A capital idea bonds and nontraditional financing options: increasing capital demands are prompting cash—strapped hospitals to take a closer look at bond offerings and nontraditional sources of capital

Healthcare Financial Management, May, 2004 by Therese L. Wareham

Jill Smith, the CFO of Community Hospital, is worried. Community Hospital's financial outlook is bleak, and Jill and the executive team are concerned about the hospital's future.

Community Hospital is a mid-size urban hospital with an aging plant and technologies verging on the obsolete. The hospital has enjoyed a good relationship with local physicians in the past, but referrals are down for the first time in recent memory. A competitor hospital nearby--one that has always had a substantial market share advantage--has just embarked on a major capital project to improve its already impressive facility and install state-of-the-art technologies that will far surpass the best that Community Hospital has to offer.

The writing is on the wall. Jill recognizes that if Community Hospital does not make a substantial capital investment in upgrading its facilities and technologies, there is a real threat that it will have to close its doors. But where will the money for these improvements come from? The organization's profit margins are scant at best, its cash reserves are limited, and philanthropic donations have all but dried up in the past two years. To make matters worse, the organization is highly leveraged, with strict covenants, and it has just seen its credit rating downgraded to BBB. Jill is hard-pressed to identify viable external capital sources. What are her options?

Access to capital for healthcare organizations is constantly evolving with changes to the credit of the healthcare industry, and not always favorably. Recent findings from HFMA's Financing the Future project present an even grimmer picture for organizations such as Community Hospital, suggesting that many hospitals are facing limited access to capital. (a) Does this outlook reflect fewer available options, or has deteriorating financial performance made some options unavailable to hospitals?

Major Funding Sources

Given the nature of tax exemption, not for profit healthcare organizations do not have access to equity market capital. Thus, they have only four primary sources of capital: internal sources, philanthropy, asset sales, and external sources.

Internal sources. Internal sources of capital are operating cash flow and cash reserves. To build these sources, an organization obviously must increase net revenues and minimize costs.

Philanthropy: Although the economic downturn has hurt the fund-raising results of many not-for-profit organizations, philanthropy can represent an important piece of the capital pie. Providence Health System in Seattle, for instance, recently reported that it expected about 12 percent of its total capital budget to come from philanthropy. (b)

Asset sales. The timely sale of "noncore" assets, such as medical office buildings, can yield significant capital, which, in turn, can be used to fund "core" activities, such as joint ventures in key market or service areas. Also, divestiture of financially struggling noncore assets stems operating losses, thereby contributing to improved financial performance.

External sources. The use of external sources (principally debt) has become increasingly important for healthcare organizations, given the significant capital shortfalls that many of them face. External sources include bond offerings and nontraditional vehicles. Because of the diverse issues that must be considered in deciding whether to access each of these sources, they warrant further discussion.

Bond Offerings

Publicly offered tax exempt bonds are the most common form of debt for hospitals. A public offering means that the debt is structured to be offered and sold by an underwriter to any interested party--individuals o r institutions. Public bond offerings can have fixed or variable rates. Fixed-rate bonds can be based on a borrower's own credit rating or on that of credit enhancement, such as bond insurance. "Plain vanilla" bond issues typically mature in 30 years.

Variable-rate bonds have much shorter interest rate horizons and can take various structures, such as auction rate securities, demand bonds, put bonds, and commercial paper. Bonds can be "put," or redeemed by bondholders, for their full face amount when they come due--typically daily, weekly, monthly, or semiannually, depending upon the program. Unless a borrower is rated AA/Aa or better and is highly liquid, variable-rate bonds require either a letter of credit or bond insurance, or bond insurance with a bank liquidity facility.

FHA financing. FHA financing is a form of public offering available through the U.S. Department of Housing and Urban Development (HUD) that has been rarely used until recently. FHA Section 242--insured loans are offered to acute care hospitals for construction financing, refinancing, remodeling, or expansion. Rates are fixed for the length of the mortgage, but variable-rate swap structures may be considered. The permanent loans are fully amortizing for up to 25 years after completion of the construction project. The financing process is rigorous, with multiple requirements and steps that can take 18 months to complete from the beginning of the process to the funding of the loan. Still, FHA is a solid source for some projects.