Kevin T. Ponton
He was the successful former hospital CFO and elegantly graying managing director at the busiest hospital investment banking firm in the country. I was the young kid who had just convinced him to hire me as the new associate in the firm.
His parting words to me as he pushed the button for a waiting conference call and I headed to the human resources department were, "Kevin, never, ever lose the common sense to blow on hot soup."
A few weeks later, as we left the office of a clearly perturbed client CFO, he asked me how I thought the meeting had gone. "We just got fired," I responded. He chuckled, and informed this young whippersnapper that the firm had never been "fired."
"So what would you do next-assuming you're right?" he asked. I suggested calling the CFO and groveling. If I was wrong, he'd be impressed at how well his "warning" had worked. If I was right, at least he couldn't criticize us for not being able to recognize when we'd been told we were toast.
So my boss phoned the client-and confirmed the bad news. When he asked me how I'd gotten it right, I replied that I was simply following his advice: blowing on hot soup.
I had another hot-soup moment shortly after Bear Stearns tanked. You need to know the significance of that event to every participant in the financial markets sector back in mid-March: If we had had a threat indicator like one used by the Department of Homeland Security, it would have been flashing red 24/7, accompanied by a constant submarine "Dive! Dive! Dive!" alarm horn.
As a quick aside, the story I'm about to tell you is mainly directed at investors who could get burned by hot soup. But there's also a message for hospitals that want to be attractive to investors. I'll leave it to you to read between the lines.
I was about to join a presale investor call about a new hospital issue. The hospital was big and well connected, with strong credit ratings and lots of clout. It was early April and the hospital's fiscal year had ended in December. Although it was still a bit early for the 2007 audit under normal circumstances, the import of a new issue for such a beefy credit would usually nudge the auditors to finish up their work in time for the audit to be included in the preliminary official statement (POS).
It wasn't there.
I thought, no problem, really: They have other outstanding debt with covenants for quarterly (albeit unaudited) disclosure within 45 days of the end of each quarter. I'll just query the NRMSIRs (Nationally Recognized Municipal Securities Information Repositories) and find the hospital's year-to-date financial report has been sitting there for the past 30 days or so.
It wasn't there, either.
Hmmmm. This situation was getting a bit warm. But hot soup? I wasn't ready to call it that.
Checking Some Ingredients
I went back to the POS and reviewed the MD&A (Management Discussion and Analysis of Recent Financial Performance) section. It showed a single condensed table of revenues, expenses, and net revenues for 2004 through 2006, and for the 11 months ended Nov. 30, 2006 and 2007. No balance sheet. No cash flow.
After the table were three paragraphs beginning with the phrase, "Preliminary unaudited financial information has become available for the 12-month period ended Dec. 31, 2007...." and ending with a caution: "The unaudited results are subject to revision and adjustment in connection with the preparation of the audited financial statements...."
The "has become available" phrase was precious. Under the circumstances, I interpreted the three paragraphs as management's way of saying, "The snippets of positive information in this POS are teasers that we can't be held accountable for, because they will probably change by the time you see the audit itself."
Right. They might as well say, "This information may be the truth, but it's nowhere near the whole truth, and it's only the part we consider positive."
A Dash of Rating Reports
Then I looked at recent reports by Moody's, S&P, and Fitch. (The rating agencies have access to privileged information-not released to mere investors like us-that might shed some light on the situation.)
One of them referred to a concern about $50 million in "illiquid investments." A big red flag. Now, I'm concerned: This is definitely hot soup.
The Taste Test
This is the tough part: You blow on hot soup because your common sense has suggested it's hot, but not, hopefully, because you've already burned your tongue. The drawback is looking silly if your common sense has fooled you. In our case, I could look like a nervous Nellie fearing a wolf behind every tree.
But here was my reasoning:
- Looking back to the audits, I noticed big increases in equity investments and hedge fund investments between 2005 and 2006.
- The equities market had dropped about 17 percent in the last quarters of 2007. Had this hospital loaded up even more on high-yielding equities that tanked during the fourth quarter?
- What if they had also loaded up on those attractive yields in hedge funds? Many of them might now be illiquid and, if so, couldn't be valued accurately.
- If at the end of the year, both of the above had happened and management and auditor couldn't agree on a valuation, we could reasonably expect the auditor to impose a more conservative position (auditors learned a lot from the execution of Arthur Andersen because of its laxity during Enron) than management might show in their unaudited reports.
- Management thus might be motivated to withhold the audit information-on whatever legal mumbo-jumbo pretext-until after this deal was done.
- Such a revelation in the audit, with the market as skittish as it is, could cause a big flap among investors even if it didn't cause significant deterioration in the credit metrics.
Here's how the conference call went:
Potential investor: "Why is the 2007 audit not included?"
Answer: "The auditor didn't finish the work in time."
Follow-up question: "What about unaudited financials for the same period?"
Answer: "The auditor would not allow their disclosure."
Follow-up question #2: "But wasn't the unaudited disclosure overdue in the market anyway, apart from this transaction?"
Answer: "Well, ummm, yeah, but we can't release it because the auditor objected...."
At which point, every other potential investor on the conference call apparently decided that the soup wasn't all that hot: Bon appétit. No further questions. The conference call ended with nary another peep.I was momentarily stunned. The what-if scenario was daunting: If the eventual audit revealed that any or all of my reasoning had been correct, could I tell our investors that I had seen no indication of the potential problem? No. Although none of the individual glitches, taken alone, was weighty enough to cause concern, was the presence of all a thoroughly different proposition? Absolutely. I had expressed my reservations, but they fell on deaf ears. This situation required some follow up.
Time for Culinary Discretion
My biggest puzzlement from this case was this: If there was even the slightest appearance of warning signs, why were so many of the parties involved so unconcerned? A mere seven days before, we had come into our offices to find one of the biggest brokers on Wall Street valued at two bucks, down about a gazillion percent from the previous day. And still investors were in denial when it came to the big issue we were working on: "No warning signs, no warning signs-la-la-la-la-la, I don't hear you!" Or as Homer Simpson once said regarding indications that Sideshow Bob was a pathological killer, "Indications, schmindications! They're all just a bunch of things that happened!" And we all know that Homer never blows on hot soup.
This case proved to me that some things need to change-but quick. If there was ever a time when market behavior was screaming for common sense and prudence, it's now. It's up to each of us-CFOs, investors, and investment counselors alike-to ask the simple questions that deserve simple, straightforward answers rather than legal or "professional" mumbo-jumbo. Go ahead and ask that stupid question. If the answer isn't convincing, blow on it.
Kevin T. Ponton is senior managing analyst, Dreyfus Funds, New York (firstname.lastname@example.org).
Publication Date: Tuesday, July 01, 2008