The first quarter of 2022 will undoubtedly be one of the most financially challenging periods for not-for-profit hospitals. Escalating Omicron cases and skyrocketing contract labor will translate into very large losses. Data published in the Kaufman Hall National Flash Report showed operating losses continuing in the month of March, and when combined with losses in January and February, first quarter 2022 results will be devasting for many.
With most of the CARES Act funds already recognized, hospitals with June and September year ends will once again have a tougher road ahead with a limited number of months to absorb the losses. Even those health systems with December year ends are signaling concerns about 2022 results, despite a nine-month runway to improve results. While maintaining different motivations, HCA, the largest for-profit hospital operator in the U.S., recently revised its guidance based on first quarter results ending March 31, 2022, citing greater-than-budgeted contract labor, lower acuity from Omicron cases, and rising inflation. I anticipate that many not-for-profit providers will likely need to revisit their forecasts given these persistent and ubiquitous challenges.
All eyes will be on the rating agencies to see how they respond to the material downturn in performance. By their very definition, ratings are supposed to reflect a long-term view of credit and withstand interim periods of stress, effectively rating through a cycle. But what happens when one quarter shows staggering losses? Every rating has a tolerance for variable performance, but the depth of the first quarter losses will test that notion.
We don’t have to look too far back to see what happened to bond ratings during the last financial shock. Many health systems reported a sharp decline in performance shortly after the auction rate failures in February 2008 when interest rates soared. Management teams moved quickly to de-risk their debt structure, despite the expensive costs at the time to do so. The auction rate failure and ensuing liquidity crisis were largely seen as an aberrant disruption rather than a fundamental change in the industry. For the most part, this disruption did not drive rating changes. It was the Great Recession that followed which led to volume declines, rising bad debt, and weaker performance. Downgrades ensued as performance was permanently impaired.
Fast forward to 2020 and the onset of a health crisis not seen before. Hospitals and health systems with June 30 year ends had the benefit of nearly nine months of good performance and the recognition of substantial CARES Act funds by June, allowing most to absorb the impact of the shutdown and meet covenants. However, hospitals with September 30 and December 31 year ends had a tougher time given the rolling surges and decline in volumes.
Communication with your investors and ratings analyst is integral to building credibility and being well-prepared for those calls is important. Detailed information should be provided that identifies one-time expenses versus permanent increases; near-term and long-term demands on liquidity and cash flow and a thorough discussion of near-term performance will enhance that discussion. Showing how performance likely improved leading up to 2022 and turnaround strategies to get performance back on track will be important agenda items as well.
Along with understanding your financial turnaround plan, the rating agencies will want to understand how you will fare with your bond and bank covenants. The importance of proactively managing your covenants cannot be overstated.
There are many tactical strategies that need to be undertaken when managing covenants. The three steps below only scratch the surface.
Know your covenants. Actively managing your covenants begins with taking inventory of them and understanding how and when they are computed. Given the various forms of debt that many hospitals use (fixed, variable, commercial paper, private placements), hospitals must often manage a multitude of covenants required by bondholders, banks and private lenders. Covenants often include a debt service coverage minimum, days cash on hand, and debt to capitalization. Often these covenants may be set at different levels and measured annually, quarterly, or semi-annually. For example, MTI bondholders may require 1.10 times debt service measured annually, while banks may require 1.25 times coverage measured quarterly, on a rolling twelve-month basis. Prepare a slide or handout that reviews each covenant, how it’s computed, the drivers behind any potential violation, what the penalties are, and the status of discussions with your lenders.
Know your non-financial covenants. While not a financial covenant per se, rating triggers may be embedded in documents, such as bank and swap documents, and require attention. Management teams must understand the implications of the triggers, which may include an event of default or in the case of a swap, termination that results in payment to the counterparty. Similarly, documents may contain Material Adverse Change (MAC) clauses, which may be more opaque in definition and allow the bank or lender certain rights and remedies if violated.
Understand the definitions…they matter. What can be included in “net revenues available for debt service” may also differ by lender. Computations and definitions can be nuanced depending on the vintage and interpretation of the documents. Shortly after the CARES Act funding was received, at least three health systems learned they were unable to include the funds in their computation of debt service coverage for their fixed rate debt as the funds were viewed as non-recurring. Notwithstanding, each system was able to meet their covenants, although with narrower headroom. Whether one-time expenses related to contract labor will be included in debt service coverage may mean the difference between making or missing a covenant. Days cash on hand will need to be forecasted net of Medicare advance payments which CMS is now recouping.
When it comes to calculating coverage, days cash on hand or whatever the financial covenant is, it doesn’t matter how the rating agencies calculate it. It matters how the trustee calculates it. Engage bond counsel early to make sure you understand what’s in and what’s out.
As seen in the early days of the pandemic, hospitals managed their covenants well. That same oversight will likely be needed again given first quarter results and the absence of additional federal funding. A difficult quarter should warrant a call to the ratings agencies, even if you do not anticipate breaching a covenant. Transparency makes a difference in building credibility with the arbiters of all-things credit, and for that matter, future investors the next time you seek to borrow debt.