The financial shocks of COVID-19 are stronger than most healthcare organizations have ever experienced.
In early March, all three major rating agencies revised their outlooks for not-for-profit hospitals to negative. In April, we found that hospitals’ outpatient revenue fell 49%, inpatient revenue dropped 25%, and operating EBITDA margins fell 174%. As for the future, the pace and degree of volume return are unknown, leaving hospitals struggling to chart a clear path to financial recovery.
These shocks are evident in the disruption hospitals are seeing in their balance sheets, starting with the initial scramble for liquidity and progressing to serious questions about debt and capital structure.
The next possible result of COVID-19’s financial hit is violation of debt covenants. Avoiding this destabilizing possibility is a top priority for America’s hospitals. And for organizations that are facing violations, immediate and tailored action is necessary, not only to mitigate violations, but in some cases to avoid even more dire consequences.
In the time of COVID, most hospitals are carefully cataloguing each financial covenant, including what and where each covenant resides, and when and how each is tested. For healthcare providers that may experience covenant violations, the ability to develop and implement a recovery plan is essential.
For some organizations, a baseline situation analysis, or a deeper dive, will show that the hospital will meet its Master Trust Indenture (MTI) and bank covenants or that any possible violation is fairly easily resolved. Organizations facing potential covenant violations should immediately begin to develop an expense recovery/revenue enhancement plan so that when they enter discussions with external parties, the plan is already well underway and demonstrating results achieved and cash flow implications for the organization.
Hospitals facing covenant violations fall into a range of situations requiring different degrees of intensity in their resolution.
For hospitals with sound levels of debt and capital structure, the mitigation strategy for violations could be fairly straightforward if addressed promptly. However, for hospitals that are over-leveraged, in need of debt relief, or facing even more difficult financial challenges, a broader and more vigorous solution is necessary.
Three Directions of Attack
For many hospitals, covenant violations are a symptom rather than a cause of existing challenges that are being exacerbated by COVID-19. Treating the symptoms as well as the underlying causes requires a three-direction attack.
Hospitals facing covenant violations will need to assess options that might include consultant call-in, revenue strategies, expense controls, harvesting investment gains, negotiations, or debt restructuring. In any case, communicating with stakeholders, including board members, rating analysts, bondholders, and banking partners, should be timely and should address the exact nature of the violation and specific remedial plans. It is essential to begin this work immediately, given that identification and implementation of margin improvements is necessary before being able to realize those improvements on the income statement.
Reworking cost structure and enhancing revenue performance are foundational parts of a holistic solution for most organizations facing balance sheet challenges and covenant violations. In many cases, debt-holders will require a plan for performance improvement as part of any agreement to hold covenant violations in abeyance. The more detailed these plans are, the greater the ability to demonstrate the positive effect on the organization’s financial plan.
Performance improvement can focus on the following key areas:
- Workforce: Productivity, overtime, and structures and processes that support the current labor complement
- Non-labor expenses: Medical and surgical supplies, pharmaceuticals, purchased services, and other expenses associated with delivery of care across the organization
- Revenue cycle: Short- and intermediate term opportunities to improve margin
- Physician enterprise: Opportunities to improve practice management, patient access and scheduling, provider productivity and compensation, and non-provider staffing
- Clinical redesign: Opportunities to drive clinical transformation and reduce clinical variation
- Service distribution: Review of all clinical programs/services to ensure an effective and efficient delivery model that meets the needs of the communities an organization services
- Operating model: Systemic evaluation to streamline corporate overhead functions and the reporting structure to enhance decision making in the future
When organizations are facing the type of significant financial challenges that COVID-19 has created, it is important to consider the continued relevance of existing strategies, and to consider how a range of strategic options may influence the organization’s ability to best serve its community moving forward.
For some organizations, that means determining what changes in strategy would be required to maintain independence. Organizations will need to honestly assess what gaps in operational or strategic capabilities exist, and whether the organization can address those on its own. Alternatively, executives will need to consider whether a partner would help fill these gaps more quickly and effectively.
If the organization considers a partnership, it needs to understand the potential formats and structures, many of which may not require a change of control. Decisions regarding what type of partnership relationship to pursue need to be guided by the gap analysis. As the number of gaps and the depth of those gaps grow, the need for more fully integrated arrangements increases.
The Risk of Waiting
When faced with a rapidly emerging and unpredictable situation, a natural instinct is to wait for the chaos to subside before taking action. However, waiting can lead to financial problems getting quickly out of control as revenues continue to track behind budget and as options to remedy the situation diminish. Far better is to get out in front of the situation while the organization still has a maximum number of options.
The financial upheaval that COVID-19 has brought requires that hospitals take immediate action, even while the pandemic and its effects are still playing out. Immediate action means better preparation for an unpredictable near-term future, and it means the greatest possible flexibility in dealing with whatever challenges lie ahead.
COVID-19 has placed unprecedented pressure on hospital leaders. The leaders that most effectively guide their organizations through this time will be those who can simultaneously manage those immediate pressures and put in place the best steps toward future success.