realistic upper bound on these costs?
Item 2. Equity Lines and Financing. On June 30th, 2017, OSEP secured a first and second mortgage with MUFG Bank NA on the OSU property detailed in the FCA, and also listed in the mortgage documents themselves (D1, D2). The first mortgage for $460M is a 30-year note, while the second one matures in 20 years. In both cases, it seems these notes are collateralized by the utility facilities being "purchased" by OSEP that reside on the land being leased - this is the description of the transaction at least for the purpose of tax assessment that appears in the Concession Agreement Summary D5 (Article 2, Section 2.6), and we would assume also for the purpose of securing the afore-mentioned mortgages.
"Open-ended" of course means that they are not fixed mortgages but rather lines of credit, not unlike an equity line of credit on a personal residential property. So OSEP has established an $850M line of credit with an effective borrowing rate almost certainly at or near prime; somewhere around 4.5%. The payments are interest-only, and fully tax-deductible at the marginal corporate federal tax rate of 35%, yielding an effective after-tax borrowing rate of about 3%. It is natural to conclude that
OSU administration proclamations to the contrary, OSEP has no need (and seems unlikely) to use its own capital for these expenditures. Moreover, the almost certainly substantial spread between the borrowing rate for these open-ended mortgages and OSU's effective interest rate on OSEP's Capex provides a powerful financial incentive for OSEP to maximize its spending on capital improvement, regardless of actual need.
Questions related to this concern (Q5 & Q6) appear below.
Item 3. Computation of Cost for Capital Improvements. In this partnership OSU is a captive customer; there is absolutely no opportunity for competitive bidding or for market forces to keep a lid on costs. Article 4, Section 4.3 of the concession agreement D6 contains a general discussion of the approval procedure, and indicates the options that exist if a particular proposed expenditure is not agreed upon. However, there is little discussion of precisely how costs will be contained or controlled, as a practical matter.
Q4. How will OSU avoid overpricing on proposed capital improvements, or paying for unnecessary ones?
There is no independent panel of experts OSU can turn to in order to answer these questions, experts that do not have a vested interest in maximizing profit for OSEP and ENGIE. In fact, the stated premise used by OSU to proceed with the OSEP arrangement was precisely that it felt the need for outside expertise in meeting its sustainability goals for the future, expertise now being provided by ENGIE through OSEP.
It would seem you believe in the importance of transparency and accountability in order to make this OSEP partnership succeed in the long run. To that end
Q5. Will you, on the behalf of ENGIE and OSEP, commit to full transparency regarding the cost and necessity of proposed capital improvements?
Q6. Will you, on behalf of ENGIE and OSEP, commit to involving the OSU faculty as full partners in the evaluation of proposed OSEP capital improvements?
Item 4. Joint Appointments and Conflict of Interest. There is discussion in the concession agreement D6 regarding anticipated academic interactions of OSU faculty with OSEP. However, there does not seem to be any mention of exactly how OSU administrators will be allowed to interact. There are scenarios which would represent clear conflicts of interest or violate ethical guidelines; two examples come to mind (there certainly are others):
*) An OSU administrator having a joint appointment with OSEP, in which they might be involved - even indirectly - with negotiations between OSU and OSEP regarding proposed capital improvements or any other activity involving a cost to OSU;
*) An OSU administrator receiving compensation from OSEP for services rendered, unless such services have been unambiguously determined as not representing any conflict of interest.
As there inevitably will be cooperation between OSEP and the OSU community on various endeavors, it would seem prudent to establish an ethics review board that applies to administrators as well as faculty and staff, that will provide independent oversight and will be authorized to evaluate any joint activity that might represent a potential conflict of interest.
Q7. Will you, on behalf of ENGIE and OSEP, commit to the establishment of such an ethics review board in which faculty will be fully represented and will act as equal partners in all oversight activities and potential conflict of interest reviews, including those of administrators?
As you may surmise from the subject line, this is an open letter, which will also be published on our AboutOSU website www.aboutosu.zohosites.com. We would certainly welcome any response to this letter that you or ENGIE might offer. In any event, regardless of whether or not you choose to respond directly, please consider the above suggestions and questions in the constructive manner in which they were intended to be taken.
Managing Editor, AboutOSU
A cautionary chronology: MUFG Bank is owned (through MUFG Americas Holding Corp.) by The Bank of Tokyo-Mitsubishi UFJ (BTMU), who established 100% ownership in Nov. 2008. Prior to that it was the Union Bank of California Inter., the primary subsidiary of UnionBankCal Corp. The following is a (possibly incomplete) list of fines, penalties, sanctions and warnings targeting these institutions over the last 13 years:
1. Oct. 2004. The Federal Reserve executes a Written Agreement with Union Bank Calif. addressing money-laundering compliance issues (copy of the agreement linked here). The money laundering concerns centered around Union Bank's business relationship with a large number of Russian banks, with whom the bank severed its financial ties in 2004 as part of this Written Agreement.
