Opportunities in Hospital Capital Access
If you run a hospital and you need capital, these are the good old days. Interest rates are at historic lows, hospitals' margins overall are expanding across most of the country, and cheap debt doesn't just come from bond offerings anymore. Hospitals are taking advantage by replacing outdated facilities and acquiring ancillary businesses such as physician practices and outpatient facilities to position themselves for the competition of the future. Even lower-performing organizations are taking advantage as the historical bifurcation of the debt market between investment-grade and noninvestment-grade facilities erodes. There's no better time than the present for such organizations to borrow to catch up. But history shows now is also the time to be judicious. When easy money replaces caution, it's usually only a matter of time before the day of reckoning. Smart organizations are using this opportunity to either take on debt that will strengthen them strategically or refinancing to pare down debt so that when spreads widen again, they find themselves on the right side of the chasm.
Philip Betbeze, senior editor-finance, HealthLeaders Media, served as moderator.
Robert A. Frank, senior vice president and chief financial officer, Jefferson Regional Medical Center.
Lisa Goldstein, vice president and team manager, Moody's Investors Service.
Margaret A. Brown, executive vice president, CIT Healthcare. Scott Wooten, senior vice president and chief financial officer, Alegent Health.
Roundtable HighlightsThe healthcare debt environment
PHILIP BETBEZE (HealthLeaders Media): As in many other industries, there's a lot of cheap debt out there for hospitals and health systems that choose to take it on. Let's start with the most obvious question. How has that environment changed the game?
MARGARET A. BROWN: On the leveraged loan side, we still see a lot of compression in spreads.
ROBERT A. FRANK: Yes, the spreads have really, really thinned. We refinanced an issue in February, and the spreads were very thin and we received a very good rate. We did a small refinancing of $14 million and received a rate of four and three-quarters percent.
BETBEZE: So how much outstanding debt do you have?
FRANK: That's one thing we've been trying to pare down. We have $108 million of debt, and this environment is good for us because we went through some very difficult financial times in the past. In the early 2000s, we were losing $7 million to $9 million a year. We were very highly leveraged for an organization our size. Since that time, we've had a disciplined approach to reducing our debt. Since 2002 we've added $120 million in capital without any additional debt.We've been adding equipment, IT systems and infrastructure along with an open heart program. We've added a parking garage and refinanced a lot of debt, but we've been doing it on the basis of our cash flow alone. We've reduced our debt approximately $40 million since then.
BETBEZE: Lisa, how has the credit environment helped Bob reduce debt?
LISA GOLDSTEIN: For the higher-rated organizations, there is wide access to capital, but even for lower-rated organizations, because rates are so compressed, there is very inexpensive capital. Interest rates are at all-time lows, so bond insurance may not be as necessary as in the past because you can borrow on your own credit for such a low cost that it doesn't pay to tack on additional fees for the insurance. Ironically, when you look at the capital markets, there are more Aaa bond insurers today than there were five, seven years ago. And you have bond insurers that are not rated Aaa but are Aa1, Aa2, that are trying to make a market in healthcare for the lower-rated, Baa-rated categories. But there are organizations that are too leveraged for their rating category, so they, like Jefferson, embark upon a plan to fund capital the old fashioned way, through earnings and paying down debt to deleverage their balance sheets, which is, from our perspective, very commendable.
FRANK: We went from Baa1 negative to stable and then to positive.
BETBEZE: Talk about how you achieved that and still funded all of the programs that you wanted to fund.
FRANK: We engaged a whole team of people working on revenue enhancements and billing, which became the source for a lot of the earnings improvement along with volume growth. We also became very disciplined with our spending. The other big part of our turnaround was the impact of our open heart program and its halo effect on other hospital services.
BETBEZE: Scott, how does Alegent use debt?
SCOTT WOOTEN: The use of debt is key to our credit rating. At Alegent we have a five-year balance sheet plan that articulates that debt is not a true source of capital. The real sources of capital are operating cash flow, philanthropy, which a not-for-profit has, and then lastly, investment yield. That being said, we have about $220 million of debt and we're getting ready to issue about $410 million more over a four-year period.
BETBEZE: Margaret, there are so many more financing options out there for hospitals and health systems.
BROWN: Not-for-profit healthcare systems have many more ways to finance themselves, such as how to finance physician joint ventures. Many healthcare systems think that is an important strategy for them both defensively and offensively in their marketplaces. Often they'll finance those JVs separately and in a taxable fashion, rather than through tax-exempt bond issuance.
WOOTEN: Physician partners tend to want a short-term return on investment versus a longer term sustained return on investment. That often leads to shorter term financing such as Margaret described through, for example, leases. We're in the process of partnering with many different physicians, an oncology cancer center, some imaging centers, several procedure centers, a GI center, and more to come.
BETBEZE: Is there a pretty simple game plan to follow with these deals, Margaret?
BROWN: There's going to be some commonality in all of these types of financings. We call it project financing. You have physician ownership, an equity contribution or skin in the game of some sort-be it cash or guarantee-because the physicians really make the venture successful. You can finance the working capital, you can finance the tenant improvement. Rarely do you finance all three.
