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Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
Financial and Bond Services for Hospital Market
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Financial and Bond Services for Hospital Market

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Overview of hospital bond market

Overview of hospital bond market

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  • 1. Financial Advisory &Acquisition Services Market Segment Brief October 2008
  • 2. DISCLAIMERInformation Advantage Group (IAG) prepared this report as a general guide and basis for furtherdiscussions and diligence on the select area of healthcare—Financial Advisory and Acquisition Services.This report includes qualitative and quantitative statements that reflect plans, estimates, data, consensusviews and beliefs of vendors, industry experts and commentaries provided by public sources and IAGanalysts. Best efforts have been made in assessing the reliability of these statements. IAG disclaims allwarranties, express or implied, as to the accuracy, completeness or adequacy of such information andfitness of this research to a particular purpose. IAG shall have no liability for errors, omissions orinadequacies in the information contained herein or for interpretations thereof. IAG advises that anydiscussion or listing of a company or product of any kind in this report should not be deemed to be anendorsement of said company or product. The opinions expressed herein are subject to change withoutnotice.This report is intended to be one of the many information sources including other published informationand analysis of these sources by the reader. The reader assumes the sole responsibility for the selectionof these materials to achieve its intended results. The reader is urged to exercise the utmost discretionmaking the information enclosed in this report available to others that may need to analyze such materialin the course of their evaluations.Each resource cited in this report is the property of the originating author or publisher and will not beindividually reproduced or distributed by the reader. VHA may contact organizations directly for copies orreprint authorization.Copyright 2011 by: IAG LLC, 3757 Webster Street, Ste. 306, San Francisco, CA 94123. All rightsreserved. Duplication or distribution of this document as presented without express written permissionfrom IAG LLC is prohibited. Page 2 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 3. Table of Contents Quick navigation -Hover over blue page and ctrl-clickEXECUTIVE SUMMARY ............................................................................................................4PROLOGUE ...............................................................................................................................6OVERALL DESCRIPTION .........................................................................................................7Implementation – Strategy & Posture .........................................................................................8External Factors - Largely Beyond the Enterprise’s Control........................................................8Internal Factors - Conditions Effecting the Enterprise’s Overall Performance.............................8COSTS .......................................................................................................................................9BUYERS, USERS ......................................................................................................................9BENEFITS RETURNS .............................................................................................................10HEALTHCARE MARKET..........................................................................................................10Market Size and Growth:...........................................................................................................10Consensus: It’s A Complicated Time for Healthcare But It Will Continue To Do OK.................12Hospital Performance – Plateaus for the Strong; Declines for the Weak...................................12Hospital Bond Rating Volatility Tracks Financial Performance..................................................13Mergers & Acquisitions .............................................................................................................13General – Steep Decline in Activity...........................................................................................13Healthcare – Strategic Buyer’s Market......................................................................................14FUTURE TRENDS ...................................................................................................................14HEALTHCARE .........................................................................................................................15Top Six Healthcare Challenges Will Intensify............................................................................15Recession Will Have A Mild Effect On Healthcare.....................................................................16Healthcare Financial Managers Remain Calm..........................................................................16Hospital Affiliations Up..............................................................................................................17VENDORS ...............................................................................................................................17OVERSIGHT & INFLUENCE ....................................................................................................19Regulatory ................................................................................................................................19Associations..............................................................................................................................20Appendix A................................................................................................................................21A Primer--Tax-Exempt & Non-Traditional Debt Instruments......................................................21Bibliography..............................................................................................................................23 Page 3 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 4. EXECUTIVE SUMMARYHistorically low interest rates, narrow Total Acute Care Bond Up/Downgradescredit spreads, and a flat yield curve that (Fitc h 2008 Report)began peaking in 2006 fueled thehospital bond market’s estimated $50 40billion performance in 2007. Thus far, in2008 available information suggests 30bond market contraction withapproximately 100 overall healthcare 20provider deals having been underwritten, 10averaging $138 million in size andtotaling $14 billion. Despite this plunge 0from record-setting days to the current 2002 2003 2004 2005 2006 2007 2008financial turmoil, healthcare remainsclear-headed and is anticipating its usualchallenges intensifying; the effects of the Total Healthcare M&A Deals Trendingrecession on it being mild; low 800confidence in the bond marketspersisting; and increasing opportunitiesfor strategic acquisitions by the strong 600being a popular strategy. 