Donald A. Carlson, Jr. 

To continue to attract investors, you need more than just bond ratings; you need a broad capital strategy.

At a Glance 

  • Investors look for hospitals that demonstrate effective balance sheet management and strong physician relations. 
  • Investors are attracted to organizations whose investment portfolios are managed as a business unit and not an endowment fund. 
  • Investors are attracted to hospitals that know how to make effective use of structured financial products. 

Hospitals' thirst for capital today is greater than ever, with the push for enhanced IT capacity and facility capacity. Yet many hospitals-challenged by rising costs and inadequate payment-are finding it difficult to remain attractive to the capital markets.

Demonstrating creditworthiness requires a solid execution of a hospital's strategic, financial, and capital plan combined. Although a hospital organization's size, geographic location, and organizational type will all affect its capital position, certain capital-raising strategies are common to, and important to, all hospital organizations.

These capital strategies should focus on ensuring the organization is able to access tax-exempt debt with optimum efficiency, because tax-exempt debt issuance will likely remain the primary source of capital for not-for-profit hospitals in the foreseeable future. Charitable donations and retained earnings will not be sufficient to fund the future capital expenditures required to meet a not-for-profit hospital's long-term objectives (although the credit strategy should also account for such capital sources).

Given the importance of tax-exempt debt issuance, you need to know what investors are looking for as they assess the future creditworthiness of hospitals and health systems. More and more, investors have been looking beyond bond ratings to make their credit decisions and determine which providers will be long-term winners. Whether those decisions are favorable for a given hospital can depend on how well the CFO understands not only the capital markets, but also the effect of the organization's healthcare operations on its access to capital.

Healthcare credit analysts typically focus on a few core aspects of hospitals' performance, such as how the hospital manages its balance sheet and how it relates to physicians, in determining whether a particular hospital can fulfill its long-term strategy and maintain its future viability. To maintain and enhance your organizations' capital prospects, your credit strategy should focus on five key areas:

  • Balance sheet management
  • Use of structured financial products to reduce borrowing costs and increase investor demand
  • Physician recruitment and retention
  • Achievement of key quantitative ratios
  • Consideration of qualitative factors that affect debt capacity

Balance Sheet Management

Actively managing both sides of the balance sheet is critical to effective capital and strategic planning. The importance of sound balance sheet management has grown as hospitals must increasingly make huge capital expenditures to meet the changing needs of patients resulting from demographic and technological trends.

Effective balance sheet management, of course, requires the CFO's close attention to how both sides of the balance sheet affect debt capacity. Two important, but perhaps less obvious, components of balance sheet management are the potential for monetization of noncore assets, and the link between the organization's investment portfolio and its operating income and cash position.

Monetization of noncore assets. The status of all the organization's facilities should be reviewed to determine whether it's possible to monetize noncore assets, such as medical office buildings, parking garages, and long-term care facilities. Under this approach, sale of the asset to a third-party financial buyer adds cash to the organization's balance sheet, increasing its debt capacity to fund core capital projects. In today's capital markets environment, numerous innovative and efficient financing structures are available to either create off-balance-sheet financings for these noncore assets or provide non-recourse financings. An example of the latter, where the debt for certain noncore assets is "on balance sheet," is financing for a nursing home or hospital through the U.S. Department of Housing and Urban Development. HUD looks only to the entity securing the bonds, and as a result, the rating agencies would not count the debt against the hospital's overall borrowing capacity. Thus, although the hospital does not benefit from a "true sale" of the asset and the cash, it does benefit from the non-recourse nature of the debt structure.

Many large health systems and freestanding hospitals have monetized their medical office building assets in recent years. These organizations have taken advantage of the high valuations that are commonly being placed on these real estate assets, thereby substantially increasing their debt capacity for capital expenditures to meet the needs of their acute care hospitals.

The same monetization strategy can be applied to parking garages and nursing homes. In such situations, the use of non-recourse financing structures can allow more capital to be spent on core hospital initiatives. By selling off a parking facility and entering into an operating lease with the buyer, thereby creating off-balance-sheet and non-recourse debt financing, a hospital can improve its debt capacity. It should be noted, however, that the credit market will sometimes count off-balance-sheet debt, which has the potential to be more expensive than traditional hospital secured debt, so this type of transaction must be carefully discussed with the hospital's auditors and rating agencies in advance.

Investment portfolio. Successful healthcare systems look at their investment portfolio as another business unit and not an endowment fund. They hold their managers accountable for achieving a narrow, more predictable range of returns within a given year that allows them to make more reliable financial projections. This approach requires more quantitative measurement of risk return, but it also gives a CFO greater confidence in forecasting investment income, thereby building credibility with investors regarding the organization's ability to get additional cash and achieve other key ratios. In contrast, a more traditional 50-50 asset allocation model and "hoping for the best" year to year makes investors more doubtful about whether a particular organization can reach its financial goal. One caveat is that the asset allocation of different healthcare organizations typically varies based on each organization's balance sheet, and some organizations therefore may have less of an opportunity to achieve substantial results with this approach.

