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EDUCATION MANAGEMENT CORPORATION - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

May 8, 2014

Key Trends, Developments and Challenges We operate in a challenging economic environment in a highly regulated and dynamic industry. During the third quarter of fiscal 2014, our financial results did not meet our prior forecasts. Due primarily to lower than anticipated application production for future periods at The Art Institutes together with a significant deterioration in our market capitalization and credit rating downgrades during the quarter, we performed impairment reviews of the carrying value of goodwill and indefinite-lived intangible assets at all of our reporting units and recorded a goodwill impairment of $433.7 million and an indefinite-lived intangible asset impairment of $75.5 million at The Art Institutes. We believe that the following developments and trends present opportunities, challenges and risks to our business and impacted our results during the third fiscal quarter and projections of future results: New regulations may have a significant impact on our business. Our business is highly regulated and there has been an increased focus on regulations designed to address the rising costs of post-secondary education in order to make higher education more affordable. President Obama announced a plan to measure performance by post-secondary institutions through a new college ratings system designed to provide students and their families with information to select schools that provide the best value. The President's plan is to roll out the college ratings system in 2015-2016. Part of the President's plan would require Congress to pass legislation that would tie federal student aid to performance by post-secondary institutions to allow students to maximize their federal aid at institutions that provide the best value. Following negotiated rulemaking sessions, where consensus was not reached, the U.S. Department of Education published a Notice of Proposed Rules in the Federal Register on March 25, 2014 which request comment on the adoption of three annual metrics for measuring whether programs offered by proprietary institutions such as ours lead to "gainful employment" in a recognized occupation. Under the Higher Education Act of 1965, as amended ("HEA"), with the exception of certain liberal arts degree programs, proprietary schools are eligible to participate in Title IV programs only with respect to educational programs that prepare a student for "gainful employment in a recognized occupation." The U.S. Department of Education previously adopted regulations that were scheduled to become effective as of July 1, 2012 and that would have for the first time set forth standards for measuring whether programs lead to gainful employment in a recognized occupation. These regulations, which were vacated by a federal court decision, would have established three annual metrics related to student loan borrowing which would have imposed certain restrictions on programs up to and including the prohibition on participation in Title IV financial aid programs in the event that the metrics were not satisfied over a period of time. The proposed regulatory language would cause each educational program covered by the rule to fail if the student-loan debt payments of graduates of the program exceed 12 percent of their annual incomes and 30 percent of their discretionary incomes, the same ratios as in the original rule. Programs whose graduates have debt-to-annual-income ratios of 8 percent to 12 percent or debt-to-discretionary-income ratios of 20 percent to 30 percent would fall in a "zone", and the institution would have to warn students that they might become ineligible for aid. Programs that fail both debt-to-annual-income tests twice in any three-year period or are in the zone or failing for four consecutive years would be ineligible for federal student aid. In response to the 2012 Court ruling, the proposed gainful employment regulation uses programmatic cohort default rates rather than loan-repayment rates as an additional test. Programs whose borrower cohort default rates equal or exceed 30 percent for three consecutive years would be ineligible for federal student aid. The comment period runs through May 27, 2014, after which the U.S. Department of Education will consider revisions to the proposed rule. A final rule must be published in the Federal Register by November 1, 2014 to be effective as of July 1, 2015. The U.S. Department of Education estimated that approximately 1,000,000 students are enrolled in programs that would either fail or fall into the zone for improvement under the proposed gainful employment metrics. If the final gainful employment rule is substantially similar to the proposed rule published for comment, it would have a material adverse effect on our business. In addition, the HEA is scheduled for reauthorization in 2014 and the reauthorization process may result in significant changes to the post-secondary education industry. Among other things, there have been proposals in Congress to amend the 90/10 rule in connection with the reauthorization of the HEA to prohibit proprietary institutions from receiving more than 85 percent of their revenues from federal funds, including veterans benefits and U.S. Department of Defense tuition assistance. Any revisions to the HEA, the regulations adopted by the U.S. Department of Education, or the 90/10 rule could have a material adverse impact on our business. An amendment to the U. S. Telephone Consumer Protection Act of 1991 became effective on October 16, 2013 which, among other things, requires specific prior written consent from consumers in order to place telemarketing calls to wireless phones using an automatic telephone dialing system. We use telephonic communications with prospective students and cannot estimate the impact of this new regulation, including compliance costs, on our business at

