Finance
General Obligation Bonds Can Meet Capital Shortfalls
By Andrew M. Pines
Although hospital operating margins have been trending upward for the last several years, there may be a substantial capital gap on the horizon because hospitals may be unable to continue funding capital requirements at a pace sufficient to meet demand. The gap emanates from three factors: 1) pressures on revenues from both government payers and commercial payers; 2) rising labor, pharmaceutical and supply costs; 3) dramatically increasing capital costs resulting from outdated health care facilities and equipment, technological advances and increased utilization of health care services.
California has served as a social laboratory for observing this capital crunch. All California hospitals are required under SB1953 to meet certain earthquake safety requirements by 2008, or 2013 if granted an extension. More stringent requirements are required by 2030. For most noncompliant hospitals, the cost of building a new facility to meet the 2030 requirements does not cost much more, and in some cases less, than the cost of a retrofit to meet the near-term standards. Many hospitals have thus concluded that a one-time rebuild is the preferred approach. Industry estimates have pegged the cost of full compliance at more than $60 billion for the whole state of California, most of which provides little return on investment.
Although SB1953 forces a specific, substantial undertaking by California’s hospitals, their situation is not unique. Hospitals across the country are facing massive expenditures to refurbish aging facilities and keep pace with new technology while, in many cases, lacking the resources to pay for these upgrades. Many institutions have been able to forestall the capital gap through near-term, stop-gap measures, such as significant philanthropic campaigns, but ultimately these methods continue to diminish debt capacity and spend down reserves.
In many cases, the financial results of the hospital continue to appear adequate because management focuses myopically on results only as they currently appear, not as they would appear after layering on the pro forma financial impact on cash, debt, depreciation and interest of a substantial capital project, even if all agree that the project is essential for the hospital’s continued viability.
However, a growing number of creative organizations in California, Washington and elsewhere have been able to meet the capital gap by tapping a source of capital—general obligation (GO) bonds—that does not place a debt burden on the revenue generating ability of the hospital, nor use any existing cash or investments. GO bonds are issued by a hospital district or municipality and are backed primarily by ad valorem property taxes.
In some cases, the district or municipality also owns and operates the hospital. In others, it leases the hospital to a nonprofit health system. And sometimes, the state sponsors a special bond initiative for certain hospitals, as California did for its children’s hospitals.
In California, a GO bond requires approval of two-thirds of a district’s voters. Rules for getting on the ballot and for approval differ by state. Some sizable deals have been approved recently, including those for El Camino Hospital District ($148 million) near San Francisco, and Palomar Pomerado Health ($496 million) and Grossmont Healthcare District ($247 million) in the San Diego area. Also near San Diego, a $596 million measure for Tri-City Hospital District failed to pass by less than 1 percent of voters. This instrument, available but relatively dormant for about 25 years in California, has made a strong return, particularly for those institutions that would otherwise be unable to finance their seismic needs.
When the public was polled about California Gov. Arnold Schwarzenegger’s infrastructure megabond, hospitals received a level of support as high as schools, roads and levees. In short, communities, recognizing that there are significant capital and seismic needs that hospitals cannot afford on their own, stepped up to support local hospitals.
From the Wall Street perspective, general obligation bonds do not usually count against the hospital’s credit since the primary source of repayment is tax receipts, unless there is a contribution or a substantial lease payment required from the hospital’s general funds.
Following are the potential applications of GO bond proceeds for health care systems. They can:
- Improve existing district or municipal hospitals.
- Form new hospital districts. In situations where a community’s local political leadership is clamoring for more hospital investment in the community, but in which the investment is not necessarily justified in a capital-constrained environment, the community itself could help fund the investment through the formation of a new hospital district and the sale of GO bonds.
- Fund growth opportunities by affiliating with existing districts. A nonprofit hospital system could approach an existing district hospital with the proposition that the system manage the facility in exchange for the district’s support of a GO bond measure.
To be sure, there are drawbacks to GO bonds. A campaign can be costly and requires voter approval, although preliminary polling can be done relatively inexpensively to get a sense of the likelihood of success. Political consultants could work with the hospital to refine its message and improve the likelihood of public support.
It is certainly easier to win in less competitive markets. Leasing from a district may be inconsistent with the maintenance of church-owned assets, and voters themselves may be less likely to approve public dollars for a facility that could potentially restrict certain services. Additionally, dealing with district politics and constraints, even if the election is successful, can be frustrating and time-consuming.
However, for those organizations with the foresight to recognize, as many in California already have, that creative means must be employed to meet the capital gap, tapping the resources of the community—its strongest base of support—may, for many, justify the political compromises that could mean the difference between meeting the capital gap and being overwhelmed by it.
Using GO bonds, by definition, requires crafting both a political and operational solution, so the involvement of hospital trustees in the process is critical in garnering political support for the campaign.
Andrew M. Pines is a Managing Director in the Healthcare Finance Group of Citigroup Global Markets Inc. He is based in San Francisco and can be reached at andrew.m.pines@citigroup.com or at (415) 951-1729.
This article 1st appeared in the December 2099 issue of Trustee Magazine.
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