Congratulations! You've laid the foundation for a vertically integrated healthcare delivery network.
Now, the network needs cash to fill in some gaps in the delivery system. No problem, you think. We'll just divert a few million dollars from the hospital's balance sheet to build that ambulatory surgery center and buy those physicians practices.
Before uncorking the champagne, better check your debt documents to make sure you're in compliance. Bond covenant restrictions may prevent you from moving enough cash out of the hospital's coffers to finance the project.
Investors typically buy hospital bonds under conditions that limit the amount of money that may be diverted outside the hospital's "obligated group" or the group of providers and corporations legally responsible for paying off the debt.
Leakage. Pauline Clark, a director at Fitch Investors Service, New York, has coined a term for the diversion of cash to network members or projects that aren't part of the obligated group. She calls it " obligated group leakage."
For bondholders, there are two risks, she said. Restrictions on the flow of resources out of the obligated group may not be tight enough. Money could be "leaking out" to other organizations in the network that aren't as financially stable, she said.
Alternatively, the obligated group may be able to substitute less creditworthy organizations as members. An organization could start out with four obligated group members that are very strong and end up with four that have far less revenue-generating capacity, she said. That creates new risks for bondholders who hadn't anticipated a change.
"I think the key is to be aware of it... as an investor," she said. "It's a very real risk."
The issue for healthcare chief financial officers, however, is having enough wiggle room in the bond covenants to be able to finance necessary parts of the network, she explained. "The CFO need the flexibility to deliver services in the most competitive, cost-effective manner to the overall system."
Before joining Fitch, Ms. Clark served as the CFO of Clifton
Springs (N.Y.) Hospital. When the hospital closed a $12.5 billion bond deal to refund existing debt, finance a nursing home and pay for outpatient renovation, the institutional investors who bought the bonds negotiated some very specific covenants on the transfer of assets and revenue-generating operations out of the obligated group, she said. Fund managers are increasingly concerned about such asset transfers, she said.
Typically, the issue has been dealt with through limits on asset transfers, said Paul R. Francisco, a partner in the San Francisco law firm of Latham & Watkins. Such limits have appeared in bond documents under the heading "deposition of assets" or similar language and require the obligated group to meet specified debt-service coverage ratios before and after an asset transfer. Historically, the test has dealt with the sale of hard assets, such as buildings, not the transfer of cash, he said.
As more healthcare organizations form healthcare networks, hospitals may need to rethink those covenants, finance experts said.
Seeking flexibility. CFOs are concerned about having enough flexibility to move cash outside of the obligated group, said Ann-Ellen Hornidge, a partner and head of the public finance department at Mintz, Levin, Cohn, Ferris, Glousky and Popeo in Boston. They need to makre sure that the "membranes are as permeable as possible."
In most public bond offerings, obligated group leakage hasn't emerged as a significant issue. But as investors, rating agencies and bond insurers begin to see defaults, they'll crack down, Ms. Hornidge predicted. " We're just at the very beginning of that cycle," she said.
Meanwhile, on high-yield bound deals, which sell below investment gra