Higher Rates and Capital Structure Management

Russia’s actions in the Ukraine upended global financial markets. While this is one more immediate headwind for investors to deal with, the ultimate considerations will be things like whether it overrides other market pressure points; whether it is the harbinger of other global systemic dislocation; and the resulting composition, severity, and duration of the impact (benchmark rates versus credit spreads).

SIFMA reset this week at 0.20%, which is approximately 87% of 1-Month LIBOR and represents a 3 basis point adjustment versus the February 9 reset.

Higher Rates and Capital Structure Management

The long-term trend for benchmark rates is higher. Maybe as important, we confront a broad set of headwinds that will impact healthcare operations and balance sheets over an extended period:

While most of these pressures support an upward rate bias, important questions around the timing, magnitude, pace, and form of change shape the three main options for responding to rising rates:

1. Get to market as soon as possible to lock in prevailing favorable fixed rate levels.
2. Hedge rate risk using a financial product (such as an MMD or Treasury rate lock).
3. Introduce capital structure risk using floating rate products, put bonds, or other structures that move debt to a lower cost point on the yield curve in exchange for assuming risk.

The first option—getting to market as soon as possible—is the best tactical hedge but is not always feasible. My colleague Steve Sohn will address financial product hedging options in a separate article; this is an important topic, and organizations should develop a point of view on whether this type of hedging is part of their debt management playbook.

The same need for a point of view applies to the topic of capital structure risk. Every debt product has a base cost expectation as well as a unique risk profile consisting of (i) cash flow risk or the potential for variability against the base cost expectation; (ii) event risk or the potential for accelerated principal repayment; and (iii) flexibility risk or the ability to easily access the debt to facilitate cost restructuring or deleveraging. The bookends are, on one side, natural fixed rate debt that offloads cash flow and event risk at the cost of reduced flexibility (10-year or make-whole call provisions), and on the other, puttable floating rate debt that retains cash flow and event risk and offers maximum flexibility (immediate call).

Capital structure management is determining where the debt portfolio and each component transaction should land on the fixed-floating continuum. Important decision-making considerations include:

• Return on Capital Structure Risk: The main pricing consideration is whether the reward (yield or flexibility pick up) attached to a particular capital structure risk product is worth its associated risks. The net opportunity reflects both absolute rates (current versus historic) and curve spread (the reduction in rate that comes from taking risk and moving debt down the curve).
• The Availability and Cost of Event Risk Mitigation: Event risks (puts, renewals, etc.) represent a claim on a healthcare organization’s unrestricted cash and investments. Organizations can either carry this risk (self-liquidity) by maintaining sufficiently large pools of short-term cash and investments or they can purchase a liquidity buffer from a commercial bank. The self-liquidity financial consideration is any opportunity cost of holding assets in high liquidity, short duration instruments versus moving them to less liquid but likely higher returning strategies; for this cohort the focus shifts to “surplus return” or the cost of debt versus the return on investments. The introduction of a bank intermediary likely reduces (or eliminates) the need to adjust investment strategies but introduces the price and terms of the commercial support and changes the resulting all-in cost versus other alternatives.
• Capital Structure Risk Capacity and Allocation: Healthcare organizations are a complex jumble of activity spanning operations, strategy, financing, and investing. Each of these functions has its own risk ecosystem that can be managed with varying degrees of efficacy. It is impossible to eliminate operating and strategic risk; but it is possible—for a price—to eliminate all capital structure risk (other than the risk of a financial covenant breach). Additionally, every healthcare organization has a unique enterprise risk capacity, which is largely a product of its cumulative financial resources (sourcing from operating cash flow as well as from financial and real asset holdings on the balance sheet). Taking too much or too little cumulative risk across all functions threatens the long-term viability of the organization. The capital structure imperative is determining whether it is better to use enterprise risk capacity to drive down debt cost (or improve flexibility) versus directing that risk capacity to other initiatives (within operations, strategy, or investments). The important step is blending siloed (or function-specific) risk allocation with the idea that risk capacity is an enterprise resource that must be cultivated, deployed, and managed on an integrated and balanced basis.

The challenge today is that while rates markets are changing, so are the operating, strategic, and investment environments. Actions like getting to market fast or using financial hedges are tactical choices that can be assessed in isolation and in the moment. But options like capital structure risk require a blending of vertical (capital structure return on risk) and horizontal thinking (how does that capital structure return on risk work versus other parts of the company); this is the only way to answer the essential question of how to allocate risk capacity to drive the highest/best enterprise return.

Trending in Healthcare Treasury and Capital Markets is a biweekly blog providing updates on changes in the capital markets and insights on the implications of industry trends for Treasury operations, authored by Kaufman Hall Managing Director Eric Jordahl.