Category Archives: Public Debt Issuance

The Not-for-Profit Healthcare Resource Chasm

Posted on by • Posted in Board, Capital Formation, Capital Formation Program, Debt Covenant Default, Debt Issuance, Debt Service Covenants, Operating Income, Operating Margin, Operating Performance, Performance Improvement, Public Debt Issuance, Resource Portfolio, Resource Priorities, Strategic Balance Sheet Management, Strategic Resource Allocation • Leave a comment

https://www.kaufmanhall.com/insights/blog/not-profit-healthcare-resource-chasm

Current Funding Environment

Healthcare debt issuance remains incredibly light. How long can a capital-intensive industry tolerate limited capital generation? Is pressure building to some tipping point when the need for capital and liquidity will outweigh defending a credit-rating position or avoiding what seems like high-cost debt? The sector generated a lot of internal and external capital in 2020-2021, but the falloff across all channels has been dramatic and residual resource positions are deteriorating.

The Need for Enterprise Performance Improvement

Recent economic releases—jobs report to CPI to PPI to retail sales—all suggest that the Federal Reserve’s efforts to bring inflation into line are yielding slower than hoped for results. The expectation is continued Fed tightening (higher rates), with a range of voices suggesting the Fed will be forced to push rates high enough to trigger a recession. Every restaurant and shop in the small town I live near has a “we’re hiring” sign in its window and each was jam-packed with very active consumers this past Presidents’ Day weekend. If success in taming inflation requires a broad-based hiring and economic slowdown, it feels like we have a long way to go.

Markets keep doing their thing, which frequently seems disconnected from the Fed’s thing. Both 30-year Treasuries and MMD are just starting to bump up against 30-year averages, the 10-year Treasury has moved higher over the past several weeks but remains below Effective Fed Funds, and the Chicago Fed’s National Financial Conditions Index continues to suggest relatively accommodative overall financial conditions.

While I question the depth and reliability of fixed income markets, the funding environment doesn’t seem as bad as the very low debt issuance activity would suggest. Channeling Shakespeare, it seems that “the fault, dear Brutus, is not in our stars, but in ourselves,”

meaning that low debt issuance is coming out of healthcare’s very profound resource problem rather than externalities.

I concluded a long time ago that not-for-profit healthcare credit and capital management is about strategic resource allocation. Healthcare leaders continuously rebalance the allocation of resources embedded in operations, credit position, and retained fixed and financial assets; and there has never been as challenging a resource generation and allocation moment as the one we are in and are likely to remain in for an extended period.

The scary version of all this is that not-for-profit healthcare has entered a resource chasm that will fundamentally degrade the sector’s credit and capital foundation.

COVID and inflation have combined to expose the brittleness of the healthcare resource chassis. The engine—operations—is bumping up against the dual pressures of:

  1. Labor-scarcity-driven strains on converting customer demand into realized financial resources; and
  2. A business model that doesn’t allow the efficient transfer of increased costs onto customers.

The result is unprecedented resource compression that leads to dramatically lower internal and external capital formation;

existential covenant threats; and the temptation, if not the necessity, to use retained wealth (i.e., spend down balance sheet) to support current operations versus funding growth or protecting long-term resiliency.

Every organization must aggressively identify and pursue operating performance improvement initiatives. But every organization needs to extend the idea of performance improvement to balance sheet, with the goal of addressing three total enterprise considerations:

  1. What Is Our Resource Portfolio? What is the catalogue of resources available to the organization? What form are those resources in? What is the roster of demands on those resources and is there balance or imbalance between the two? What are the consequences of imbalance and the costs of moving to balance?
  2. What Are Our Resource Priorities? How dependent is your organization on balance sheet to achieve success? Is balance sheet a critical liquidity or credit buffer against elevated operating and strategic volatility—the bridge between today and a successfully implemented operations performance improvement plan? Is it a source of external capital to fund strategic initiatives or defend overall liquidity? Is it an actual funding source and is this a departure from past practice? Is it an independent and alternative source of (non-operating) cash flow? Is the balance sheet role changing and what does that mean to operations, credit, resiliency, etc.?
  3. How Should Our Resources Be Positioned? Are balance sheet resources in their best form or is there a benefit from converting them into something different (like cash)? Will performance improvement initiatives alter positioning conclusions and, if so, does that improvement occur over an acceptable time frame? Can various resources be successfully converted today or are there cost or other impediments?

The need is to move out of siloed and into integrated and enterprise-centric performance improvement, which requires one consistent resource allocation mindset applied across operations, liabilities, real estate holdings, financial asset holdings, and every other class of organizational resources.

The need is to transition from thinking that balance sheet and operations can be disconnected thoughts to seeing them as two sides of the same coin.

Covenant threats continue to escalate, all centered on how reduced resource generation impacts debt service coverage.

We reiterate that it is critical for every organization to understand how its specific covenants work and to have a rolling forecast on expected performance.

As an example, many organizations now have coverage covenants where default requires two consecutive years of below the coverage ratio. This is an unconditionally good thing, but many of these same organizations may face a consultant call-in at year one and some of them may also confront year-two limitations on additional debt, merger, sale, disposition of assets, and a host of other important management levers. So, the good thing has conditions that are essential to understand and, perhaps, get ahead of. We have a robust library of covenant-related thought leadership on our website—ranging from written content to webinars—and our team is always ready to help.

