An Interview with Ziegler's David Johnson
An HFMA Healthcare Financial Pulse Resource
The healthcare industry is entering a period of greater volatility in operating performance, according to David W. Johnson, managing director and co-head of Ziegler’s healthcare investment banking practice in Chicago.
The payment system’s ability to tolerate variation (e.g., twice as much care in Miami as in the Twin Cities) that has kept operating performance within fairly narrow boundaries is crumbling, he notes, as hospitals and health systems respond to payer and consumer demands for better outcomes, higher quality care, and lower costs.
How should such a shift be influencing your hospital’s capital planning and investment strategies?
In this interview with HFMA, Johnson provides perspective on credit market expectations and market orientation, as well as hospital strategies to improve liquidity, better manage unfunded liabilities, optimize performance reporting, choose the right financing vehicles, improve credit standing, and prepare for the future.
Are you seeing any changes in what credit markets are seeking?
Johnson: Credit analysts historically have valued balance sheet strength more than profitability and cash flow. Consequently, a health system’s levels of debt and liquidity have had more influence on credit standing than operating performance statistics. These days, the credit focus is broadening to emphasize operations. However, it is impossible to overstate the narrowness of bond investors’ perspective. At the end of the day, all investors assess the likelihood of repayment of the bonds they purchase from healthcare providers. Discussion related to mission, strategy, performance, and physician relationships serves to help answer the question, “Is an organization reasonably stronger or somewhat weaker in terms of its ability to repay the debt investors are supporting?” If I’m right that we are entering a period of volatility in operating performance, then credit markets will evaluate whether organizations are generating sufficient volume and profitability to make their bond payments. Healthcare providers and investors have learned that poor operating performance can drain cash reserves quickly.
How has the profile of healthcare borrowers changed?
Johnson: Historically the majority of hospitals have accessed the debt markets with “A” category credit ratings. As the U.S. healthcare system has become increasingly market-oriented, the numbers of “AA” and “BBB” healthcare credits have increased significantly. Consequently, there are more distinct “winners” and “losers.” It has become more difficult for health systems at the lower end of the credit spectrum to gain access to capital. At the margins, this market-oriented system may encourage health systems to invest in programs and services that generate profits at the expense of programs and services that may meet their communities’ healthcare needs more directly. Hospitals also are reducing their financial risk by converting floating-rate bonds to fixed, unwinding swaps, changing their asset allocation, and reducing risk in their operations.
What sorts of strategies are hospitals following to improve liquidity?
Johnson: There are several “levers” management can “pull” to improve organizational cash flow and build cash balances. Frequently, the first action is to reduce or freeze capital spending. Each dollar not spent on capital is a dollar that remains in hospital’s cash account. Many hospitals seek to manage their revenue cycles more aggressively and cut expenses. Some expense cuts are symbolic — for example, reducing travel budgets — while others strive for true efficiency improvement. The overall goal with both revenue and expense initiatives is to build organizational liquidity by applying incremental cash flow to cash reserves.
What should hospitals do to better manage unfunded liabilities, in particular, pension obligations?
Johnson: Healthcare providers with defined benefit pension plans need to monitor their plans carefully, particularly those organizations with underfunded plans. Health systems need to integrate their strategies for pension funding with their overall approach to managing the organization’s assets and liabilities. The goal is to make specific asset-liability decisions that complement one another so as to increase the likelihood of fully funding liabilities. This will become more difficult to accomplish as the level of volatility in operating performance increases. Health systems with a better handle on information related to all of their assets and liabilities, including pensions, will be better positioned to manage their enterprise risk in a holistic way.
What can hospitals do to better manage performance reporting?
Johnson: Health systems can move toward disclosure practices similar to registered companies. The market typically exacts a fairly significant “penalty” from healthcare borrowers, including higher interest rates, more security requirements, and more stringent covenants than borrowers in other industries. This occurs because the disclosure that health systems provide for public debt offerings is not always consistent, timely, and comparable. There is even uncertainty about core concepts: What is revenue? What is bad debt?
