Not-for-profit hospitals and systems are paying a hefty penalty for the industry's financial woes: higher costs and tougher terms for capital.
Over the past 18 months, not-for-profit providers have seen their freewheeling access to the bond market disappear as investors, banks and bond insurers reduce their exposure to healthcare.
Experts hesitate to call the situation a crisis, since most hospitals are still able to issue debt at historically low rates. Not-for-profits also pay significantly less for capital than investor-owned companies.
But the credit squeeze has changed the dynamics of the market, perhaps for good. Higher yields and fees, stricter security provisions and more-frequent financial reporting are among new conditions of capital access.
Investor pickiness has created a divide between those with access to affordable capital and those without.
Hospitals with low credit ratings and less-than-dominant market shares, which previously had no trouble issuing debt, are hit especially hard by higher costs and restrictive terms, investment bankers say. And those credits that are below investment grade--meaning Baa3 by Moody's Investors Service or BBB- by Standard & Poor's--are essentially shut out.
Previously, one way weak hospitals solved their capital access woes was to merge their operations with strong hospitals or systems. But today, with all players operating on thinner margins, few systems are willing to jeopardize their own credit by acquiring weaker players.
"It just contributes to uncertainty in the industry," says Kevin Ramundo, senior vice president in public finance at Moody's.
Some hospital executives and their bankers say tighter access to capital is long overdue. For most of the 1990s, access was dangerously easy, as institutional investors scrambled to fill their portfolios with tax-exempt healthcare bonds despite weak security provisions and skimpy reporting requirements.
"We had all gotten complacent in terms of the industry risk," says Glenn Wagner, a principal at Morgan Stanley Dean Witter.
Sister Geraldine Hoyler, chief financial officer of Catholic Healthcare Initiatives in Denver, says the system saw its capital costs increase by almost a percentage point between its fall 1998 bond financing and its latest deal in this year's first quarter. Despite increased yields and insurance premiums, Hoyler, a 30-year industry veteran, says, "I don't think (credit) is unreasonably tightened. I think it's reflective of the healthcare industry's performance in a market where the financial markets have just been stellar."
New strategies. To lower capital costs, some not-for-profits are borrowing strategies from the investor-owned sector by launching investor relations programs and aggressively marketing new issues.
"It's a different game out there," says Bob Chrencik, CFO of the University of Maryland Health System in Baltimore, which conducted a three-city road show for investors before its $124 million offering April 4. "The old approach of getting bond insurance and letting the underwriter sell the issue no longer applies."
When it comes to higher costs, hospitals are being hit from all sides.
* Yields for new issues have increased relative to other municipal credits in order to compensate investors, who perceive healthcare as a greater risk than bonds financing municipal infrastructure projects. Making matters worse, overall interest rates have climbed, and the robust stock market has sucked capital away from bonds.
* A wider chasm in interest rates between strong and weak hospital credits has enabled bond insurers, which protect investors from default on long-term debt, to increase premiums as much as threefold.
Top-rated bond insurers, which two years ago were wooing B-rated hospital credits, have pulled back, increasing their premiums and shutting out credits rated BBB+ or lower.
Insurers say they need to set aside greater capital reserves to offset increased industry risk following the 1998 bankruptcy of Allegheny Health, Education and Research Foundation, which affected $320 million of insured debt.
* Similarly, banks have as much as tripled charges to issue or renew letters of credit, which protect buyers of variable-rate debt. Lenders such as Toronto Dominion, Toronto, and Rabobank, the Netherlands, have pulled out of healthcare altogether.
* Underwriting fees have also inched up, according to some industry sources. Banks say they need to pass on higher commissions to induce brokers to sell healthcare debt.
The post-AHERF era. It's no mystery why investors have recoiled from healthcare. The AHERF bankruptcy, which affected some $900 million of tax-exempt debt, served as a wake-up call to investors that not-for-profit hospitals aren't immune to catastrophic loss (See related story, p. 76).
A sudden erosion of profit margins attributed to managed care and the Balanced Budget Act of 1997, along with failed integration strategies resulted in a cascade of rating downgrades and served to confirm investor wariness.
"There is a shakeout occurring, and I don't think anyone can guarantee who the winners and losers will be," says Carolyn Tain, a managing director in healthcare at MBIA, an Armonk, N.Y.-based bond insurer. MBIA reduced its new healthcare business by about half from 1998 to 1999 as a result of premium hikes and increased selectivity.
Investors and guarantors have narrowed their comfort zone.
"If we're looking at three hospitals in a service area, we're more likely to insure the No. 1 player," Tain says. "We're less comfortable insuring the No. 2 or the No. 3. player, and we prefer regional systems, because we see a diversification of risk."
