Last month I was on a very bumpy flight from Chicago to New York. So bumpy that I swore we were going to vaporize right there and then.
Thankfully, the pilot navigated the bad weather and we landed safely, but I could not get that flight out of my head. I described it to my son, who patiently explained that the plane was not shaking, the air was. “Mom, imagine the plane immersed in a bowl of jello. The plane isn’t shaking; the bowl of jello is.”
While that fact may be helpful to know, when you are going through turbulence, it is disturbing, no matter the cause. In recent months, hospitals of all sizes and ratings are reporting tremendous financial turbulence, primarily due to externalities such as the nursing shortage and the need for expensive contract labor. Length of stay is up due the scarcity of staff at post-acute care facilities and the inability to discharge a patient. The ability to “make it up on volume” no longer holds true, as volume remains unpredictable. Add in bond and equity market turbulence, and for many, the bottom line has vaporized.
When it comes to evaluating credit, the causal factors for a financial downturn are important but may not preclude a rating downgrade. At Kaufman Hall’s Healthcare Leadership Conference in October, we discussed rating tolerance during turbulent financial times with the rating agencies. Typically, rating agencies endeavor to “rate through the cycle,” but this cycle appears be over. What’s left is a new level of lower margins, at least for the time being. To that end, the three rating agencies stated that they do not anticipate a uniform downgrade of all ratings given the new normal. Rather, each rating will be reviewed individually, as they were during other tough times like the Great Recession or the years following the Balanced Budget Act of 1998.
A rating affirmation, rather than a downgrade, also depends on where the rating is on the rating scale. A highly rated system (say “AA”) may be given more time to course correct, because it typically has greater size, scale, and resources to absorb the challenges. The rating decision also depends on where a rating is within its category. Those that are solidly within their rating category when compared to medians and like-rated peers may be given more time. Likewise, a hospital that already pushes the envelop—for example, with high leverage—may be given little to no runway.
In the past, a strong absolute and relative cash position could buy an organization time when operations were challenged. Today, many hospitals report substantially weaker cash positions given investment depreciation, lower cash flow, and the recoupment of Medicare advance payments. Rating agencies have seen the impact of unstable equity and bond markets before, but not coupled with the level of profound and possibly permanent operating challenges today. A sharp decline in liquidity may limit a rating agency’s tolerance for operating losses, especially if the decline in liquidity is due to cash burn rather than investment disruption.
Sharing your organization’s comprehensive plan to stabilize performance may make the difference between an affirmation and a downgrade. Providing quantification around current challenges, such as specific expenses around contract labor, and expected savings from all components of the improvement plan will show solid command. Additionally, lessons learned from the early days of the pandemic should be brought to the rating committee as examples of the ability to navigate tough times ahead.
Including a discussion on covenants is also warranted. Rating agencies remind us that they do not rate to the covenants. That said, a rating committee will quickly pivot to the rights and remedies of bondholders and away from credit fundamentals if there is concern of or an actual violation. As my Kaufman Hall colleague and covenant expert Matt Robbins reminds me: “Technical covenant defaults lead to the same section in the Master Trust Indenture as payment defaults: Events of Default and Remedies. You have to know your covenants.”
Just squeaking by the covenants may be good enough to ensure compliance, but the rating agencies will want to see how an organization will increase headroom to those covenants. Among the thousands of presentations I witnessed as a ratings analyst, I never saw a slide deck that started with capital structure and covenants and the following opening salvo: “Everything we are going to discuss over the next three hours will inform how we will create ample headroom to the covenants.” They didn’t have to. Maybe now they should.
Veteran rating analysts know that hospitals have been through turbulent times before, that a turnaround may not fit neatly within a fiscal year, and that the flight to a stable margin may be bumpy. That said, communicating a comprehensive and realistic plan during financially difficult times may buy you some extra runway on your rating.