Use of Structured Financial Products

The use of structured financial products to reduce current debt service and financing fees is an important aspect of balance sheet management, but one that also is a direct means to attracting broader investor interest. By reducing a hospital's cost of capital, such products can increase the hospital's resources for completing necessary capital projects, thereby enhancing the organization's profile from the perspective of investors. Hospitals that can use these products can often attract investors seeking specific product structures to meet their portfolio objectives.

The efficiencies of the swap markets and other structured financial products, such as tender option bond programs and CPI-indexed tax-exempt bonds, provide a means to reduce an organization's current debt service and financing fees. Here's a brief overview of some of the options.

Swaps. The swap market for all rating categories of hospitals has grown dramatically in the past five years. The ability to issue synthetic fixed-rate debt, at significant savings to a conventional rate issue, or to swap existing variable-rate debt to a fixed structure to lock in today's low long-term rates can provide a huge benefit in lowering hospitals' future borrowing costs. Even BBB-category hospitals have broad access to executing swap transactions, as long as the prospective swap counterparty "bidders" understand and accept a hospital's long-term strategic plan.

Variable rate market products. In the past three years, a host of new product offerings has emerged in the tax-exempt variable rate market to meet specific investor demand while also reducing hospitals' overall borrowing costs and lowering their financial risk profiles. The products that are emerging involve varying degrees of risk and accounting impact. It's important, though, to understand that while options with the lowest cost of capital, such as the self-liquidity structure, do have higher "structuring risk," it's a risk that may be more than offset by the lower capital costs. For example, a healthcare system that has a strong cash position and a conservative investment portfolio can take advantage of using some portion of its debt structure in this type of product, while hospitals with less cash would be incurring greater risk. Each of these products must be reviewed in the context of the particular hospital's balance sheet strength or weakness.

The ability of even a BBB-category hospital to incorporate certain of these products into its capital structure can have a profound impact on the hospital's cost of capital. In many cases, these variable-rate products are swapped to fixed-rate structures, saving the borrowers 50 basis points, or more than a conventional fixed-rate offering.

Tender option bond programs. A TOB program gives a hospital borrower the ability to take existing fixed-rate debt that is callable and sell the bonds into a "securitization trust" that synthetically converts the fixed-rate debt to variable, thereby reducing the organization's borrowing cost, without the need to issue new refunding bonds. Such financial structures are not limited to only the highest-rated, larger hospital systems; they can also be used by hospitals with lower ratings to manage their debt structures and capital costs more efficiently. TOB programs have gained wide market acceptance by money market investors and serve as an effective alternative to a refunding.

CPI-indexed bonds. CPI-indexed bonds are modeled after the inflation-linked treasury bonds that the government issued in record volume in 2004. For investors concerned that inflation increases are eroding their long-term fixed-rate investments, CPI-indexed tax-exempt bonds can offer protection, while offering borrowers a lower fixed-rate cost by issuing fixed-rate bonds with an annual adjustment mechanism linked to the CPI index. In 2004, it is estimated that $400 million of tax-exempt bonds were issued using this structure. As the tax-exempt market demand for this product increases, many hospitals will be able to incorporate some portion of their debt structure in these products and further reduce their borrowing costs.

Risks. There are no free lunches in weighing a lower capital cost against the structuring risk associated with each of these product areas. It's very important, therefore, for CFOs to understand how the rating agencies and investors will measure these various risk components. Also, regarding swaps, it's important for the senior management team and the board finance committee to thoroughly understand the accounting implications and the potential swap mark to market on the operating-income line.

Physician Recruitment and Retention Issues

Although the rating agencies and investors have always understood the conflicts and risks involved in hospital-physician enterprises and collaborations, current market pressures have significantly exacerbated the problems around such initiatives, and have intensified the challenges for hospitals in attracting and retaining physicians. With new opportunities to build their own ambulatory surgery centers and other outpatient facilities, large physician groups are in a position to leave partnerships with their affiliated hospitals and compete with the hospitals for ancillary business.

Meeting this challenge is a complex task that requires careful planning. You need to consider factors such as market share, market position, cost structure, quality of care, and physician management competence-a detailed discussion of which is beyond the scope of this article.

With respect to financing, successful hospitals are pursuing financing structures that can allow for more effective hospital-physician "partnering" and better align each group's incentives. Nationwide, numerous joint venture structures have been created to resolve hospital-physician conflicts. Each structure carries various legal risks, particularly surrounding compliance with Stark regulatory issues, and each presents challenges in meeting its specific alignment objectives.

