So the strategy your hospital was planning to use to secure capital just went out the door. Now what?


At a Glance

Today's lending dynamics are leading many hospitals to revisit their strategies for accessing capital:

  • Fixed-rate bonds will likely be a centerpiece of just about any organization's capital structure going forward.
  • Joint partnerships with physicians may provide opportunity for specific service-line strength without heavy investment in facility and equipment.
  • Many hospitals are evaluating the sale of noncore and core assets as well as the use of ground leases or arrangements that would permit them to repurchase the assets at a later time.

It's hard to believe: Double-digit plunges in the Dow Jones Industrial Average, S&P 500, Nasdaq, and the New York Stock Exchange composite. Billion-dollar weekly withdrawals from stock mutual funds. Heart-stopping 700-plus daily drops in the stock market. Volatility indices at or near 21-year highs. A credit market in stagnation.

The infusion of U.S. Treasury dollars to help banks shore up their balance sheets is beginning to loosen the frozen short-term debt markets. But credit is still not widely available: Yields on commercial paper are still high in the face of weak demand for debt. What little market activity there is demonstrates that investors strongly favor low-risk structures with highly rated entities. The London Interbank Offered Rate (LIBOR) has fallen from a mid-October high of 4.82 percent, but further declines have been slow in coming.

With high rates on fixed and variable-rate demand bonds (VRDBs) and investors shying away from hospital bonds, standard avenues for accessing capital have all but closed for many healthcare facilities. Although plain vanilla forms of financing are likely to open up again sometime down the road, it will be at a high cost. Some complex derivative financial instruments may resurface for large, financially sound institutions in a few years. In the meantime, however, hospitals are searching for the ways and the means to find the capital they need to grow and compete.

"The short-term availability of capital for day-to-day operations is working itself out," says Francine Machisko, senior principal with Noblis Center for Health Innovation, Atlanta. "The markets right now are very turbulent, the cost of capital is very high, and there are virtually no bonds being dropped at this time. But those are temporary things."

That said, Machisko predicts the long-term availability of capital for construction projects will be slower to work out. "I'm not sure we will ever get back to where we were before, although we may get close. Also, over the long term, borrowers will be expecting more from those who are seeking capital. The expectations related to what hospitals and others will have to maintain in order to access capital will be more stringent than in the past."

The Incredible Shrinking Credit Market

2008 was a tough year for healthcare financing. The auction rate securities market failed in the early months, when the debt market lost confidence in bond insurance companies that had been tied to the mortgage crisis and were downgraded.

With the fall of the bond insurers, hospitals and health systems fled to VRDBs and fixed-rate bonds to refinance their auction rate securities debt, issuing more debt between April and June than in any quarter since 1990, notes Scott Clay, senior principal at Noblis.

Hospitals paid a premium. Fixed-rate debt for an "AA"-rated hospital bond traded a little over 6 percent in September, up from 5 percent the year before. Variable-rate debt, which was 3.8 percent in the fall of 2007, was close to 8 percent a year later.

Then all credit markets froze. "Banks stopped loaning to each other," Clay recalls. "Investors started hoarding cash and getting out of investments that were losing value. Healthcare organizations that had been planning to go to the credit markets to restructure debt or issue new debt had to hold back until things calmed down because the market was too volatile, and their borrowing rates were so high."

The financial crisis squeezed other sources of capital as well. The turbulence in the financial markets started eroding hospitals' investment portfolios even before September's credit crunch. Kaiser Foundation Health Plan and Hospitals reported a loss of $295 million in nonoperating income in the first quarter of 2008 compared with a $177 million gain in investment income in the first quarter of 2007.

Fund-raising suffered throughout the year. Donations in the first three quarters of 2008 fell below 2007 levels for more than a third of 2,700 not-for-profit organizations, the highest proportion of organizations seeing declines in fund-raising since 2003, according to GuideStar, a not-for-profit charity data-gathering service in Williamsburg, Va.

Cash flow tightened with the softening of the economy and the downstream utilization of health services. "We are seeing the front end of a long-term economic recession, and it is already causing consumers to hold back on healthcare spending," Clay says, noting that the recession will probably have great impact on hospitals because consumers generally are responsible for the first dollar of medical care, and they are holding back on preventive, routine, and elective services.