The higher costs come as many hospitals face thinning margins because of government and private-sector cost controls, losses from HMOs and physician practice operations, and rising expenses for salaries, pharmaceuticals and information systems. And despite a surplus of hospital beds in many markets, experts expect demand for capital to surge in the next 12 to 18 months as hospitals attempt to replace aging plants and revamp computers.
To appease lenders, some hospitals are agreeing to pledge more of their assets in the form of first-lien mortgages and other covenants that restrict their future borrowing ability. Moreover, they are often promising to give public, quarterly reports on their finances.
In fact, public disclosure of financial statements on a quarterly basis, rather than on the previous annual standard, has become a de facto requirement for new issues. Investors have demanded more frequent reporting to improve the liquidity of bonds on the secondary market.
In the long run, more disclosure could discourage small issues, experts say, since analysts lack the time to track all 800 or so not-for-profit hospital credits in the market. "That could become another capital access issue," says Robert Muller, a managing director at J.P. Morgan Securities.
While their investor-owned competitors can sell equity to raise funds, not-for-profits have fewer capital options. Also unlike their for-profit brethren, not-for-profit hospitals are generally unaccustomed to nurturing ongoing relations with investors and bankers.
Emphasizing disclosure. At a conference on healthcare financial disclosure in March, sponsored by the Municipal Securities Rulemaking Board, institutional investors complained that CFOs of not-for-profit hospitals routinely don't return their phone calls. Hospitals have cited federal securities law, which requires uniform reporting to the market, for not communicating with individual investors.
Many investment bankers are urging their not-for-profit hospital clients to be more open with the markets.
The appearance of openness is what some 30 hospitals and systems hoped to achieve last week at an unprecedented not-for-profit investor forum in New York City, sponsored by the American Hospital Association and the Healthcare Financial Management Association and organized by Salomon Smith Barney (April 10, p. 116).
"The divide between the haves and have-nots is not only a function of the credit rating, but also a function of how the market perceives that credit," says Errol Brick, president of Killarney Advisors, an advisory services and investment banking firm in New York. "Hospitals and systems that go out of their way to provide frequent disclosure will get a better reception than those that don't."
Even if the news is bad, Brick says, "if investors trust you, they'll still buy the bonds."
Officials at Geisinger Health Care System in Danville, Pa., believe a policy of openness has lowered their capital costs. Geisinger noticed a slight increase of .05 to .10 percentage points in the interest rates it was paying on its variable-rate debt immediately after its Nov. 18, 1999, announcement that it was unwinding a merger with Penn State University-Milton S. Hershey Medical Center in Hershey, Pa. Investors apparently were spooked by the news.
With the help of its investment banker, J.P. Morgan, Geisinger quickly organized conference calls with investors and credit-rating agencies during which CFO Kevin Brennan and Treasurer Patrick Kameen explained the system's position that the unraveling of the merger was positive financial news.
Within days, the interest rates on Geisinger's debt fell back into line with rates for similar issues, Brennan says, and Standard & Poor's placed its AA rating on CreditWatch with a positive outlook.
"We think that's specific evidence that proactive, factual communication really made a difference," he says.
Two weeks after the announcement, the financial officers, along with Geisinger's chief executive officer, chief operating officer and chairman of the board, followed up with a personal visit to the rating agencies in New York.
This year, Geisinger is implementing a formal investor-relations strategy that includes quarterly public disclosure of its financial results and semiannual conference calls with investors. Geisinger also began sending financial reports directly to bondholders, some of whom had complained of waiting as long as 120 days while reports were filed with a trustee and forwarded to a public repository.
Geisinger executives plan to issue new debt this fall and expect that their efforts to woo investors will pay off in the form of lower interest rates.
Getting aggressive. Similarly, the University of Maryland believes its aggressive strategy to sell its bonds may have saved it millions.
Previously, the system used bond insurance to enhance its draw with investors, Chrencik says. But after a six-year hiatus from the market, it learned that bond insurance had become prohibitively expensive.
The system was uncertain how its paper, with a Baa1 rating from Moody's, would be received. Two similarly rated systems--Mountain States Health Alliance in Johnson City, Tenn., and Palmetto Health Alliance in Columbia, S.C., paid high yields, of 8% and 7.55%, respectively, when they issued debt in the first quarter.
Top executives at the University of Maryland system hosted forums for mutual fund managers in New York, Boston and Chicago. The system also put quarterly reporting and extra security provisions in its bond documents, without waiting for investors to ask.
Their investment bankers at Banc One Capital Markets priced the bonds aggressively, Chrencik says, at 7%.
Yet when the bonds were put to market, orders far outstripped supply, allowing bankers to lower the yield slightly to 6.9%, saving the system an estimated $2 million.
"You're throwing a big party and you're not sure who's going to show," Chrencik says. "We were pretty pleased with the way it turned out."