2. Sept. 2007. Union Bank Calif. settles with US Dept. of Justice and the US Treasury Dept. after its implication in an extensive money-laundering scheme involving a network of Mexican drug cartels operating through the Mexican exchange house Ribadeo Casa de Cambio. The amount in penalties and forfeitures totaled $31.6M (Forbes article on this settlement linked here).
In 2008, as indicated above, Union Bank Calif. is purchased by the Bank of Tokyo-Mitsubishi (BTMU) - a wholly owned subsidiary of the Mitsubishi Financial UFJ Group (MUFG) - which has had its own issues with compliance.
3. Dec. 2012 . BTMU pays a settlement of $8,571,634 to the US Treasury as a penalty for financial dealings with sanctioned countries (copy of consent order detailing money-laundering offenses linked here).
4. June 2013. Bank of Tokyo-Mitsubishi UFJ settles with the State of New York after regulators identify a total of 28,000 transactions with internationally sanctioned countries (including Iran) totaling $100 Billion dollars from 2002 - 2007. BTMU pays $250M as part of their money-laundering settlement with the State of New York (description of charges against the bank and terms of settlement detailed in WaPo article linked here).
5. Nov. 2014. Previous penalty of $250M paid by BTMU to State of New York in 2013 increased by an additional $315M due to discovery that BTMU had improperly pressured PricewaterhouseCoopers during their preparation of a report on BTMU's financial misdeeds (articles describing the details of this additional penalty linked here; also here). The total fines and penalties incurred by BTMU for the money-laundering activities detailed in the original NY complaint, and their subsequent efforts to mislead investigators, reaches $565M.
6. Jan 2016. Japanese "information" magazine Sentaku publishes an article explaining the serious financial straits in which BTMU/MUFG currently finds itself, due in significant part to the state of the Japanese bond market and the debilitating impact of negative interest rates (article linked here). It concludes:
"Buds of growth are scarce in MUFG's domestic operations. The only hope for growth was in overseas operations, including those in the United States. If MUFG's business abroad hits a snag, the group will have nowhere else to turn."
7. July 2017. MUFG's "overseas operations" now include OSU.
SM: Your article certainly clarified a number of points left unaddressed by the administration's misleading presentation of the CEMP agreement. However, along with the FCA, it also raises some additional questions.
To start off, has this deal been finalized? Does the State have to approve it, for example? Or is this now a done deal?
HCA: To my knowledge (and I am not a lawyer), it is now a "done deal."
SM: What’s the timeframe in which you see this deal causing financial problems for OSU? And can we really predict what will happen over such a long term?
HCA: As explained in my article, I calculate there will be a significant annual cash-flow shortfall for many years: almost certainly for the next decade or two, probably for three or four decades, and perhaps for the entire five decades of the loan. On the plus side, however, the value of the OSU endowment in 2067 almost surely will be higher with than without the $1.015B loan, and 50 years from now any extra money will generate annual distributions that will no longer need to be used to make the escalating annual loan payments to OSEP. It is impossible to know how much extra value this will provide to OSU without predicting the performance of endowment fund investments and inflation for the next 50 years, among other unpredictable things. The downside effects are virtually certain and begin immediately, while the upside effects are uncertain and (if they arise) will not be seen for decades.
SM: What about the savings related to improved energy efficiency?
HCA: There is little doubt that savings will be realized in this area. Other colleges and universities have invested in energy efficiency improvements and have documented nice savings, and of course almost everyone appreciates the idea of not wasting as much energy.
However, the $1.015B loan is completely independent of any such gains because it has nothing at all to do with energy usage or efficiency. It’s a (massive) sideshow tacked onto the energy deal—the tail wagging the dog. The energy efficiency savings would be realized even if OSU had not demanded this massive up-front loan as part of the deal.
Furthermore, the interest rate OSU will be paying on the $250M of capital expenditures to make energy efficiency improvements is outrageously high compared to the interest rate it would pay if it borrowed in a conventional manner through the credit markets rather than borrowing from OSEP. If OSU borrowed in the usual fashion it would still get the energy savings that will arise from this plan.
In other words, the additional financial burdens placed on OSU as a result of the unfortunate financial provisions of this deal cannot be viewed as being even partially offset by potential savings from energy efficiency.
SM: It seems like the OSU administration is taking a $1B+ cash advance on a credit card with a high interest rate, thereby trapping OSU in growing levels of debt for decades to come. What is motivating the OSU administration to launch OSU onto such a dangerous path? Could it be that there are hidden interests in play?
HCA: It's not quite a credit-card interest rate, but the point of the question is spot-on. The effective interest rate is relatively high compared to what OSU would pay to borrow transparently and traditionally by selling bonds, as it has routinely done in the past to make significant capital expenditures.
There’s no short answer to the question of what might have motivated OSU administrators to set up this deal. We know the state has not been generous with higher education funding recently, and it has severely restricted tuition increases for years. I therefore speculate that the OSU administration's feelings of desperation in the face of this pressure might have contributed to some unwise financial decisions, including this one. In other words, I want to offer an explanation in which people were misguided rather than sinister. At least two plausible motivations for the deal come to mind in this view.