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this early stage of compliance. However, we believe that it contributed to lower than anticipated application production across our organization for future academic terms due to delays in contacting prospective students. In January 2014, the U.S. Department of Education commenced negotiated rulemaking sessions to implement changes to the Clery Act required by the Violence Against Women Act which, among other items, requires institutions to compile statistics for certain additional crimes reported to campus security authorities or local police agencies, and include such information in its annual security report. Consensus was reached, and, therefore, it is expected that the U.S. Department of Education will publish a final rule by November 1, 2014 with an effective date of July 1, 2015. Finally, another series of negotiated rulemaking sessions to address program integrity and improvement issues was held in February, March, and April 2014, with a final session scheduled for May 2014, to address cash management of Title IV funds including use of debit cards and handling of Title IV credit balances; state authorization for programs offered through distance or correspondence education; state authorization for non-U.S. locations of domestic educational institutions; clock to credit hour conversion; the definition of "adverse credit" for borrowers under the Federal Direct PLUS Loan Program; and the application of repeat coursework provisions to graduate and undergraduate programs. The agreements governing our indebtedness include financial covenants which, though we are in compliance as of March 31, 2014, we anticipate violating as of June 30, 2014, which will result in our being in breach of the agreements unless we obtain a waiver or are able to refinance the indebtedness. At March 31, 2014, we had $1.3 billion of indebtedness outstanding. The terms of our debt agreements restrict us from certain activities such as incurring additional indebtedness and require us to satisfy and maintain a maximum total leverage ratio and a minimum interest coverage ratio. While we have satisfied the financial ratios in the past and at March 31, 2014, the margin between the actual results and the covenant requirements has decreased significantly over the past 12 months due to declining operating performance. Based on revised projections for the fourth quarter of fiscal 2014, we believe that we will likely not satisfy the financial covenant compliance ratios for the twelve month period ending June 30, 2014. A violation of these covenants, unless waived by the lenders or otherwise cured, would constitute an event of default under the senior secured credit facilities and indenture pursuant to which the PIK Notes were issued, thereby allowing the lenders to demand immediate payment in full of all amounts outstanding and terminate their obligations to make additional loans and issue new letters of credit under the revolving credit facility. We are currently in discussions with our lenders with respect to the potential violation of the financial ratio covenants with a view toward obtaining amendments to the debt agreement or waiver of the covenants so as to be in compliance as of June 30, 2014. While we believe that we can negotiate an acceptable resolution, we may not be able to negotiate such amendments or waiver and such amendments or waiver may not be on terms that we find to be acceptable. The factors negatively impacting the higher education industry, which have adversely impacted our business, have also made it more difficult to refinance our indebtedness due to investor uncertainty about our projected results from operations. To the extent that we do refinance any portion of our debt, that refinanced debt is likely to be subject to higher interest rates and fees than our existing debt and may impose additional restrictions on our business. If we are unable to obtain a waiver from our lenders or amend the terms of the debt agreements on acceptable terms, it would have a material adverse effect on our business and financial position. We have increased our focus on student affordability, which can have a negative impact on our net revenues. In the past, we and other providers of post-secondary education were able to pass along the rising cost of providing quality education through increases in tuition charged to students. As a result, the cost of a post-secondary degree increased substantially while incomes earned by families stagnated due to a weak economy. In order to make our programs more attractive to prospective students, we have introduced a number of initiatives to limit or decrease the cost of obtaining a degree from our institutions, including freezing tuition at The Art Institutes through 2015 for students who enrolled by October 2013, decreasing the number of credit hours necessary to complete certain programs, reducing certain fees and other charges, and substantially increasing the availability of scholarships to students. We have awarded approximately $106 million of scholarships in the nine months ended March 31, 2014, an increase of 53 percent compared to the nine months ended March 31, 2013, the majority of which have been awarded at The Art Institutes. We anticipate awarding approximately $140 million in scholarships in fiscal 2014, an increase of approximately 50 percent from fiscal 2013. Due to our focus on decreasing the cost of education at our schools, we estimate that the average debt incurred by students graduating from the Art Institutes has decreased by approximately 13 percent since fiscal 2011. We believe that our limited ability to increase tuition will continue for the foreseeable future. We have adopted a number of initiatives to make our business more efficient and to respond to changing market conditions and will continue to do so in the future. We have adopted a number of measures designed to make our business more efficient in order to decrease the cost of an education for our students and to respond to changing market conditions. Primarily through process efficiencies and productivity improvements, we believe we will be able to achieve gross cost savings at the high end of our previously disclosed range of $100 million to $125 million during fiscal 2014 as compared to fiscal 2013. For example, during fiscal 2013, we 38