FRANK: The other factor, too, is that technology is changing so rapidly that to go out and incur long-term debt for PET/CT scanners and things like that just doesn't make sense anymore.
BETBEZE: For hospitals, what about using capital to purchase physician practices? Is that back in vogue now?
FRANK: A lot of ours that we're divesting were primary-care physicians. The trend now is purchasing of specialty practices as those become more scarce.
GOLDSTEIN: A couple of years ago, we noticed a return to the physician employment strategy after hospitals incurred huge losses on them about a decade ago. So when we heard about the return to employment, it was hard to take. What's going to be different this time so that you don't incur large losses? So what we're hearing is that hospitals are taking a much more methodical, rational approach to acquisition.
BETBEZE: Let's talk about private equity and hedge funds boosting the amount of liquidity available.
GOLDSTEIN: In high-growth, non-certificate-of-need states, hedge funds and venture capital funds are investing big dollars in joint ventures with physicians. And they're building not only imaging centers and same-day surgery centers-that's kind of yesteryear-they're building whole hospitals. And they're not specialty hospitals. They have emergency rooms. They may be small and hard to find, but they have them.
GOLDSTEIN: And because they are for-profit but not publicly traded, disclosure is very limited so it's hard to know what their strategies are. They are being constructed either across the street from the established not-for-profits and even the established for-profits. They're skimming the commercial business. They don't want the Medicare patients, they don't want the Medicaid patients. So the not-for-profits in particular markets have had to step up with their own joint ventures and look for outside lending and taxable lending to fund their own hospital strategies and outpatient strategies. So there's a new type of for-profit out there.
BETBEZE: For example, Scott, Alegent is defending its market among a host of competitors. One strategy you're employing even now is with the quick-clinic concept in grocery stores, right?
WOOTEN: We've really tried to embrace a consumer-friendly strategy. In fact, we want to be a leader in our market on consumerism. We did focus groups in the Minnesota market to understand what the business model was for Minute Clinic. And we augmented it by partnering with the local grocery store chain and deploying those low-cost, easy in-and-out, 20-minute kind of access points throughout the market.
BETBEZE: You protect your brand, you're not letting others skim some of the more profitable services or the referrals that you get from some of those places.
WOOTEN: That loyalty factor with the customer is absolutely key. The physician partner is becoming a partner-competitor, so maintaining a collaborative relationship that's sustainable in the long term is essential. And that requires, in our market at least, very aggressive participation in joint ventures in order to sustain our mission and be the safety net in many of our communities.
FRANK: But I wonder how quickly those margins can erode as reimbursement rates can change with the stroke of a pen from a legislator, or volume is controlled by managed care companies as they look at increased utilization. It'll be interesting to see over the next couple of years if those entities will be able to sustain themselves.
BETBEZE: Do they realize the legislative risk premium they face?
BROWN: It's still caveat emptor because there are so many risks involved. We do a lot of due diligence in our project financings around the physician groups and their practice patterns in the market to see if they really can draw in the volume that you're basically lending against. It'll be very interesting to see how some of these deals shake out.
WOOTEN: Very small niche competitors are going to proliferate. And, it's going to change the nature of competition for the traditional community, nonprofit healthcare provider. And consumerism is going to become more of a driver in that process.
BETBEZE: Well, let's talk about consumerism here. How does focusing on it improve your long-term viability, and thus your access to capital in the future? Scott?
WOOTEN: Traditionally, in inpatient care, we have a high-cost delivery system and reimbursement continues to go down relative to cost. In an outpatient venue, it's the exact opposite. So there has to be a leveling, and competition will create that leveling. For sustainability there will have to be some realignment to an inpatient model again.
GOLDSTEIN: There's been this paradigm shift refocusing on the inpatient rates more than ever, because outpatient rates, once the most lucrative part of a hospital's charge structure, are just being pancaked and compressed.
WOOTEN: And consumerism is driving that outpatient compression. We have a little cost transparency tool by the name of My Cost. Well out of the gate, one of several thank-you letters we've received is, 'thank you for being so transparent with your cost. We chose to go to one of your competitors because it was less.' It could make the CFO shrink.
Housing meltdown parallels?
BETBEZE: Let's get back to talking about liquidity. Margaret, what's different today compared to the past?
BROWN: It's a tremendously liquid capital market right now with hedge fund money and private equity money. Trillions of dollars are in alternative investments today. They're all looking for places to invest those funds, and you can't ignore healthcare because it's such a big piece of the gross national product.
BETBEZE: So there's a lot of money out there looking for a place to land. We saw the bad results of that kind of liquidity recently with the residential housing bust due to subprime mortgage problems. Are there any cautionary tales that we could learn in this side of the industry from the mortgage meltdown that we've seen recently?
BROWN: It's a very good question, and it's something that we think about quite a bit because I'm in the risk business. And what I tell our people is that it's OK to lose deals. I have seen at least three healthcare cycles. And if you don't maintain discipline, you're going to lose money. A lot of these hedge funds are managed by people who are very young. They haven't been through a single cycle. They think, 'Oh, why can't you leverage a healthcare company six, six and half times?'
