The staggering losses reported by many not-for-profit hospitals in the first quarter of 2022 showed deficits that the industry has rarely seen. A skittish patient population, an unrelenting workforce crisis, and a virus that just won’t quit have translated into unenviable financial results, with covenant measurement dates quickly approaching.
Credit analysis endeavors to rate through the changes in a business cycle. A rating should withstand financial aberrations. However, the magnitude of recent results and potential covenant violations will challenge that notion. Rating agencies will need to decide if a covenant violation, in and of itself, will cause a rating downgrade. To that end, they will look closely at the factors driving the violation and management’s proactive steps to manage lender relationships.
That said, if ratings were to move up and down with frequency, they would fail to provide a steady view of an organization’s creditworthiness to investors. Fluctuating ratings would also make comparisons to peers and normative data, such as medians, impossible. Just as hospital finance executives seek consistent financial performance, so do analysts when assigning ratings and comparing health systems. An “A is an A is an A” must hold true.
Clearly, we are heading into a period of credit stress. In fact, on its recent Spring webinar, Fitch Ratings said as much with a somber warning of downgrades ahead given the labor challenges and first quarter results. Unlike last year, the ability to lean on liquidity as a bulwark to volatile operations will quickly evaporate given cash burn, market depreciation, and the repayment of CMS advances in 2022.
It is important to note that hospital ratings have been upgraded during the pandemic, a seeming incongruity given that $175 billion in CARES Act funding was needed to stabilize a teetering industry. What does that tell us? Two things: 1) Credit doesn’t stop during a crisis, but actually becomes part of the credit story, and 2) upgraded hospitals demonstrated improving long-term financial performance that likely began prior to the pandemic and continued during the pandemic. The factors undergirding the improvement will support durable financial momentum and improving debt service coverage.
Many hospitals managed through their COVID surges with herculean skill, calling upon the entire workforce—clinical and non-clinical—to help. Many a hospital CFO put down their Excel spreadsheets and worked the command center to manage volumes and the phone lines to secure PPE and liquidity. How well the organization managed through COVID was a source of great pride, but managing through a crisis in and of itself does not warrant an upgrade. Managing through tough times is what great leadership is supposed to do, and many organizations did so, and continue to do so, brilliantly.
Rating agencies are often accused of being slow to upgrade but quick to downgrade. Given a highly competitive industry that remains sensitive to volume trends, maintains minimal negotiating power with payers, and only has two means of funding capital (cash flow or debt), that accusation has merit. Rating upgrades can be hard to come by and must be earned through durable improved performance. Downgrades may happen in short order if the erosion is pronounced and unmitigated. In many examples over the years, when hospital financial performance starts to unravel, it does so quickly. So too must a rating action.
Here’s the good news regarding ratings that is often overlooked: The vast majority of ratings are affirmed every year. Hundreds of them. An affirmation signals to the investor that financial performance is within a band of tolerance, even during times of turbulence. It subtly says keep doing what you are doing, it’s working, at least from a credit perspective. Upgrades will be fewer and far between as the industry will work through labor challenges over the years ahead. In my opinion, an affirmation is the new upgrade. Take it and keep moving forward.