First, the OSU administration wants to be seen (remembered) as having massively increased the value of OSU's endowment. I'm not sure why this is so important to them beyond personal aggrandizement; maybe endowment fund value is a factor in some sort of university ranking system in which they think they can make OSU move up. There is no doubt this motivation was at play in the parking deal a few years ago, and there is little reason to believe it is any less relevant today, the departure of Gordon Gee notwithstanding.
Second, I have to believe OSU's own claims that it doesn't have enough cash on hand to pay for the infrastructure improvements required to dramatically improve energy efficiency. So, OSU has to borrow that money if it wants to be seen as "green". Some $250M in such loans beyond the $1.015B up-front loan will come from the concessionaire, OSEP, for this purpose. Why borrow from a private entity at a high interest rate? OSU might be at or near its effective, or perhaps its legal, conventional borrowing limit, and cannot get $250M for new capital projects through normal channels. OSU has hinted as much in some of its recent press releases about this deal. In other words, OSU literally might be unable (as opposed to unwilling) to borrow enough to make the desired energy efficiency improvements in the conventional way by selling bonds to investors. If it wants energy efficiency improvements, it now has to pay dearly for them by borrowing these funds at a shockingly high interest rate.
Solving the first problem, increasing the endowment, clearly required some creative financing to disguise a big loan (with proceeds put into the endowment) as the "consideration" for OSU "selling" part of the campus to the lender. Surely conventional borrowing would not have been possible simply to raise money to put into the endowment. I find this aspect of the deal hugely objectionable in principle as well as a bad financial move. It just doesn't pass the smell test.
Solving the second problem, finding money for energy-related capital improvements, is a different matter. Borrowing from a private firm might have been the only way OSU could get enough money to make energy infrastructure improvements. It's just going to pay far more for these loans over the next 50 years than if it had gone through the usual financial markets where it has recently borrowed huge sums for the Medical Center, north dorms, and other capital projects.
While not suggesting anything truly sinister, these explanations raise serious questions about the competence of the OSU administration and especially the Board of Trustees: the many dubious provisions of this deal, the repeated efforts to hide those provisions from the public, the very idea that OSU might have reached a point financially where anyone would feel compelled to pull an end-run on borrowing limits, etc. If OSU is really at the end of its conventional borrowing rope for capital projects, who has been minding the store? The mantra seems to have been that interest rates are low so let's borrow now! If you have to borrow, sure, it's been a good time to do it. But maybe OSU's long-range planning for capital projects hasn't properly accounted for borrowing limits.
As I mentioned before, I am trying hard not to submit to the temptation to impugn the motives of those who propose, promote, and approve dubious financial deals like this. I have no evidence that this isn't simply an act of desperation related to the apparent problems mentioned above. But if evidence of misbehavior surfaced, I admit I would be more disappointed than surprised.
SM: Has the BoT approved a dangerous course of action without performing a “due diligence” investigation into all the details of the deal, and its implications, including the long-term financial viability of OSU?
HCA: It's hard to know what the Board of Trustees understood about this deal before voting to approve it. The media reported the BoTs admittedly did not examine a letter an opponent sent to them before the vote that outlined some financial issues one hopes they would have considered. Essentially all their deliberations take place behind closed doors. If you've ever attended a Board of Trustees meeting, or a meeting of one of its committees, you’ll realize it's all carefully orchestrated to make sure there is essentially no opportunity for public discussion or debate.
SM: Is there any hint of a quid pro quo involved with this deal, as there seemed to have been when Geoff Chatas was hired by the firm that signed the lease for the parking deal right after the deal went through?
HCA: We'll have to wait and see if anything like that materializes. However, I'd be shocked if Mr. Chatas hasn't learned a lesson from the previous fiasco.
SM: The tax arrangements associated with this deal seem questionable at best. In particular, depreciating an "asset" that you don't actually own would seem to qualify as tax evasion. Is this arrangement actually legal? And, again, if they (OSEP) don't actually own the assets, then why should there be local property taxes for OSU to pay?
HCA: Not only am I not an attorney, I'm also not a CPA. To me, it also seems like tax evasion, and I'm pretty sure that if you or I or any other normal individual engaged in such shenanigans we'd quickly find ourselves conversing with IRS agents. However, I understand that while this area is complex and in some respects confusing even for experts, it apparently is legal for a private company to have "tax ownership" of something even while title rests with, say, the State of Ohio. Evidently this requires some sort of concessionaire agreement that lasts for a fairly long time; hence the 50-year deals we're seeing here and with OSU parking. This kind of arrangement permits the private entity to depreciate those assets over a relatively short term, less than 50 years, thereby considerably reducing its tax bill during those years.
In other words, the taxpayers of Ohio and the rest of the US effectively wind up paying some of the private company's tax bill—the taxpayers of Ohio having first paid for the state assets that now have been "sold" to the private company in order that it can get this tax break.
Regarding local property taxes, I suspect you can't legally have your cake and eat it, too. That is, if you claim tax ownership of something to depreciate it for federal income tax purposes, probably you also own it for local property tax purposes. The maddening thing about this deal is that OSU completely insulates OSEP from its resulting property tax obligation by agreeing to pay all of those property taxes—which OSU does not pay now because OSU property is state property and not subject to local property taxes.
