Our outlook for last year was right in one important respect: “There are few signs,” we wrote, “that volatility will continue to abate as 2020 begins.” On the horizon were renewed tensions in the Middle East, still-simmering trade tensions with China, and an upcoming and potentially divisive presidential election. Unknown at the time, of course, was the arrival of a pandemic that would make 2020 one of the strangest and most disruptive years in U.S. history.
Healthcare organizations have been at the pandemic’s epicenter. They have faced waves of COVID-19 patients, shutdowns of non-emergency services, and tremendous stress on their staff and resources. They have also established, once again, how essential they are to the communities they serve.
On the finance side, most healthcare organizations were able to survive the liquidity crunch of the pandemic’s early days, helped by the Federal Reserve’s efforts to unlock liquidity and CARES Act funding. As the year progressed, hospitals and health systems were able to take advantage of low interest rates to take on new debt or restructure and de-risk existing debt. In the short term, this has had a positive effect on credit, with fewer downgrades in 2020 than were initially anticipated.
Looking forward, the outlook is uncertain. The pandemic has reached new peaks, and mutations in the coronavirus are introducing potentially more infectious strains. Development of effective vaccines has been a true success story; the pace at which they can be administered—and the percentage of the population willing to be vaccinated—remain unknown. The elections resulted in a new presidential administration, but also very narrow Democratic majorities in Congress, which may impede passage of any major legislative efforts.
There is hope of change over the course of 2021, but for a good part of the year, the lessons learned in 2020 will still apply. In this year’s outlook, we start by looking back at those lessons. We then highlight some of the questions hospital and health system leaders will face and how a focus on resiliency can help them get through the many unknowns that lie ahead.
2020: Lessons from a COVID world
As we worked with clients on market access and credit and rating management in 2020, we learned several key lessons that we believe will remain important in 2021. These include the following:
- Credit discussions and debt capacity analytics have changed. Given profound dislocations in operating performance, comparisons against trailing credit metrics such as median ratios or rating scorecards are only marginally helpful. Debt capacity is more nuanced than ever before, and most rating conversations have become focused on where an organization is within a challenged-to-thriving matrix. Balance sheet is proving to be the credit foundation while operating performance is proving to be much less dependable. This means that organizations with a strong balance sheet have a material advantage, and operating variability becomes the tipping point for organizations with less robust balance sheets.
- Capital structure decisions are more about risk tolerance than available returns on risk. Interest rates have fallen to historic lows and yield curves are relatively flat. Expectations for significantly higher rates remain muted while the Fed remains accommodative. Organizations with a strong credit rating are asking several questions. First, does the organization want to take capital structure risk (i.e., use of put bonds or floating rate notes)? Second, does the organization have the capacity to take capital structure risk? And finally, are you paid well to take these risks in the current market?
- Foundational documents and their embedded covenants need to be reviewed at every point of debt issuance. Every Master Trust Indenture (MTI)—regardless of its vintage—should be reviewed to assess whether to pursue adjustments to the definitions that drive debt service coverage. Key considerations range from how revenue dislocations from COVID-19 affect income available for debt service coverage to how debt service is calculated on non-amortizing taxable bonds. Any MTI updates should be identified so that the potentially long “springing” process can be incorporated into the MTI and begin today.
- Financing teams are dislocated, and borrower teams are stretched. Financing team members are working remotely and likely will continue to do so at least into the summer. It has been amazing to see organizations respond and figure out how to process transactions, but it is still a different process that carries some execution risks. The burden is especially high on borrowers who need to draft Appendix A and assemble the due diligence information while combatting a global pandemic. Consequently, taxable transactions have growing appeal because of the relative speed and ease of execution.
- Investor engagement has changed. Every conversation with investors today comes back to their desire for more and better disclosure, both at the point of debt issuance and on an ongoing basis. A baseline consideration is ensuring that enough high-level disclosure is provided to allow discussion of current recovery trends with investors.
- Market timing and transaction pricing dynamics have become more complex and volatile. The onset of the COVID-19 pandemic represented a significant point of market volatility, with both tax-exempt benchmark rates (MMD) and credit spreads widening quickly and significantly. All pricing components have since improved and transactions are getting done at favorable rates, but volatility may reemerge if the course of the pandemic worsens or political disruption intensifies.
2021: Questions for Healthcare Organizations
The most significant questions for healthcare organizations revolve around the pace of recovery from the pandemic in 2021, and include the following:
- How quickly will the economy recover? The economic impacts of the pandemic were mixed in 2020. Revenues plummeted and unemployment rose sharply in sectors of the economy that faced shutdowns, capacity restrictions, or reduced demand. At the same time, the stock market reached historic highs and individual savings grew significantly. As 2020 drew to a close, there were signs that longer-term negative impacts were emerging, as consumer spending fell for three consecutive months and recovery of the jobs market stalled, caused in part by a resurgence of the coronavirus in many areas of the country.
