Jason H. Sussman
Michael W. Louge
Richard J. McKeown
Given the complexities of today's financing options, having a well-defined debt management policy is no longer just a matter of choice for tax-exempt hospitals-it's a necessity.
At a Glance
- A debt management policy should be considered an essential part of a hospital's comprehensive approach to balance sheet management.
- Management and the board should be educated regarding capital structure management benefits and risks.
- The debt management policy should outline the policy statement and purpose, scope of authority and responsibilities, analytical requirements, approved financial products, and specific debt and derivatives policies.
How do you position your organization to achieve the lowest possible cost of capital within prudent risk parameters? Gone are the years when tax-exempt hospitals and health systems could obtain lowest-cost capital simply by issuing "plain vanilla," fixed-rate 30-year bonds and essentially forget about the bonds until they matured.
To optimize the opportunities created by changing interest rates, yield curves, financial products, and increasingly complex organizational financial structures, today's healthcare financial executives must manage, with equal attentiveness, both the investment/asset and debt/liability sides of their balance sheet.
The active management of capital structure requires that financial executives determine the optimal mix of debt and equity financing, traditional versus nontraditional financing employed, and the appropriate levels of fixed rate and variable rate debt. Financing options available to tax-exempt healthcare organizations, including interest rate swaps and other derivatives, have increased dramatically in recent years. These mechanisms can significantly decrease an organization's all-in cost of capital without requiring the issuance of additional debt.
Swaps and derivatives are extremely complex, however. Their use requires that management and the board clearly understand the benefits and risks involved.
A Debt Management Policy- What Is It?
A debt management policy is an organizationwide policy that defines specific parameters for implementation of liability-related management initiatives. Approved by the hospital or health system's board of trustees, it establishes benchmarks for development of specific strategies related to:
- Issuance of debt
- Interest rate management
- Refunding savings targets
- Application of debt-generated funds
The policy also defines the universe of financial products that can be used to implement the identified strategies.
Source: Kaufman, Hall & Associates, Inc. Used with permission.
A comprehensive policy that addresses the strategic issuance and management of debt and derivatives can provide a roadmap to guide a hospital or health system toward achieving increased capital access, added financial flexibility, and the lowest possible cost of capital, all within board-approved risk guidelines.
The Need for a Coherent Policy
During the past year, the capital markets, particularly the credit rating agencies, have strongly suggested that tax-exempt organizations maintain a policy governing the use of derivatives and other complex financing options. This recommendation reflects credit-market concerns about transactions that may be exposing healthcare organizations to significant risks-risks that are not readily apparent and, perhaps, not well understood by the organizations employing the financing options.
Specifically, rating agencies are evaluating whether organizations have a coherent strategy for use of swaps and other derivatives. They also are evaluating the degree to which healthcare organizations' management and boards understand and communicate the risks that such financial products pose to the organization.
In September 2004, Standard & Poor's introduced for not-for-profit healthcare organizations and other public issuers a "Debt Derivative Profile" scoring system, which assesses the risks associated with certain derivatives and the potential effect such risks could have on credit quality and ratings.a The system provides an aggregate score of one to five (five being the highest risk) for an organization's swap portfolio and the quality of swap and debt management policies and procedures, among other components.
In May 2005, Fitch Ratings provided guidance on use of swap and variable rate debt and outlined parameters, such as operating flexibility, access to capital, potential for collateral calls or termination payments, and financial management capabilities, that would be considered in evaluating the credit impact of an organization's portfolio financing vehicles.b
Assessing a Debt Management Program
The following factors, adapted from the criteria used by Standard & Poor's to assess risks associated with swaps, provide a framework for evaluating the quality of an organization's debt and swap portfolio and overall management of debt and debt-related instruments:
- Existence of a plan or policy on debt and debt-related instruments
- Required formal plan approval by governing body
- Risks identified and discussed (oral or written) for all types of instruments
- Annual portfolio review by management
- Comprehensive disclosure of debt and debt-related instruments in audited financial statements
- Valuation of debt-related instruments (i.e., swaps) on at least a semiannual basis
- Existence of a net variable rate exposure policy
Three additional factors provide an evaluation framework relative specifically to swaps and other derivatives:
- Counterparty diversification or existence of a minimum ratings policy
- Existence of an optional swap termination policy
- Existence of a collateral or insurance policy
Source: Adapted from Standard & Poor's, Public Finance Criteria: Debt Derivatives Profiles, New York: Standard & Poor's, Sept. 29, 2004.
