"Off-credit" vs. "off-balance sheet": a notable distinction: the distinction between the terms "off-balance sheet" and "off-credit" is crucial in accurately describing a healthcare institution's credit strength to third-party analysts working for rating agencies, credit-enhancement companies , and institutional investors - letter of credit banks and bond insurers - Treasury Management

Healthcare Financial Management, August, 2003 by Kevin T. Ponton

The distinction should be of particular importance to healthcare treasurers, particularly those who work for multihospital systems or hospitals that are part of complex corporate structures.

The Healthcare Finance Forum offers the following explanation of the two terms:

   By making an off-balance-sheet "sale," not-for-profit
   hospitals can obtain cash and additional debt capacity
   and still retain control of tenants, management, and
   fees. These arrangements are carefully analyzed by
   rating agencies and investors and are often factored
   into the credit analysis whether they are technically
   "off-balance sheet" or not. They must be structured as
   true nonrecourse debt to be considered truly "off-credit"
   by the rating agencies."

"Off-balance sheet" is certainly the more common of the two terms. In fact, the term "off-credit" was virtually absent from the literature of healthcare capital finance prior to the citation above, and it has occurred only rarely in the general finance media. (b) However, healthcare analysts at national credit rating agencies now are discussing (if not writing) the term "off-credit" more often as a way to clarify their treatment of the credit implications of a number of different "off-balance- sheet" financing structures that are increasingly being used by not-for-profit healthcare organizations.

The key common element of these "off-balance-sheet" financing structures is that their repayment obligation does not appear as a liability on the rated organization's balance sheet. These financing structures include:

* Sale/leaseback transactions

* Real estate investment trust (REIT) financings

* Various operating leases or operating guarantees

* Contribution agreements between unrelated parties to finance jointly owned assets

* Public or private joint ventures or partnerships

Standard & Poor's emphasizes, "Issuers and obligors often perceive off-balance-sheet financing as a means to preserve debt capacity and enhance operating flexibility, with no impact on their senior debt rating--a free lunch, if you will. However, this is clearly not the case." (c)

Every off-balance-sheet obligation is, in fact, recorded on the balance sheet of some entity. Careful consideration must be given to the nature of the obligation: the same obligation that is either completely or partially nonrecourse to one entity will be of recourse to another entity. If the two entities are related by control, or if the transaction is deemed important to their ongoing business welfare or core mission, they will both share the burden of a credit obligation regardless of on which balance sheet it appears.

Healthcare Corporate Entities

Corporate America has had at least a century of experience with complex business structures, arguably extending back to the late 18th-century days of trusts and trust-busters. Not-for-profit hospitals, however, did not start forming multi-institutional corporate entities until the 1980s. Some dropped their not-for-profit status to join the first proprietary hospital-management companies, which could raise external capital through offerings of equity as well as debt.

The not-for-profit multihospital systems chose to retain their tax-exempt status and maintained their access to tax-exempt debt using the obligated group structure. As healthcare integration swept the country in the 1990s, the obligated group arrangements became more complex in response to a number of factors, including the following:

* Clinical strategies (combining separate business entities offering different levels and types of service across the range of the healthcare continuum)

* Competitive forces (combining hospitals across county and state borders that defined the jurisdictions of the traditional quasi-public "conduit issuers" of healthcare debt)

* Pressure to reduce costs (allowing systems the flexibility to redeploy services more efficiently, eliminate redundancy, and close their weaker facilities)

As those newly formed obligated groups presented their first debt transactions (in the form of consolidated financial statements) for scrutiny by analysts at rating agencies, bond insurers, and bond fund portfolios in the early 1980s, they encountered a response that would have major impact for years to come: the outside analysts requested the consolidating financial reports.

As every treasurer knows, the consolidated reports are short and neat; the consolidating reports are long (in terms of both page length and the size of the pages, which need to be fan-folded to fit in the bound audit report). The added page length of the consolidating-information allows each individual corporate entity's detailed information to be viewed side-by-side with that of all the corporate entities.

The consolidating reports allowed analysts to track intercompany transfers from entity to entity and to see exactly which ones were responsible for the group's overall strengths and weaknesses as summarized so neatly in the consolidated report. (Imagine the following scenario: a credit analyst opens a FedEx package containing the anxiously awaited consolidating audit for Humongous Health System, fans out the folded pages, and shouts "Eureka!" as she sees the operating losses at Humongous Physician Group and in Humongous Managed Care--all of which are countered by the profits at the Humongous Flagship Hospital. That scenario played itself out a lot in the 1980s.)