The recession is likely to place new pressures on the bottom line. "When volume softens, it has a negative impact on the hospital's ability to generate revenue," he says. "An overall recession also negatively impacts the hospital's ability to generate philanthropy, and it places pressure on Medicare and Medicaid programs to cut back funding."

Signs of Recovery

There are, thankfully, some preliminary indications of improvement. The variable rate market has shown some positive signs of return in terms of interest rates. There has been a consistent decline in the short-term variable rate index (SIFMA) from peak levels in October. As a result, a number of major transactions have been successfully remarketed and effectively priced in recent weeks, notes Andrew J. Majka, partner and COO, Kaufman, Hall & Associates, Inc., Skokie, Ill.

VRDBs, which currently are the primary variable rate product available to tax-exempt organizations, can be challenging financing structures to access and manage, however. To access this market, most organizations, especially those that are "A"-rated or lower, need to find a highly rated commercial bank to issue a letter of credit so investors will be confident enough to purchase their bonds.

"The problem is that many banks have their own credit concerns, and with just a few exceptions, no one knows who is going to be a long-term market survivor right now in a deteriorating and rapidly consolidating bank industry," Majka says. "On top of that, all banks have significant capital constraints resulting in less capacity, much higher pricing, and more stringent terms. In many cases, this market simply won't be available or won't be available at previously assumed levels to many healthcare borrowers."

VRDBs consequently can be highly unpredictable because of factors on all sides of the transaction: The bank could be downgraded. The bank may choose not to renew the arrangment or may increase pricing to prohibitively high levels. The hospital could be downgraded and lead the bank to pull the letter of credit. The bonds might not trade well, or the market could seize up due to supply and demand imbalances. Still, VRDBs will be an important part of most hospitals' capital structure given assumed interest rate savings and flexibility, Majka adds.

This is a market that has been on a roller coaster ride of interest rate levels. Within a span of weeks, SIFMA peaked close to 8 percent, and then rates retreated below 2 percent. "A practical rule of thumb nowadays-which the rating agencies have been evaluating closely-is that if you don't have a substantial amount of cash above and beyond the amount of the outstanding variable rate debt outstanding, then you probably have no business being in this market over the long-term," he says. For many affected borrowers with a disproportionate amount of underlying VRDBs, any transition away from VRDBs will take time and will depend upon the fixed rate markets opening up.

In light of the VRDB concerns, fixed-rate bonds will likely be a centerpiece of just about any organization's capital structure going forward, Majka says. The fixed-rate bond market, which was entirely frozen in late September, began to thaw slowly in late October for "AA" category borrowers. It's a buyer's market, and investors have been incredibly more discerning these days regarding which bonds they'll invest in and the associated covenants and security provisions. "With so many organizations looking for stable footing and predictability in their capital structure, I think the predominant vehicle for the future will be fixed-rate bonds, assuming this market recovers and reopens to more borrowers in 2009," Majka says.

Even complicated derivative financial instruments, such as interest rate caps, interest rate swaps, and swaptions, could eventually make a comeback, according to Claudia Stone Gourdon, Healthcare Financial Group, New York. Although it is risky to be placing derivative financial instruments in today's volatile market, in a couple of years swaps could be useful as hedges against the risk of issuing long-term debt for larger, more financially sound hospitals that can absorb credit and other risk, she says.

Joint Ventures and Other Partnerships 

Joint ventures and leasebacks allow hospitals to couple with other healthcare providers, third-party developers, or institutional investors on capital projects and at the same time preserve cash. For example, hospitals may link with physicians in for-profit cardiology, oncology, and orthopedic centers to share equipment costs and revenues, or may join with third-party developers to develop ambulatory care centers or medical office buildings.

"Hospitals have to grow and serve their patients and compete in spite of economic and capital market headwinds," says Michael Lincoln, executive vice president of marketing and business development for Lillibridge, Chicago. "One of the ways to do that is to enter a partnership to use third-party capital to finance projects, as opposed to going through the more traditional methods of using external debt, cash flow, philanthropy, and investment income."

Third-party financing through developers is particularly attractive for hospitals that don't have the wherewithal to develop particular service lines, such as oncology, but don't want to wait and sacrifice strategy. Lincoln gives the example of an "AA"-rated healthcare system in the Northeast that did not have the money to support a new 150,000-square-foot ambulatory care facility. Its choice was to either proceed with the project using third-party taxable money and enter a lease transaction or put the project on the back burner. The opportunity cost of waiting was too high in terms of the risk of losing a competitive edge and branding in a desirable demographic market not to mention the economic contribution the new service line would bring. So the system entered an agreement with Lillibridge to build, own, and lease the facility back.