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created The Center, which provides support services to our four education systems through the centralization and automation of certain non-student facing activities, including financial aid packaging, the qualification and transfer of prospective students to school admissions teams, student billing services, certain registrar services, support call center services for our students and employees, and remote student advising services. Additionally, during fiscal 2014, we have taken measures to decrease our reliance on third party lead generators which we anticipate will continue into the fourth quarter of fiscal 2014. Some of these projected savings will offset cost increases in other areas of our business that we have incurred and expect to incur during the remainder of fiscal 2014. We believe that these affordability efforts, some of which increase the risk associated with our future operating results, contribute significantly to our core mission of educating students. Changes in the availability of PLUS program loans contributed to a reduction in student enrollment and net revenues at The Art Institutes during fiscal 2013 and 2014 and are likely to adversely impact new students in fiscal 2015 and beyond. Approximately 50 percent of the campus-based students attending The Art Institutes education system are considered dependents for Title IV program purposes. These traditional-age students often receive financial support from their parents to help pay for their education. As part of this support, parents often participate in the PLUS program, which allows parents of a dependent student to borrow an amount not to exceed the difference between the total cost of that student's education and other aid to which that student is entitled. During fiscal 2012, the U.S. Department of Education implemented more stringent underwriting criteria for PLUS program loans, which resulted in a decrease in the percentage of our net revenues we received from PLUS loans from 12.4 percent in fiscal 2012 to 8.3 percent in fiscal 2013. Total new students at The Art Institutes decreased approximately 12.8 percent in fiscal 2013 as compared to fiscal 2012, which we believe was due in part to the decrease in PLUS loan availability. We have undertaken a number of actions to address this issue including, among other measures, expanding our scholarship programs at The Art Institutes and extending greater amounts of credit to those Art Institute students who are denied PLUS program loans but who still enroll in school. Additionally, we increased the maximum length of payment plans we offer students from 36 months beyond graduation to 42 months beyond graduation in fiscal 2013. Further, we commenced a program under which we purchase loans awarded and disbursed to our students from a private lender during the fourth quarter of fiscal 2013. All of these initiatives have negatively impacted our liquidity. The changes we have made with respect to the extension of credit to our students have resulted in higher gross long-term student receivable and purchased loan program balances, which were $74.2 million at March 31, 2014 and $45.8 million at March 31, 2013, and higher bad debt expense as a percentage of net revenues compared to prior periods. Bad debt expense was 7.1 percent and 6.8 percent of net revenues during the nine months ended March 31, 2014 and 2013, respectively, and 6.9 percent and 5.9 percent during the fiscal years ended June 30, 2013 and 2012. Investigations of proprietary education institutions, adverse publicity, and outstanding litigation have adversely impacted our operating results and student enrollment. Although we believe that there are a number of factors that should contribute to long-term demand for post-secondary education, recently the industry as a whole has been challenged by a number of factors, including the overall negative impact of the current political and economic climate. We and other proprietary post-secondary education providers have been subject to increased regulatory scrutiny and litigation in recent years. On July 30, 2012, the majority staff of the US Senate Committee on Health, Education, Labor, & Pensions (the "HELP Committee") released a report, "For Profit Higher Education: The Failure to Safeguard the Federal Investment and Ensure Student Success" which was drawn from hearings on the industry beginning in August 2010. While stating that proprietary colleges and universities have an important role to play in higher education and should be well-equipped to meet the needs of non-traditional students who now constitute the majority of the post-secondary educational population, the report was highly critical of these institutions. In light of the HELP Committee investigation and staff report, a number of other investigations have been undertaken and lawsuits filed, including the following: A number of State Attorneys General have launched investigations into proprietary post-secondary institutions, including a number of our schools. We along with three other publicly traded proprietary education companies are the subject of a multistate investigation by 14 State Attorneys General which was announced in January 2014 regarding our business practices. The investigation of our schools is being coordinated through the Attorney General of the Commonwealth of Pennsylvania. We previously received subpoenas from the Attorneys General of Florida, Kentucky, New York, Colorado, and Massachusetts in October 2010, December 2010, August 2011, September 2012, and January 2013, respectively, and the San Francisco, California City Attorney in December 2011 in connection with investigations of our institutions and their business practices. As previously disclosed, on December 5, 2013, we entered into a Final Consent Judgment with the Colorado Attorney General's Office. We received subpoenas from the Division of Enforcement of the Securities and Exchange Commission in March 2013 and May 2013 requesting documents and information relating to our valuation of goodwill in fiscal 2012, bad debt allowance for student receivables, and letters of credit we posted with the U.S. Department of Education. 39



