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This is the first installment in Trustee's yearlong series exploring the future of health care. Upcoming Future Focused articles will examine the hospital ownership landscape, medical breakthroughs and demographic trends.

The transformation of U.S. health care is under way nationwide, changing the industry from one focused on sick care to one focused on health care. The activity-based model, operative in health care for many decades, will transition to a new business model — one that shifts providers from delivering acute care services in hospitals toward managing the health of individuals in a coordinated manner across all settings.

Care delivery and payment will change significantly as the fee-for-service approach that is centered on services provided for episodes of care (Point A) moves to a value-based approach, defined with quality, cost and access dimensions (Point B). Given the focus on keeping people well and out of hospitals, inpatient revenues are expected to decline and then flatten. The right place to provide the right care at the right time with the right quality, cost and access increasingly will be ambulatory, office and home settings. To succeed, the nation's hospitals must invest in new capabilities to reshape the services they provide, while at the same time reducing their cost structures to maintain profitability.

The speed of transition from Point A to Point B will differ by area, but all regions will experience this change during the next decade. The good news is that this is the right way to proceed; it provides opportunities for organizations to improve the health of patients in their communities. The bad news is that hospitals must determine how to get from Point A to Point B in an enormously difficult environment.

To achieve sustainable transformation, three finance-related considerations will be critical for health care trustees:

  • the financial impact of accelerating industry pressures;
  • robust financial planning that guides the organization toward sustainable success and access to capital, if and when needed along the way;
  • creditworthiness and the external capital markets that provide money to hospitals based on an assurance of repayment; investors seek additional certainties in an industry with uncertain profitability.

A closer look at each follows.

Industry Pressures

Medicare payment reductions, the beginning of insurance exchange coverage, and Medicaid expansion — each mandated by the Affordable Care Act — will affect provider finances, perhaps positively in the short term and more negatively in the longer term.

On the upside, hospitals may experience benefits from lower bad debt as the uninsured population gains insurance. In the near term, volume and revenues may increase a bit as the newly insured access care. But on the downside, as individuals shift from employer-based coverage into exchange-based insurance products — many of which have significantly lower provider payment rates and narrow networks — payer mix and volume will deteriorate.

Rapidly emerging competition from nontraditional players could disrupt many local and regional health care markets. For example, in the private sector, Walgreens is opening clinics to diagnose and treat chronic care in its stores nationwide. DaVita HealthCare Partners is exporting its ambulatory-focused population health management model to new markets across the country. Payers also are building care capabilities and completely bypassing hospitals and their outpatient facilities to offer them directly to employers and consumers.

Capital spending to build competencies to manage a population's health is required, adding more pressure for hospitals in spending areas well beyond bricks and mortar. These include sophisticated information technology, physician practice acquisition, clinically integrated network development and other "getting to Point B" initiatives. Such initiatives typically cannot be funded by debt accessed through traditional tax-exempt markets.

These industry pressures will create for hospitals what may look and feel like an abyss, as expenses rise and revenues fall during the transition period. As illustrated below, expenses will need to be much, much lower. Mergers and other types of partnerships are occurring nationwide as hospitals take steps to reposition themselves for the transition.

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A Financial Plan as Guide

To get from Point A to Point B, boards must ensure a disciplined financial and capital planning process, resulting in a multiyear plan that is used to guide the organization.

The current planning environment has new variables and uncertainties, but the fundamental approach to planning remains unchanged. The guiding principle is as follows: "Financial performance must be sufficient to meet the cash flow requirements of the strategic plan and, at the same time, maintain or improve the financial integrity of the organization within an appropriate credit and risk context."

This principle requires hospital leaders to balance the organization's funding equation — with such variables as cash, capital, debt and operating profitability — through use of a rigorous financial planning process [see The Essential Questions of Organizational Finance, Page 21]. Each element must be optimized within an appropriate credit and risk framework that supports organizational access to external capital. No major organization can fund its capital needs solely from cash flow and remain financially viable. Capital access is a critical organizational asset and competitive differentiator.

Answering the essential questions of organizational finance through back-to-basics financial planning enables leadership to understand the current position of their organization and its likely trajectory over the next five to 10 years. Such an approach requires management teams and trustees to re-examine their existing financial and strategic plans, quantify current and future initiatives, and rigorously test revised plans. The revenue and volume impact of new payment methodologies, alignment strategies and care delivery systems must be quantified along with capital needs and operating expenses.

Strategic and operating realities increasingly have become complex, so modeling based on objective analytics from strategy, finance and operations, is critical. Such modeling assesses the range of possible outcomes and their impact on financial performance. It helps executive teams and boards to understand which initiatives and capital projects their organization can afford — in short, how to balance their sources and uses of capital within an acceptable credit and risk context. Leaders then must monitor and revisit plans on a regular basis to ensure that the plans address the realities of the changing environment.

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Creditworthiness and the Current Capital Markets

Credit rating agencies that rate health care debt are watching the industry closely to help gauge for investors the creditworthiness of health care borrowers. Overall, the agencies express concern about health care; due to the uncertain and changing environment, credit risk is increasing for the nation's health care organizations. Moody's Investors Service, Fitch Ratings Inc., and Standard & Poor's each gave the nonprofit hospital sector a negative outlook in 2014, citing slowing revenue growth, increasing capital investments, lower operating margins and higher health reform-related performance volatility.