In other words, the taxpayers of Ohio not only suffer the indignities mentioned earlier, but under this agreement also pay OSEP’s local property taxes. And remember that OSU also will reimburse OSEP each year for even more—perhaps much more—than OSEP will pay in federal income taxes on the interest income it receives from OSU on the total of $250M in loans for infrastructure improvements.
All this tax business is so deeply buried, in arcane tax rules and detailed provisions of the concessionaire agreement deliberately withheld from the public until hours before the Board of Trustees' approval vote, that it's no wonder there has been no public outrage over it yet.
SM: Assuming this arrangement between OSU and OSEP is legal from a tax law perspective, at the end of 50 years OSEP will have fully depreciated assets and capitalized improvements worth well over $1B. How can this be "transferred" back to OSU?
HCA: I can only speculate, as I did not notice anything about this in the concessionaire agreement. Maybe OSEP could "sell" back all the property that OSU has now "sold" to OSEP in return for a payment of $1 in the year 2067. Maybe OSU could treat the return of its property as a gift, but as a state entity would have no tax liability for it. In fact, now I have to wonder whether maybe OSEP could get a huge charitable deduction in 2067 for giving everything back to OSU. I hope not.
SM: The fact that OSU has agreed to pay the to-be-incurred commercial property taxes associated to the assets being acquired by OSEP - and the resultant tax exposure to OSU arising from this deal - was an aspect of this arrangement that, for some reason, the administration never mentioned in their presentation of the CEMP agreement.
However, it seems that it may very well be substantial, for the following reason: the undiscounted tax rate for commercial property in Columbus OH is roughly 8.7% (i.e., $87/$1,000) (see http://www.franklincountyauditor.com/public/documents/pdf/eb2ba03b-fabc-f095-58ac88efd2023a50.pdf). And the basis used for tax valuation of real property in Franklin County is often very close to the most recent sales price, if there was a recent sale.
Now OSU is claiming that the money they are getting from the CEMP partnership is not a loan. In other words, for tax purposes, this transaction should be viewed as a sale. If so, that would put the tax valuation of the "property" being "sold" at approximately $1B, potentially yielding an annual property tax bill of about $87M. This is in addition to the concessionaire fee that OSU will be paying, which starts out at $45M. And even if this is substantially discounted - say by 75% - this would still be an enormous addition to OSU's financial burden, adding at least another $1B in unadjusted tax dollars to the total cost over 50 years.
Does this seem possible? Am I misunderstanding the tax exposure being incurred by OSU?
HCA: I'm afraid I don't know enough about how such taxes work, nor how to interpret the relevant provisions of the agreement, so I can't hazard a guess about this. I hope someone outside the OSU administration who has such knowledge will be able to examine the agreement and estimate how much this commitment might increase the total cost to OSU.
Truthfully, I would be shocked if OSU were agreeing to pay tens of millions per year in property taxes in a provision that seems almost an afterthought in the agreement. They might be considered not very smart for paying too-high interest rates, etc. But if the property tax liability were anything like what you have estimated, this deal would border on insanity and certainly should bring into serious question whether anyone responsible for this agreement at OSU is upholding their fiduciary duty, which includes understanding what they are doing financially. I suspect the OSU administration (thinks they) are going to pay very little because of this provision. Someone knowledgeable in the tax arena needs to check that.
It is relatively easy, by way of contrast, to estimate the impact of the provision by which OSU covers OSEP's maximum possible federal income tax liability for the interest OSEP will receive for lending OSU $250M for infrastructure improvements. This tax liability to OSU is what makes the effective interest rate paid by OSU on these loans rise from a nominal 6.5% to over 7.5%.
SM: It seems there is another potentially significant cost that the administration accidentally forgot to include in their presentation of the CEMP agreement, having to do with the awarding of bonuses to OSEP in the event they surpass their Energy Use Intensity (EUI) 10-yr targets. This is discussed in Schedule 21 (pp. 2530 - 2531) of the final version of the FCA (linked here). If I am reading it right, they are anticipating spending $250M over 10 years to increase energy efficiency (as they measure it) by 25%. Of course, OSU is paying that $250M back with substantial interest.
Now, if by 6/30/2028 they i) spend less than $250M, and/or ii) increase the EUI by more than 25%, they get a (onetime?) bonus paid by OSU. According to the table on p. 2530: if, for example, EUI is improved by 35% for a cost of $200M, their bonus amounts to $70M. And in the extreme case EUI is improved by 40% with an expenditure of only $100M, then OSU will pay them a bonus of $150M.
Am I interpreting this correctly? And am I to understand that OSEP will be the ones who will be in charge of computing the 10-yr improvement in EUI (which will then determine their bonus)?
