An HFMA Healthcare Financial Pulse Resource
Many healthcare entities enjoy the structural advantages and pricing efficiencies obtained by incorporating a derivative into their financing structures. Too many entities, however, have been surprised by multiple unforeseen risks that were embedded in these interest rate management products. In addition, it is now clear that many sellers of these products have interests that can be in direct conflict with the interests of the healthcare organizations buying them. As a result, many financial managers are considering limiting the use of these risk management tools in the future.
Before simply counting this option out, however, understand that following a few—but important—guidelines can help many healthcare organizations experience the benefits of using derivatives while avoiding many of the risks and maintaining a leveling playing field with their derivative counterparties.
With this in mind, Joanna Manthei and Andrew Labovitz, senior vice presidents with the investment banking and strategic advisory firm Cain Brothers, encourage healthcare executives to consider the following to-dos before entering into an interest rate derivative.
Strive to know as much as the person sitting across the table.
Don’t allow a derivative counterparty’s use of unfamiliar terminology make you feel you should simply trust what is stated because you’ll never “get it” yourself. Information on basic derivative mathematical concepts is easily obtained. Also, the person explaining the derivative to you should want you to understand the transaction inside and out. You should feel empowered to ask any question you have, no matter how obvious you suspect the answer may be.
Seek specifics.
Some derivatives have multiple pieces and factors that can all be quantified individually. Derivative counterparties likely won’t give you false information, but they may not tell you everything. Ask for specifics about the derivative’s features. As just one example, while you may not understand the math of how volatility factors impact the pricing of a trade, you should know whether volatility is an input to your derivative valuation and that the impact of a volatility shift can be quantified.
Recognize that the basics may do.
Many banks would prefer that you agree to complex trades rather than plain-vanilla derivatives (e.g., pay fixed / receive one variable index swaps). One reason is that simple transactions are so transparent and easy to comparison shop that derivative counterparties are forced to price these transactions with less profit in order to win the business.
Vanilla swaps, options, and cap contracts can be priced very competitively and typically accomplish a majority of the healthcare entity’s financial goals at less cost. In contrast, conditional options, multiple options within the same trade, and variable leg indices that change depending on the level of rates can add enough pricing complexity and variability to a trade that it becomes difficult to quantify the transaction cost or obtain comparative pricing.
Ask an unbiased expert to be your advisor.
The expert should be able to examine the healthcare entity’s existing debt and asset positions and only recommend derivatives that are tailored to the risk profile of the entire balance sheet. An unbiased expert should never recommend a particular arrangement or limited counterparty pool without citing its specific benefits--and potential drawbacks--compared with others. Similarly, this expert should never recommend purchase of a derivative that doesn’t fit with the organization’s philosophies and strategic goals.
Look beyond rate and price.
If a bank is merely quoting the swap rate, then it is not fully disclosing its profit. Ask the bank to give you its total fees (profit + credit costs + hedging costs) in basis points and as a present value dollar figure. These amounts are built into the rate on the derivative. It is the buyer’s right to have complete transparency on the costs and profits embedded in the transaction.
Also, recognize that there is more to a derivative than the price. Language used when legally documenting the trade can be negotiated as part of the business deal. Significant value can be obtained through favorable documentation terms that are included as part of the price. Choose a pricing advocate with significant and recent document negotiation experience to assist in pricing your derivatives.
Don’t ignore the derivative once it is in place.
The healthcare entity’s efforts shouldn’t stop at time of sale. Specifically, executives should monitor the derivative counterparty’s credit quality and exercise the organization’s rights under the legal documents if credit provisions are triggered. Obtain mark-to-market trade valuations from an unbiased source daily. Also, independently verify the periodic payment calculations provided by the derivative counterparty. (Counterparties make a surprising amount of calculation errors that usually go unnoticed and uncorrected.)
Processes also should be in place to identify when collateral is due to the healthcare entity. The derivative counterparty is not required to inform an organization of collateral owed or when the collateral it has posted may be returned.
Seek professional accounting advice. Derivatives can be structured and documented in ways that deliver favorable accounting treatment. Unfortunately, local accounting partners aren’t always familiar with these options and may not be permitted to give strategic guidance before a derivative is priced. Always hire someone with experience specific to obtaining favorable derivative accounting for a healthcare setting.
Protect your interests when it comes to termination value.
All too often, healthcare organizations mistakenly assume they have to take the swap counterparty’s termination value, whatever it is. Yet it is in the swap counterparty’s interest to make a profit on the derivative termination.
Most derivative documentation allows the healthcare entity to have a fair amount of control over the method of determining the termination value. Rather than hiring a third party to simply provide a fair market valuation, healthcare executives should seek an expert that has derivative execution experience and will review the legal documentation to propose an optimal exit strategy.
Joanna Manthei is a senior vice president, Cain Brothers, Indianapolis, jmanthei@cainbrothers.com.
Andrew Labovitz is a senior vice president, Cain Brothers, N.Y., alabovitz@cainbrothers.com.