Negative outlooks attached to individual health care debt ratings have increased. Hospital medians for key ratios, including operating and operating cash flow margins, are weakening and median annual expense growth rate is now outpacing revenue growth. Recognizing that "cash remains king," leadership teams have increased days' cash on hand and balance sheet metrics remain strong — but the question is, for how long?

To evaluate the creditworthiness of individual organizations, rating agencies, direct lenders such as banks, and investors are asking key questions, including:

• Does the provider have what is needed to manage the newly insured and the impact of health insurance exchanges?

• Is the provider modeling the range of possible effects of market forces and the "unintended consequences" of its transitional and go-forward strategies?

• Does a successful provider of the future need all the Point B pieces (that is, inpatient, outpatient, ability to assume risk, a health plan, physicians, sophisticated IT and care management infrastructure)?

• Does the provider have the capital capacity, scale and size for the changing delivery model? Can the provider do it alone or does it need a partner?

These are questions that hospital boards should be asking and answering, whether or not their organizations require external capital at this time.

Buyers of tax-exempt health care bonds — the major source of financing for nonprofit organizations — want to know that the borrower will pay the principal and interest it owes. Investors also want communication about organizational strategies and progress. They will probe the borrower's survivability, defining success according to specific criteria. Moody's has defined and is tracking industrywide value-based metrics related to demand (for example, covered lives) and risk (for example, percentage of risk-based revenue and number of employed physicians).

Credit ratings matter in a significant way. Access to and cost of bonds and other financing options are entirely credit-dependent, reflecting the organization's current and expected future position in its specific market.

Since the credit crisis of 2007–2008, volatility in the global capital markets is making it more difficult for organizations to secure financing for the initiatives approved through the planning process just described. Financing options for nonprofit hospitals generally include:

Tax-exempt debt: Secured through public or private sources at fixed or variable rates, tax-exempt debt proceeds must be used for depreciable assets that are, or would be, used for tax-exempt purposes.

Taxable debt: Also secured through public or private sources at fixed or variable rates, taxable debt proceeds can be used for any purpose, but the cost is higher because investors must pay taxes on the interest returns.

Another entity's money: This capital is secured through an arrangement, such as a merger or partnership.

Nontraditional sources: These include direct lending from banks, leasing and private equity.

Different products have different investors who may be focused on different objectives. Some investors look for interest rates or return on investment; others may be more focused on credit and ability to repay debt. For example, investors in taxable bonds are corporate buyers. Because they understand health care less than other industries, these investors are willing to offer bonds with long (20- or 30-year) maturities only to health systems with the highest (AA) credit rating, thereby representing the lowest credit risk.

Traditional financing methods may not be appropriate for new types of initiatives. Access now exists to a broader range of products to fund nonexempt capital needs, but the investors in such products are more credit-sensitive.

External capital for nonprofit hospitals currently is concentrated in two core sources: commercial banks and mutual funds (representing institutional investors), both of which buy municipal tax-exempt bonds. Interest rates on fixed-rate, tax-exempt bonds have been at historic lows due to a low-rate environment "manufactured" by the Federal Reserve's long-term bond purchasing program. Municipal rates are now rising, due largely to concerns that overall interest rates will increase in 2014 as the Fed tapers this program.

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The figure above shows borrowing costs on 30-year municipal bonds for AA-rated and BBB-rated organizations and the spread from the municipal market data benchmark for tax-exempt debt, or MMD. Trustees should note the significant 1 percent cost differential for debt borrowed by AA-rated and BBB-rated organizations. Over the lifetime of a bond, lower cost of capital can amount to hundreds of thousands of dollars in savings. Interest rates on variable-rate, tax-exempt bonds remain low and hospitals are likely to continue issuing such debt.

Because banks currently have money to lend, much of U.S. hospital "new" money and refunding business has been occurring as direct bank placements. In such arrangements, bonds are directly purchased and owned by the bank. The bank prices the bond as a spread from a benchmark interest rate, based on its lending appetite and the borrower's credit position.

The issuance of taxable bonds by systems has increased since late 2011, and is concentrated among large organizations. Such bonds provide flexibility of use, such as with physician practice acquisitions and pension funding. For-profit capital, including private equity, is available to fund nonprofit health care growth. The challenge will continue to be the design of structures to benefit all parties.

Get Going

Health care delivery is changing rapidly to a significantly different delivery and payment system, representing both risk and reward to health care borrowers and investors. Lowering costs while improving quality will be challenging for many organizations.

For U.S. hospitals and systems, a robust financial planning and management process is critical to sustainable transformation. Among other benefits, this process assesses the organization's credit position, quantifies its financial gap, and matches the uses of capital with appropriate capital sources in traditional and nontraditional debt markets. Overall financial and operating risk cannot exceed the organization's ability to carry it, given its desired credit rating. Carefully mapped and monitored from Point A to Point B, viable paths exist for hospitals. But the journey must begin.

Therese Wareham (twareham@kaufmanhall.com) is chief executive officer and managing director, Kaufman, Hall & Associates Inc., Skokie, Ill.