VAT policy to spur UK private schools M&A deal activity

There are specific regulatory requirements, and further obligations relevant to charities, that operators will need to navigate to successfully complete such transactions.

The market environment

Public and private schools across the UK are operating in an ever-more-challenging environment.

The hangover from the Covid-19 pandemic, the impact of the war in Ukraine, and domestic political and economic shocks have contributed to higher energy costs and a rise in the cost of borrowing. It has led to an increase in running costs, exacerbated by social factors, like falling birth rates, a decline in the numbers of international students and fewer students taking up boarding, as well as teacher shortages and salary pressures. Many private schools have felt forced to increase their fee rates in response.

A new tax risk has also come into focus. In its general election manifesto, the Labour party committed to removing the VAT exemption that currently applies to private school student fees. With Labour sweeping into government with a landslide victory on Thursday night, that policy is expected to be implemented – and soon.

The policy will push private school student fees up further and, amidst the continuing cost-of-living crisis, cause many parents that currently pay for or planned to pay for private school education for their children to send them to state schools instead. This will increase pressure on the state school system, which in many places is already operating at capacity and under severe financial pressures, and lead to falling attendances at private schools – the Independent Schools Council (ISC) has already reported a 2.7% drop in enrolments and predicts a further decline ahead of the next academic year.

The financial impact is likely to be felt most acutely among smaller private schools. There are already some schools that have announced they will shut, due to growing financial pressures. It is against this backdrop that there is clear potential to see an uptick in M&A activity in the sector, with the economies of scale that can offer.

Regulatory considerations

In England, the Department for Education (DfE) is the principal regulator of independent schools.

Where a school restructuring is planned, it is likely that an application will need to be made to the DfE to change the individual or body with ownership control over the school. Where that proprietor is a corporate body, the DfE would carry out an identity and enhanced disclosure and barring service (DBS) check – including a banned list check – on the chair of the proprietor’s body of directors or another lead director.

Further notifications of change in ownership may also need to be made to the Independent Schools Inspectorate and Ofsted, which have an inspectorate function over schools within their respective remits. Ofsted would only need to be informed if the restructure would trigger an additional Ofsted registration – such as, if a new boarding provision were added – though they would likely seek to inspect the school within a few years of a merger or restructure.

Following any restructure, private schools would still need to comply with the regulatory requirements that apply to independent schools. These include the DfE’s independent schools standards, safeguarding and safe recruitment requirements, and the relevant inspection framework. Schools will have existing policies and procedures in place to comply with these requirements, but prospective buyers will want to carry out a gap analysis to identify issues as part of a robust due diligence exercise ahead of completing an M&A deal.

Charity considerations

Private schools are invariably structured as charities, and the governing body, as charity trustees, therefore have things they need to consider and duties to comply with, which are likely to have a significant impact on any merger or investment. The impact on the school’s beneficiaries – the students – should be at the forefront of the trustees’ decision.

In the context of a merger, it will be important to understand the basis on which assets are held and alignment of charitable purposes. There may be additional requirements and consents required where the school has endowments, whether in the form of school property or investments, such as scholarship funds. In some cases, the endowments may have to be retained in separate trust arrangements outside the newly merged charity, though with the property or investments capable of being applied towards the original school. Additional consents may be required where the school has historic ‘linked’ charities, which are separate charities that are linked with the main charity school for charity registration and accounting purposes.  

Private school charities may also meet an additional requirement of seeking ‘material change’ consent from the Department for Education to change the proprietor of the school.

A private school will normally be set-up as a company limited by guarantee or potentially a charitable incorporated organisation which has members. There is no ability to extract value through that membership interest. Members are also obliged to act in a fiduciary capacity. This means it is not as simple as third party investors just taking equity in a newco and having it acquire the private school and then treating it like a regular subsidiary.

As a result, any private school acquisition would most likely take the form of a business and asset sale, with consideration being paid to the charity trustees. However, the Charity Commission may not approve an acquisition of a charity’s undertaking and assets at a significant undervalue. The pricing and the terms of the deal will need to be drafted with the regulatory angle in mind. The charity trustees would also need to consider how it is going to fulfil its purposes and apply the assets going forward. This is likely to tie in with the basis on which approval for the deal is sought from the Charity Commission – where buyers will want to be able to demonstrate that the funds used to complete the acquisition will go to benefit current and future students.

Specific ‘school-related’ due diligence will be required, including due diligence in relation to charity law, regulatory, endowment, constitutional, education, safeguarding, inspections, tax, and other regulatory matters. These issues and liabilities can be material and should be considered at an early stage in the acquisition.

For example, there are often challenges around the acquisition of schools’ land and buildings, as there will be layers of charity restrictions and trust arrangements. It is common for school grounds to only be partly owned by the school and for a separate charitable trust to own the bulk of the land. This can impact how quickly and easily an acquisition can be completed, so property due diligence should be a high priority.

The school’s land and investment endowments may not be capable of acquisition and may need to be held in a separate charity or charities. Structuring and governance options can be considered and negotiated but may trigger additional requirements for regulatory consents. Any proposed security over charity land will also trigger additional requirements. This means specific tax and tax structuring advice should be sought.

Co-written by Tom Denslow of Pinsent Masons.