410 523 534 489 400 423Those holding the financial reins athospitals are dealing with many trans- 200departmental issues leaving littlebandwidth to handle the details of 0transforming their capital positions or 2003 2004 2005 2006 2007 2008handling merger and acquisitionactivities—enter the financial advisory firm. Working with the board and financialleadership, these advisory firms provide the expertise and finesse to evaluate ahospital’s dynamics and then plan and execute a strategy that gives the fundingsources, bond rating services and Market Share - Capital Advisory Servicesunderwriters a favorable view of a [1985-2007 Total Deals Value (Billions $)]hospital’s credit worthiness. For themedian hospital, these firms produce avalue of $1.6 million for each 100 basispoints in average borrowing costs Ponder & Coavoided. 48% KillarneyThree of the top five healthcare financial Group Kaufman Halladvisory firms are part of larger national 3% 24% Publicfirms with the remaining two being Shattuck Financialgrowing stand-alone, privately held Morgan Mgmt.firms. The leading firm claims twice the Keegan 20%number of deals as the next two closest 5%competitors—the fourth and fifth placefirms halve this amount again. These firms account for an estimated 10% of thetotal bond underwriting for healthcare provider organizations; tend to be involvedin deals that average smaller in size ($54 million verses $138 million for all of Page 4 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 5. healthcare): and have created a twenty-two year collective average of $5.54billion/yr. Page 5 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 6. PROLOGUESince the early 1990s, a hospital’s access to traditional sources of capital--bonds, bank loans,philanthropy and equipment leases--was relatively easy. These debt instruments fueledstrategies for healthcare systems to scale up aggressively by buying physician practices,increasing corporate girth through merger and acquisition, cutting deals to grow their integrateddelivery networks and investing in the latest revenue producing technology. However,healthcare has been experiencing a tightening on these common funding sources over the lastdecade that has illuminated a widening gap between hospitals in strong financial health andthose who are not. The effects of this trend include:• The total amount and mix of capital accessed from traditional sources has dropped—bank loans have decreased and leasing has become more popular. Capital-Intensive• The percentage of hospitals defined as having broad Challenges access to capital has declined. • Conversely, the percentage of hospitals with limited Changing Competitive access to capital rose more sharply. Landscape • Rising Costs of• Operating margins for both hospital types has also Delivery declined—more so for limited-capital-access hospitals. • Aging Facilities • Hospital M&AMuch of this movement between these two groupings is • Alternate Siteattributed to a host of capital-intensive challenges that Competitorskeep healthcare’s financial landscape in flux. Coupling amixture of these challenges with the current rocky • Referring Physicianeconomy makes it hard to find an acute care enterprise of Relationsany substance that has not seen its equity holdings and • Declining Philanthropyaccess to capital suffer. For example, the University ofPittsburgh Medical Center generates approximately $7 IT Requirementsbillion/yr with a revenue growth of 12% CAGR in revenue • Major Legacyduring 2003-07.1 Yet despite this track record, it was not Upgradesable to stop a 99% drop in its investment income during • EMR & Clinicalthe second half of 2007. 2 This type of drop has not only Systemsraised the common concerns about budget, but, more to • Siloed Systemsthe point, liquidity issues that add to the challenge of Integrationaccessing debt instruments to survive and grow the • Compliance (SOX,business. HIPAA)Today, most hospitals are surviving, in part, by trafficking Employee Issuesin a plethora of debt instruments (See Appendix A). To • High Turnover Ratesremain debt worthy, consensus states that hospitals need • Limited Skilled Talentto return to the basics by focusing on what matters most to Poolthe capital markets—robust cash flow, a strong balancesheet and strong returns from capital, quality and safety Reimbursementinitiatives. It is also thought that with the future earnings Pressurespotential of hospitals always being challenged and choices • Uninsured • Declining Page 6 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 7. for accessing capital becoming more sophisticated, the need for guidance to negotiate atortuous list of options will exist.This report will focus on financial advisory services that help acute care enterprises prepare forand manage access capital funding sources.OVERALL DESCRIPTIONFinancial advisory firms and practices that are focused on helping health systems accesscapital typically provide expertise and services that include:Planning for Capital Access:• Define financing goals and needs• Analysis of current credit and debt capacity• Risk analysis and articulation• Staging for market conditions• Develop a clear understanding of the financial strategy with the boardTransaction Implementation:• Provide detailed knowledge of financial products to be used• Negotiate fees and interest rates to pay underwriters• Complete appropriate legal and credit documentation and filingsContinuing Surveillance:• Monitor for developments in financial products markets; e.g. security provisions, interest