Downgrades and the Rating Sword of Damocles

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The number of not-for-profit hospital rating downgrades has escalated in 2023. By Labor Day, year-to-date downgrades had already exceeded the number of downgrades for all of 2022 for two of the three rating agencies. Before long, the third rating agency will reach this grim milestone. We can easily predict that by year end, the ratio of downgrades to upgrades will start with at least a “2” for each rating agency.

Key downgrade drivers include lower financial performance that rating committees viewed as the hospital’s new operating level and weaker debt service coverage as a result. For others, the downgrades reflect lower days cash on hand given the rise in daily operating expenses. Some of the downgrades follow covenant violations (or near misses) that reflect a fundamental, permanent shift in operating performance rather than a non-recurring or bespoke issue.

There is some good news when it comes to ratings: rating affirmations remain the predominant rating action in 2023 by all three rating agencies, as they have been in every year. There have also been a few rating upgrades in 2023 despite industry headwinds. Moody’s, Fitch, and S&P continue to remind us on our quarterly rating agency webinars that they will not downgrade all ratings in one massive action, despite the industry challenges. Rather, ratings continue to be evaluated on a case-by-case basis. The sheer number of rating affirmations evidence that.

The rating agencies took a wait-and-see approach during the pandemic given the swift and substantial CARES Act funds and Medicare payment advances. Rating changes were at a low point during 2021. While most ratings were affirmed, several hospitals saw their ratings outlooks revised to negative from stable. Rating outlooks provide investors with an indication of near-term rating action, usually over a one-to-two-year horizon.

Fast forward one to two years later and the rating committee is now charged with resolving the hospital’s negative outlook. (It is highly unusual to maintain a positive or negative outlook for an extended period of time unless there are new factors to consider.) In its deliberation, the rating committee will review if the hospital triggered any of the downgrade factors discussed in the last report. It is not a checklist-driven decision, however. The rating committee will want to know what the plan is to get back on stable financial footing and incorporate the likelihood of the improvement in its decision.

That said, the pace of downgrades thus far in 2023 suggests that benefit of the doubt is running out. Given the industry’s challenges, all hospitals—irrespective of the rating outlook—need to go the extra mile when preparing material for their rating agency meetings. The presentation should be well-organized, informative, and get to the matter at hand quickly. If there is an elephant in the room, address it upfront. Dedicate real estate in the presentation to address every downgrade factor outlined in the prior report and how each one is being managed.

Here are three specific scenarios for a team to address:

  1. If you missed budget, acknowledge it. For example, if you set a budget of a 6.0% operating cash flow margin but came in at 5.7%, explain the miss and quantify the reasons.
  2. If you exceeded budget, explain it. Per the example above, if you set a budget of a 6.0% operating cash flow margin and came in at 6.3%, explain what the key factors were. Rating analysts will want to know if this higher level of performance is durable and if the quality of earnings support a higher level of performance going forward.
  3. If you improved over the prior year but missed budget, unpack it. Per the example above, if the organization achieved a 5.7% operating cash flow margin, which was an improvement over the prior year of 5.2%, but missed the 6.0% budget, the improving trend may not be good enough to hold on to the rating. Explain the improvement but also why the organization missed budget.

A management team should manage its rating as if it were under the “rating sword of Damocles.” Per the ancient parable, court jester Damocles took a cautionary approach to protect himself when entertaining the powerful, suspicious, and sensitive King Dionysius. As the story goes, a sword was hanging over Damocles’ head, suspended by a strand of horsehair. Ratings don’t hang by a thread but are grounded in quantifiable and qualitative factors, and it’s up to management to defend its organization’s creditworthiness at every turn. At some point, a rating committee needs to act when there is a non-stable outlook, particularly a negative outlook, and resolve the rating. In a time of elevated downgrade activity, the more thorough the discussion, the more confidence the ratings analyst can carry into the rating committee on your behalf.

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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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