Rating Agency Update: Covenants, Consolidation, and Capital Spending

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Kaufman Hall hosted its 2023 Summer Rating Agency Update on July 12, featuring Eva Bogaty, Associate Managing Director at Moody’s Investors Service, Suzie Desai, Senior Director at S&P Global Ratings, and Kevin Holloran, Senior Director at Fitch Ratings. Major themes included the impact of covenant violations, rating agency perspectives on industry consolidation, and the implications of a slowdown in capital spending and investment in strategic initiatives. A summary of the conversation follows.

2023 will be a make-or-break year

Downgrades have surpassed upgrades at all three rating agencies through the first half of 2023, although affirmations remain the most common action. At Moody’s, for example, out of more than 80 reviews through the first half of the year, there have been 56 affirmations versus 25 downgrades and three upgrades. Similarly, S&P Global Ratings has maintained 136 ratings, downgraded 23, and upgraded eight. Fitch currently has a three-to-one ratio of downgrades to upgrades, but the percentage of organizations on negative outlook has gone from 6% in 2022 to 3% in 2023 as negative outlooks from the prior year have been resolved. All three panelists anticipate that the pace of downgrades will level off, although many organizations are not yet out of the woods.

In the near term, the rating agencies describe 2023 as a “make or break” year for rated organizations. The period of rapid deterioration in financial performance is likely behind us but the pace of recovery has been slower than expected. Organizations that are seeing continued operational losses in 2023, a slower pace of recovery, and a weakened balance are most at risk of a downgrade. Organizations that can demonstrate a clear pathway forward and have maintained balance sheet strength will be in a better position. There is no intention to move the portfolio down a notch; ratings are based on each rating agency’s respective criteria, along with how an organization is performing in comparison with its rating category peers.

That said, it will likely be harder to secure an upgrade in the current environment. Rating committees are taking a tougher stance, requesting more information and taking longer to reach their decisions. The goal posts have not moved, but many organizations are now farther away and it may take longer to reach them.

Clarity on covenants

Breach of a covenant will not result in an automatic downgrade, but it will be a factor in rating decisions, particularly where the issue is compounded by market conditions (e.g., an over-bedded community), liquidity issues, or other factors that may make it difficult for the organization to come back into compliance with its covenants. Often, a covenant breach represents a “canary in the coal mine”: a sign that there are deeper issues that the organization must resolve. The rating agencies will be very interested in understanding what progress the organization is making with banks and investors on waivers and amendments, seeing the consultant call-in report, and receiving regular updates (e.g., quarterly) on how well the organization is keeping pace with performance improvement objectives.

All three panelists encouraged organizations to provide as much clarity on their covenants as possible (a sample covenant catalog prepared by Kaufman Hall, referenced in the webinar, is available here). Key issues include a description of how various bond and debt documents relate (e.g., where possible cross-defaults exist), what constitutes a covenant violation, and what remedies are available to lenders and investors.

The rating agencies are fielding more phone calls from investors, especially when quarterlies are published, and receive many questions related to covenant violations and remediation efforts. The most common question they are asked is, “How patient are you going to be?”

Consolidation’s impact on credit

The panelists noted the trend toward cross-regional mergers, which are becoming more common as federal and state legislative and regulatory restrictions make mergers within existing markets more difficult. Cross-regional mergers are a relatively new phenomenon, and the rating agencies are watching to see whether expressed goals of the mergers are achieved. There is a growing emphasis on strategic goals—improving quality, building value-based care capabilities, addressing health equity concerns—beyond more traditional cost-saving goals.

The agencies have similar approaches to incorporating merger announcements into rating decisions, especially early in the process. Generally, no action will be taken when a letter of intent or memorandum of understanding is announced; at this stage, many announced transactions will not successfully close. When the transaction moves to the definitive agreement stage, the agencies’ approaches diverge slightly. S&P Global has group rating methodology criteria that it applies when systems merge. If there are separate obligated groups, S&P looks at how each entity relates to the merged system’s overall strategic goals. Moody’s and Fitch tend to “follow the documents” when a merger occurs, keeping obligated groups separate unless they become commingled to the extent that the rating must be harmonized. A bellwether for such commingling is a decision to issue debt together. Moody’s also will account for the credit impact of a larger organization’s support of a smaller organization when large and small obligors combine.

The rating agencies continue to see clear benefits to size and scale. That said, from a rating agency perspective, no organization is “too big to fail.” Regardless of size, no organization is immune from a credit downgrade.

Spending on capital projects and strategic initiatives

The panelists are seeing a mixed approach to capital spending and borrowing. Some organizations are moving ahead and issuing debt, while others are holding back. Projects can affect ratings—and the agencies will be interested in knowing where the organization may have off ramps or flexibility if conditions deteriorate—but there are also risks in a spending slowdown. Depending on such factors as market competition or existing age of plant, a spending slowdown can put an organization at risk of falling further behind and losing competitive advantage or market share, which could lead to a negative outlook or downgrade.

Ultimately, the panelists agreed, organizations need to pursue strategic projects when they need to pursue them; the desire to maintain a rating should not stand in the way. If the project results in a downgrade, it does not mean that the project was a bad idea; instead, the project might simply put the organization in a different risk profile. Above all, organizations need to remain effective in their markets.

Concluding thoughts

Labor issues have improved, with external contract labor costs and per unit costs for specialty RNs coming down to more manageable levels, but difficulties persist. Organizations are doing everything they can to recruit and retain talent, both widening the funnel to look at individuals they may not have considered in the past and shortening the funnel to move recruits through the human resources process more efficiently.

With respect to medians, the rating agencies do not expect full-year medians to improve over preliminary medians. Moody’s, for example, is currently seeing 5.6% median operating cash flow and 210 days cash on hand in its preliminaries and believes there may have been further erosion. A persistent 15% to 16% of the Moody’s portfolio has less than 1% operating cash flow.

Finally, in presentations, the rating agencies are encouraging a return to including a discussion on strategy, even if financial performance will continue to occupy a significant part of the update. We are, happily, moving beyond COVID. What is your strategy moving forward and what is your plan to achieve your goals?

Our three rating agency panelists will reconvene for the Therese L. Wareham Rating Agency Panel at Kaufman Hall’s Healthcare Leadership Conference, October 19 and 20 at the Four Seasons Hotel Chicago. Registration information is available on the Kaufman Hall website at

Example of Covenant Catalog
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Lisa Goldstein is a nationally recognized analyst, speaker, writer, and expert on not-for-profit healthcare. At Kaufman Hall, she is a member of the Treasury and Capital Markets practice and Thought Leadership team.
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