rates and regulatory requirements• Monitor for opportunities to reduce interest costs or turn a profit like terminating a swapDerivative Services:• Advise and negotiate structure, terms and financing on exchanging one type of debt instruments (e.g. fixed interest payments) for another type (e.g. floating interest payments)• FAS 133 Reporting: the standard for financial reporting of derivatives and hedging transactions since 2001Investment Management Services:• Act as an independent investment advisor to manage funds that include: • Project or construction funds • Reserved funds for debt service • General corporate funds • Board-designated fundsMerger & Acquisition Services:• Provide oversight and management for all steps of the acquisition and divestiture process• Value healthcare assets• Negotiate the terms and conditions of buying or selling of business assets Page 7 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 8. Implementation – Strategy & PostureOverall, the funding sources, bond rating services and underwriters want to seethat hospital management and the board have a clear strategy. The advisoryfirm must assure that in planning a strategy numerous external and internaldynamics are evaluated including: 3External Factors - Largely Beyond the Enterprise’s ControlReimbursement for Services:• Tightening reimbursement continuing for the foreseeable future• Quality-based pay-for-performance requirements negatively impacting payment“Graying of America”:• Demographics of Americans ages 65 and older will increase by 19 million between 2000 and 2020—how will the hospital handle the volume?Regulation:• Increased scrutiny of tax-exempt status and community benefit• Increased transparency through stricter reporting requirementsConsumerism:• Health care consumers want access to high-quality care at reasonable costs• Hospitals will need to invest in meeting the market’s needs or loose shareInternal Factors - Conditions Effecting the Enterprise’s OverallPerformance Operating Performance:• Costs, margins, bad debt, accounts receivable, financial ratios, plant condition and other incomes are among the metrics used to assess financial strength, performance and liquidity of the enterprise.Competitive Posture:• Market share, competing hospital services, patient volume, community perception and breadth of services are used to assess an enterprise’s attractiveness to a patient population and ability to capture share.• The demographic fit with offered services and strength of the local economy assesses growth potential over the long term..Governance & Leadership• Pivotal to organizational performance is planning for executive succession; board composition and involvement; and oversight and accountability of leadership coupled with long-term strategic, financial and capital planning.Reimbursement Mix:• The percentage of patients covered by state, federal and commercial insurers and the breakout for managed care, co-pay, self-pay and uninsured care offers insight to revenue source and planning for leaner future reimbursement. Page 8 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 9. Physician alignment• Number of physicians, their specialties, certifications, general satisfaction and aging indicates the strength of the hospital-physician relationship.• Hospital must have planning to balance physician needs with the communities to offset contraction in reimbursement and expansion of physician ventures that preempt hospital revenues.The end result of this planning is the creation of a “We want to make surefavorable credit worthiness profile for the funding sources that management andthat includes leading bond rating services (Fitch, Moody’s, the board have a clearStandard & Poor’s). These ratings rank the likelihood of strategy that runs out forhospitals to default on a bond issue; provides guidance on five to 10 years.”the level of risk associated with investing in the hospital; or Jeff Schaubfacilitates the ability of hospitals to access the debt market Sn. Director—the higher the rating the lower the cost of capital.COSTSTotal costs are dependent on duration and extend of services or a percent of total bondtransactions. A basic costing may look like:4Financial Advisor (based on bond size):$2- $4 Million $20,000$4- $7 Million $36,000$7- $10 Million $50,000Issuer:Fee On All Bonds: 0.25%BUYERS, USERSThe ultimate buyer of Financial Advisory Services is the Board Member Experience CriteriaBoard of Directors for the acute care enterprise. The Financial & Business 63%board is typical composed of relevant stakeholders, such Strategic Planningas the medical staff and those from the community, and 49%represents different skill sets critical to the hospital’s Public Relations 33%success. This general composition of the board means Academic Training 31%that there will be varying competencies about accessing Quality Mgmt. 26%capital through a variety of debt instruments. To Other Boards 26%compensate for this, the formation of a Financing Safety & Quality. 19%Committee is typical and includes board members with Fund Raising 15%knowledge of capital financing and key hospital personnel Clinical Practice 13%that includes the CFO and CEO. Conflict Mgmt. 11%The overall composition of the board is of utmost importance due to bond-rating agencies(Fitch, Moody’s) increasing their examination of the board’s composition more closely. A boardthat has the correct balance of knowledge and experience to achieve the financing missiongarners a more favorable evaluation and thus, positively effects bond ratings. Page 9 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 10. Finally, the size of the healthcare organization matters. With payer and case mixes beingsimilar, those organizations with more than $2 billion in revenue typically perform better thansmaller organizations. This stronger profile makes it easier for them to secure funding andtypically indicates a more aggressive growth path that would require advisory services. 