In this business profile, Amy Gross, senior vice president of Key Government Finance, discusses the benefits of private placement transactions to support large-scale financing projects.

Amy GrossWhich industry drivers are prompting healthcare organizations to consider tax-exempt options to finance new assets?

Amy Gross: The nature of health care is changing, and we're seeing a steady stream of major consolidations and acquisitions that require large-scale financing. In addition, sophisticated technology can necessitate significant capital investments, and some hospitals are even seeking financing for working capital to fund growth strategies.

Fortunately, hospitals and health systems have access to a range of financing options. Not-for-profit organizations are especially interested in securing financing that offers lower costs and flexible terms. Given current market conditions, characterized by historically low interest rates, these organizations are evaluating their options, including strategies for refinancing existing debt on more favorable terms or new capital projects through tax-exempt financing structures.

In the not-for-profit segment, 501(c)(3) hospitals and healthcare organizations can qualify for tax-exempt financing by partnering with a state or local government issuer that serves as a financing conduit to issue tax-exempt financing on behalf of the 501(c)(3) organization. In this vehicle, the government or other qualified agency uses its borrowing authority to issue a tax-exempt obligation, and then makes proceeds available (by loan or otherwise) to the 501(c)(3) hospital to be used for completion of a capital project—such as a new facility or new equipment—related to a 501(c)(3) organization's exempt purpose. Such an arrangement is referred to as conduit borrowing, with the state or local government issuer typically assuming no obligation on the debt.

What are the different types of tax-exempt financing available for conduit transactions?

Gross: Generally speaking, there are two financing structures commonly used by healthcare providers and municipalities for the issuance of tax-exempt debt. The first is a public issuance of traditional bonds. This is accomplished through a long-term structure. Bonds can be very effective for large projects that span an extended period. It wouldn't be unusual, for example, to have a bond issued for hundreds of millions of dollars for a 30-year term. These are typically issued through a broker-dealer and taken to the market where bond investors fund them in tranches—related investments offered at the same time that have different risks, rewards, and/or maturities. The downside of the traditional bond option is that the issuance costs can be higher. Also, bonds are relatively standardized in that they typically are offered at a fixed rate and structured as a sequence of serial and term bonds sold publicly to institutional investors.

The second structure is a private placement, which can be tailored to the specific needs of each borrower. In this model, the credit is privately negotiated and held on the balance sheet by a specific bank or single institutional investor. The transaction resembles a conventional bank loan in many respects, with a straightforward structure involving only one holder of the debt instrument who can exercise all administrative, oversight, and enforcement functions present in a lending transaction. This structure can be more appealing because it requires limited or no Securities and Exchange Commission reporting, no credit enhancement or letters of credit (LC) fees, and limited involvement from third-party financing professionals. Often, the financing can come together—from commitment to approval—in as little as 90 days, and a private placement can bring some needed diversity in lending sources. In addition, the private placement offers more flexibility with pre-payment penalties compared to a public issuance where pre-payment is typically locked out for 10 years.

The dollar value for private placements generally ranges from $5 million to $50 million. We find that most fixed interest rate commitment periods are in the seven- to 10-year time frame with up to a 25-year financing term, allowing the lender to price on a shorter yield curve, which is more attractive.

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Smaller private placements are usually purchased by a bank. That can translate into fewer and less-restrictive covenants because of the local relationship and trust with the borrower. Typical covenants include a minimum debt service coverage ratio, days-cash-on-hand requirements, and financial reporting obligations. An appraisal may be required where a mortgage is pledged to ensure it meets the loan-to-value test.

Who should be involved in the financing decision?

Gross: On the hospital side, decisions typically are the responsibility of the chief financial officer—and sometimes the treasurer as well—along with an external financial adviser who represents the hospital and provides additional counsel and expertise. The financial adviser will solicit proposals from banks and make recommendations to the hospital's board. In some cases, the registered municipal financial adviser is involved to help manage the municipality's bond investments and private placements. This individual may not always meet with the hospital's board of trustees, but that wouldn't be unusual.

Why do state and local government issuers participate in conduit transactions?

Gross: There are several reasons why tax-exempt conduit transactions are favored by state and local government issuers. First and foremost, there is a strong impetus to create an environment that's favorable for healthcare systems. The presence of a vibrant healthcare infrastructure contributes significantly to the quality of life for an area's citizens. It can be a factor in attracting employers and new residents, which, of course, ultimately increases the local tax base. Plus, history has shown that these types of financing structures have proven to be a reliable and low-cost financing option available to 501(c)(3) hospitals and healthcare organizations.

What are some other considerations to keep in mind?

Gross: When working with a private-placement bank, there are often incentives to coordinate and arrange ancillary business services to strengthen the relationship. Some term sheets may even make these ancillary services a condition. These can include cash management, credit card and payment solutions, and depository and trust services.

We recommend paying close attention to the private placement's covenant requirements. For example, how much cash on hand will you be required to carry? What's the debt service coverage? Are the financial reporting obligations reasonable and feasible?

Finally, be sure that the bank with which you're partnering has the resources to properly support the transaction. Often, a hospital will have a relationship with a smaller, local bank that may be attracted to large private placement borrowing to preserve the relationship, but the local bank doesn't have the expertise or lending capacity within its portfolio to execute efficiently.

How should an organization get started with a private placement financing project, and what should it look for?

Gross: Before making this leap, it's important to select a lending partner with the necessary credit underwriting expertise to properly price private placement bonds and evaluate the specific terms and covenants required.

The responsibility for underwriting private placement bonds falls on the lender, so they need the diligence to analyze and price credit risk. They'll also need considerable legal expertise. Successful lenders form strong relationships with issuers, placement agents, financial advisers, and bond counsel. They also participate in the market frequently enough and hold a private bond portfolio with sufficient scale to make their credit underwriting, legal, and back office infrastructure investments pay off.

Are there any educational materials you would like to share to help healthcare providers in these efforts?

For more information on our tax-exempt financing practice, visit the Key Government Finance website.

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Publication Date: Sunday, May 01, 2016