These rating agency commentaries clearly indicate that policies covering the management of debt and financing transactions are vital, and that use of products posing potentially high risk to organizations with a more vulnerable financial position can result in adverse credit consequences.
External requirements notwithstanding, hospitals and health systems also can benefit from internal guidance as to where to focus treasury management efforts and how to structure acceptable debt and derivative strategies. Organizations need to define the big-picture-as opposed to transaction-specific-context for dialogue between management and the board regarding the debt side of the balance sheet.
To meet these external and internal demands, many CFOs, treasurers, and other healthcare leaders are increasingly feeling the need to develop a broad debt management policy.
Case Study: Policy Development at OhioHealth
OhioHealth, a not-for-profit health system serving 46 counties in Ohio, began work on developing a debt management policy in 2005. Although OhioHealth is larger than many healthcare organizations, organizations from small community hospitals to even larger health systems can learn from its experience. OhioHealth's need for a debt management policy, the benefits achieved through such a policy, and the policy components and development process are applicable to all healthcare organizations.
OhioHealth's overall goals for developing its policy were to:
- Establish parameters for approved financing strategies with the board
- Increase board knowledge of, and acceptance of, financing techniques in advance of individual transactions
- Provide a defined structure within which senior financial managers could execute transactions
- Meet the requirements of the credit markets
For OhioHealth, the comprehensive debt management policy was the final component in the creation of a total balance sheet management approach. The organization already had in place a detailed investment policy for the asset side of the balance sheet, which outlined investment goals and objectives, defined authority and responsibility, and provided guidance for day-to-day treasury investment decisions. The investment policy also articulated the organization's tolerance for risk, identified approved products, and determined the requirements of external parties supporting treasury investment functions. The asset-related investment policy enabled OhioHealth to manage its treasury function according to the guidelines known and approved by its board.
See Exhibit 1
In addition, OhioHealth had in place a thorough and effective capital management process, which included integrated strategic financial planning and capital allocation. This process enabled OhioHealth to select projects and other investment opportunities that could ensure the organization's long-term strategic and financial sustainability and competitive performance.
In management's view, a debt management policy outlining for the board and external credit market constituencies the tie between debt management and the organization's overall financial strategy would complete the full strategic-financial-capital loop for the organization. The goal was to create a debt management policy that, item for item, would address and mirror each goal and objective achieved by the investment management policy.
See Exhibit 2
Defining the Appropriate Level of Authority
Before OhioHealth drafted its debt management policy, the organization's management and board discussed the scope and level of authority that the board would be willing to delegate through the policy. The expectation was that because the policy represented groundbreaking work with new, sophisticated financial products, delegation would increase over time.
Board knowledge and board-management relationships often are influenced by organizational structure and culture. Members of boards of trustees do not all share the same understanding of, and focus on, the benefits of effective capital structure management, including the application of financial products and their associated risks.
To ensure that a board is comfortable with delegating authority to management, management needs to demonstrate a solid track record of appropriately integrated strategic, financial, and capital planning; careful, transparent, and consistent measurement and monitoring of whether goals are met; and implementation of achievable action plans to address shortfalls. In addition, to support any level of material delegation, management must set credit rating and capital structure management targets, provide annual financial plan updates, and educate the board about the various financial products.
Indeed, the importance of management credibility to the effective development and implementation of a debt management policy cannot be underestimated. The greater management's credibility and the board's sophistication and knowledge of capital structure management benefits and risks, the greater the board's comfort level with delegated authority.
Structure of the Policy
OhioHealth's comprehensive debt management policy addresses the following six key topics.
1. Policy statement and purpose. This portion of the policy outlines the organization's overall debt management objectives, which are twofold:
- To provide a basis for active debt structure management in order to achieve the lowest cost of capital, the highest possible credit rating, and acceptable levels of risk
- To ensure comprehensive, ongoing evaluation of all key factors affecting debt structure decisions, including industry and market environment, state of the organization, and state of the capital markets
For example, the policy addresses ongoing evaluation of the capital structure implications of OhioHealth's partnership arrangements, such as joint ventures with physicians, which introduce the need to incorporate alternative strategies for raising new capital.
2. Scope of authority and responsibilities. This section outlines the policy's coverage of the issuance and management of all debt, lease financing funded from the capital markets, the use of interest rate swaps and other derivative products, the use of credit enhancement and liquidity, and guaranties.
