Many organizations still have a window of opportunity to rely on their most recent, pre-pandemic audited financial statements if they have plans for future borrowing or other transactions that could be accelerated. Consider plans to accelerate transaction activity.

 

Background and Context

Most health systems focus on their debt service coverage as a maintenance test: they must maintain sufficient debt service coverage every year for covenant compliance as well as creditworthiness. But debt service coverage also is the basis of incurrence tests, which are tests performed at specific times if the borrower wishes to do certain things. Among the most common events that trigger incurrence tests are taking on additional debt, merging with another system, reconfiguring the obligated group, or taking assets out of the obligated group.

As health systems face the uncertainties of recovery from the COVID-19 pandemic, they may want to review the language in their Master Trust Indenture (MTI) for events that trigger an incurrence test and the options the MTI provides for meeting the test. If an organization has plans for any of these triggering events, it may want to consider acting sooner rather than later.

 

Debt Incurrence Test Options

A typical MTI will provide multiple ways to issue debt. The language often will be found in a section titled “Limitation on Additional Indebtedness” or something similar. Overall, there are usually two methods for issuing additional long-term debt, with separate tests and factors applied if the debt is short-term, a refunding, subordinated, nonrecourse, or for project completion.

The first method for incurring additional long-term debt measures historic pro forma debt service coverage. The prior year’s income available for debt service is divided by annual principal and interest payments that include the debt intended to be issued. If the minimum test level threshold is exceeded, the debt can be issued by submitting an officer’s certificate to the master trustee with that calculation.

If the threshold is not met, the second method must be used. This method has two prongs. The first requirement is meeting a minimum level of debt service coverage of existing debt (typically the rate covenant level) for the prior year. The second requirement is a financial forecast demonstrating compliance with a minimum level of debt service coverage for the next two years, including the new debt.

In this COVID-19 period—with depressed cashflows and thus lower debt service coverage levels than in prior years—borrowers must be mindful of how those actual coverage levels will dictate their ability to borrow in 2021. As noted above, the two main methods for issuing additional long-term debt have an element of the prior year’s income available for debt service. Importantly, if a borrower does not meet its rate covenant level of debt service coverage in 2020, it will be unable to use either of the two primary methods for new debt incurrence. Regardless of projections, the borrower still has to show it met the rate covenant minimum debt service coverage level for 2020.

There may be one other avenue for borrowing under modern MTIs that would allow debt to be incurred without relying on debt service coverage. There is a provision referenced as a basket test that provides for borrowing amounts up to a percent of Total Revenue or debt-to-capitalization ratio (percentages differ by situation). In total, the borrower can “fill the basket” with up to that amount of debt, and the borrower can subsequently “unload the basket” in future years when management can certify compliance with one of the two methods for issuing additional long-term debt described above. Note that borrowing under the basket test still requires that the borrower meet its annual maintenance test for debt service coverage. As such, if you rely on the basket test in 2021 to incur debt because you could not meet your rate covenant in 2020, make sure you are confident that you will be able to meet your rate covenant in 2021, including the additional debt service.

 

Ramifications for Other Actions

In most MTIs, the incurrence test defined for additional indebtedness (historic pro forma or two years forward-looking) is also used as the basis for limitations that relate to other actions (often called “transaction tests”) that appear throughout the MTI, including for proposed mergers, obligated group reconfigurations, or obligated group member sales of assets. As with the test for additional debt, the transaction test will look to the debt service coverage ratio after the transaction is completed.

 

Weighing the Risk of Uncertainty

Many organizations still have a window of opportunity for relying on their 2019 (most recent pre-pandemic) audited financial statements if they have plans for future borrowing or other transactions that could be accelerated. Once the current year’s audit (reflecting COVID-19) becomes available, it may be difficult to comply with incurrence tests. Moreover, given the uncertainty many hospitals and health systems face as they respond to and recover from the impacts of the COVID-19 pandemic, forecasting revenues and expenses for the next two fiscal years may pose unique challenges. They should weigh the costs and benefits of acting now against the risk of uncertainty in the near future.

Organizations should also note that the language in their MTI may differ. They should consult with counsel on the specific terms of their MTI.

 

For more information, please contact Robert Turner by email or phone at (214) 498-1292.

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Robert-Turner

Robert Turner

Managing Director
Robert Turner is a leader in the Treasury and Capital Markets practice. He consults with healthcare clients nationwide, focusing on issues related to capital structure strategy, and the analysis and implementation of debt transactions.
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