"The system got a project in a market it wanted to serve," Lincoln says. "Physicians got a new place to practice and take care of their patients. The healthcare system used third-party capital so it could diversify its own sources of capital and have the financial flexibility to roll the lease into regular tax-exempt financings when it recapitalizes or refinances other projects."

Equity financing is another option. Rather than raise money through debt financing, hospitals may decide to fund a project with equity from a private equity firm and anticipate refinancing when the markets are better.

"It just may not be worth taking on long-term debt and paying high rates within a highly restricted structure if you can finance a project with equity," notes Gourdon of Healthcare Financial Group. But the differential between the taxable cost of third-party money and tax-exempt capital, which is fairly wide and changes daily, needs to be factored into the financial feasibility analysis. 

Asset Sales and Leasebacks

Hospitals are evaluating the sale of noncore as well as core assets, including the hospital, and the use of a ground lease or some sort of entail that permits them to repurchase the assets at a later time. 

Asset sales and monetizations actually have been a major source of capital for hospitals and healthcare systems for some time. The option is being evaluated for the first time by even some financially strong "AA"-rated credits. "They are asking, What do I have on my balance sheet in terms of noncore assets? How am I using them currently? How could I use them more productivity and more efficiently? What are these assets worth? What would my cash position be if I monetized them?" Lincoln says.

Hospitals that rejected the idea of divesting assets they considered to be strategic now may be revisiting that notion as well. They need to look at all potential sources of capital and consider ways of maintaining and enhancing their position and relationships without tying up a hundred million dollars in the process.

The economic benefit is two-fold: a direct injection of liquidity from the proceeds of the sale, plus savings in capital expenditures and building maintenance. "You get an immediate balance sheet impact, but you also are saving the cash flow for the new roof or chiller or boiler or windows," Lincoln says.

It should be noted, however, that properties currently attractive to buyers should be separated from those that have occupancy or other problems. "It doesn't make sense to put some assets out on the market if they will have limited buyers and get a low price," notes Margie McHugh, senior vice president, Lillibridge. "Monetization is about what the buyers of the assets are looking for, what a hospital or healthcare system wants to do with the dollars the assets are worth, and whether it needs to pay off debt, generate more cash, or pump in financing for other programs right now."

Loans and Leasing

Some hospitals are obtaining working lines of credit or bank loans for day-to-day capital investments and small projects, including technology and equipment purchases. Bank lines and loans can be appealing today as a small-scale financing vehicle or bridge loan structure. Granted, these are often structured with taxable rates. In today's market, however, taxable rates (in particular, floating rates based on LIBOR) are not necessarily unattractive depending on what credit spread might be applicable. Also, in some instances, bank loans can be structured as tax-exempt vehicles.

Another potential drawback is that amortization terms are quite compact. Working capital lines of credit often call for an annual repayment, and loans may have a 10-year amortization or a 20-year amortization with a 10-year balloon. Such a structure would require a hospital to take a close look at how the arrangements would work with covenants based on maximum annual debt service. That said, bank loans often may be secured from a local or regional bank.

"For working capital lines or direct loans, you don't necessarily need the biggest banks in America like you do with a letter of credit to support variable rate demand note bonds," says Majka of Kaufman, Hall & Associates. "Smaller hospital facilities that might not have access to more traditional financing markets could look to their local banks to get $5 million or $8 million to fund some of their capital needs." With the housing and commercial real estate crises impacting nearly every community in the country, many local and regional banks may in fact view the hospital as the most creditworthy borrower in the region, he says.

In addition, leasing arrangements with equipment leasing companies or equipment vendors may be available. Although these arrangements are highly structured with short repayment terms, increasing numbers of hospitals are nevertheless examining leasing structures so they don't have to commit their own capital.

Same-as-cash or bridge-to-budget leasing structures permit a hospital to take delivery on a device or new technology and decide later whether it will continue with a traditional or highly structured lease transaction or treat the transaction as a cash purchase as it develops or revisits its budget.