By contrast, registered companies must follow SEC guidelines for more robust quarterly disclosure, which enables investors to make risk-reward investment decisions with precision. This reporting practice translates into greater liquidity and tighter pricing for corporate securities in both the primary and secondary markets. Health systems can realize similar benefit by moving toward SEC-style disclosure. Improving quarterly disclosure is an essential component of an effective investor relations program.
Do you anticipate any changes in the near future in the types of financing vehicles that will be used?
Johnson: Until recent events, many healthcare organizations did not fully understand or appreciate the risk associated with the financing structures they put in place. Our industry focused attention during the past five years on the risk profile of derivative products and synthetic debt structures. By and large, interest rate swaps themselves have worked as anticipated, although there have been some large negative marks on certain types of LIBOR-based swaps. Catastrophic risk — the risk of restructuring debt — actually resides in variable rate debt instruments. This became apparent with the collapse of the auction rate securities market, the subsequent implosion of the bond insurance industry, and the reshaping of bank letters and lines of credit in such a way that they became less available, were more costly, and were accompanied by demands for incremental business.
Health systems feel burned, and many have developed an instinctive negative reaction to risk. Until we as an industry address the underlying attitudes driving this instinctive reaction, health systems won’t be in a position to undertake rational discussions regarding risk, return, and the merits of complex financing structures. I still believe swaps are a valuable financial tool that can provide tangible benefits under the right circumstances. They have a place in the capital structure for many health systems as part of a managed liability program where the risks are fully documented and management actively monitors program performance. If I were a CFO, I would have no more variable rate debt than I could reasonably expect to restructure in a difficult time. However, given the savings that a very steep yield curve represents, I might want even more variable rate exposure and choose to use a swap to achieve that objective.
What strategies should hospitals pursue to improve their credit standing?
Johnson: Health systems have been programmatic in managing their investments. They typically structure an investment portfolio that targets an annualized return within established risk tolerance levels and detailed investment policy. They also measure and report on the portfolio’s performance quarterly, making adjustments as required. By contrast, health systems tend to approach liability decisions on an episodic basis. They conduct significant analysis in advance of a transaction, wait for the next transaction, and then repeat the process. I would like to see health systems manage liabilities on a programmatic basis as well.
To do this, health systems would target an annual funding cost, assess risk positions, measure performance quarterly, and make adjustments as necessary. Being programmatic enables health systems to manage both their assets and liabilities more effectively.
How important will mergers and acquisitions be as a strategy going forward?
Johnson: There will be more mergers and acquisitions. Volatility in operating performance will be a contributing factor. The strong will become stronger and consolidate weaker healthcare providers into their operations. Already, credit downgrades are disproportionately affecting lower-rated borrowers, driving them to seek out stronger partners.
How do the credit markets perceive or account for risks inherent in today’s healthcare industry?
Johnson: Rating agencies are becoming more conservative in their industry outlook and tougher on liquidity metrics. They now review the amount of short-term assets relative to variable rate debt. For example, Moody’s suggests that the strongest AA-rated credits should not have more than 50 percent of their debt in variable-rate instruments. These liquidity-based metrics dovetail with my belief that organizations should not have more variable rate debt that they can restructure under duress.
What other issues related to capital access should be top of mind for today’s hospital leaders?
Johnson: The debt markets experienced a remarkable period of stability through the middle of 2008 that included low interest rates, low-risk premiums, and ample liquidity. This volatility ended dramatically last September in the wake of Lehman Brothers’ bankruptcy. It is naïve to think that we will return anytime soon to a world with low rates, plentiful buyers, ample credit, and low perceived risk. Health systems now confront debt markets that have less liquidity, higher interest rates, and more stringent security/covenant requirements. In this “new” world, it is prudent to be more conservative in managing investments, strive for higher liquidity, focus on the core business, and prepare for whatever regulatory changes may emerge from Washington.
While this is a very challenging operating environment for healthcare providers, the challenges are clear. Health systems need to be more conservative in managing their capital structures and in restraining capital spending. They need to transition their organizations to achieve operational improvement, greater efficiency, and greater transparency in reporting financial performance, quality, and outcomes. Health systems that are at the leading edge of this transformation will become the industry’s consolidators. Health systems that lag risk continued under-performance and potential takeover.
Return to Pulse Home Page