5BENEFITS RETURNSThe role of those holding the financial reins of a hospital have changed. As exampled, the CFOused to be focused on balancing the books and achieving some type of revenue. Today, thestakes are much higher. Price transparency, pay for performance, regulatory compliance andquality are blurring operational lines and health systems need a much more diverse personinteracting with all departments including those who are actually providing the patient care.As their reach is extended by these conditions, financial leaders have to expand theirknowledge base and resources as well. It is the addition of a financial advisory services thatprovides the periodically needed bandwidth, transactional expertise and surveillance thatspeeds access to capital at the lowest cost--failure to do so can become expensiveWith today’s higher borrowing costs and complexity of transactions, timing a hospitalsborrowing needs and the types of debt it has previously utilized weighed against what’s wise forthe hospital now is the basis of all benefits. The simplest of examples tell us for each increaseof 100 basis points in average borrowing costs the annual interest expense for the medianhospital would increase by $1.6 million.6HEALTHCARE MARKETMarket Size and Growth:(NOTE: Due to most firms being privately held and the Total Acute Care Bond Up/Downgrades (Fitc h 2008 R eport)highly niche nature of this service, publicly availablemarket data on the capital access advisory services 40market is insufficient to construct estimates that are 30anything more that rough at best.) 20Market Size: 10• The leading top five capital access advisory 0 firms are involved in an estimated 10% of the 2002 2003 2004 2005 2006 2007 2008 total bond underwriting for healthcare provider organizations. • The twenty-two year collective average of bond deals completed by these five firms is $5.54 billion/yr.• The top five firms tend to be involved in deals that average smaller in size ($54 million verses $138 million) than those handled by the large financial bankers. • The average deal size was roughly the same among the top five vendors. • The leading firm claims twice the number of deals as the next closest competitor—the third and fourth place firms halve this amount again.Market Growth: Page 10 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 11. • Bond rating agency’s empirical growth projections indicate that, despite healthcare’s general lag in responding to gyrations of the economy, this market will continue to see slowing growth from the highs of early 2007. • “Flight to Quality”: The strongest financial performers with the highest bond ratings will lead the list of those organizations seeking additional funding to grow and modernize their system while those of lesser strength will find funding difficult to attract.2007 saw a continuation of hospital finance directors taking advantage of historically lowinterest rates, narrow credit spreads, and a flat yield curve that began peaking in 2006.• The $27.1 billion produced overall by healthcare in the "Hospitals that have first half of 2007 showed a 40.1% increase over the been issuers over a long same period a year earlier most of this growth was in period of time have the first quarter.7 generally seen that over • Combined issues, which include refundings and new a 20-year period, the money, rose 125.2% to $10 billion from 2006s first lowest cost of capital half.8 has been in variable-rate • Straight new-money issues fell by 3.6% from the debt." 2006 period.9 Ken Kaufman Founder • Refundings increased 70.4% to $6.3 billion compared with the same period in 2006.10 • Hospitals issued more than $15 billion of fixed-rate debt verses $11 billion of variable- rate.11 • Variable-rate long bonds increased 2,267% from $125 million in 2006 to nearly $3 billion in the first half of 2007.12Hospital Funding:• Up through September 2008, available information October, 2008 suggests that around 100 overall healthcare bond deals ... because of the lack of have been underwritten.13 liquidity in the market • These provider bond deals total $14 billion, ...hospitals have been averaging $138 million.14 postponing plans to sell • Banner Health, the largest non-profit system in the new bonds to fund capital US, closed the largest deal thus far at $917 million.15 improvements such as• Although data is incomplete, the market could slow to renovations and new half its previous growth spike and size until more building.... favorable liquidity returns. Lisa Martin SVP Moody’s HCLeading Hospital Financial Advisory Services:• During the 1985 to January 1, 2008, there were 2,270 transactions (103/yr) accounting for $122 billion ($5.54 billion/yr) in funding among the top five identified leading capital access advisory vendors. • The average transaction was for $53.7 million.16 • VHA’s current vendor Ponder & Co claims the lion’s share with an average forty-six deals per year through 2007.It is anticipated that the severe dislocation in the bond market will presumably ease asgovernment interventions take hold and market confidence returns. However, prudence Page 11 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 12. dictates that, even in the event of effective government intervention, future credit and liquidityfacilities from banks to support new issues will be more difficult and more costly to obtain for thenear future.Consensus: It’s A Complicated Time for Healthcare But It Will ContinueTo Do OKThe agreement over a litany of anticipated negatives precipitating a slowing inhealthcare’s bond market activity is matched by a sense of calm about the lowimpact they will have on the sector.Most of the last decade found hospitals enjoying a market with high liquidity that easilyfacilitated borrowing at affordable costs. However, the current financial crisis is producing anemerging consensus about what hospitals can do and expect over the short term:• Many are delaying plans to sell new bonds to fund capital improvements.17• Bad debt will grow due to the weakening economy forcing companies to shift costs in the form of higher deductibles and co-pays or eliminating employee coverage all together.18• The tighter economy and anticipated tax hikes will cause higher-income patients and community supporters to be less inclined to make charitable donations to their local hospital.19• Hospitals that implemented a strategic plan requiring back-end borrowing may be stuck with very large investments that they financed on lines of credit--expecting to refinance these lines is not going to be as easy as before.Still, top bond-rating agencies see hospitals financial performance in 2008 continuing tostabilize or moderately decline from 2007, despite a weaker economy and negative effects onpatient volumes and revenues.20Hospital Performance – Plateaus for the Strong; Declines for the WeakHospitals with high bond ratings are seeing a leveling of financial performancewhile those with rating of “BBB” or lower are scaling back.A Sept. 25, 2008 special report by a leading bond rating % Community Hospitals With Negativeagency and based on audited financial data from 270 T otal Marginshospitals and systems for fiscal 2007, excluding specialty 35and those with significant municipal support, found:21 30 25• After several years of stable and improving financial 20 performance, acute care hospitals are experiencing a plateau.22 15 • Those with bond rating of “A” or higher are showing 10 the strongest performance, even though there is a 5 slight decline in profitability during 2006-07.23 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 Page 12 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 13. • Most notably is a downward financial performance trend in the lower end of the investment grade bond scale (“BBB” and lower). 