HCA: This is also my reading of the bonus provisions. The agreement stipulates a one-time bonus is to be computed in 2028, paid to OSEP in equal installments over the following 10 years. The bonus theoretically could be as much as $150M. But the bonus schedule strikes me as a bit odd, so I doubt OSU will pay the maximum bonus. The reason is that there is a significant incentive for OSEP to spend as much as possible of the $250M it has committed to fund energy conservation measures. This way, it gets not only the return on this $250M in loans (with OSU paying an effective interest rate that begins at over 7.5%) but also the opportunity to earn up to a $60M bonus for achieving energy efficiency gains that exceed 25%. In other words, I would be surprised if the OSEP loans to OSU for infrastructure improvements ended up being much less than $250M.
SM: We understand that part of the arrangement is that OSU has agreed to borrow, and pay back to OSEP, at least $250M for building and system improvements to enhance "sustainability". But the bidding for this is purely non-competitive. How is OSU going to avoid price-gouging on the costs?
HCA: I have noticed no mention of competitive bidding or protection against price-gouging in the concessionaire agreement, though there is some legal language about obtaining bids for infrastructure improvements. OSU is permitted not to authorize any particular improvement proposal from OSEP, but if it really wants to meet its energy efficiency goal then what can it do other than authorize the expenditure by OSEP to make the improvement, even if it's 10% or 20% more expensive than a price it might have gotten some other way? I'm not sure whether there are other provisions, e.g., state law, that mandate competitive bidding.
SM: Clearly there is a big push to boost the endowment fund at the expense of the long-range economic health of OSU. This will be a boon to the financial managers of that fund, whose annual service fees seem to be about 2-3% of the funds' value. In other words, this injection of capital into the endowment fund represents a windfall of $20-30M for those managing the fund. Who exactly manages the fund? And do those managers have any other business connections with members of the BoT?
HCA: The OSU web site (http://investments.osu.edu) says, "We implement the asset allocation model by partnering with external managers." I have no idea who those external managers are, but the OSU people involved are shown on this web site. If there were enough investigative journalists still employed to look into such things, maybe some connections between the unnamed external managers and the BoTs would be found. But I don’t know of any information that would suggest this.
SM: Does the return-on-investment quoted by the administration represent the gross return, or the net after all of these financial service fees have been paid?
HCA: The OSU web site (http://investments.osu.edu/portfolio-returns.html) says "net of fees," so I think it does account for management fees. LTIP, by the way, is the acronym used on that site for "long-term investment pool", i.e., the "endowment funds" (or at least the part of the endowment funds into which the $1.015B is to be put).
SM: The loan is $1.015B. With the payment schedule and a 1.5% increase on the payment per year, what would you estimate the total amount of money OSU will pay back in 2017 constant dollars? I understand this will require estimating what the inflation rate will be on average over the next 50 years.
HCA: I've created a simple spreadsheet [linked here] that contains some calculations of this sort. For those who want to examine it carefully, here’s a quick explanation.
Column D addresses your question. I've assumed the average annual inflation rate is 2.5% but you can change this in cell D2. With 2.5% annual inflation, the total fixed fee payment in 2017 dollars is almost $1.8B.
OSU administrators would surely argue that column C is more important: the net present value of the payment stream. Of course, based on how OSU modeled the parking privatization financials, they would want to use a ridiculously high discount rate of 9%. I believe it's common practice for companies to use a much lower discount rate when doing these sorts of calculations (which are arguably ridiculous in any case because you're trying to predict and summarize economic conditions over the next 50 years). Anyway, the NPV of the payments is under $1B even at an arguably reasonable 6% discount rate. So, OSU administrators surely would conclude that we should be happy to get $1.015B for this payment stream.
The problem is that neither of the above calculations is actually what we need. Moreover, both analyses require predicting inflation and/or market performance over the next 50 years, which makes them highly suspect. What really matters is how this deal compares to conventional borrowing: my argument is that OSU will be paying far more to borrow all this money from OSEP than it would pay with conventional borrowing.
In particular, if OSU sold bonds, there would be no adjustment of payments to account either for 2017 dollars or for net present value. There would be a fixed interest rate and OSU would pay interest each year on the remaining principal balance, which would not change. So, for example, if OSU borrowed $1.015B at 3.7% for 50 years, its interest payments each year would be fixed at $1.015B x 3.7%, or about $37.5M. However, at the end of 50 years, OSU would need to come up with $1.015B to pay back the principal. In the deal with OSEP, the payments start at $45M but there is no $1.015B principal payment due at the end of 50 years. So, is the payment stream OSU now faces a good deal or a bad deal compared to conventional borrowing?
To make a fair comparison, I claim you (first) need to look at the borrowed money as if it were amortized like a conventional 50-year mortgage, where some of each annual payment pays the interest on the remaining balance and the rest reduces the principal, so that after 50 years the principal balance is zero. For example, if OSU borrowed $1.015B at 3.7% for 50 years in this model, its interest payments each year would be about $44.9M. (I’ve chosen 3.7% as the interest rate in these examples because the annual payment is almost exactly $45M, the first annual payment for OSU in the actual deal with OSEP. However, the payment to OSEP actually increases by 1.5% each year so it reaches nearly $95M in year 50 rather than remaining fixed at $45M.)