The pace of economic recovery will affect the operating strength of healthcare organizations in several ways. First, healthcare is among the industries that have been subject to suppressed demand for services. While this has been offset by the need to care for COVID-19 patients, especially in acute care, return of demand for non-emergency and elective services as the pandemic recedes will be driven in part by the health of the economy. Second, high unemployment rates over the long term will affect payer mix, with growth in the number of Medicaid beneficiaries and uninsured patients and a lower percentage of commercially insured patients. Proposed changes to eligibility for premium subsidies and further expansion of Medicaid under the Affordable Care Act may help reduce the number of uninsured patients but will depend on the new Biden’s administration ability to pass legislation through a divided Congress.
- Will the pandemic result in permanent shifts in demand for services? Apart from economic pressures on demand, healthcare organizations face the question of whether the pandemic has caused long-term shifts in how consumers will want to access services, especially lower-acuity services. Emergency room utilization remained depressed throughout 2020, for example, even as volumes returned for other services. Telehealth utilization remains well above pre-pandemic levels and may represent a significant shift in how consumers access primary care and lower-acuity services. This may have significant implications for real estate strategy and portfolio positioning.
- How long will a low-rate environment continue? The incoming Biden administration is counting on continuation of today’s historically low interest-rate environment to justify the costs of another round of COVID relief and stimulus spending, which would add almost $2 trillion to the national debt. Over the past twenty years, the national debt has grown from $5.8 trillion—approximately 55% of GDP in 2001—to just below $28 trillion, an amount that now exceeds the country’s total annual economic output. How large the debt can grow, and how long low interest rates will persist, are unknowns. Certain inflationary pressures may emerge if the economy rebounds quickly after the pandemic is brought under control, but again, the long-term impact is unknown.
How to Respond: A Focus on Coordinated and Sustainable Resiliency
COVID-19 has been an all-out assault on the U.S. healthcare operating model. As noted above, median ratios and other relative performance metrics can be less reliable in periods of dislocation. We believe the idea of structural resiliency that situates an organization within the challenged-to-thriving matrix offers a more helpful and more durable indicator or benchmark of institution-specific viability and credit position. In the coming year, hospital and health system leaders should focus on the drivers of resiliency—balance sheet, operations, and strategy—and on adopting a coordinated resource allocation mindset to ensure that all resources available to the organization are fully and optimally allocated in support of resiliency.
With respect to resiliency drivers, balance sheet is the resiliency anchor, and operations and strategy are the variables. The central question is whether the balance sheet is strong enough to absorb the three stages of crisis: the initial systemic shock experienced in the early weeks of the pandemic, followed by the transition to stabilization begun in 2020 and the grind back to normalization that we anticipate will occur over 2021 (with the strain of this last transition being largely dependent on how much “normal” differs from the pre-pandemic business model). Embedded in this dynamic is the importance of continuous performance improvement—the optimization of both revenues and expenses. The more “stability” that can be embedded into the operating chassis, the lower the load that is placed on the balance sheet; and the lower the load on the balance sheet, the greater the opportunity to secure a better spot on the challenged-to-thriving matrix. Coordination amongst these disciplines is more important than ever before.
Everything about this moment calls for a coordinated and sustainable resource allocation mindset, which means dynamically integrating the management of operations, strategy, capital spending, financing, and investments. Hospitals and health systems are incredibly complex, which makes them vulnerable to component or siloed management by vertical expertise. Because COVID-19 is attacking the business model on all sides, it requires a horizontal response that gathers every available resource together and then deploys them as part of one intentional, consolidated, and coordinated response. The opportunities for success and the stakes of failure vary, but the need for this response is the same regardless of where your organization sits on the challenged-to-thriving matrix.
We have espoused this coordinated approach to resource allocation for some time. To that, we want to add a new dimension, which stresses both establishing a coordinated resource allocation framework and now also monitoring it on an ongoing basis. The need for monitoring actual results versus pre-established guardrails for risk and resource levels is now more important than ever as business conditions shift daily. Such an effort will aid providers in knowing whether their organization remains “in bounds” relative to key initiatives and material exposures to potential volatility and therefore risk. Significant progress has been made in developing real-time tools such as rolling forecasting, liquidity tracking tools, and other technologies to aid with this effort. Much more will be written about this in the coming months as this effort to monitor and sustain resilience becomes tantamount to survival/success.
Finally, we offer a note of thanks to all our clients and colleagues for making Kaufman Hall the no. 1 financial advisor to not-for-profit hospitals again in 2020. We are grateful to work together with you on some of the most critical issues of our time.