24 • These enterprises tend to be more volatile due to their smaller size and thus are limited during contracting negotiations due to limited economies of scale. 25 • They are also experiencing eroding profitability that is resulting in reduced capital investments.26Hospital Bond Rating Volatility Tracks Financial PerformanceThe number of upgrades and downgrades are at parity, but look for upgrading—especially for “BBB+” or above rated bonds-- over the next two years.During the period from 2003 and thus far in 2008, bond Acute Care Bond Upgrade Trend (Fitc h 2008 R eport)volatility (ratings upgrades or downgrades) has shown: 27 30• “A” rated bonds and higher remained the least volatile showing little tendency to migrate. 20• “A-” & “BBB+” exhibit a propensity for mildly moving up.• “BBB” & “BBB-” are the most active and trend negative, 10 if they don’t remain neutral. 0As to the up and down grading trends nine months into 2002 2003 2004 2005 2006 2007 20082008, the pendulum has swung back from 2006 when Acute Care Bond Downgrade T rendupgrades spiked and exceeded downgrades for the first (Fitc h 200 8 R epo rt)time. 30• The number of upgrades and downgrades are currently at parity. 28 20 • Upgrades tend to be for large higher rated 10 enterprises with improved financial profiles.29 • Downgrades are for smaller, lower rated enterprises 0 with eroding profitability and volume losses-- 2002 2003 2004 2005 2006 2007 2008 increased debt had a small effect.30• Upgrades will likely match or slightly lag downgrades through the next 12 – 24 months.31 • Stronger hospitals should fare better by virtue of the characteristics that got them to high ‘A’ or ‘AA’.32 • Expect more downgrades than upgrades at lower end of the investment grade rating scale.33Mergers & AcquisitionsThe slowing of M&A activity in 2007 resulted in a restructuring that eliminatedunderperforming and marginally strategic assets to create stronger regionalnetworks.General – Steep Decline in Activity• The $1.6 trillion in worldwide M&A activity thus far in the “It has taken a long time first half of 2008 shows a 36% decline from the record for the pendulum to set during the same period a year ago.34 swing...the market conditions clearly favor Page 13 of 25 the buyer...” Jim Beecher Publisher © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and Buyouts Magazine proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 14. • Activity in transactions under $500 million showed best performance with only an 18% decline and totaling $369 billion.35• As of late July, 2008 only 36% had hope for an improved outlook in the second half of 2008; up from 24% in December 2007.36Healthcare – Strategic Buyer’s MarketThe implosion of the credit market in midsummer 2008 has prompted a reduction in healthcareM&A activity--especially in those transactions with considerable real estate components. Thiscontraction is seen as producing two key effects:37• Financial buyers have retreated from the market. • These buyers seek opportunities to buy organizations and then sell equity assets like real estate.• Strategic buyers, who did not care to compete with T otal Healthcare M&A Deals Trending financial buyers and have always accounted for the largest share of acquirers, will take advantage of the 800 current pricing deflation. 600 • Hospital pricing in 2007 showed an average price- 489 410 523 534 to-revenue multiples of 0.74x, down slightly from 400 423 the 0.75x of 2006, yet above the 2004 200 measurement of 0.61x.38 • Expect some opportunistic activity from the stronger 0 systems while the weaker unload non-strategic 2003 2004 2005 2006 2007 2008 assets.Healthcare’s service sectors M&A advisors enjoyed a bull 2007 Healthcare Services M&A Dealsmarket from 2003 into 2007. Since then, overall M&Aactivity declined 8% in 2007 from the record year of Long Term Care 1272006.39 Still, the $57 billion spent in 2007 eclipsed all H ospit als 58other years with the exception of the $90 billion in 2006.40 Labs, MR I, Dialysis 54More to the point, the 2007 hospital acquisition activity Home Health Care 48paralleled the activity in the overall M&A market: Physician Groups 41• 58 transactions totaled $8.8 billion and involved 149 Managed Care 28 hospitals accounting for 22,440 beds; a decrease from Rehab 15 the $35 billion in involving 57 transactions involving Behavorial H ealt h 13 249 hospitals and accounting for 54,550 beds in 2006.41 Other Services 105 • 2006 included the largest transaction ever--$33 billion privatization of HCA by a consortium of private equity firms.42FUTURE TRENDSAs of September 2008, industry observers have noted no evidence of lack of capital available,but have seen the sources of funding shift toward strength and quality--the money is going afterdeals with big-name companies. The general trends include:43 Page 14 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 15. • Lending continues to large, financially sound companies like Siemens or Chevron.• Smaller companies with higher risk are paying higher rates due to their weaker credit status. • The large companies with excellent banking relationships and reservoirs of credit are borrowing and then extending credit to their channels and trading partners.• Municipal bondholders have responded to the crisis with a huge flight to quality—high-grade short-term issues are highly coveted right now.44 • Although the yields are up in the long end of the market, 30 years, demand is down and that is why people are buying short term.