The question then arises: how can we compute an effective annual interest rate with the unusual increasing payment stream OSU faces for the next 50 years? Here’s what I’ve done in columns E-H of the spreadsheet. It makes sense to me but is unfortunately a bit complicated. Basically, with payments increasing each year, this loan can be treated like a new loan with a new amortization schedule each year. In the first year, we know the principal balance ($1.015B) and the payment ($45M) and the remaining term of the loan (50 years), so we can compute the effective interest rate being charged on the principal balance in the first year (which turns out to be 3.719%). This allows us to compute how much of the first payment goes to interest ($37.752M) and how much goes to principal reduction ($7.248M). And this tells us what the principal balance is for the following year, at which time we effectively have a new loan for that amount with a term of 49 years. We also know the payment for the second year ($45M increased by 1.5%), so we repeat the calculation. And we do this each year. The effective interest rate increases each year until it is over 17% in year 50. To summarize this analysis, the interest rate OSU will be paying on the principal balance starts at 3.719% in the first year and increases each year to reach over 17% in year 50. Ouch!
Note that the calculation in columns E-H does not involve any assumptions about inflation or discount rates. It simply shows the annual interest rates being paid to borrow the money: rates that seem quite reasonable in the first few years and become increasingly usurious as the years pass.
It's still not clear what the "average interest rate" or the "effective interest rate" is for this kind of loan. Is it literally the arithmetic average of all these 50 effective interest rates (7.454%)? Is it the interest rate that, with fixed annual payments, would result in the same total of all payments (6.213%)? I think I can justify the claim that it's over 6% no matter how you look at it, but I frankly don't know how an accountant would define it. Perhaps someone could check this and/or do some kind of standard accepted calculation of the effective interest rate on this kind of loan, if there is one, and if it matters to anyone.
Even compared to the relatively high 4.8% interest rate paid by OSU for the $500M in “century bonds” it sold in 2011, an effective interest rate over 6% for a 50-year loan doesn’t seem particularly attractive. Interest rates are still low right now. You or I could get a 30-year mortgage at about a 4% interest rate. Even for a 50-year loan, one would hope OSU could get a comparable interest rate.
Why is the interest rate OSU is paying on the century bonds a relatively high 4.8%, then? I understand OSU chose to make those bonds taxable. Why, if it could have paid a much lower interest rate by making them tax-free (municipal) bonds? OSU said it planned to—and we hope it did—set aside a non-trivial portion of the bond proceeds to put into much riskier investments in the expectation (i.e., hope) that over 100 years those funds would have grown by far more than 4.8% annually, i.e., enough to pay off the century bonds’ principal a century from now. This kind of arbitrage, in which one borrows at the municipal rate and invests some of the proceeds at a taxable investment rate, evidently is not permitted by law. Sounds like a good law. It’s basically the same thing that prevents you or me from borrowing money on a home equity loan, investing the proceeds in the stock market rather than making home improvements, and deducting the interest paid on the loan.
SM: What could the OSU administration privatize next? All of its buildings? The main campus itself?
HCA: At the time of parking privatization, the administration made some noise about considering privatizing (or selling) the OSU Airport and the OSU golf courses. At some point, I heard a rumor about privatizing the dorms (which has been done by a few other universities) and another about the medical center. Gordon Gee vehemently denied any interest in selling/privatizing Ohio Stadium, but Michael Drake may have other ideas. Who knows what they'll think of privatizing next? The only thing that seems certain is that this will not be the last scheme to privatize OSU assets unless there is a lot more public pushback than we've seen on parking and energy management privatization.
SM: What type of transparency is there going to be regarding this entire process? Is there going to be effective oversight, or is the process going to take place behind closed doors?
HCA: If history is any indication, it will be done behind closed doors. OSU will report early and often that everything is going great and will pat itself on the back for having made a fantastic deal.
Observations by HCA's Child
On April 7, 2017, the OSU Board of Trustees unanimously approved the administration’s latest privatization scheme, the comprehensive energy management privatization plan (CEMP). This article summarizes three issues related to the CEMP agreement: (1) how OSU thwarted public scrutiny of the deal; (2) how we now understand why OSU was so eager to keep the financial details under wraps until it was too late for public review; and (3) how OSU’s public relations campaign to promote CEMP amounts to a heap of … “alternative facts”.
The Deal According to OSU
CEMP is now advertised on OSU’s project web site FAQ as follows, viewed April 9, 2017:
Ohio State has entered into a public-private partnership for comprehensive energy management to strengthen the university’s sustainability while providing new resources for the university’s academic mission. On April 7, 2017, the Board of Trustees approved a 50-year concession agreement and lease with Ohio State Energy Partners, a consortium made up of ENGIE North America and Axium Infrastructure.
There are four components to comprehensive energy management:
Operations: OSEP will operate the systems that power, heat and cool Ohio State’s Columbus campus under a 50-year lease of the university’s energy assets.
Sustainability: OSEP will propose, provide the capital funding for and implement energy conservation measures to improve Ohio State’s sustainability. During the first 10 years of the agreement, OSEP is required to meet the university’s goal of a 25 percent improvement in energy efficiency on the Columbus campus. The university will review each capital project and would approve only those that will provide appropriate environmental and financial benefits.
