In last week’s edition of the Weekly Gist, I shared an exchange I’d had with the CFO of one of our clients during a meeting of their health system’s board of directors. The topic was the importance of the system’s AA bond rating to the board, and the impact that maintaining that rating might have on the strategic flexibility of the system. I wrote, “As big strategic decisions loom (shifting the business model, taking on risk, responding to disruptive competitors), it’s worth at least asking whether we’ve passed the time for “keeping dry powder”, and whether systems are being held back by conservative financial management.”
One of the true pleasures of our work at Gist Healthcare is engaging in an ongoing dialogue with our clients, readers, and colleagues across the industry. Shortly after sending out the Weekly Gist last week, we heard from long-time friend Mike Slubowski at Trinity Health. He shared his somewhat different (and much more informed!) view of the importance of bond rating to hospital systems, and was kind enough to engage in a brief Q&A over email to expand on his thoughts. We hope you’ll find his perspective as enlightening as we have.
Gist Healthcare: How do you think about financial strength for a health system? What characteristics and metrics are most important?
Mike Slubowski: Financial strength is ultimately measured by strong operating cash flow—is the system generating enough cash to cover expenses including debt service, fund depreciation, and to meet capital spending requirements? Operating margin, days’ cash, and leverage ratios are also important metrics of financial strength. We compare these metrics to published ranges from Rating Agencies on rating categories. Finally, what is the organization’s profitability or loss on Medicare? Is the cost structure of the organization (as measured by cost per adjusted discharge or similar metrics) competitive and attractive to payer and purchasers, or is it a high cost organization that’s been living off high commercial payment rates because of its market relevance? That will come back to bite them at some point in the not-too-distant future. Finally, financial strength is simply a means to an end. In the case of not-for-profit health systems, our mission is to improve the health of the people and communities we serve. Are we using that financial strength to make a measurable difference for our communities? That question has to always be pondered.
In my opinion a system’s bond rating is very important. Our organization strives to maintain an AA rating
GH: How important is the bond rating, and the broader evaluation of the system’s financial outlook by the banking community?
MS: In my opinion a system’s bond rating is very important. Our organization strives to maintain an AA rating. While it is true that the interest rate spreads between, say, an AA and an A rating are small, the reality is that a positive financial outlook and rating from the rating agencies is a “Good Housekeeping Seal of Approval” for a not-for-profit health system. In most instances, acquisitions in not-for-profit healthcare are accomplished by member substitutions, and rather than cash changing hands, the entity being acquired agrees to merge because of future capital investment commitments made by the acquiring entity and their belief that the acquirer will bring economies of scale. They aren’t going to join a system if it has a weak credit rating, because they’d be concerned that the acquiring system wouldn’t be able to fulfill the capital investment commitment.
GH: What are some considerations you’d recommend to health systems thinking about “trading off” a strong bond rating to gain strategic flexibility?
MS: A difficult question, to be sure. First of all, it depends on your starting point. There’s a lot more risk in going from an A- to BBB rating than, say, an AAA rating to an AA rating. Second, it really depends on what strategic opportunities the organization is pursuing—are they opportunities within the wheelhouse of the organization’s leadership competencies? There have been a lot of providers that have ventured into other businesses, such as insurance, long-term care, physician practices and other for-profit ventures, and they have lost a lot of money because they spread themselves too thin and didn’t know how to successfully manage these different businesses. Does the opportunity provide more market relevance? Is the new opportunity accretive? Is there a solid business plan that gives the organization confidence that the new opportunity will be accretive within a defined timeframe? There are a lot of “hockey stick” business plans (i.e., up front losses that predict large profits in later years) that never deliver the desired results. So rating agencies and investors are always wary of these wildly optimistic business plans.
I’m not suggesting that organizations become so conservative that they don’t take risks on strategic opportunities—but it’s important to go into these new ventures with eyes wide open. I think it is important for health care organizations that have been acute-care focused to develop a continuum of services that grow cost-effective home-based services, primary care and other ambulatory services, as well as consumer-focused digital health solutions. They also need to develop clinically-integrated provider networks that are positioned to assume risk for cost and outcomes as payers shift from fee-for-service to value-based payment. Otherwise they will be one-trick-pony dinosaurs while the rest of the world around them is transforming and diversifying.
I’m not suggesting that organizations become so conservative they don’t take risks…but it’s important to go into new ventures with eyes wide open
GH: As health systems take on more risk (strategic, actuarial, operational), how can they best make the case to their financial stakeholders (bondholders, shareholders, public funders) to justify increasing risk?
MS: I think that historical track records are important. Does the organization have an experienced and competent leadership team? Do they recruit leaders with needed skills for new businesses? How has the organization performed with previous new ventures? Have they been able to adjust if things go south? Do their business plans include a sensitivity analysis with upside and downside potential, along with immediate actions they would take if performance does not meet the plan? Does the opportunity improve market relevance and create a diversified portfolio and/or a continuum of services? At the end of the day, confidence in an organization and its leadership comes from their track record.