Science

Debt financing: academia's funding alternative Universities can purchase replacements for obsolete equipment with tax-exempt loans, rather than the usual cash from grants, contracts

I ι

Rudy M. Baum C&EN, San Francisco

To business, the idea is anything but new: Money is borrowed to purchase needed equipment or facilities, and the loan is paid back over a period of time with interest. But to colleges and universities seeking funds to purchase scientific equipment and facilities for research, the concept is a bit rad­ical.

It isn't radical to George G. Olson, vice president for research at Colo­rado State University, Fort Collins. In the past 17 years, he has been in­volved in using various tax-exempt debt mechanisms to purchase more than $25 million worth of scientific equipment and research facilities. And Olson thinks a number of factors will force other universities to turn to debt financing as well.

Colorado's Olson ( left), Hanson: any university could use debt financing

A number of recent reports, in­cluding the joint Department of Ed­ucation-National Science Foundation report, "Science and Engineering Education for the 1980's and Be­yond," and the reports of the Na­tional Commission on Research, have made the point that much university scientific equipment is obsolete. This obsolescence is hurting scientific re­search and education directly, and it contributes to universities' problems in holding onto high-quality faculty members in the face of competition from industry.

At the same time, funds earmarked

for equipment purchases are drying up. When the National Science Foundation's chemistry division was told to cut $2 million from its fiscal 1981 budget, the funds came out of the equipment budget. And the Rea­gan Administration's proposed 1982 NSF budget eliminates a new pro­gram that would have provided $75 million for new equipment (C&EN, April 20, page 21).

Universities usually have pur­chased scientific equipment after raising the money to pay for it. The money has come from direct state and federal appropriations, endowment

Tax-exempt financing can take several forms Revenue bond—issued by govern­

ment subdivisions (a category not well defined by the Internal Revenue Service) or by agents on behalf of various insti­tutions, including colleges and univer­sities. If an institution, such as a state university, is prohibited from incurring debt itself, an independent corporation, such as a nonprofit research foundation, may issue revenue bonds on behalf of the institution. Debt is serviced through use charges on the facility being fi­nanced. Debt security is limited to the facility. Upon retirement of the debt, title must pass to the institution for whom the bond was issued.

Industrial development bond (IDB)—a type of revenue bond issued by a city or county with no obligation to the taxpayers. IDB's originally were con­ceived to help depressed areas increase their tax base by attracting industries,

but they also can be used to finance purchase of scientific equipment or re­search facilities. IDB legislation has been enacted by 47 states. The debt is serviced through a direct lease between the municipality and the user, or through a lease to a third party with established credit (such as an independent research foundation) to guarantee payment and manage the debt. Security can be lim­ited to the facility being financed or in­clude additional security offered by the user or by the third party. Upon retire­ment of the debt, title may pass to the user or to the third party.

Municipal lease—a mechanism that allows government subdivisions to pur­chase facilities or equipment without officially incurring debt. As opposed to a bond, which is a long-term debt com­mitment, the term of a lease is on a fis­cal-year basis with renewable options.

(This allows state universities, barred from incurring debt, to borrow directly because the debt can be canceled.) The lessee must be a government subdivi­sion. Liability on a municipal lease is limited to the terms of the lease, and the rate of payment must include principal and interest. Municipal leases generally conform to Office of Management & Budget Circular A-21 requirements, however, because the lessor is an "arm's length agent" (the lessor cannot control the actions of the lessee) and because the lease can be canceled. Upon retirement of the debt, title must pass to the lessee at completion of nominal payment.

Tax-exempt commercial borrow­ing—essentially a revolving, unsecured line of credit obtained from a bank. In­terest to the lender is tax-exempt be­cause of the nature of the borrower—for example, a tax-exempt, nonprofit re­search foundation.

20 C&EN June 1, 1981

Industrial development bond used for research computer

Project

Cost

Terms

issuer

Authority

Debt servicing (a third-party lease)

Advantages of third-party lease

TRIe

Cray Research Inc., Cray 1 computer for the National Center for Atmospheric Research in Boulder, Colo.

$9 million

10 years at 6% interest in 1977

Boulder County, Colorado, for Colorado State University Research Foundation (CSURF)

State and federal industrial development bond laws

CSURF purchased the computer from Cray Research and leases it to NCAR; rent includes principal and interest; terms include a 90-day cancellation clause

Provides additional equity, default management, and tax-exempt financing experience

CSURF, which has agreed to sell the computer to NCAR for $25 upon retirement of bond

funds, and particularly from indi­vidual scientists' contracts and grants.

"The scientific funding mechanism is dominated by the single-investi­gator grant, and that mechanism is clearly failing to provide adequately for instrumentation," according to Cornelius J. Pings, vice provost and professor of chemical engineering at California Institute of Technology and former director of the now dis­banded National Commission on Research.

Like Pings, Olson thinks the tra­ditional patterns for funding the purchase of scientific equipment simply haven't worked. "Universities can and must adopt a businesslike approach to equipment financing," he says. "The typical university research administrator refuses to be a risk manager. There is a downside risk in borrowing money to purchase equip­ment, but even that has advantages because it forces careful evaluation of an investigator's or a project's strength."