Supply: OSEP will work to enhance Ohio State’s effectiveness in the procurement process for electricity, natural gas and other energy sources. The university will continue to buy directly from providers, and Ohio State will continue to determine its priorities in terms of sources.
Academic collaboration: In addition to its $1.015 billion upfront payment to the university, OSEP will fund and carry out a $150 million commitment to support academics in specific areas requested by students, faculty and staff during the bidding process. Among these projects are a $50 million research hub and support for scholarships, internships, faculty and students.
The winning bidder—and we do mean winning, as you’ll see below—is a foreign consortium (ENGIE is French, Axium is Canadian) now known as Ohio State Energy Partners (OSEP). There is nothing particularly negative to say about these companies. Their web sites say they’re trying to make money by operating and financing energy infrastructure, and it seems they are good at it. OSU might well end up with a physical plant offering better energy efficiency in a few years. So, some good may come out of this. But at what price?
“Public-private partnership” is a euphemism for privatization of public assets. You may or may not like the idea of privatization of public assets; it’s something of an ideological question when taken in the abstract. One could rail against privatization of public assets on various grounds. But we won’t do that here because we now have another concrete instance that can be directly analyzed for what it is—if the relevant financial details are available.
How OSU Thwarted Public Scrutiny of CEMP
The first obvious question is: Why would any private firm agree to take on all these commitments? According to OSU’s summary, it seems to have nothing but obligations! Who can make money doing that? Read the rest of the FAQ and all other information I’m aware of coming from OSU before April 5 and you’ll find no mention of this question or the faintest hint of an answer, even though this critical piece of missing information was pointed out to OSU as early as October 2015. This glaring omission serves as a gigantic red flag to those of us who opposed OSU’s 50-year lease of parking operations that was approved some five years ago despite being opposed by over 80% of OSU faculty as well as many staff and students. (That’s another story entirely.)
A public records request to OSU seeking information about such details of CEMP was submitted on February 14, 2017. Excuses and delays followed the public records request. Finally, even after the OSU administration had received final bids and had decided which one to accept, OSU still refused to release the concessionaire agreement until a legal action was filed with the Ohio Supreme Court on April 4. On the evening of April 5 OSU responded with a link to the concessionaire agreement (linked here). Though there were still redactions claimed to involve “safety”, as far as one can see no financial details were redacted.
The provided document is 2,268 pages long. It deserves more study. However, some very disturbing financial issues were discovered quickly. These were outlined in an e-mail sent to the Secretary of the OSU Board of Trustees at 8:30 AM on April 7, the day of the vote. There is no indication that any Board members read this e-mail or, if they did, that they cared one whit about what's actually in the agreement they hastily and unanimously approved.
The failure of OSU to release the concessionaire agreement before it did, and the failure of the Secretary even to acknowledge receipt of this e-mail from a concerned citizen, speak loudly. The Board of Trustees was in no mood for any sort of public scrutiny of this proposal. Why?
No Wonder OSU Wanted to Keep the Financial Details Secret
Here are some of those disturbing financial issues.
Contrary to OSU’s past claims about leasing but not selling state-owned assets, the CEMP concessionaire agreement explicitly states that OSU is selling public assets to OSEP; at least, this is what federal, state, and local tax agencies are to be told. The sale is said to be in return for the up-front payment called the “Closing Consideration”. The actual dollar amount of the Closing Consideration is not shown in the concessionaire agreement that OSU finally released as a public record. Later public announcements from OSU did not make clear whether it was $1.015B or $1.165B, the latter figure including some $150M that OSEP is said to be committing to a joint energy research center and related programs. For purposes of the rest of this article, we use $1.015B.
Unsurprisingly, OSU actually is paying OSEP for its services and its money. The agreement involves three separate streams of annual payments from OSU to OSEP, together called the “Utility Fee”. A preliminary analysis of each stream shows that this is a terrible financial deal (for OSU, not for OSEP) in which OSU is borrowing massive amounts of money from OSEP rather than borrowing via the usual credit markets. Moreover, about 80% of the borrowed money is destined for an account in the OSU endowment, from which account distributions are promised to fund OSU operating expenses such as scholarships and faculty/staff compensation rather than capital projects—a dubious practice at best. And the lending arrangement itself can only be characterized as predatory.
OSEP does not appear to be taking any financial risk on this deal at all, but is guaranteed a tremendous, well-above-market return on its investment.
There is some indication in OSU statements beginning last week that OSU may believe suffering through this arrangement will somehow protect its credit rating so it can borrow even more millions or billions for other projects in the near future. But are the bond-rating agencies really so clueless that they will (all) fail to notice that OSU is incurring a 50-year obligation here to pay off over $1.25 billion in loans that just happen to fall outside the usual credit markets?
The Shell Game in OSU's PR Campaign
So far we’ve focused on OSU’s outflows, i.e., payments to OSEP. We know what they are for and we know—with surprising precision because the core of the “operating fee” for actually running OSU’s energy infrastructure is only about 20% of the “fixed fee”—how much money changes hands. It’s not pretty for OSU.
