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Past their prime?

Healthcare borrowers not immune from roiling credit market, but effects more subtle


By Cinda Becker
Posted: October 1, 2007 - 12:01 am ET
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Those good times with unbelievably rosy financial outlooks that boosted the capital-spending confidence of even the weakest hospitals? They’re gone.

Blame the tangentially related subprime mortgage market for the end of an unprecedented two-year period of wafer-thin spreads between the highest- and lowest-rated credits.

Although the hospital industry is traditionally considered a relatively low-risk, stable investment, turmoil in all the financial markets is rippling through healthcare in subtle ways. The nervousness exhibited in the markets since July was precipitated in large part by defaults in so-called subprime mortgages.

The chain reaction was triggered by investors flush with money burning holes in their pockets. Banks were getting “more and more aggressive in terms of how much capital they were willing to commit to transactions,” says Burk Lindsey, managing director in the healthcare investment banking group at Raymond James & Associates in Nashville. That made it easier for borrowers, creating a competitive environment that couldn’t be more accommodating in terms of low interest rates and loose, if not nonexistent, covenants on big transactions.

In the interest of selling attractive financial instruments to investors, banks started packaging the subprime mortgages they sold to borrowers with poor credit, marketing them as securities. When some of those mortgages turned bad, the securities “faltered,” Lindsey says. That spoiled the appetites of the institutional buyers who had invested in those collateralized mortgage obligations; before long, the tremors spread to other markets, Lindsey says.

“What I’m hearing about the subprime markets is that everybody is trying to plumb the depths, which is a little alarming. Everybody knows it is out there, but they don’t know how bad it is going to be,” says Iain Briggs, managing director at FTI Healthcare, Brentwood, Tenn., which provides consulting and interim management services to hospitals. Nevertheless, the anguish “will be tangential” for healthcare, perhaps hitting the financially weakest hospitals the hardest as they try to access the bond markets. On the other hand when it comes to finance, difficulties for one kind of player often means opportunities for others. Bond insurers, which weathered a drought when the narrow credit spreads rendered moot the need for bond insurance, are “in an interesting place” that will likely only grow more competitive, Briggs says.

Indeed, as the spread between what the financially strongest and weakest hospitals paid in interest rates tightened, the bond insurance industry curtailed writing policies, says Terence Smith, chief executive officer and chairman of Smith’s Research & Gradings, which provides credit opinions to investors. With the spread now widening, “they are starting to write quite a bit more business,” he says. “I think the winners will be America’s hospitals that garner AAA guarantees using bond insurance” in addition to the insurers themselves, he says. “Clearly the losers are people who lent money to junk hospitals at investment-grade rates.”

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West Penn beats the clock

That would include people who lent money to the likes of West Penn Allegheny Health System in Pittsburgh. Apparently there was little concern on the part of bond investors at the time of the issue. The bonds, which were priced on May 16, sold quickly with more than 40 investors participating, officials reported at the time. There were $1.4 billion in orders—double the amount of the issue.

On June 19, when West Penn Allegheny closed on $750 million in tax-exempt bonds, David Samuel, senior vice president and chief financial officer, experienced a CFO’s version of an adrenaline rush.

Thanks to near-perfect conditions in the municipal bond market, the four-hospital system slashed the interest it was paying on junk grade debt—a legacy of its notorious predecessor, the bankrupt Allegheny Health, Education and Research Foundation—from 9.25% to a true interest cost of 5.375%. The refinancing saved the system more than $17 million a year in debt service—nearly a 30% reduction. The deal is considered the largest speculative healthcare financing ever and the fifth-largest overall in municipal bonds.

But throughout the refinancing process, which began in late fall of 2006, Samuel was acutely aware that the welcoming market was also fragile. And just as he anticipated, less than one month after the deal closed, the weather turned dark for financially weak hospitals that were not able to take advantage of the friendly bond market. Samuel appreciates just how close his system came to turning back into a pumpkin.

“Our biggest concern was that those spreads would widen, which would eliminate the benefit. We needed (Internal Revenue Service) approval and it was taking a long time, so we pushed really hard to get an IRS decision. In retrospect, our concern was legitimate,” Samuel says. “I’m happy we pushed the transaction and got it done as fast as we could, but clearly none of us could anticipate that it got as bad as it did as quick as it did. So we’re feeling a little lucky.”