"Such an arrangement allows hospitals to get leading-edge technology now and gives them an additional three to six months to decide which financing best fits their needs," says Mike Sweeney, general manager for healthcare finance for US Express Leasing (USXL), a Tygris Commercial Finance company in Parsippany, N.J. Hospitals can determine whether they want to use their own budget dollars or revert to a lease or structured type of arrangement with the financing company.

Hospitals also may opt for a capital lease so they can purchase a piece of equipment for a nominal cost at the end of the lease period, or they may select a fair market lease, which has lower monthly lease payment requirements but sets the purchase price of the equipment at the fair market value at the end of the leasing period. A fair market value lease helps hospitals keep up with technological developments by giving them the option to return the equipment, buy it, or upgrade to the next level. "Hospitals are thinking about using the financing company to take the risk of what the equipment's value will be three
to five years out, rather than assuming the risk of technology obsolescence themselves," Sweeney says.

Back to the Drawing Board

Many hospitals with strong balance sheets and strong returns on their investments over the past five years are in the process of rebuilding physical infrastructure. Although these hospitals are not necessarily taking all major projects off the table, they are revisiting their capital plans now that the cost, terms, and conditions of financing have changed and cash, pension, and endowment portfolios have declined as a result of the stock market meltdown.

"Hospitals need to understand exactly how the higher cost of capital will affect the organization and the project as well as their credit rating," Majka says. "Especially since organizations have a lot less cash with declines in their investment portfolios." St. Louis-based SSM Health Care is building a new hospital in Janesville, Wis., and completing some major renovations in existing facilities. Kris Zimmer, FHFMA, CPA, SSM's senior vice president of finance, notes that the organization has to slow down or stop some of these projects as it reassesses what will be happening over the long term. "We are trying to maintain the balance sheet so the patient care piece doesn't collapse," Zimmer says. "It has to keep supporting us when investments are not. As soon as the storm begins to lessen, then we'll figure out what's next."

The situation is similar for Iowa's Grinnell Regional Medical Center. The organization should have been able to complete remodeling of its physical and occupational therapy departments, laboratory, and emergency department, but it has slowed those projects down, according to Todd A. Nelson, Grinnell's CFO and vice president of finance. 

"We are moving them forward as philanthropic support comes in, but without taking on additional debt," he says. "We've slowed down our major construction projects, because even though they do need updating, our facilities are all right for now. Capital targeted for technology is different. We're continuing to move ahead because if you don't keep up with technology, patients just don't come."

These days, hospitals considering major renovations or expansions are taking a second look at their projects to make sure they are sized appropriately. Also, hospitals are examining their service lines to be sure they are providing the right services in the right places at the right time. As an example, Gourdon notes that it may be a good time to look at outpatient clinics and other services to take some of the pressure off of the emergency department.

Obviously hospitals have an obligation to provide an array of services, not all of them being equally profitable, says Machisko. "But they really do need to determine whether their service lines are in markets that can support or sustain them," she says. "They need to make sure they can speak to their balance sheet and liquidity."

It's also important to note that utilization declines, deterioration of the payer mix, unbudgeted interest expense increases, investment losses, and uncertainties around capital access are setting the stage for consolidation, and not just of hospitals with lesser credit quality.

"Credit-worthy organizations in the "A" category that are looking for growth and leverage in their markets, especially in major metropolitan markets, may begin thinking about teaming up with other large systems," Majka says. "We haven't seen a lot of high credit quality stand-alone providers begin to consolidate in the industry, but I suspect that in 2009 every organization regardless of credit rating will be reconsidering their long-term competitive position and market opportunities."

Today's Credit Market

As Majka notes, there are no silver bullet solutions to the current credit crunch. "You can overturn every rock at this point and end up with a large pile of rocks behind you but not a lot of attractive opportunities for financing," he says. "There are no particularly new or innovative financial products available to most not-for-profit hospitals and health systems, but I suspect we'll see new products evolve."

For now at least, he says it is sort of a back-to-basics time for protecting an organization's credit rating. "You need to be reevaluating what has always been available and rethinking how those options might be useful going forward."

Nelson, too, doesn't see a quick fix. "As CFOs, we need to put on our conservative hats and preach, 'Budget, budget, budget.' That's the tune we need to sing, because I don't see the credit market coming back tomorrow," he says. "It will be several tomorrows."


Karen M. Sandrick is a healthcare writer based in Chicago.

Publication Date: Monday, December 01, 2008

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