"Healthcare Finance in Challenging Times"

 David A. Lips

 Health Law Symposium

Indiana State Bar Association 

February 25, 2010

• Very low operating margins (10-12% EBITDA)

• Capital intensive (4-6% net revenues)

• Revenue cycle management

• Slow payment of accounts receivable (DSO 75-125 v. 30-60 norm)

• Dependence on Medicare and Medicaid (42% gross revenue from Medicare, 11% Medicaid; underpayments)

Issues Key To Hospital Finance

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• Bad debt expense

• Loss of health insurance (75% through e/er; e/er subsidy 85% for individuals, 73% for families)

• High co-pay requirements (18% workers in $1k deductible plans)

• Increase in charity care

• Declining margins

• Competition (ASCs, imaging centers, free-standing clinics)

• Postponing elective procedures (labs, drugs, OBGYN, hip and knee replacements)

• Greater use of emergency treatment

• Interest expense increasing ($148m median total debt in 2007)

Impact of Economy on Hospitals

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Capital Finance Alternatives

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• Interest exempt from federal income tax

• Issued through 'municipalities' (conduit)

• Non-government healthcare providers must be 501(c)(3) organizations

• Qualified 501(c)(3) bonds must devote 95% of proceeds to tax-exempt purpose

• At most 5% of bond-financed property may go to private use (2% cost of issuance)

Tax-Exempt Bonds

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•Fixed interest rate

•Variable interest rate (SIFMA Municipal Swap Index, % of LIBOR [London Inter-Bank Offered Rate])

•Variable rate demand bonds

•Auction rate securities

Types of Bonds

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• Bond insurance

• Traditionally increases bond rating

• Gives security to bondholders

• Often preferred for auction rate securities

• Letters of credit

• Provided through banks

• Associated with variable-rate demand bonds

Credit Enhancement

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•Long-term bonds sold in short-term markets

•Attractive low interest rates

•No put option

•Dependent on ratings of bond insurers

•Sold in "reverse auctions"

Auction Rate Securities

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• Auction process

• Interest rate set at highest rate that will clear the market in an auction

• If there are not enough bidders to buy at the offered interest rates, the auction fails.

• If auction fails, interest rates reset at maximum

• No put option

• If auction fails, ARS become illiquid

Auction Rate Securities, II

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• Credit enhancement

• Gives assurance to bond buyers

• Liquidity enhancement

• Obligates bank to buy put bonds that are not remarketed

• Bond financial covenants

• Days cash on hand

• Debt service coverage ratio

Letters of Credit

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• Downgrades of bond insurers (ACA Capital Holdings; AMBAC, MBIA)

• The collapse of ARS

• Spikes in the interest rate

• Conversion to VRDBs

• Bankruptcy of Lehman Brothers (9/15/08; 9/16/08 AIG, $85m loan, 80% equity)

• Massive redemptions ($50B) (Tax-exempt money market funds)

• Flight to quality (Early 10/08, 95% healthcare bond deals pulled)

• (VRDBs tendered to trustees, failed remarketing, LOCs, bank bonds, i increase)

• Bank failures (2007: 3, 2008: 25, 2009: 140, 2010: 15) (Top 6 banks wrote down capital $160B – mark-to-mark accounting)

• Tightening credit

• Financial covenants breached (Debt service coverage ratio = net operating income/total debt service) (Days cash on hand)

• Hospital capital projects put on hold

The Credit Crunch

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Recent Developments• Moody's and Fitch recently gave negative

appraisals of the nonprofit hospital industry

• Moody's: "Over the next 12 to 18 months, we believe the not-for-profit hospital sector will face one of the toughest environments in decades. The lingering effects of the weakened economy remain, and recovery will likely be delayed until well after the broader economy heals."

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Recent Developments, II

• In 2009, Catholic Healthcare West and Catholic Health Initiatives both had big bond deals.

• But overall, bond issues were 25% fewer in healthcare than they were in 2008.

• There is now only on municipal bond insurer. Three years ago, there were seven.

• Consolidations among hospitals13

Recent Developments, III• LOC renewals – Major issue in next 2

years

• Start planning now and advise your clients to start planning now

• Many will not be able to get renewals

• Those that do will pay much higher prices for them and the renewal contracts will have tighter financial covenants

• Banks may require all banking be done there.

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Recent Developments, IV

• Fixed-rate bonds without credit enhancement

• Often secured by security on the hospital's property and assets

• American Recovery and Reinvestment Act of 2009Banks are often not allowed to deduct interest earned

from tax-exempt bonds. Exception for small issuers.Makes it more attractive for banks to buy bonds: $30m

v. $10m per calendar year. Ends at end of 2010.

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Recent Developments, V• Healthcare projects as economic

developmentMay qualify for new government incentives

(for example, disaster bonds; recovery zone facility bonds)

The bond markets are coming back, but primarily for the top credits

Summer 2009: Tim Geithner: "It's going to be hard to know what the new normal will be."

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Conclusion

I wrote a detailed book about healthcare finance and encourage you to read it to learn more about the subject and about ways that hospitals are dealing with constraints on their finances.

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