David Cyganowski, managing director and healthcare co-head for Citigroup, which served as senior manager of the West Penn Allegheny issue along with Lehman Bros., admits in an e-mail that the hospital system “hit the jackpot.” It sold the bonds at a spread of only 100 basis points over the Municipal Market Data, or MMD, index of AAA general obligation bond yields—an all-time record low for a below-investment-grade not-for-profit healthcare system, he says. In September, those same bonds were trading at as much as 130 basis points over MMD. Still, Cyganowski says, the credit spreads are nowhere near the width they reached in the post-AHERF days of the late 1990s. For example, according to data obtained from Citigroup, in September 2000 hospitals rated AA were paying interest rates 16.5 basis points over AAA insured credits while hospitals rated BBB- were paying 196 basis points more.

Richard Stein, director of credit research for the Rochester, N.Y., division of OppenheimerFunds, is philosophical about such investments, putting a positive spin on it. He notes that the slowing of the general economy increases the risk that lower-rated borrowers will be unable to honor all of their financial obligations, boosting the yields that investors require.

New era of opportunity

“Since bond prices move inversely to yields, bond prices of lower-rated borrowers have declined over this period,” Stein says in an e-mail. “To the extent that you owned bonds issued by lower-rated borrowers, either directly or through a mutual fund, their market value has dropped since the end of June. While some investors may be concerned to see a decrease in the value of their portfolio, the result is that there are currently tremendous buying opportunities in the municipal bond market. Entire categories of lower-rated as well as nonrated tax-exempt bonds, including hospitals and healthcare, have been beaten down in price. The fun is to sort through the rubble and find the gems. Now is the best time in several years for long-term investors to put new money to work.”

That said, on a historical basis, credit spreads “are what I would consider to be normal,” Stein says. “It’s just that the spreads were so small for so long, many people thought it would continue forever. … This is an absolutely great time to invest money in tax-exempt bonds in general and healthcare in particular.”

On the for-profit side, there has been a downturn in announced mergers and acquisitions since the middle of the year when the disturbance in the subprime market “leaked over into the institutional loan market,” Raymond James’ Lindsey says. Private-equity companies have been a “significant driver” of merger and acquisition activity in recent years in healthcare, he says, most notably in the $33 billion leveraged buyout of HCA. But although private equity’s interest in healthcare hasn’t dried up, these investors are perhaps a little less accommodating than they were when they were flush with capital to invest.

“The meltdown began in earnest in August,” Lindsey says. “When investor preferences change, they can change rapidly.” If the private-equity firms that took HCA private were to have done it today, “it would be exceptionally hard if not impossible to do. The debt market would have a hard time supporting it. It’s not a comment on HCA, it’s just the market for financing those very large transactions,” Lindsey says.

Healthcare is countercyclical to other industries in many respects, as there is always a demand to care for sick people. So healthcare as a “growth sector” is not going to change, Lindsey says. “What has changed are the financial markets that support mergers and acquisitions and private equity. Those markets are exceptionally weak today,” Lindsey says. “Healthcare is just as attractive as it’s ever been, and if the economy turns downward healthcare will be more attractive, but the markets financing healthcare don’t exist in a vacuum.”

Noting that healthcare is generally the place “where people might come when there is volatility” in the markets, that is not necessarily happening this time, says Jerry Doctrow, managing director at Stifel Nicolaus & Co., a financial services firm in Baltimore. “It has less to do with the subprime market, as we are in an election cycle and there are performance issues within healthcare, so that healthcare is not the safe haven that it has been historically,” he says. The number of uninsured is growing, bad debt is rising and there’s much talk about healthcare reform and tighter regulations.

Still, although one would expect the cost of borrowing to increase for healthcare operators, it is not rising as dramatically as one would expect as the 10-year treasury rate is declining, Doctrow adds. “If you are a credit-quality borrower, your cost has gone up but not as dramatically as you would think. If you are less than a good-quality borrower, then you might be having more problems,” he says.

What do you think?
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