But wait, supporters of the plan will say. OSU gets an extra $1B to put into its endowment fund, and the returns on that $1B will be substantial if the stock market keeps going up. Even if OSU is paying 6% interest on the $1B, if the markets go up more than 6% annually over 50 years it will all have been a huge win!
Are they right? First, here’s what the project FAQ says OSU promises to do with the distributions it receives from the extra $1B in endowment funds:
Initially the proceeds of the upfront payment will be invested in Ohio State's endowment, dedicated to priorities being finalized in the university's strategic plan. These areas of investment include the following:
• Student financial aid to support access, affordability and excellence
• Compensation enhancements for faculty and staff to support competitiveness with academic peers; a portion of this will be tied to improvements in teaching effectiveness
• Classrooms, research labs and performance and arts spaces across disciplines (in combination with other sources of funding)
• A fund to enhance sustainability efforts
• Other strategic initiatives
The claim that there will be any “proceeds of the upfront payment” is an insidiously bogus ”alternative fact”. At least for the next many years, even a sustained bull market (and how likely is that when the bulls already have been running for almost eight years?) will leave OSU seriously in the red each year. Sure, 50 years from now, the endowment fund principal probably will be larger with this agreement than without it. But for most or maybe all of those 50 years OSU will be hemorrhaging money as a result of this deal because distributions from the project’s endowment account will be inadequate even to cover the “fixed fee” paid to OSEP.
Here’s why. The Board of Trustees has adopted a formula for the amount to be distributed from an endowment account each year. Let’s say, for example, that $1B buys 150,000 shares of the OSU endowment fund at $6666.67 per share. (Yes, this is really how it works, and the actual numbers are about right.) The Board’s distribution formula dictates that the annual distribution is 4.5% of the average value of those 150,000 shares over the previous seven years. The market basically has been going up for those seven years so the average share price over that period of time is lower than it is now, probably around $5600. This means the first annual distribution is to be about 4.5% of 150,000 shares times $5600 per share, or under $38M.
The “fixed fee” alone starts at $45M. The net loss is over $7M in the first year. Instead of massive amounts of money going into scholarships, faculty/staff “compensation enhancement”, etc., $7M has to come out of other OSU programs just to cover the shortfall.
In the future, if the markets go up fast enough, eventually the distribution will be sufficient to cover the “fixed fee”, which grows at “only” 1.5% per year. But by then OSU will certainly have borrowed much of the $250M from OSEP for those required infrastructure improvements, and the debt service on those funds will add to OSU’s outflow. There’s no specific schedule for when these improvements are to be made so it’s hard to analyze this more precisely. Yet if OSU is going to meet its 25% energy efficiency improvement goal within 10 years, much of this money will need to be committed in the very near future and substantial debt payments will certainly commence within the next few years at most.
If the endowment fund seven-year average share price goes down, of course, things will be considerably worse. The distribution formula damps out swings in the markets but it doesn’t ultimately guarantee anything.
The Board of Trustees could try to cover for its own mistake in approving the CEMP by changing its currently prudent distribution formula to something far more aggressive. It could take 5.5–6% of the last-seven-year average value to approximately cover the entire $45M “fixed fee” in the first year. Or it could take, say, 9% to cover the $45M plus provide some $30M of new money for scholarships and faculty/staff “compensation enhancements”. The problem is that such an aggressive formula can’t apply for long because it would soon leave too little in the endowment account to protect the principal in perpetuity (as it should for endowment funds).
What if the Board authorized the administration to use a ridiculously aggressive 9% distribution formula for the first year, just to get off on the right foot? Then there would be maybe $30M in the first year to be split among all those nice programs. How much of a faculty/staff raise would be possible? Oops, sorry, not a raise; what’s promised is a “compensation enhancement”. In other words, something like a bonus, because this would have to be a one-time payment. A salary increase would need to be taken out of the endowment distribution every year in perpetuity and that’s just impossible if you’re taking out something like 9% each year.
So, how much of a bonus could it be? OSU has about 30,000 faculty and staff, so if none of the $30M were allocated to increased student financial aid and none were allocated to any of the other nice things that are promised, the one-time bonus would average about $1,000 per employee. Better than nothing? Notwithstanding the improbability of these assumptions that could make even a modest $1,000 per person bonus possible, compare it to the $1,219,139 bonus received by OSU CFO Geoff Chatas in 2015 for arranging fabulous financial deals like this for OSU (http://www.bizjournals.com/columbus/blog/2016/03/osu-salary-database-updated-for-2016-plus-the.html), and a $1,000 bonus just doesn't seem all that impressive.
Who’s minding the store? The Board of Trustees may simply be willing to believe that the financial geniuses in OSU’s administration are telling the whole truth and nothing but the truth in OSU’s all-positive public relations releases about these privatization fiascos. Maybe they’re buying it all hook, line, and sinker, just like the legislature, governor, et al. Or maybe they’re complicit in hiding that truth from the public. Either way there’s a big problem, and little or nothing the public can do except try to bring it to light in the hope of preventing the privatization train from rolling smoothly into the next station.
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