By: Ken Gould & Brian Cafarella, Lancaster Pollard
Facing increasing financial pressures and a difficult operating environment, more and more rural and community hospitals are seeking to merge or affiliate to gain operating efficiencies.
The recent acceleration of consolidations has in part been fueled by the Affordable Care Act (ACA), which has applied downward pressure on reimbursement rates while costs for regulatory compliance and infrastructure continue to increase. A recent report by Kaufman Hall noted that in 2013 there were 98 affiliations/mergers, a 3% increase from 2012 and a 51% increase over 2010. As such, hospital CFOs are keeping very busy evaluating potential merger opportunities.
Given the amount of time and due diligence invested in considering potential combinations, one post-merger synergy that must be considered is improving the debt structure of the newly-combined system. Such debt synergies can be defined as cash saving opportunities derived from refinancing, consolidating or restructuring debt post-merger.
How to Determine if a Debt Synergy Exists
Understanding the financial profile and debt structure of the combined system post-merger should be the first step to determine if debt synergies are available. This is easier said than done. Nonprofit hospitals and health systems have historically been financed with many varieties of debt and structures: fixed or variable interest rates, a range of terms and amortizations, sinking funds or escrows, taxable or tax-exempt structures, derivatives, capital leases and obligated groups among other structures. Since the devil is in the details, a thorough review and understanding of the existing debt structures and corresponding agreements for the combined system, coupled with an assessment of the combined system’s proforma financial profile, is paramount to understanding if potential debt synergies exist.
Assessing the Combined System’s Financial Profile
When assessing the financial profile of the combined system, management needs to understand where the system stacks up in terms of “as-is” operations. This is based on the actual combined last 12 months (LTM) operating earnings before interest, depreciation and amortization (EBIDA) of the two entities that merged. It also considers proforma operations, which incorporate the projected operating synergies gained from the consolidation. These operating synergies are generated by either revenue enhancement opportunities (i.e., specifically driving volumes, gaining market share) or cost reductions (i.e., eliminating duplicative procedures or overhead, renegotiating contracts). These should be quantified as part of the post-merger plan along with specific timetables assigned for each synergy initiative. Management will need to be able to clearly articulate to potential debt providers the plan and provide support for the projected gains from the operating synergies.
Once the as-is and proforma LTM operating EBIDA is mapped out, management should ensure it has a strong understanding of the combined financial position of the system (i.e., the consolidating balance sheet). Breaking down the balance sheet into a consolidating schedule by entity as of the effective date of the merger is key to understanding which entities within the system are holding the majority of the liquid assets (unrestricted cash and investments), which entities are obligated under the existing debt obligations and if there are any restricted cash accounts associated with the existing debt. The EBIDA and balance sheet analysis can then be used to calculate the financial ratios, which are the basis for the financial profile of the system.
The “Big Five” Financial Ratios
So which financial ratios should be calculated? The “Big Five” financial ratios, as we’ve labeled them, are the ones debt providers are most interested in when evaluating the credit quality of the system:
- Net debt to EBIDA.
- Days cash on hand.
- Debt service coverage.
- Debt to capitalization and cash.
- Investments to debt.
- Extend amortization on existing debt to lower debt service. If assets with longer lives (30 years) were previously financed with aggressive amortization schedules (15, 10 or 7 years), an opportunity exists to extend these amortizations with a refinance to provide significant debt service savings.
- Restructure the obligated group. Depending on proforma operating metrics, the hospital system may be able to exclude a foundation or other previously obligated entities that hold significant assets of the organization by restructuring the obligated group, thus creating greater financial flexibility.
- Renegotiate covenants. The ability to provide greater financial flexibility by changing covenants is another benefit from a post-merger debt restructure.
- Release restricted assets. Sometimes existing debt structures may have required a debt service reserve, especially with more challenging credits. Thus, an improvement of a credit profile post-merger along with a refinance may provide the ability to release a restricted cash account, thus improving the unrestricted liquidity of the system.