COVID-19 is creating material and ongoing financial dislocations that will significantly reduce operating cash flow for some period of time. The early results make it clear that these disruptions pose a risk to compliance with ongoing financial covenants contained in various debt documents, especially cash-flow-based tests. Based on our internal analysis, a number of hospitals may face covenant challenges in the coming months. Federal programs could have a material positive effect on covenant compliance, depending on the magnitude of the revenue and expense gap, the funding payments received, and how such payments are booked. In any event, hospitals should review their debt covenants within the context of their expected financial performance and position.
Immediate Action Items
These are the four steps clients need to take proactively to address near-term covenant-related concerns:
- Understand your covenants
- Develop and maintain ongoing financial projections
- Understand your options and develop a plan
- Develop communication outreach
Step One: Understand Your Covenants
Refresh your understanding of your debt documents and consult with counsel as appropriate. Because every situation is unique, definitions are critical. Key components include “the what, where, when, and how.”
What are they? For most organizations, principal financial covenants consist of some variation of Debt Service Coverage and Days Cash on Hand, and to a lesser degree Cash to Debt and Debt to Capitalization. Given the impacts COVID-19 has on projected operating cash flow and unrestricted investments, the covenants most at risk over the near-term are Debt Service Coverage (where a borrower commits to a certain ratio, typically 1.0x or 1.1x, of Income Available for Debt Service relative to Debt Service Requirements) and liquidity (where a borrower commits to a certain amount of Days Cash on Hand or Cash-to-Debt). Failure to pass these tests on an ongoing basis ultimately creates a technical default under the relevant documents. Technical default is different from payment default, but it nevertheless requires compliance. As discussed below, default of covenants given to publicly-offered bonds are more difficult to remedy than those covenants given to direct lenders.
Where are they? Hospitals typically have a Master Trust Indenture (MTI) which provides for a common covenant and security package made available to all debt issued in accordance with the MTI. Covenants in the MTI are generally more permissive but harder to modify because modifications require the consent of 50% (or sometimes more) of current noteholders under the MTI. Each debt instrument secured under the MTI may also have covenants specific to that instrument. Therefore, covenants can manifest themselves in public documents, bank private placements (usually in the loan document or a continuing covenant agreement), or other lending arrangements (e.g., lines of credit or capital leases). Many organizations have all these types of debt instruments.
Even if the covenant is confined to a single bank document agreement, if other lenders have most-favored nation clauses, they will get the benefit of those covenants as well and may become part of any resolution to a covenant violation. Additionally, most MTIs and bank agreements are structured with cross-default provisions, meaning that a default event on any one of these obligations will trigger defaults on other debts across the organization. Typically, publicly offered bonds are widely owned, and provide just the MTI covenants to the investors. As such, seeking waivers or amendments from public bondholders is problematic given the number and nature of those holders. Covenants provided to banks or other lenders are easier to remedy, given that the borrower knows who to call at that institution.
When are they tested? Testing frequency varies by legal document and creditor. Most public covenants are tested on an annual basis and generally at fiscal year end. Private placement covenant testing varies widely but generally has more frequent testing intervals. An organization’s entire debt structure can be at risk at any time that any one component of the structure is tested, given cross-defaults and most-favored-nation provisions. Organizations with June 30 fiscal year ends should be looking at this immediately.
How are they tested? Specific language guides the detailed calculation of any covenant. Some debt documents provide borrowers with flexibility to exclude “extraordinary items,” “unrealized gains and losses on investments,” “governmental restrictions,” or “gains or losses from discontinued operations not in the ordinary course of business” from their calculation of “Income Available for Debt Service.” Does force majeure language apply, and under what circumstances? If an organization has such flexibility and receives appropriate accounting guidance as to the treatment of some COVID-19 events, it may be able to exclude certain items incurred (improving overall financial performance) or add back any unrealized losses on investments. Given the magnitude of potential COVID-19-related losses, these provisions are worth considering and pursuing when calculating your organization’s financial covenants. Federal assistance is rolling out and will have an impact, but the accounting treatment will vary by program, and how federal support is booked may affect covenant compliance. Some calculations can be provided by an officer’s certificate, and others require certification by your auditor and must reflect GAAP. Consult with your auditor as needed.
Step Two: Develop and Maintain Ongoing Financial Projections
Immediate and ongoing scenario planning is required for a multitude of purposes: to assess near-term operating and liquidity impacts of COVID-19, as a communication tool for key constituencies, and as a platform to inform strategic and tactical decisions, among many others. Rigorous scenario planning will also inform organizational perspectives on meeting or falling short of financial covenants in advance of testing dates.
Develop and maintain financial modeling capabilities that monitor covenant surveillance relative to the legal and financial analysis. Ongoing financial modeling is required to understand headroom versus covenants based on today’s actual and tomorrow’s projected performance. This exercise serves as a barometer to assess actual performance results as they occur and as the impacts of COVID-19 continue to shift. Ongoing scenario analysis will be required based on several variables: duration of pandemic, severity of surge, and post-surge strategies and tactics. Understand that it will be necessary to solve and resolve as conditions evolve.
Step Three: Understand Your Options and Develop a Plan
If potential covenant challenges arise, develop an action plan. Options for relief from covenant violations vary and can have significant ramifications. Options may include consultant call-in, revenue strategies and expense controls, harvesting investment gains, focused forbearance/waiver negotiations, or a need to restructure debt. Each option will bear a risk, cost, and likelihood of achievement. Some options are outlined clearly in documents; other options require more dialogue, interpretation, and implementation effort. Work with your team of advisors to develop and implement an action plan. Understand that the quality of your analysis will become the support for your conclusions and the justification for your action plan.
Step Four: Develop Communication Outreach
Once you get your arms around the potential for technical covenant default, you may need to manage a wide variety of stakeholder communications. Those stakeholders include board members, rating analysts, bondholders, and banking partners, among other parties. The level of dialogue will vary depending on the audience, ranging from board education to rating notification to requests for waivers and discussion of go-forward action plans (e.g., investors and banks). Communications need to be properly timed and have an appropriate level of detail. Premature or excessive communication to any one party might mean losing control of messaging and release of “non-public” information, a lack of clarity in ask/messaging, or inaccuracy of expectations. Delays in messaging could mean limited resolution options.
If Kaufman Hall can be of assistance as your organization evaluates covenant concerns, contact Robert Turner through email or at (214) 295-3200 to discuss, Matt Robbins through email or at (224) 724-3262, or Gavin McDermott through email or at (224) 724-3167.