Strategies for effective capital structure management: executive summary

Healthcare Financial Management, August, 2005

HFMA's Financing the Future series began the process of highlighting strategies hospitals and other healthcare providers could use to improve access to capital. HFMA's Financing the Future II project continues this process. By providing practical how-to information in the form of concrete strategies, tools, timelines, and other materials, the second Financing the Future series seeks to help healthcare organizations of all sizes "raise the bar" on financial performance and capital investment strategies.

The six reports in Financing the Future II are being released over an 18-month period. HFMA's partners for Financing the Future II are GE Commercial Finance Healthcare Financial Services and Kaufman, Hall & Associates, Inc. The first report in the series named seven guiding principles for best practice financial management and contained details on the application of the first three principles. Future reports will address additional principles. For information on all the Financing the Future reports, go to www.financingthefuture.org.

The "right" capital structure supports strategic-financial goals, while optimizing flexibility and minimizing cost. That principle is one of seven key principles presented in the first report of HFMA's Financing the Future II series. Of course, achieving the "right" capital structure for your organization is a complex task. The second report of Financing the Future II, which is summarized here, offers strategies that can be used to achieve that elusive but vital goal.

Capital structure is the combination of debt and equity that funds an organization's strategic plan. Capital structure management can be approached by answering the question, What is the appropriate amount, mix, structure, and cost of debt and equity to support the organization's strategic-financial goals? The proper and strategic management of capital structure ensures access to the capital needed to fund future growth and enhance financial performance.

The key benefits of effective capital structure management are increased capital access, added flexibility, and lower overall cost of capital. "Organized properly in an organization of any size, a capital structure can be easily adjusted to meet changes in interest rates and the changing shape of interest rate yield curves," notes Kenneth Kaufman, managing partner of Kaufman Hall. "Capital structures by themselves can lower the overall cost of capital and can maximize the return of assets versus the cost of liabilities. Clearly, the creatively managed capital structure has become a competitive advantage. Perhaps most important, over a 10- to 20-year planning horizon, the quality of a hospital's capital structure can cost or save the organization millions of dollars."

Effective capital structure management can he achieved by healthcare organizations through consistent use of the following eight strategies.

STRATEGY 1. ORGANIZE FOR EFFECTIVE CAPITAL STRUCTURE MANAGEMENT

The essential building blocks for effective capital structure management include obtaining and providing education, establishing the team, and defining the organization's attitude toward risk.

Education ensures that the board of trustees and senior leaders are on the same page about the benefits and importance of effective capital structure management to the organization's competitive financial performance. Both large and small hospitals and health systems generally establish a knowledgeable senior management team that is chaired by the organization's CFO or vice president of finance. High-quality investment banking, legal, and consulting assistance is usually required as well. Capital structure decision making should reflect the level of risk the organization wishes to assume.

STRATEGY 2. DETERMINE THE APPROPRIATE LEVEL OF DEBT CAPACITY

Debt capacity, the amount of debt an organization is capable of supporting within a particular credit rating profile, establishes the parameters of the debt portion of the capital structure. The figure must expand each year if the organization wants to remain strategically and financially competitive. "The amount of debt organizations are willing to incur has to be balanced against their tremendous capital expenditure needs for information technology, new inpatient capacity, outpatient facilities, and a whole host of other spending opportunities," says Randy Fuller, hospital segment manager of GE Commercial Finance Healthcare Financial Services. "An organization's overall ability to support or sustain the level of debt is key."

STRATEGY 3. DETERMINE THE OPTIMAL MIX OF DEBT-TO-EQUITY FINANCING AND TRADITIONAL-TO-NONTRADITIONAL FINANCING

Once an organization determines its debt capacity, it knows how much it can borrow in the debt markets and how much capital will need to come from other sources, both traditional and nontraditional. Targets for the appropriate debt to equity ratio are based on debt capacity, rating agency benchmarks, and tolerance for risk.

Up through the early 1990s, healthcare executives relied almost exclusively on not-for-profit tax-exempt financing. Now, they have many more financing options to choose from, including off-balance-sheet options, real estate investment trusts, participating bond transactions, receivables financing, and private placements, among other options. When considering which traditional and nontraditional financing vehicles are appropriate for an organization's circumstances and credit position, healthcare leaders should consider factors including all-in borrowing rate, costs of issuance, use of proceeds, and credit position.