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We received a subpoena from the Office of Inspector General of the U.S. Department of Education in May 2013 requesting policies and procedures related to Argosy University's attendance, withdrawal, and return to Title IV policies. The Consumer Financial Protection Bureau ("CFPB") and State Attorneys General are investigating student-lending practices at proprietary education institutions. In February 2014, the CFPB filed a lawsuit against a publicly traded proprietary education company alleging that it engaged in predatory lending practices. On January 30, 2014, the Federal Trade Commission (the "FTC") announced a new system to handle complaints from military veterans and service members regarding higher education institutions, providing online reporting forms to file complaints directly with the U.S. Department of Veterans Affairs and the U.S. Department of Defense regarding issues such as cost of attendance, marketing, graduation rates, program quality, employment prospects and course credit. Students may also email similar complaints to the U.S. Department of Education. These complaints will be forwarded to the FTC's Consumer Sentinel Network database. In addition, in February 2014 the FTC requested documents and information from a publicly traded proprietary education company about the company's marketing, advertising and sale of post-secondary products and services in order to determine whether violations of the Federal Trade Commerce Act occurred. The Chair of the U.S. Senate Subcommittee on Financial and Contracting Oversight sent a survey to 350 post-secondary institutions in April 2014 addressing sexual assaults on campus. Several of our schools received the survey and intend to respond. These investigations, together with the Washington qui tam lawsuit in which the U.S. Department of Justice and Attorneys General from five states have intervened, have led to a significant amount of negative publicity for the proprietary education industry and our schools. These numerous investigations could result in additional litigation and investigations regarding proprietary education. Student concerns regarding the assumption of additional debt in light of the current economic climate have given rise to reluctance to pursue further education. Due to the effects of the current economic climate, many prospective students are unable to make cash payments towards their education. Recently, there has been a significant amount of negative publicity surrounding the incurrence of excessive debt to pay for a post-secondary education. On July 19, 2012, the CFPB and the U.S. Department of Education issued a report describing what they characterized as risky practices in the private student loan market over the past ten years, among other things. According to the CFPB's estimates, outstanding student loan debt in the United States exceeded $1 trillion in 2011, consisting of $864 billion of federal student debt and $150 billion of private student loan debt. A number of media outlets have published stories linking student loan indebtedness to the recent mortgage loan crisis. We believe that the negative publicity surrounding student indebtedness, together with the inability of students to pay cash for their education and the effect of a stagnant economy and challenged employment prospects, have led to a reluctance in a number of prospective students to enroll in our schools. The education industry is rapidly evolving and highly competitive. The U.S. higher education industry, including the proprietary sector, is experiencing unprecedented, rapidly developing changes due to technological developments, evolving needs and objectives of students and employers, economic constraints affecting educational institutions and students, price competition, increased focus on affordability, and other factors that challenge many of the core principles underlying the industry. Related to this, a substantial proportion of traditional colleges and universities and community colleges now offer some form of distance learning or online education programs, including programs geared towards the needs of working learners. As a result, we face increased competition for students, including from colleges with well-established brand names. In addition, we face competition from various emerging nontraditional, credit-bearing and noncredit-bearing education programs, offered by both proprietary and not-for-profit providers. These include massive open online courses (MOOCs) offered worldwide without charge by traditional educational institutions and other direct-to-consumer education services, which some educational institutions are now accepting for credit. Further, according to information published by the National Student Clearinghouse, enrollment in post-secondary institutions decreased by 1.5 percent from the Fall of 2012 to the Fall of 2013, and enrollment in four-year proprietary institutions decreased by 9.7 percent during the same time period. We must adapt our business to meet these rapidly evolving developments. We are working to accelerate the enhancement of our offerings to remain competitive and to more effectively deliver a quality student experience at an attractive price. 40



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