BETBEZE: So as experienced players in this and people who have seen these cycles come and go, how does that make you guys feel as far as irrational exuberance is concerned in your business?
BROWN: Large institutions that have a lot of exposure to healthcare will say, 'We've taken some big losses, we're going to cut back.' They'll shrink their healthcare practices down or they'll just shut them down. And others-who perhaps have been more disciplined-they will see this as an opportunity. There's a saying in hedge fund land: You lend to own.
GOLDSTEIN: Let's make our money, trade out, and on to the next industry. It depends on the philosophy behind the fund.
BETBEZE: What happens when funds head for the exits and leave a lot of these overbuilt markets?
BROWN: There will be collateral damage, without a doubt. But I don't think that Bob or Scott have to worry about hedge funds buying their bonds at a discount hoping to reshape their healthcare systems.
WOOTEN: We probably have more exposure from an investment portfolio perspective.
BROWN: Oh yes, the other side of your balance sheet.
BETBEZE: What possible shocks could cause the spigots of cheap debt to dry up?
GOLDSTEIN: Another large bankruptcy filing or payment default-which is what keeps us up at night-will be a shock to the industry and its ability to borrow at low rates.
BETBEZE: And we've had a period of relative calm, too. What about legislative risks?
GOLDSTEIN: Bob, you talked about the bond insurers pulling back. Last year, in Illinois, when the state attorney general tried to institute charity care mandate of 8 percent, bond insurers were vocal and said, 'We're not insuring any more Illinois hospital paper if this passes.'
FRANK: It's too radical of a change.
GOLDSTEIN: So, it didn't pass but we fully expect for it to be back on the agenda this year. And I think Oregon is looking at legislation now that will limit not-for-profit hospital margins to 2 percent and limit days cash on hand to 100 days.
BETBEZE: From the hospital CFO's perspective, when you do a joint venture, what are the financing options that you consider?
FRANK: If we're doing an imaging joint venture, for example, there may be some equity contribution from each of the members for working capital, but we typically lease the equipment. We don't build facilities but rather rent the space.
WOOTEN: We've done five joint ventures in the last 12 months. And surprisingly, the liquidity came from the physicians. Four of the five were full-equity deals between the health system and physicians, so we didn't have to borrow. To the extent that there was financing involved, it was in the form of equipment leases. Or, in two of the transactions, they chose not to make it a real-estate investment strategy, and so they used a developer.
BETBEZE: On a big-picture basis, are hospitals taking full advantage of low interest rates to refinance their debt?
GOLDSTEIN: It seems like every other transaction has a big refinancing. It's good capital management.
BROWN: It's just like with your mortgage. Why wouldn't you take advantage of the lower interest rate?
BETBEZE: Indeed, but a lot of homeowners are asleep at the switch. Are hospitals? Bob, it made sense for you.
FRANK: It makes more cash available for investments in other ventures and capital acquisitions, so it does free up cash flow.
WOOTEN: On the other hand, it becomes difficult because then there are all these competitive pressures to bring on the latest and greatest technology.
GOLDSTEIN: Also, if you have too much cash, the regulators, the feds, the unions ask why a not-for-profit is banking all of its money. It adds a whole new element to it.
WOOTEN: We tend to emphasize that we are here for the long term. That requires financial strength. For instance, I have $500 million in cash on hand at Alegent. It's hard for the common person to understand those multiples. Our sense is that there could be some rainy days ahead or we might need to fund future growth.
BETBEZE: That brings me to another point. Are hospitals going back to basics-getting more horizontally integrated and away from vertical?
GOLDSTEIN: Yes. About five years ago, we saw a return to the basics as they divested nursing homes, home-health, durable medical equipment shops and the HMO business. Joint ventures with physicians are more of a short-term focus.
BETBEZE: We see a lot of hospitals implementing quality initiatives. Is their ability to demonstrate quality having any effect on how they're able to access capital?
GOLDSTEIN: Quality initiatives are commendable, but until the payer side steps up with its reimbursement favorably acknowledging those that demonstrate higher quality, I don't think you'll see tremendous bifurcation in borrowing attributed to that.
WOOTEN: Employers are very interested in it and while the reimbursement mechanisms haven't fully aligned yet, employers are starting to hold everyone's feet to the fire.
GOLDSTEIN: I will say that with malpractice insurance we have seen cases where malpractice premiums are coming down because of quality initiatives, so there is some financial impact. We would expect if you are a high-quality hospital your volumes will be going up, you are recruiting the better physicians, your market share should be climbing.
BETBEZE: Another way to get capital is to have someone give it to you. In the past year, we have seen a $75 million gift in South Florida and a $400 million gift in South Dakota. Are you guys stepping up the fundraising efforts?
FRANK: I think that's where you definitely have the haves and the have-nots, because you have the academic teaching facilities that can garner huge endowments and donations. Our hospital embarked upon a capital campaign that has been successful, but it won't garner those types of donations and bequests. Community hospitals need to do a better job of talking about their organizations and relating it to the people who can afford those kinds of donations because they are two distinct missions. Academic centers teach and do research. Community hospitals need to do a better job explaining their role and mission. It goes back to sustaining that resource for the community.
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