Rating Agency Update: Operational Challenges, Covenants, and ESG

3 minute
HLC 2022

This year’s Therese L. Wareham Rating Agency Panel at the 2022 Kaufman Hall Healthcare Leadership Conference featured panelists Eva Bogaty, Associate Managing Director, Moody’s Investors Service; Suzie Desai, Senior Director, S&P Global Ratings; and Kevin Holloran, Senior Director, Fitch Ratings. A summary of our discussion with them follows.

Operational and financial performance challenges

The operational and financial challenges that hospitals and health systems have confronted throughout 2022 were top of mind for the panelists and conference attendees alike. The panelists agreed that, despite these challenges, there would be no systematic downgrade of their portfolios. All hospitals and health systems are facing the same problem at the same time, and some are doing better than others; a systematic downgrade would not be an appropriate response. The agencies will continue to determine rating actions on a credit-by-credit basis. That said, the panelists anticipate that downgrades will outpace upgrades over the next few years, given the difficult environment.

When considering individual credits, several factors help determine whether the rating action is an affirmation or a downgrade:

  • The health of the organization’s balance sheet, which has been a critical buffer against operational losses
  • The size of the operational loss relative to the size of the organization
  • The speed at which the organization can turn around and get on the road to recovery
  • Where the organization is positioned within its rating category; organizations that were near the line to begin with are more likely to be downgraded to a lower category

The panelists noted that there have been several multi-notch downgrades in recent months; these have been concentrated among lower rating categories (i.e., Baa2/BBB/BBB or below) and have involved organizations facing multiple issues.

One of the greatest headwinds has been labor expense, driven by both inflationary pressures on wages and staffing shortages that have required greater reliance on more expensive contract labor. The panelists saw some positive emerging trends: agency usage and rates are still higher than they were before the pandemic, but they have come down from their highest levels. Retention issues also may have turned a corner, with more people joining healthcare organizations than leaving them. Wages have likely reset at a higher level, however, and organizations will have to manage to this new level of labor expense and tighter margins.

With respect to debt and capital spending, the panelists have seen some movement away from expensive inpatient beds toward ambulatory and virtual care, but not a significant slowdown in capital spending, especially in markets where a health system has a strong presence. Some organizations, especially larger systems, are thinking about issuing debt to ensure that they can stay on course with strategic initiatives and have access to funds that enable them to act as opportunities arise.

The panelists do not see any additional government support in the near future. Some organizations are working to secure FEMA funding, but they are not putting it in their budget, which the panelists saw as a best practice given uncertainties around the timing and availability of FEMA funds.

The impact of covenant breaches

The panelists agreed that a covenant breach would not trigger an automatic downgrade. The remedies available to creditors are more important than the covenants, some of which are less consequential than others, and many creditors have been willing to grant waivers. The potential for acceleration is obviously an issue, especially where the debt is significant and the issuer has very little cushion on its balance sheet.

The panelists noted that they are familiar with bond debt, but organizations may have other covenants in instruments such as lines of credit which could create the potential for cross-defaults. Organizations should be sure that they have a clear view across all their debt instruments and associated covenants.

If an organization thinks a breach is imminent, communication is critical. Do not assume that the rating analyst will see a post on EMMA; reach out to them and let them know. Also, if an analyst calls for more information, be sure to return the call.

The evolution of ESG frameworks

The rating agencies have developed frameworks to assess issues related to environmental, social, and governance (ESG) concerns in response to investor demand. More investors are including ESG as a factor in their investment decisions—especially (but not limited to) European investors—and the ESG frameworks are intended to make that information easier for investors to access.

The panelists agreed that ESG frameworks are not adding new criteria for rating decisions; they are intended simply to bring ESG-related information that has already been part of the rating decision to the forefront. These frameworks are the product of conversations between the agencies, investors, and rated credits, and will continue to evolve.

The rating agencies are not looking for significant, formal presentations on ESG issues. If, however, an organization faces a significant ESG-related risk (e.g., is in a hurricane zone), the agencies would like to hear how the organization is mitigating that risk.

Considerations for rating presentations

The session concluded with a discussion of what to emphasize in rating presentations, given current challenges and uncertainties.

With respect to operations and labor, the panelists noted that their ratings reflect a 12- to 18-month outlook. Within that timeframe, what does the organization expect with respect to key labor trends in areas such as anticipated vacancies, turnover rates, etc.? The rating agencies understand that there is not always great clarity in today’s environment, but where an organization does have visibility on its operating outlook, the agencies would like to hear it. They also would appreciate some degree of granularity around the big drivers of operational performance. How are these drivers being addressed or mitigated? How is actual performance holding up against expected performance?

If a turnaround or performance improvement plan is in place, any detail on what is known and what is unknown in terms of expected outcomes should be provided. The agencies would also like to hear what the organization believes is its worst-case scenario, and what factors would create that scenario. Organizations should not be afraid that their projections will be wrong; the rating will ultimately depend on where the organization ends up, not on whether a projection proved correct.

Organizations should not lose sight of their longer-term strategic initiatives. The agencies are interested in hearing how these initiatives are being prioritized, and how much cash flow will be required to move prioritized initiatives forward or get them back on track. While the focus of the rating is on the nearer term, the agencies are interested in hearing where you think your organization will be in the next five or 10 years. In other words, how are you solving today’s problems, but also, how are you planning to solve tomorrow’s problems?

A thank you to our panelists

We are grateful for the time our panelists contribute to make the Therese L. Wareham Rating Agency Panel a highlight of our Healthcare Leadership Conference, and we look forward to continuing our conversation with them over the months and years to come.

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