Tax-exempt hospital systems without fortress balance sheets and top quartile operating performance will be capital constrained in the future healthcare economy, even if tax-exempt debt continues be cheap and accessible. Stating the obvious: operating a hospital is a capital intensive activity. Historically, hospitals have required about $1 of invested capital to generate $1 of hospital revenue. As hospital systems contemplate changing their facility-based fee-for-service models into health enterprise models responsible for managing populations of patients and being at risk, capital will need to be deployed into new areas. Many of these new investments are impossible to fund with traditional tax-exempt debt, no matter how cheap.

To maintain existing facilities, hospitals need to fully fund annual depreciation, which industry-wide, averages about 6% of net patient revenues. This also means 6% of the average operating and EBITDA margins are consumed by capital expenditures. For stronger systems, capital expenditures typically exceed annual depreciation expense by 20 to 30%. In addition to traditional uses of capital to upgrade facilities, equipment, and technology, hospital systems transitioning to the new health care delivery models need capital to support risk-based population management systems. These investments may include building out physician networks, more comprehensive (and integrated) information technology systems, risk management infrastructures, capital reserves to take risk (similar to insurance reserves), post-acute care asset investments, and many other needs. Furthermore, as hospitals shift from fee-for-service to risk based revenues, a performance trough will occur that must also be accommodated. Significant declines in operating margins for several years will naturally occur as volumes decrease and population management development expenses escalate.

Funding these new capital requirements on top of traditional facilities-based investments requires financial performance strength (in our estimate 12% or better EBITDA margins), balance sheet strength (180+ days cash on hand), and scale (at least $2 billion in revenues, if not more). Financial performance strength is necessary, because many investments such as building physician networks and managing the infrastructure to support these networks is costly, with much of the cost borne on the income statement. Balance sheet strength is necessary, because funding population management infrastructure, including risk reserves, is not efficient or even possible by issuing tax-exempt debt. Funding must come from operating cash flow, cash on the balance sheet, or taxable debt, all negatively impacting overall credit strength. Scale is necessary both to reduce per unit delivery costs and to underwrite risk in an actuarially sound manner.

For less than top tier rated hospital systems, these capital demands create a capital conundrum: building both balance sheet strength in the form of increased days cash on hand and reduced leverage, while also spending capital that is not financeable with tax-exempt debt and very difficult without extraordinary operating margins.

To address this capital conundrum, hospital organizations are deploying a number of strategies. The most obvious, and reflective of the current high level of consolidation activity, is to merge with larger, better capitalized systems to achieve scale. These transactions come in many forms, including straight sales, membership substitutions, joint operating agreements, and so forth. Other less transformational strategies include formation of loose affiliations such as Allspire, Stratus, BJC Collaborative, Midwest Health Cooperative, and others. For some organizations intense focus on improving operating performance to generate significant incremental cash flow has been the primary strategy, often with a view to merger later in the cycle. Under any circumstance, doing nothing is not an option.

Whether sustaining long-term viability requires $2 billion in revenues or $20 billion in revenues, the hospital industry is undergoing unprecedented change that requires careful assessment of where and how capital is generated. It is unlikely that the traditional tax-exempt financing model can sustain this transformation. For that reason we expect to see the pace of conversion and inclusion of taxable organization models to accelerate. The Baylor/Tenet joint venture is reflective of that.

By Carsten Beith (Cain Brothers)