Why weren’t we downgraded?

One of the questions that a hospital executive recently asked me at a conference was one that I had never received as a ratings analyst: “Why weren’t we downgraded?”

Usually, the question was just the opposite: “Why weren’t we upgraded?”

In this case, the hospital had reported below average financial performance following the pandemic with a sizable borrowing planned in the months ahead. The management team was prepared for a downgrade and had socialized the likely downgrade to the board. Despite the pressure on numerous metrics, a detailed study of medians and peers and a downgrade premonition by external advisors, the rating was affirmed. Management was baffled, having been ready to rip off the rating bandage and get on with the business of running a hospital.

The answer to “why weren’t we downgraded?” is multifaceted and will depend on each hospital’s circumstances. Here are the three factors that I suggested to the executive.

1. Rating tolerance allows for variance. Every rating has bandwidth and investors have communicated to the rating agencies that they don’t want to see ratings go up and down frequently: They prefer that the agencies use a “rate through the cycle” approach. For example, an A+ rating that is viewed as a “strong” A+ should have greater room for performance that is off budget or a new debt issuance. The A+ rating may go from “strong” to “weak” in rating committee but nonetheless remain an A+. Likewise, a rating that is weak within its category may push the envelope when performance is off budget or new debt is issued, or both, resulting in a downgrade. The best way for management to know where the rating stands is to simply ask the analyst: Are we viewed as a strong, middle or weak rating?
   
   Rating outlooks (negative, stable or positive) can also indicate where a rating is within its category. That said, ratings can be downgraded without a negative outlook if a new debt issuance is deemed too material for the rating category or an event occurs that will result in a new level of lower financial performance or decline in liquidity. The same can be said for upgrades, particularly when a higher-rated system guarantees the debt of a lower-rated hospital following a merger. In recent years, in fact, many of the rating upgrades have been due to mergers, rather than consistent financial improvement, given high inflation and other persistent industry challenges. A high reliance on variable supplemental funding can also make rating analysts wary of upgrading.
2. Understand the role of medians. In part, the expectation of the downgrade in my example above was due to the comparison of the system’s financial results to medians. It’s important to note that medians are the by-product of ratings; ratings are not a by-product of medians. Medians are also a year behind. For example, hospitals with a June or September fiscal year-end will already be concluding their next fiscal year when the medians are published. Medians are most helpful when the industry is experiencing stability, as the metrics do not change materially year after year and can be helpful to use as benchmarks or guardrails. When there is disruption in the industry, such as the pandemic, the medians can show wide swings year after year, which can lessen their role in determining a rating. As ratings move down the rating scale to a low BBB category or below investment grade, the standard deviation within a rating category may widen as the hospitals become less uniform and “credit stories” with unique circumstances may influence a rating decision. For example, a hospital that is experiencing a rapid decline in performance and liquidity may see the rating moved multiple notches to get it to the appropriate rating category. Likewise, financial improvement following a turnaround can happen quickly, so the rating may be adjusted upward once durability is established.
   
   Each metric is computed and analyzed for each borrower on its own merits. For example, cash to debt, an industry standard that measures leverage, will be computed using: 1) recent audited results, 2) unaudited interim performance, 3) next year’s budget, 4) pro forma (audit plus new debt) and 5) projections. Analysts may take the projections and discount them further to provide their own forward view of results. That’s six of different views of one ratio. Multiply that by about 20 key metrics and it’s a lot of trending data. Typically, ratings will not be determined based on just one metric but will be the holistic assessment of all metrics with an emphasis on the forward view.
3. Finally, messaging matters. Thorough presentations are invaluable to an analyst’s understanding of an organization and how management is addressing the key challenges. A well-crafted presentation expresses the seriousness by which the team is taking the rating, too. Take the time to read the last rating report and address the challenges outlined. Every slide should be crisp and supported by crisp data. Great slides will be shared in the rating committee and are the most effective way to get an organization’s message directly to the group making the rating decision.
   
   The CEO or senior executives attending the meeting should take the time to organize their key messages and express accountability when the hospital is not meeting its targets or plans outlined at the last rating meeting. “The buck stops with me” can be highly effective. Chronicling tough decisions and changes that were made to get the hospital back on track are what the analysts need to hear. When new debt is stretching leverage metrics, it is important to discuss how the debt will be absorbed. As a rating analyst and as an advisor, I have seen hundreds of occasions where the rating presentation and discussions contributed to an affirmation when the metrics suggested otherwise.

I have no doubt that the management team who was surprised by the rating affirmation stuck the landing on the presentation, and it made a difference. Upgrade, downgrade or affirmation, management’s clear articulation of a hospital’s strengths and challenges will help build credibility with rating analysts and investors over the longer term.