Two years after leaping into senior living, ProMedica says bet is paying off

ProMedica's finance chief doesn't blame people for being skeptical when the not-for-profit health system took on more than $1 billion in debt to buy a massive, bankrupt senior living provider.

"So many people were like, 'What in the world are these guys doing?'" said Steve Cavanaugh, chief financial officer of the Toledo, Ohio-based health system. "They just assumed, 'It's going bankrupt. It must be a broken company.'"

ProMedica's leaders say they knew buying HCR ManorCare meant sacrificing—at least in the short run—their debt ratio and perhaps even their credit ratings. Indeed, all three rating agencies have since downgraded the health system, citing its debt ratio. The tradeoff, they say, was made in service of a larger, multipronged strategy that's just starting to bear fruit.

A little over two years after ProMedica's $1.4 billion purchase closed and in the midst of a global pandemic, HCR appears to be a stable component of the health system's operations. In the first half of 2020, HCR—which now makes up almost half of ProMedica's revenue—posted a 7.7% operating margin, boosted by $156 million in federal stimulus grants, compared with a -1.9% margin in ProMedica's provider division, which drew $84 million in federal grants.

Even in 2019, before the pandemic and resulting federal grants, ProMedica's senior care division posted a 2.4% margin, compared with 0.4% in its provider division and -3.9% in its insurance division.

"I just think they had a strategy, they went in and executed it and ManorCare has been that piece of the strategy that's been very consistent," said Kevin Holloran, senior director with Fitch Ratings. Holloran admits he was one of the deal's initial skeptics.

Like many senior living companies, HCR had struggled beneath rising rent payments before the deal. When Welltower purchased HCR-occupied properties from the previous landlord, it was able to recapitalize the assets ultimately reducing the rent expense from $450 million to $150 million. Even though HCR's contract still includes a 2.75% annual escalator, Cavanaugh said the lower rent means HCR will generate cash for the system despite the rent increases. ProMedica now owns 20% of HCR's real estate, while Welltower owns the other 80%.

"What has really damaged some of the leased skilled nursing facilities over past couple years has been annual increase in lease levels," said Steve Kennedy, executive managing director with VIUM Capital. "You've got ProMedica to some extent on both sides of that coin. … I think it makes a lot of sense."

S&P Global Ratings, by contrast, views that 2.75% lease escalator as a potential problem if senior care reimbursement doesn't keep up, said Anne Cosgrove, a director with S&P. The agency issued a multi-notch downgrade of ProMedica the month after it bought HCR, citing its issuance of $1.15 billion in debt and $524 million in cash to fund the deal.

"We have written about it as a potential risk factor because if you don't have cash flow growth that exceeds that, you're going to start seeing more compression," she said.

The broader strategy

The biggest misunderstanding about the deal initially was the perception that HCR was an operating and financial mess because it was going through bankruptcy, which was not the case, said Cavanaugh, who was HCR's CEO when the deal closed. Even when it was on the brink of bankruptcy, HCR was performing well operationally and financially, he said. The floor fell out when its main revenue source, Medicare, shrunk its reimbursement.

"We had a lot of leverage like a lot of private equity-held companies do," Cavanaugh said, "and when the reimbursement changed, it just sank the company. It wasn't really about the operations."

The vision behind bringing HCR and ProMedica together was bigger than just lower rent payments. The deal transformed HCR into a not-for-profit subsidiary of ProMedica, which allows it to bring the same quality initiatives used in ProMedica's hospitals into its senior living facilities, Cavanaugh said. ProMedica's senior care division is also in partnership talks with a handful of other health systems around the country.

"HCR as a standalone company would not have been able to have those kinds of conversations and get to the finish line on them," Cavanaugh said.

Mark Shaver, Welltower's senior vice president of business strategy and health systems initiatives, said that in addition to serving as a strategic capital partner, ProMedica used Welltower's business insights and data analytics capabilities to expand and identify key divestitures, which ProMedica used to sell three facilities in Maryland.

Being not-for-profit also opens up HCR to access tax-exempt as well as taxable markets for capital, Kennedy said. HCR can now take advantage of government options for low-interest loans especially for skilled nursing and senior housing operators, he said.

"Given their scale, if you can reduce your cost-to-capital on the real estate by a significant number of basis points, that can translate into large dollars," Kennedy said.

Then there's the fact that ProMedica now controls a system of acute-care, senior living and insurance operations, which creates somewhat of a closed referral system in areas where it operates all three divisions.

That type of environment is something many skilled nursing operators have tried to create in recent years, said Cynthia Romano, CohnReznick's global director of restructuring and dispute resolution. How well a skilled nursing operator performs is driven by the number of people in their beds and the proportions that have commercial insurance versus Medicare or Medicaid.

"If you have a feeder directly into that, like an acute-care facility, that obviously helps," Romano said.

On top of that, Fitch's Holloran added that if the health system insurers those patients, they can keep it all in-house and better control costs.

There's also the rapid aging of the U.S. population to consider, and the increasing rates of dementia, which will cause demand for senior living to spike in the coming years. The number of Americans with Alzheimer's disease and other forms of dementia is projected to roughly triple from about 5 million in 2014 to nearly 14 million in 2060, according to the Centers for Disease Control and Prevention.

The pandemic has been particularly difficult for skilled nursing facilities. Although less than 0.5% of the U.S. population live in nursing homes, those residents accounted for roughly one-quarter of all COVID-19 deaths in the country.

As a skilled nursing operator, HCR benefits from its facilities being less optional than assisted living facilities, such as memory care facilities. Residents typically enter them because they're undergoing rehab following a surgery and are too frail to return home or have other comorbidities.

"We used to always joke when I ran HCR: 'The next person that wanted to be in a nursing home would be the first,'" Cavanaugh said.

Dementia care, by contrast, typically falls on family members until it's no longer safe for those patients to live at home. To some extent, those families can defer making that transition during the pandemic. In ProMedica's case, occupancy in its skilled nursing facilities was 78% as of June 30, compared with 86% as of June 30, 2019. In assisted living, that was 76%, compared with 80% as of June 30, 2019.

Even after COVID-19, senior living providers have to contend with declining reimbursement from Medicaid and Medicare and more expensive skilled nursing labor, Romano said.

"I think the real question is, 'What does it look like in Q1?" she said, "when stimulus money runs out and we don't yet have a vaccine."