For St. Louis-based Sisters of Mercy Health System, the road to financial freedom began with a blank sheet of paper.
Starting from scratch, Sisters of Mercy's investment banker, Bear, Stearns and Co., devised a framework for issuing debt that would satisfy the AA-rated healthcare system's capital needs into the future.
"What we were looking for is as much flexibility as we could get . . . with as little red-tape recordkeeping as we could get," said Carroll E. Aulbaugh, the system's senior vice president, chief financial officer and treasurer.
What Bear, Stearns delivered was a structure affording not-for-profit Sisters of Mercy the same kind of financial and operational flexibility enjoyed by corporate issuers of debt. The new structure, which debuted with the system's October 1995 sale of $103.3 million of variable-rate bonds, gives system officials significant latitude to manage corporate assets as they see fit.
Eighteen months later, the so-called "restricted affiliate" or "corporate" model is stirring a debate, pitting the companies that underwrite and rate such deals against skeptical bond buyers.
In recent months, at least four not-for-profit multifacility systems have adopted a corporate structure similar to the one Sisters of Mercy pioneered. Many others are clamoring for the same kind of bond deal.
Recent refundings and financings have enabled strong systems to replace or supplement their existing master trust indentures-contracts describing terms of the bond deal-with new contracts holding the corporate parents responsible for making principal and interest payments.
"We're talking to a lot of our strong system clients about this," said Dave Johnson, a managing director with Merrill Lynch's Chicago office. Among the really strong healthcare credits, "a promise to pay would be as good as with a General Motors or a real strong corporate credit," he said.
As the healthcare industry's financing needs have changed during the past 15 years, so too have the credit and legal structures underlying tax-exempt healthcare bonds. Systems have netted more flexibility and fewer pesky covenants. The corporate model is the latest wrinkle.
"It's just the next step on the evolutionary ladder," said Larry Majka, senior vice president of finance and CFO of Advocate Health Care, an eight-hospital system based in Oak Brook, Ill. "We think it's a reasonable compromise between meeting our needs for flexibility and the bondholders' needs for security."
Advocate adopted the corporate model through a two-part refunding in December and January.
Under the corporate model, "the only entity that's truly on the hook is the corporate parent," explained Shirley M. Cagle, an associate director with New York-based Fitch Investors Service. It differs from the popular "obligated group" model, which held the parent and its affiliates jointly and severally responsible for repaying debt.
From systems' point of view, the new model has several advantages. For one, "It allows for a more corporate view of resource allocation," Cagle said.
It also eliminates what can be a problem with the obligated group itself, noted Jim Blake, a director in the Chicago office of Smith Barney. When the group that's obligated to pay back the debt consists of the system's "stars" but excludes the "dogs," investors get a skewed picture of performance, reflecting only a select part of the entire organization. The corporate model, by contrast, looks at "the whole system that rolls up into the parent," he said.
For systems actively expanding or restructuring networks, it's also less cumbersome than maintaining an obligated group, experts said. That's because the corporate model allows the parent to freely designate or undesignate restricted affiliates. The parent also has full authority to move cash out of the restricted affiliates to pay its debt to bondholders. In healthcare finance lingo, that's called "upstreaming" cash. It also eliminates restrictions on the transfer of assets outside the group.
For example, not-for-profit Carolina Medicorp, a Winston-Salem, N.C.-based parent of a three-hospital system, has designated all seven of its affiliates as "restricted." One of the seven, Carolina Medi-Plan, owns a majority stake in Partners National Health Plans of North Carolina, a for-profit HMO.
Moving to the corporate structure allows Carolina Medicorp to freely tap the HMO for cash to pay debt service. Including the for-profit health plan "actually enhances debt service capacity," according to Fitch's report on the deal. It doesn't work both ways, though. As a for-profit entity, the HMO can't use any proceeds from Carolina Medicorp's sale of tax-exempt bonds.
Under the corporate model, Carolina Medicorp may remove or add restricted affiliates, as long as cash exceeds principal and interest owed by at least 2-to-1.
But detractors contend the corporate structure represents a further deterioration of fragile bondholder protections.
"We think it is a material change, a weakening in the legal structures," said John Goetz, a vice president with Massachusetts Financial Services, a Boston-based buyer of healthcare bonds.
Currently, only the cream among healthcare credits-systems rated at least AA-are issuing bonds under the new corporate structure. So, according to backers of the structure, the likelihood of bankruptcy among such credits is remote.
"To some extent you can use that argument, but where do you draw the line then?" countered Goetz. "The (legal covenants) in the hospital world are so weak anyhow."
Already some A- and BBB-rated systems have begun to inquire about moving to a corporate structure. They may get their wish, but not in the near future.
In a special report dated Jan. 20, Fitch acknowledges that the corporate structure "is inappropriate for all but the strongest borrowers." But for those credits, it says "the change in structure should not necessarily impact the rating."
But Moody's Investors Service tends to side with skeptical bondholders.
"It's a weaker security for bondholders," said Bruce Gordon, an assistant vice president with the New York-based bond-rating agency. "All other things being equal, a switch from an obligated group to a restricted affiliate structure rated by us is viewed as a negative for bondholders."
Some investors are concerned that some healthcare systems' parent organizations are nothing more than shell corporations. In many cases, all or most of the assets are held by affiliates of the parent.
But according to Fitch, which has rated many of the deals, "With all resources within a system accessible to the corporate obliger, the structure allows a more methodical allocation of resources across the system."
This doesn't wash with Tom Weyl, a vice president and municipal credit analyst at Eaton Vance Management, a Boston-based money manager. "The argument for the corporate credit structure is specious at best," he charged. Unlike corporations, tax-exempt healthcare institutions cannot access the equity markets. And in the corporate market, the rating agencies differentiate the credits based on the debt security (pledges of receivables, for example). By contrast, most corporate healthcare deals are unsecured obligations. Furthermore, healthcare institutions typically issue 30-year debt, while corporations sell 7- to 10-year bonds.
Weyl said bondholder protections gradually have weakened over the years. He blames the recent deterioration on competition among the credit-rating agencies.
It's rumored that some systems have had to pay a bit of a premium, maybe 5 to 10 basis points, to entice bond buyers to accept the new structure, but systems deny it. According to Smith Barney, the bonds have sold well, even in the secondary market.
Before going to market in November, Larry McGee, vice president for legal affairs at Carolina Medicorp, and Paul Wiles, president and chief executive officer, got a taste of investor skepticism as they briefed potential bond buyers on the company's proposed finance and corporate structure.
"This was something new. Whenever you do something new, people are going to be a little disconcerted by it," McGee said.