• The generation of money through the use collateralized debt obligation by leasing companies has found the current market unreceptive.HEALTHCARETop Six Healthcare Challenges Will IntensifyOne of the more important steps for hospitals to do is establish a formal investor relationsprograms that include consistent, open and honest communications with Wall Street. Theseefforts will keep the capital expenditure pipeline open and full as hospitals reconfigure to meet avariety of needs.45 A centerpiece of this program is to answer how hospitals are addressing:Expenditure Control: For Medicare/Medicaid payors, budgetary pressures will hinder rateincreases and may lead to restructured payment programs to control costs over the long term.• Healthcare costs for workers and employers will increase by an estimated 5.7% in 2009, the same rate as 2008.46Decline In Cost Shifting: The commercial payer sector is seeing its ability to shift costs to theinsured impeded by flattening prices.• 59% of U.S. businesses plan to increase employees’ deductibles, copays or out-of-pocket spending limits.47 • Nearly half are encouraging enrollment in high deductible/lower premium health plans.48 • 19% want to offer a consumer-directed health plan.49Rising Costs For New Projects: Profitability will be negatively impacted by increasing capitalcosts from new projects and the rising cost of borrowing.The Business Physician: As physicians continue to compete with hospitals, alignmentstrategies with them will ascend to being a top priority.Consumerism Rises: Community and patient Reimbursement Gap: Actual Cost v.s. Medi/Medi Under Payment (billions)empowerment will bring demands for investments that $30foster improved transparency, quality, safety andcommunity benefit. $25 $20 $15 Page 15 of 25 $10 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and $5 proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860. $0 2000 2001 2002 2003 2004 2005 2006
  • 16. Uncompensated Care: the current economic slowdown and resulting unemployment isescalating the movement by employers to reduce benefits costs and thus driving up co-paysand deductibles.• The percentage of individuals with employment-based health benefits decreased from 68% in 2000 to 62% in 2006.50• As of September 2008, the nation’s short-term acute care hospitals (STACHs) have reported almost $124 billon in uncompensated care costs over the last five years.51 • More than 20% of uncompensated care Medicare cost reports have not complied fully with reporting requirements.52 • Not-for-profit hospitals have 4.8% of uncompensated care costs.53Recession Will Have A Mild Effect On HealthcareWith the exception of credit being tight, a recession lasting through 2009 is anticipated toproduce a mild effect on the healthcare sector. The most visible change will be a spike in thehealth spending/GDP ratio primarily due to a shrinking economy and the costs of providinghealthcare growing at 9.6% in 2009; down from 9.9% in 2008.54 A retrospective analysis of thepast six recessions to see how a slowing economy might affect healthcare showed:55• The health industry is not as closely linked with the rise and fall of business cycles—it takes at least a one or more years for the effect to show up, if at all. • A medical price [inflation adjusted Medical Consumer Price Index (MCPI)] tends to rise where the general CPI declines usually during or towards the end of a recession. • National Health Expenditures (NHE) and the Net Cost of Private Health Insurance (PHI) do not always fall during a recession. • NHE increased during the 1970, 1974, 1980, 2002 recessions and tended to decline about one or two years after. • PHI increased during 1970, 1974, and 2002 but declined during 1980, 1982 and 1990 recessions. • The number of uninsured does not track well with the ebb and flow of a recession—rising with some recessions and sinking with others.56Healthcare Financial Managers Remain CalmThe sub-prime crisis has lead to a near complete disintegration of two bond instrumentsaccessed extensively in the past by hospitals--Auction-Rate Securities (ARS) and the Variable-Rate Demand Bond (VRDB) market. The impact on hospitals has been significant.• Auction-Rate Securities (ARS), no longer a favorite of hospitals, saw a nearly complete destruction thus far in 2008.57 • 33% to 50% of all hospitals are in the auction rate market and everyone with this type of debt has had problems--these rates could not possibly be supported for long. 58 Page 16 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 17. • Healthcare enterprises with these types of instruments started the process of restructuring to move their debt out of this troubled market to VRDBs, fixed-rate bonds, and other forms of debt in March and April 2008. • Some have structured this debt with built in protections; for others, fast rate increases as high as 17% have been levied. 59 • The ARS breakdown spread into the Variable-Rate Demand Bond (VRDB) market in some specific situations.Even with this much violent churning in the market, a late September 2008, analysis ofhealthcare financial manager’s attitude highlighted that they were concerned, but confidentlywaiting for the waters to calm. Observations included:60• Despite Lehman and Merrills problems, variable rate bonds trading, popular among hospitals, had barely been affected.• Managers were worried about the interest rates on their bonds, particularly auction-rate debt that have moved up to double-digits.• One of the primary concerns centered on the paper they currently held and the resultant challenge to determine what mix of debt they should carry.• The more financially fit health systems and hospitals trying to acquire smaller ones were not struggling to find financing to do so.• Activity within the private equity investors market continued to be brisk.Hospital Affiliations UpCompetitive pressures, tightening reimbursement and the long-term demand for capital hasmotivated independent community hospitals to affiliate with health systems.