The authority section defines the policy review and approval process, identifying who has authority to administer the policy and the frequency of required reporting. The section also specifies what the board must authorize and what authority the board will delegate to the management team to facilitate efficient and timely management of the organization's overall debt and derivative position. Responsibilities and accountability for ongoing relationships and continuing disclosure with credit rating agencies, bond insurers, credit banks, and bondholders are defined in full.
See Exhibit 3
3. Analytical requirements. This section of the policy identifies the management prerequisites to support continuing delegation of capital structure management authority. It outlines specific credit rating goals and targets and how elements of the long-range strategic financial plan, which is prepared annually by management and approved by the board, are integrated into the analytical process. For example, defined, required plan elements include recommendations for debt issuance to fund capital project expenditures and the associated debt service requirements.
This section of the policy also outlines a long-term capital strategy, including specific analytical requirements, such as asset-liability management analysis, analysis of diversification of financing vehicles, and management of specified risks. The targeted range for variable rate debt is identified, as are the components of a periodic debt structure review process.
Overall, this section of the policy ensures that the metrics, quantification, and analysis of debt options occur up front with ongoing education related to the state of the capital markets and available financial products. These activities are specifically tied to policy implementation success.
4. Approved financial products. This section of the policy identifies specific debt and derivative-based financial products that are available and appropriate for managing capital structure, indicates which products are approved for use, and describes the process for adding or deleting specific instruments. After the board approves the policy, the CFO and treasurer will know that they have authority to pursue any product specified on the list to meet debt management needs within the analytic parameters of the policy.
The approved list is reviewed periodically for changes, based on management assessment of the organization's credit position, capital market acceptance of the products, and organizational risk-tolerance parameters.
5. Debt policy. Constituting the bulk of the policy, this section addresses the appropriate use of long-term debt, short-term debt, variable rate debt, lease financing, real estate financing, and guaranties. It also defines qualified credit
In many organizations, creation of a dedicated derivatives committee can facilitate identification and completion of appropriate derivatives transactions.
OhioHealth's debt management policy is designed to provide its board and the capital markets with assurance that those managing the organization's debt understand, measure, and analyze the risks associated with various capital structures and transactions. The policy gives OhioHealth's treasury team a roadmap as to where to focus efforts and defines the agreed-upon boundaries, bringing a discipline to the day-to-day management of debt and debt-related transactions. The policy does not require that the board receive comprehensive education on each transaction, but it does give the board the assurance that all debt structures and debt-related transactions will be consummated within board-approved parameters.
Because the policy will require ongoing review of the debt structure in the context of a dynamic capital markets environment, it will ensure consistency in strategy related to asset-liability management going forward. In addition, OhioHealth's debt management policy will ensure that, whatever debt management initiatives the organization undertakes in the future and, equally important, whoever is managing those debt initiatives, each debt management transaction will be linked to the organization's overriding financial strategy.
An Ongoing Process
Review and revision of the policy will be ongoing at OhioHealth. Circumstances in the capital markets and the strength of the organization's financial condition are dynamic and thus subject to change, so OhioHealth's finance team built in flexibility, as necessary, to respond to such change with policy modifications. New products may emerge, changes to the scope of authority granted to management may become necessary and appropriate, and other conditions may warrant policy modification. The policy's structure explicitly will enable the board and management to adjust nimbly to current conditions.
The Right Policy
A debt management policy can provide benefits to organizations of all sizes, but the policy must be tailored appropriately. Every organization, its board included, has a different level of risk tolerance, a different credit position in the capital markets, and a different approach to granting authority to management.
Debt management is a critical financial management function. Every organization should determine its philosophy and approach to debt management, document that approach clearly, obtain board support and approval for the defined policy, and use the policy as a roadmap going forward.
About the authors
Jason H. Sussman, CPA, is partner, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA's First Illinois Chapter (firstname.lastname@example.org).
Michael W. Louge, CPA, is senior vice president and CFO, OhioHealth, Columbus, Ohio, and a member of HFMA's Central Ohio Chapter (email@example.com).
Richard J. McKeown, CTP,is vice president, treasury, OhioHealth, Columbus, Ohio (firstname.lastname@example.org).
a. Standard & Poor's, Public Finance Criteria: Debt Derivatives
Profiles, New York: Standard & Poor's, Sept. 29, 2004.
b. Fitch Ratings, Investment and Debt Portfolio Trends of Hospitals and Health Care Systems-1995-2003, New York: Fitch Ratings, May 23, 2005
Publication Date: Tuesday, August 01, 2006