Recalibrating a Responsive Capital Formation Program

Posted on by • Posted in Board, Capital Deployment, Capital Deployment Conviction, Capital Formation, Capital Formation Program, Counterparty Risk, Credit Quality, Credit Ratings, Federal Reserve, Federal Reserve Board, Public Debt Issuance, Risk Management, Unemployment, Unsustainable, Unsustainable Trends • Leave a comment
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Current Funding Environment

Wednesday’s inflation print showed a March increase of 0.1% versus February and a year-over-year increase of 5.0%, both of which were better than expected. Markets rallied following the news, at least until the specter of recession caused a reversal of equity gains. The game remains the same: markets want easy money and inflation plus unemployment plus recession equals Fed policy and interest rate levels. Memories of the long 1970s slog through declining and then accelerating inflation levels suggest that it’s too early to declare victory (5.00% is still a long way from the Fed’s 2.00% target range). Nevertheless, hopes increased that the Fed may truly be at or very near the end of its tightening cycle.

Unsustainable Trends

The web version of The Wall Street Journal got rid of its special section on the “2023 Bank Turmoil,” which is a sign that we’re past the worst of this chapter in the Dickensian saga in which our financial system hero navigates all sorts of unfortunate characters and events in search of a new “normal.” Banking distrust ripples continue, with various clients sharing the work they are doing to peel back layers of counterparty risk to understand whether threats loom in downstream financial dependencies. Our regulatory infrastructure has shown itself to be a mile wide and an inch deep, which fuels the kind of skepticism about the reliability of designated watchdogs that leads to self-directed risk assessments.

At one level, this is a helpful and important exercise. The credit and financing structure of any complex healthcare organization is just another supply chain, and it is good to understand how yours works and whether there are vulnerabilities that should be investigated. But it is equally important to assess whether the progression of COVID to inflation to Silicon Valley Bank has caused your organization to drift from risk management into retrenchment. Organizations naturally migrate along a risk continuum as they shift between prioritizing returns or resiliency. The important question isn’t which of these bookends is right, but rather what shapes the migration; the defining event is the journey, and

the critical Board and C-suite conversation is whether your risk management program is enabling or constraining future growth.

We continue to monitor the extraordinary decline in not-for-profit healthcare debt issuance. Sources we rely on show healthcare public debt issuance through Q1 2023 down almost 70% versus Q1 2022. Similar data sources aren’t available, but anecdotal input from our team suggests a comparable drop-off in healthcare real estate as well as alternative funding channels. At the same time, although margins have recently improved, operating cash flow across the sector has been weak over the past 12-18 months. If capital formation from internal and external sources is a sign of vibrancy, healthcare is listless.

The primary culprit isn’t rates; the sector has raised capital in much higher rate environments with fewer financing channels (including most of the pre-2008 era). Instead, the rationale most frequently advanced is concern about the reaction from key credit market constituents during this time of unprecedented operating disruption. Of course, this makes sense, but sitting underneath this basic rationale is the question of what might be called “capital deployment conviction.” Long experience confirms that organizations armed with a growth thesis they believe in aren’t shy about “selling” their story to rating agencies and investors and are willing to suffer adverse outcomes on rates, ratings, or covenants, if that is the price of growth. This isn’t happening right now, which introduces the troubling idea that issuance trends are about much more than credit management.

No matter the root cause, recent capital formation is not sustainable.

Good risk management leads to caution in challenging times, but being too careful elevates the probability that temporary problems become permanent. $2.8 billion in quarterly external capital formation ($11.2 billion annualized—pause and let that annualized amount sink in) is not sufficient to maintain the not-for-profit healthcare sector’s care delivery infrastructure, especially when internal capital generation is equally anemic. But introduce any competitive paradigm and the underinvestment that accompanies this level of capital formation becomes a harbinger of hard times to come. To riff on Aristotle, capitalism abhors a vacuum, and organizations looking to avoid rating pressure today may be elevating the risk of competitive pressure tomorrow; and it is easier to cope with and eventually recover from rating pressure than it is to confront the long-term consequences of well-capitalized and aggressive competitors. Retrenchment might be the right risk management choice in times of crisis, but once that crisis moderates that same strategy can quickly become a risk driver.

Machiavelli, Sun-Tzu, Napoleon, George Washington, and other great tacticians all advanced some variation of the idea that “the best defense is a good offense.” In the world of risk response, this means that the better choice isn’t to de-risk and hibernate but rather to continuously reposition available risk capacity so that you keep the organization moving forward. Star Trek’s philosopher-king Captain James Tiberius Kirk captured the sentiment best when he said, “the best defense is a good offense, and I intend to start offending right now.”

While getting back on the capital horse is important, clearing rates, relative value ratios, risk premia, and flexibility drivers have all reset over the past 12-18 months, so recalibrating a good capital formation program requires reassessment and may lead to very different tactics.

This means that a critical step is to get organized around funding parameters:

debt versus real estate versus other channels; MTI versus non-MTI; tax-exempt versus taxable; public versus private; fixed versus floating. The other important part of this is gaining conviction about capital structure risk versus flexibility: do you want to retain flexibility at the “cost” of incurring the market risk embedded in short-tenor or floating rate structures or do you want to sell flexibility in exchange for capital structure risk reduction?