• In 2007, 56% of hospitals were part of health systems—a 10% rise since 2001.61VENDORS 2007 Long Term Municipal New Issues Leading Firms Ranking [ (#tra ns a c tio ns )/ b illio ns ]There any number of financial advisory services that Sourc e: T he Bond Buyer/ Sec urity Data Companyrange from large financial bankers to small boutiquefirms specializing in just one of the services PFM (625) $43.4described in this report or a specific industry or First Southwest (630) $29.3niche. However, there are only a handful of full RBC Capital Markets (244) $11.3service financial advisory firms strictly focused oncapital access for healthcare; most are privately held; Kaufman Hall (75) $8.6many have a strong regional presence. Three of Lamont Financial (42) $5.9these are on this report’s vendor short list. Morgan Keegan (71) $5.7Market leaders short list, as ranked by total value of Ponder & Co (50) $5.6healthcare deals completed for the 1985-2007 Raymond James (5) $5.5periods are: Kelling Nort hcross (77) $4.91. Ponder & Co. Market Share - Capital Advisory Services2. Kaufman Hall [1985-2007 Total Deals Value (Billions $)]3. Public Financial Management4. Morgan & Keegan (Shattuck)5. Killarney Group Ponder & Co 48% Page 17 of 25 Killarney Group Kaufman Hall © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and 3% 24% Public proprietary information must be held in strict confidence and not disclosed to any other parties withoutFinancial Shattuck the express written permission of IAG LLC, San Francisco, CA 415-346-3860. Morgan Mgmt. Keegan 20% 5%
  • 18. • If the total number of deals was the criteria, Public Finance Management and Kaufman Hall would switch rankings.Notables:• The American Hospital Association (AHA) has endorsed Kaufman Hall. 62• Morgan Keegan(acquired Shattuck Hammond Partners in 2007 for their healthcare focus) been recognized as the top municipal bond underwriter in the South Central United States (Arkansas, Kentucky, Tennessee, Mississippi, Alabama and Louisiana) for fifteen years.63 Market Distribution of Vendors Based on Annual Revenue When Available 1 Structure and Revenues Vendor as available [in millions] Ponder & Co Privately held, employee 30 years in business owned • Ranked first in U.S. healthcare finance by dollar volume and number of bond issues over the last 20 years, and have helped raise more than $58 billion of debt capital in 1,021 financing transactions. • Prepared more than 500 capital access plans, debt capacity and asset/liability analyses • Advised on the terms, conditions and price of interest rate swaps for $17 billion in the last two years • 100 completed M&A engagements ranging from $4 million to $1.5 billion. • Actively manage a $2 billion portfolio in fixed income investments for clients. Kaufman Hall Privately held • Founded 1985 • Also offers software suite for planning, in addition to its consulting services • Endorsed by American Hospital Association Public Financial Management Privately held • Founded 1975 • A division of the PFM Group (“PFM”), that includes the PFM Asset Management LLC • Has advised on more than $30 billion of completed health care transactions since 1990 • Claims to have been consistently ranked the nations number one financial advisor • Very large firm; national presence1 Source: Publicly available records Page 18 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 19. Market Distribution of Vendors Based on Annual Revenue When Available Structure and Revenues Vendor as available [in millions] Morgan Keegan (Shattuch Hammond) Privately held • Shattuch Hammond acquired by Morgan & Keegan in 2007 • Founded1993 • 160+ M&A transactions totaling $10.8 billion in transaction value • Completed $12.9 billion as underwriter, placement agent, financial advisor on equity and debt financings • Served as competitive bid agent on interest rate swaps and reinvestment contracts totaling $3.4 billion • Remarketing agent for variable rate issues of approximately $500 million Killarney Group Privately held • Founded 1995 • Small shopOVERSIGHT & INFLUENCERegulatoryU.S. Securities and Exchange Commission (SEC)’s mission is to protect investors, maintainfair, orderly, and efficient markets, and facilitate capital formation. The laws and rules that theSEC enforces governs the securities industry in the US and are based on the concept that allinvestors, whether large institutions or private individuals, should have access to certain basicfacts about an investment prior to buying it, and so long as they hold it.The SEC oversees the key participants in the securities world, including securities exchanges,securities brokers and dealers, investment advisors, and mutual funds. Here the SEC isconcerned primarily with promoting the disclosure of important market-related information,maintaining fair dealing and protecting against fraud.The most recent and notable SEC laws are the Sarbanes-Oxley Act of 2002. This legislationmandated reforms that enhanced corporate responsibility, improved financial disclosures andcombated corporate and accounting fraud, and created the "Public Company AccountingOversight Board," also known as the PCAOB, to oversee the activities of the auditingprofession. Direct impact on hospitals and capital access includes hospitals posturing for bondrating agencies by forming audit committees, in addition to finance committees in preparationfor to questions like: 64• Does the board have a separate audit committee; what’s its role? Page 19 of 25 © 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 20. • Has the hospital or health system adopted a code of conduct or code of ethics or whistle- blower policy that allows for anonymous submission of complaints regarding accounting, internal controls and financial matters?• Does the hospital’s auditor routinely recommend audit adjustments? Are they reviewed by the board?• Which officers certify the financial statements?AssociationsThe Securities Industry and Financial Markets Association (SIFMA) and its Investing in Bondsprovides a regulatory voice and information services to its 650 member firms.National Council of Health Facilities Finance Authority focuses on issues that raise theavailability of tax-exempt financing for healthcare facilities. This Council represents themember authorities that are the tax-exempt bond issuers and does not represent specifichospitals or healthcare systems. Since 1990, NCHFFA members have issued over $50 billionof healthcare bonds. Page 20 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 21. Appendix AA Primer--Tax-Exempt & Non-Traditional Debt InstrumentsOf these methods access to capital in the form of tax-exempt bond offerings and non-traditional vehicles are the Four Key Ways Not-for-most common and include: profit (NFP) Access Capital• Bond Offerings: Most common are publicly offered tax- • Self -Generation: