Not-for-profit health systems are increasingly using taxable debt to finance strategic priorities.
For decades, not-for-profit healthcare organizations have relied on tax-exempt debt to finance capital expenditures. Historically, tax-exempt bonds typically have carried lower borrowing costs, and long-dated maturities suited a business model focused on the inpatient bed tower.
But as the hospital business evolves beyond acute care, not-for-profit healthcare leaders are increasingly turning to a less familiar source of capital financing—the taxable debt market.
“Over the last few years, the typical health system’s list of strategic priorities has been muddled,” says Brian Carlstead, a director on Citi’s not-for-profit healthcare investment banking team.
“It’s no longer a world in which the primary investment is the ‘bricks and mortar’ bed tower. The priorities are now about caring for the community more broadly, Carlstead says.”
These new priorities call for investments in physician practices, outpatient care, information technology, and other non-traditional uses of capital. The problem is that these investments are generally ineligible for tax-exempt financing.
“If your capital investment priorities are not tax-exempt-eligible, which we are finding more and more these days, then you need to find an alternate way to finance your strategic plan,” Carlstead says.
Besides using cash on the balance sheet, another opportunity is to access the taxable bond market. “The proceeds from issuing taxable bonds are very flexible,” Carlstead says.
Differences Between Tax-Exempt and Taxable Debt
In most respects, the taxable debt market is similar to the tax-exempt debt market. However, according to Carlstead, there are a handful of key differences:
Issue Size. “At the end of the day, investors either buy and hold a bond or sell it,” Carlstead says. “For investors in the taxable market, a bigger issue size qualifies the bond for index eligibility, resulting in greater liquidity to sell if needed.”
Given the taxable debt market’s preference for larger issues, large hospitals and health systems are usually the best candidates for taxable financing. However, alternative arrangements such as private market direct placements do allow smaller borrowers to access taxable debt at smaller par values.
Payment structure. Tax-exempt debt can generally be amortized. Healthcare borrowers can liquidate this debt through regular installment payments generally manageable within normal cash flow. “In the taxable bond world, however, investors prefer bullet maturities,” Carlstead says, “so the entire amount will be due on one day 10, 20, or 30 years out.”
In addition, taxable bonds are generally not economically redeemable prior to the maturity date. “This is a big difference from the tax-exempt market, where the borrower can choose to redeem the outstanding principal at par, typically 10 years after issuance,” Carlstead says.
What about interest rates? Many healthcare executives assume that borrowing costs on tax-exempt debt are much lower than rates available in the taxable market. However, in most cases, the cost of taxable debt is comparable to tax-exempt debt when on a yield to maturity basis.
Potential Advantages of Taxable Financing
Although the structure and terms of taxable debt may represent unfamiliar territory, taxable bonds do offer several distinct advantages.
Finance a wide range of priorities. As noted, tax-exempt debt is restricted based on use. Generally speaking, the proceeds of tax-exempt bonds can only be used for charitable purposes. This rules out most uses beyond the construction of an acute care facility.
In contrast, the taxable debt market offers much more flexibility. “Taxable bonds can be used for any corporate purpose,” Carlstead says. For example, a health system positioning itself for value-based payment may decide to invest in physician alignment, consumer-friendly points of care, new information systems, and data management capabilities. These expenditures may not be eligible or ideally financeable by tax-exempt bonds, but they can be paid for with taxable bond proceeds.
Given the pace of change in healthcare, taxable debt could even be an appropriate option for financing traditional construction projects. “Say you are developing a facility that you plan to use for a tax-exempt purpose,” Carlstead says. “Then five years later, your system’s priorities change and you want to use the building in a different way that doesn’t qualify for tax exemption. You will then have a remediation issue.” Consequently, finance leaders who are concerned about a possible future change in a building’s use may want to consider taxable financing.
Reduce the effects of negative arbitrage. When financing a construction project, health systems often issue the bond well before the shovel hits the dirt. “But when you borrow money in the tax-exempt market, you typically have to put the proceeds into a construction fund,” Carlstead says. This potentially exposes the money to negative arbitrage—earnings that are lower than the cost of borrowing.
“But if you do a taxable bond instead, the proceeds from that taxable bond could be put into your investment portfolio,” he says. “Healthcare finance departments typically have more flexibility with that portfolio, so that money can earn a higher interest rate in the interval.”
Reduce overall risk by increasing access to capital. “For healthcare organizations, it’s better to have experience issuing and accessing multiple pools of capital rather than just one,” Carlstead says.
Diversification can offer protection against potential difficult lending conditions. “Look at 2008 as an example,” he says. “Public markets are volatile, rates are high, institutional investors are under pressure, and banks are not willing to lend.”
Imagine a hospital system has an invoice that needs to be paid or a strategic priority that needs to be financed during a difficult period like that. “Having the ability to finance the organization from multiple pots of capital is better than being isolated to one pot of capital,” Carlstead says.
Strategies for Mitigating Risk
For many finance leaders in not-for-profit health care, the stumbling block to assuming taxable debt remains the bullet maturity bond.
“Having a big one-time payment changes your risk exposure,” Carlstead says. “You want to think about the plan in advance, because if you don’t have a plan, it could be disruptive.” He says there are several ways to manage bullet maturity risk.
Save as you go. The first strategy is simply to save enough money every year to pay off the bullet maturity when it comes due. This is probably the easiest approach from a cash flow perspective. “You take a little money every year and ring-fence it for future repayment of debt,” Carlstead says.
Negotiate special repayment terms. Under certain circumstances, a bullet maturity can be broken up into several installments. “For example, with a $300 million 30-year taxable bond, you could arrange to pay $100 million in year 28, $100 million in year 29, and $100 million in year 30,” Carlstead says. This repayment feature can usually be secured without an interest rate penalty.
Refinance the bond when it comes due. Like tax-exempt debt, taxable bonds can be refinanced. “The largest for-profit healthcare systems do not necessarily pay off their debt in all cases,” Carlstead observes. “Sometimes when a bullet maturity becomes something they have to deal with next week, they access the market, refinance the debt, and put it out 10 years.” Not-for-profit borrowers can also use this strategy.
Access taxable debt through the private placement market. This lesser-known financing option can allow healthcare borrowers to combine the flexibility of taxable debt with the benefits of amortization. “In addition to selling taxable bullet maturities to institutional investors, hospitals can also access the taxable ‘private placement’ market,” Carlstead says. “This allows you to directly place securities through a placement agent to, most often, life insurance companies.”
Like all taxable debt, the proceeds of a private placement offer flexibility in use, and the interest rates are generally competitive. The big advantage of private placement is that the debt can be amortized. “So in lieu of issuing a bullet, you can issue the same amount but pay it off over time,” Carlstead says. “That can sometimes make a deal more palatable, and it can sometimes make the economics line up better.”
A Flexible Tool
As not-for-profit health care evolves, many of its strategies have outstripped traditional financing methods. Taxable debt is an important option for finance leaders who need a flexible tool for funding current operations and future growth.
Interviewed for this article:
Brian Carlstead, is director of not-for-profit healthcare investment banking, Citigroup Global Markets, Chicago, Ill.