Credit Downgrades: How Could They Impact a Hospital's Capital Structure?

Through the first six months of 2012, non-profit hospital credit downgrades have outnumbered upgrades 23 to 20, and there were 12 downgrades alone in the second quarter.

It's easy to overlook the plethora of credit upgrades, downgrades and affirmations when ratings agencies release their reports, but astute hospitals that are looking to maintain solid standings in the credit markets should understand the bearings behind the credit market and how downgrades could negatively impact their capital structures.

The basis behind downgrades

Three credit rating agencies assign ratings for hospital and health system issuers: Moody's Investors Service, Standard & Poor's Ratings Services and Fitch Ratings.

Depending on the agency, a hospital will receive a credit rating when it issues debt. For S&P and Fitch, anything above and including "BBB-" is considered to be investment-grade, while "AAA" is the highest rating. For Moody's, anything above and including "Baa3" is investment-grade, while "Aaa" is the highest.

The important term there is "investment-grade." Not all hospitals have strong enough balance sheets to be considered "ratable," says Paul Goldberg, CFO of LibertyHealth in Jersey City, N.J. For example, safety-net hospitals such as LibertyHealth's Jersey City Medical Center have higher rates of charity care and uncompensated care, meaning their operating margins are slimmer. Consequently, instead of going through the investor markets, smaller hospitals and safety-net providers will go through the U.S. Department of Housing and Urban Development or other lower cost conduits because ratings agencies won't give them a rating. "It takes time to explain our position, but we always manage to get through everything," Mr. Goldberg says. "But it's just a factor of demographics and of life."

So for hospitals that do go through the regular debt markets, how could they be saddled with a credit downgrade? How can a hospital go from an "A"-rated entity to a "BBB"-rated entity over the course of a couple years?

In order to lessen the subjective nature of credit ratings, each category (e.g., the broad "A" ratings) and subcategory (e.g., "A+", "A" and "A-") have different hospital medians. For example, the average hospital with an A2 rating from Moody's in fiscal year 2011 had 403 beds and net patient revenue of $497.7 million. There are several other different metrics and ratios that are scrutinized, and they cover areas such as utilization statistics, payor mix and balance sheet.

Hospitals usually receive a credit downgrade if their revenues and/or profits start to take a hit, says Andrew Schrage, co-owner of Money Crashers. Mr. Schrage has worked closely with credit ratings agencies and closely monitors financial trends with healthcare organizations. In today's environment, many hospitals have posted stable revenue numbers, but profits are not guaranteed, especially as uninsured care has risen. "Many Americans are putting off non-immediate medical procedures because of personal finance issues caused by the slow economic recovery," Mr. Schrage says. "Furthermore, a decrease in privately insured patients and an uptick in the number of people who simply can't pay their bills after services are rendered contribute greatly to the reduced profitability of medical centers."

Hospitals could also receive downgrades or have their credit reviewed if certain negative actions or events occur. For example, last year, Fitch Ratings downgraded Lowell, Mass.-based Saints Medical Center's $45 million in revenue bonds to "B-" from "BB+", citing the hospital's terminated acquisition discussions with Boston-based Steward Health Care as a key driver. (The hospital has since merged with Lowell (Mass.) General Hospital.)

This August, Moody's analysts officially placed the Ba3 bond rating of Lewes, Del.-based Beebe Medical Center on review with an "uncertain" direction in light of the hospital's pending class action lawsuit and settlement involving a former pediatrician who was convicted for sexually abusing 86 patients.

A final example was in June. Moody's officials downgraded the bond rating of Minneapolis-based Fairview Health Services from "A2" to "A3" due largely to the unexpected departure of CEO Mark Eustis and Fairview's image following the investigation of its debt collection agency, Accretive Health.

Why a hospital's credit rating matters

A hospital's credit rating is vital to its capital structure for several reasons. First, a better credit rating helps hospitals to borrow money at more favorable interest rates, Mr. Schrage says. Lower interest rates equal a better ability to pay off debt, which allows hospitals to borrow even more money to expand and stay in business.

Additionally, a credit downgrade, especially to a non-investment-grade level, could be very detrimental for a hospital's finances, says Frank Ciesla, chair of the healthcare law practice at Middletown, N.J.-based law firm Giordano, Halleran & Ciesla. For example, the New Jersey Health Care Facilities Financing Authority will only issue investment-grade revenue bonds to hospitals and health systems. If a hospital loses its investment-grade status, that impacts not only its ability to borrow but also the current holders of their bonds.

"Downgrades could be very damaging," Mr. Ciesla says. "If a credit downgrade puts you below investment grade, you won't have that vehicle of the Financing Authority, and it limits how much you can borrow elsewhere. It also affects current holders of bonds because they may not get the same return if they try to sell the bonds. Also, if the hospital itself is not investment-grade, it will need to employ a credit enhancement device, which will both cost money and will likely impose additional restrictions on the hospital."

And whether it's fair or not, credit downgrades usually lead to a sense of worry or loss of confidence in the hospital or health system. In the previous examples of Beebe Medical Center and Fairview Health Services, both organizations are still within the realm of investment-grade, but a credit downgrade — or the potential of one — only reinforces the reputational risks that brought the hospital there in the first place.

How to avoid credit downgrades in the future

Hospital credit downgrades clearly impact an organization's ability to borrow, but that doesn't mean a hospital can't avoid the situation from the get-go. Ratings agencies closely look at a hospital's financial profile before issuing ratings and affirmations, so hospital CFOs and other financial executives must focus on what can be controlled to avoid a downgrade, including:

•    Expand market position if possible. In ratings reports, agencies consistently look at what a hospital's or health system's market share is. If it is a dominant provider, it is viewed as a strong entity because it is a necessary organization within that market. Expanding market share through mergers, acquisitions or building new facilities such as surgery centers or freestanding medical buildings will also increase revenue — an important metric for credit ratings.

•   Smaller hospitals should consider merging with larger organizations. If a hospital is running perilously close to negative margins, it may want to look at merging with a larger hospital or health system with a lot of market influence, Mr. Schrage says. If a smaller hospital joins forces with a system, it could reduce its inefficiencies and then become part of the system, which has a stronger credit profile. Hospitals and health systems that take on low-rated facilities usually do not have to worry about a damaging impact to their credit rating because their larger economies of scale will swallow up any negativity associated with the lower-rated entity.

•    Don't overlook simple financial fixes. Mr. Schrage says in general, there are several things hospitals can focus on to shore up their financial position: cut costs where possible, streamline operations, stick to the outlined budget goals, increase patient satisfaction by providing better care and convert to fixed-rate debt if possible.

•    Always remember: Cash is king. Dawn Javersack, CFO of Boca Raton (Fla.) Regional Hospital has helped her organization maintain its investment-grade credit rating since she joined the hospital in 2010. Her number one focus? Monitoring cash flow. She consistently tracks days cash on hand, cash-to-debt ratio and cushion ratio because she knows ratings agencies want to see if hospitals have the ability to weather an unexpected financial storm.

"You get in front of rating agencies, and they want to know how much cash you have and if you can service your debt," Ms. Javersack says. "My focus as CFO is to make sure the organization is positioned for the long term in addition to the short term. The maintenance of a credit rating is important not only in terms of accessing the capital markets but also in maintaining community confidence in the organization as well."

More Articles on Hospital Credit Downgrades:

2 Hospitals Receive Credit Downgrades in Past Month

Moody's: Hospital Downgrades Surpass Upgrades in 2Q of 2012

Financial Fitness: A Well-Rounded Credit Profile Improves Access to Capital

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