Colorado State got involved in debt financing, Olson says, out of necessi­ty. The Colorado State University Research Foundation (CSURF) had been incorporated in 1941 to handle university patents and inventions, and in 1960 it began to handle con­tracts and grants on a regular basis. In 1966, the university wanted to pur­chase its first scientific computer, a Control Data Corp. 6400, and to set up a center for disease control labo­ratory.

"Essentially we were an unknown university, pretty much in the middle of nowhere, in a state not strongly behind basic research," Olson says. The university requested that the state legislature appropriate the $2 million to $3 million for the computer and was turned down. The legislature suggested that CSURF finance the project. The research foundation used revenue bonds to raise the money for the computer, as well as $1.3 million for the center for disease control laboratory.

Since then, CSURF has used a revenue bond to purchase a 200-acre research farm; an industrial devel­opment bond to purchase a $9 million scientific computer for the National Center for Atmospheric Research; municipal leases to purchase several small research computers, a satellite station computer data bank, and two research aircraft; and has established a tax-exempt line of commercial credit used to purchase an assortment of research equipment including chemistry instrumentation costing

between $10,000 and $50,000 each. The foundation is in the process of applying several forms of tax-exempt debt financing to raise more than $30 million for the purchase of a CDC Cyber 205 research computer, the building to house it and the CSU computer science department, and to install a new university telecommu­nications system.

"We tell our faculty members they

can have any piece of equipment they can pay for," Olson says.

Although Olson acknowledges he would rather have cash from tradi­tional funding sources in advance to purchase equipment, he also notes several advantages of debt fi­nancing:

• The equipment becomes avail­able to the scientist sooner than if traditional funding were sought and,

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22 C&EN June 1, 1981

Science

because the tax-exempt interest rate is generally lower than inflation, the equipment is less expensive.

• The university administrator becomes more actively involved in managing equipment—planning ob­solescence, replacement, and upgrading.

• Cooperation is fostered among individual scientists and among uni­versity departments because, usually, a number of projects pay for and use a piece of equipment. This often leads to more efficient use of the instru­ment.

Olson thinks almost any university could use debt financing to purchase scientific equipment, but he warns that it isn't something to be entered into lightly. "It involves a lot of time and a lot of research," he says. "You need good professional advice. An investment banking firm and good legal tax counsel are essential. We spend a lot on legal advice, but with constantly changing tax laws and regulations it can't be avoided." And, according to Olson, it takes a certain amount of determination. "More than one lawyer told us it simply couldn't be done," he says.

The independent status and pro­fessional staff of CSURF also have contributed significantly to the suc­cess of the CSU effort. The president of the foundation, Cynthia J. Hanson, and vice president, Ronald B. Kaiser, both have business backgrounds. Besides managing about $30 million (soon to grow to about $60 million) in debt, they manage 13,000 acres of property owned by the foundation, as well as the university's patent and copyright income.

"A good way for a university to get started in this," Hanson says, "is to establish a tax-exempt line of com­mercial credit for small equipment purchases. It is simpler than becom­ing involved in bond issues or leases." It also helps establish the kinds of cooperation required to evaluate a proposal's chances of success.

One tricky aspect of debt financing equipment is including interest in use charges. Some granting agencies are reluctant to allow it, and Office of Management & Budget Circular A-21 allows it only under certain circum­stances. CSU has finessed the prob­lem by, in some cases, writing cancel­able leases to satisfy Circular A-21 requirements and, in other cases, paying the interest from other sources of income such as that from patents. But Olson believes that changes should be made in Circular A-21 and in the NSF Grants Manual. "OMB is considering allowing interest charges

associated with buildings," he says. "I don't see how equipment is any dif­ferent."

According to Olson, other univer­sities are becoming interested in the concept. He has held two seminars on the subject, and the most recent at­tracted representatives from about 30 colleges and universities. Olson says that the University of Wyoming and the University of Utah, among others, plan to try debt financing.

One of those in attendance at the seminar, JoAnn Treat, associate ex­ecutive director of the Texas A&M Research Foundation, says that Texas A&M is well funded in terms of purchasing facilities but not equip­ment. The research foundation is looking into debt financing as a way of helping the university alleviate the equipment problems, she says, but because of OMB Circular A-21 re­quirements, they are not sure it will work.

Charles G. Overberger, vice presi­dent for research and chemistry pro­fessor at the University of Michigan, also believes the A-21 requirements would cause many universities prob­lems. He also believes that although direct federal funding for equipment purchase is still inadequate, the agencies have made a concerted effort in the past several years to redress the problem. "In terms of equipment we still have problems at Michigan," he says, "but we are in much better shape than we were 10 years ago." Overberger is concerned that at a university the size of Michigan, an inordinate amount of central control would be required to make debt fi­nancing work.

Caltech's Pings believes the idea has merit, but he also believes the government must allow interest to be included in use charges. "If interest were allowed," he says, "it would foster development of creative mechanisms to purchase equipment. Government should hold universities to good business practices, but it should not stand in the way of those practices."

But Pings thinks it would be re­grettable if debt financing became the only way to purchase equipment. "The government has an ongoing re­sponsibility to provide for instrument procurement," he says. "The mecha­nisms should be mixed."

Olson agrees. "When we talk to people about this, we emphasize that debt financing isn't the best way to buy equipment. In a way, it is the worst. But in many cases today, it has become the only way to get the equipment you need." D