exempt bonds with fixed or variable rates are sold on the Operational cash reserves open market by an underwriter. and flow are raised by a • Fixed Rate Bonds: Typically a 30-year term to net increase in revenues maturity with the rate based on the credit rating of the while dropping costs. borrower or credit enhancements like bond insurance. • Disposal of Assets: • Variable Rate Bonds: Unless a crediting rating of Divestiture of AA/Aa or higher and a highly liquid financial posture nonproductive assets or can be demonstrated, a letter of credit or bond non-core assets—like real insurance from a bank is usually required of the estate—can yield capital borrower. Term to maturity is shorter; can vary from and improve financial daily to multi-year; and can be structured more performance. commonly as: • Philanthropy: More • Auction Rate Securities: These debt instruments mainstream than in past are typically corporate or municipal bonds that use periods, donations of a Dutch auction (seller and buyer demand is used “time, talent or treasure” to set the interest rate) to reset the interest on a is part of every healthcare regular basis. Preferred stock that uses this same financial profile. process to set the dividend also falls into this • External Capital category. Access : Principally debt • Tax-exempt hospital and health system issuers in the form of bond make up approximately 25% of the auction-rate offerings and non- market.65 • Demand Bonds: The borrowed funds are payable upon demand by the lender; charged interest is typically based on prevailing money market rates, like the prime rate. • Put Bonds: Also known as a multi-maturity bond, option tender bond or variable rate demand obligation give the bondholder the option of requiring the bond issuer to repurchase this security at specified dates before maturity. This may happen either once during the lifetime of the bond (known as a one-time put bond), or on a number of different dates. Of course, the special advantages of put bonds mean that some yield must be sacrificed. • Commercial Paper: An unsecured short-term debt instrument that is typically issued by a corporation to finance accounts receivable, inventories or other short-term liabilities. The debt is usually issued at discounted prevailing market interest rates; only corporations with high-quality debt ratings will find buyers easily without having to offer a substantial discount. It does not need to be registered with the Securities and Exchange Commission (SEC) if matures before nine months—a major inducement to Page 21 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 22. use. • FHA Financing: Gaining some popularity recently, this is essentially a form of public offering by the U.S. Department of Housing and Urban Development (HUD). • FHA Section 242 loans are insured and offered to acute care hospitals to finance constructions, remodeling, expansions or refinancing. • It is usually a fixed rate for a term of up to 25 years from the end of construction with variable rate swap structures often being a consideration. • Private Placement: Raising capital via private placement is the product of selling securities to a small number of investors such as pension or mutual funds, banks or insurance companies. • It can take the form of leases, loans, notes, or bonds; be taxable or tax-exempt; and have fixed or variable interest rates. • Because of the limited number of investors, public disclosure of detailed financials, the need for a prospectus and registration with the Securities and Exchange Commission (SEC) is waved.• Nontraditional Offerings: These offerings are post 1990s when not-for-profit tax-exempt financing was the rule of the day. Today, non-traditionals most frequently come in the form of: • Off-Balance-Sheet (OBS) Options: By using a method of reclassifying financing, large capital expenditures are kept off of a companys balance sheet. • Joint ventures, partnerships focused on research and development, and operating leases (one of the most common forms for capital equipment). • Real Estate Investment Trusts (REITs): These are essentially third party ownership of the real estate that is formed to monetize the hospitals assets by selling securities on the major exchanges. • REITs have increasingly partnered with physician groups and other health care enterprises to selectively develop and manage medical properties like medical office buildings, specialty hospitals, outpatient and ambulatory treatment and diagnostic clinics. • Accounts Receivable Financing: A form of asset-financing where an enterprise sells or uses its receivables--money owed by patients—in an amount that is reduced in value based on the length of time the money has not been paid (“ageing”). • Subordinated Securities: These are lower-rated classes of securities that bear higher interest rates. They are sold to other investors or, in the case of securitization deals, held by the originator. • In the event of problems, the higher-rated (senior) securities receive payments prior to the subordinated ones. Page 22 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 23. Bibliography Page 23 of 25© 2011 IAG LLC Inc. Non-disclosure: IAG LLC retains all rights to the use and distribution of this document. This confidential and proprietary information must be held in strict confidence and not disclosed to any other parties without the express written permission of IAG LLC, San Francisco, CA 415-346-3860.
  • 24. 1 Ziegler, A. (2008, July 8). Trend: Hospital investment returns still looking shaky. Fiercehealth.com. Retrieved from: http://www.fiercehealthfinance.com/story/hospital-investment-returns-still-looking-shaky/2008-07-082 Ziegler, A. (2008, July 8). Trend: Hospital investment returns still looking shaky. Fiercehealth.com.http://www.fiercehealthfinance.com/story/hospital-investment-returns-still-looking-shaky/2008-07-083 Presenting your story to capital markets. http://www.hhnmag.com/hhnmag_app/gateFold/pages/JUNE08.jsp4 http://ida.lacity.org/pdfs/Other/bond_issuance_fees.pdf5 Clark, R. (2008, May). Size and focus: healthcare provider organizations are beginning to see the benefits of size.Retrieved 10/9/08 from: http://findarticles.com/p/articles/mi_m3257/is_/ai_n254494796 (2008, Fall). The Impact of the Capital Markets Crisis and Economic Slowdown on Hospitals and Health Systems. ShattuckHammond. 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