Recently, hospital organizations have begun to consider a new, evolving financing structure, called a participating bond transaction, which allows tax-exempt bonds to be issued to fund physician-hospital projects and initiatives. Essentially, a PBT is a tax-exempt financing structure that enables physicians to participate in higher-yielding tax-exempt securities in exchange for meeting certain financial performance targets, clinical protocols, or quality initiatives that the hospital requires. By effectively aligning incentives between a hospital organization and its physicians, a PBT can advance efforts to achieve hospital-physician objectives and substantially reduce the risk of physician defections.

Focus on Key Quantitative Ratios

No single ratio determines future debt to capital or pushes a hospital's ratings into a different rating category. However, the following three ratios, in particular, are gaining importance in healthcare credit analysts' overall credit review process.

Operating margin. Hospitals that have historically relied heavily on investment income to achieve a positive bottom line are going to find it increasingly difficult to gain broad investor support. Given the volatility of the equity markets and the effect of the low interest rate environment on returns for debt securities, investors are becoming much less comfortable relying on investment income to show an overall bottom-line profit. Most investors look for a consistent operating margin of at least 2.0 percent as an indicator of an organization's long-term viability. They want to see some consistency in financial performance and in management's ability to quickly adapt to changing conditions as payment cycles change the operating environment. "No margin, no mission" will become even more pronounced in the future as investors look more carefully at core operations as the driver of success.

Days cash on hand. Rating agencies' medians for DCOH have increased over time, underscoring the need for higher liquidity in the increasingly volatile healthcare environment. A situation involving a hospital with under 100 DCOH can be troublesome to many investors, although numerous BBB- and even A-rated category hospitals have only 70 to 100 DCOH.

If a hospital's DCOH level is below 100, the hospital needs to have a compelling explanation of how cash will increase over time to give it an adequate cushion during lean or more volatile operating environments. On the other hand, a hospital that maintains too high a cash level at the expense of investing in its plant needs to allay investors' concern that the hospital is not making the necessary long-term investments to remain competitive.

Annual capital expenditures as a percentage of earnings before interest, taxes, depreciation, and amortization. Investors want to see that a hospital's capital plan is linked to future financial performance and cash flow. Hospitals that consistently generate above-average cash flow often can maintain higher ratings despite a sometimes-weaker balance sheet. Hospitals that set a limit on how much capital they will spend as a percentage of EBITDA, and consistently remain within that parameter, give creditors significantly more comfort that capital expenditures will be reduced if financial projections are not met. Some multihospital systems have established benchmarks of 70 percent to 80 percent of their EBITDA for annual capital expenditures. Senior executives need to determine their organizations' benchmarks and communicate them to investors.

Qualitative Credit Factors 

Hospital executives all too often overlook the importance of adequately measuring important qualitative factors in determining credit worthiness and debt capacity. It's essential to tell your organization's "complete" credit story to all of its credit constituencies. Success in the healthcare industry depends on management making good long-term strategic decisions, and those decisions and their effects are an important part of the story. Investors are buying 30-year debt and need to look beyond purely quantitative analyses. Important credit measures, therefore, are certain qualitative factors that weigh heavily on how investors measure credit risk. These include:

  • Market demographics
  • Market share in certain specialty services
  • Depth and experience of management
  • Quality and effects of board governance
  • Medical staff relationships
  • Internal controls and disclosure policies

An organization that routinely highlights these factors with investors can gain greater capital access, and reduce its cost of capital, all without lowering its existing bond rating.

Focus, not Hocus Pocus 

There's no magic or sleight of hand involved in ensuring your organization will have ample access to capital in the future. What is required is that you focus intensively on how the capital markets perceive your organization, as well as on the key measures in which they are most interested. There remains tremendous demand in today's marketplace for not-for-profit healthcare bonds, even for institutions with lower credit ratings, including subinvestment grade, as long as the management team is focused and adept at optimizing the organization's performance with respect to these measures. In short, the use of sophisticated structured finance products, coupled with proactive balance sheet management and effective physician relations, can significantly affect your organization's capital access.

There's just one more caveat: senior healthcare financial leaders of large hospitals and health systems today require not only strong operating skills and strategic acumen, but also an ongoing thorough awareness of new product innovations in the expanding and increasingly sophisticated bond market. Smaller hospitals challenged to attract and retain CFOs with this wide range of skills will need to rely on highly trusted and skilled advisers to help them manage today's complex capital planning and market access issues. Either way, the opportunities and challenges remain, and neither can be ignored.

FASB Statement Regarding Derivatives 

For a summary of the accounting and reporting standards for derivative instruments and hedging activities set forth by the Financial Accounting Standards Board in its Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (issued June 1998), go to

Publication Date: Sunday, May 01, 2005

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