The good news about West Penn Allegheny Health System's landmark junk bond financing this month is that the bonds found buyers. The bad news is that the cost will be steep.
The $476 million bond issue, priced on July 19, is believed to be easily the largest noninvestment-grade, tax-exempt healthcare issue to date. It also met expectations as one of the costliest municipal financings in the current market, priced at yields as high as 9.7% for uninsured 30-year notes.
Of the total bond issue, $76 million was insured.
The financing was a critical final step in a plan to rescue the Pittsburgh affiliates of the bankrupt Allegheny Health, Education and Research Foundation by merging them with Western Pennsylvania Healthcare System (June 26, p. 26). The new system--West Penn Allegheny--officially commences Aug. 9, the date of the bond closing.
The system and its investment bankers hailed the deal as a triumph.
"The market has spoken," says West Penn Allegheny President and Chief Executive Officer Charles O'Brien Jr. "We have a large number of institutional investors that are part of this."
David Cyganowski, a managing director at Salomon Smith Barney, the issue's lead underwriter, says nothing close to a $400 million deal has been attempted in noninvestment-grade healthcare debt. "People just thought it couldn't be done," he says. "I think the success of the transaction will give other systems the hope that they can continue to get the money they need."
Jerry Solomon, associate director at Bear, Stearns & Co. in New York, agreed that it was a positive sign that buyers were found. "Their inability to refinance probably would have been another dent in the healthcare market," he says.
But others said it won't inspire the increasing pool of hospitals and health systems with junk ratings to enter the bond market anytime soon, unless absolutely necessary.
"Everyone has now seen the dark side," Robert Muller, a managing director at J.P. Morgan Securities in New York, says of the high interest rates the issue required.
Muller noted that West Penn Allegheny's debt caries higher interest than that of for-profit hospital companies such as Tenet Healthcare Corp., which is paying between 8% and 9% on its taxable bonds. Generally, tax-exempt issues carry interest rates that are about 70% of those for taxable securities.
In 1998 Santa Barbara, Calif.-based Tenet purchased eight hospitals in Pittsburgh that AHERF had operated.
"It's fundamentally a sign of how bad the (investor) overreaction is to the problems of healthcare, and shows that the corporate (debt) market is not in as much of a freak-out mode," Muller says.
West Penn Allegheny is likely to become one of the most highly scrutinized healthcare systems as investors chart its progress in carrying out a financial turnaround and integration. The system is saddled with the legacy of the AHERF debacle, which left bond insurers holding the bag for massive debt.
James Reynolds, president of Reynolds & Co., a New York-based healthcare financial consulting practice, says he believes the system is overestimating potential service volume growth and cost-cutting abilities and underestimated the future impact of the Balanced Budget Act of 1997.
"A whole new set of people are sitting there with what could be a time bomb,' Reynolds says, referring to bondholders.
James Cain, a principal and founding partner of Cain Brothers investment banking firm in New York, says the hospitals will operate under a "fairly significant burden of debt service."
O'Brien shrugged off such concerns. He says debt service will be less than 5% of the system's revenue, which he called "a very manageable amount."
West Penn Allegheny's senior management and its bankers aggressively marketed the bonds with potential investors via a nine-city road show. Salomon officials said the bonds were sold quickly to about 30 institutional investors.