Credit Enhancers for Hospitals and Major ClinicsBy Melvin J. Howard
Credit enhancement refers to the use of bond insurance, letters of credit, guaranties and other devices by which a third-party (the credit enhancer) guarantees the payment of principal and interest on the bonds, providing additional assurances of payment to the bondholders and therefore lowering the interest rate demanded by investors.
Providers. The most common forms of credit enhancers for hospitals and major clinics are:
1. Bond insurers, which provide bond insurance over the life of long-term bond issues in return for a payment of an up--front fee.
2. National and international banks, which provide letters of credit, for a period of 5 to10 years, with annual fees.
3. Local banks, which provide letters of credit, usually in smaller amounts. Local banks are sometimes more flexible than national and international banks in their terms.
Making the selection process. In theory, choosing if and how you use credit enhancement is quite simple: If the interest rate savings exceed the costs of the credit enhancement, the credit enhancement is worth buying. For a letter of credit, the market rates for the unenhanced credit are compared to the gross interest costs of the enhanced transaction, i.e., actual interest rates plus the annual fees for a letter of credit and remarketing if variable rates are used. For bond insurance, since the premium is paid in advance, the comparison is between the present value of debt service on an unenhanced issue with that for an insured issue. This calculation should reflect the fact that the insurance premium is usually paid out of the bond proceeds and therefore increases the principal amount of the bonds. In actuality, the cost benefit analysis is more complicated because of:
Transaction costs. Transaction costs both in terms of delays and increases of such matters as counsel fees.
Timing. If credit enhancement is selected before the marketing of the bonds, it may be impossible to measure accurately whether credit enhancement is cost effective. On the advice of underwriters, hospitals frequently "go into the market" without credit enhancement, obtaining a ruling and circulating the preliminary official statement and then deciding during the actual marketing of the bonds whether to use credit enhancement. This process, however, complicates the role of hospital counsel in negotiating reasonable covenants with the credit enhancer.
Managing the Selection Process. If the hospital has sound credit, it may have the option, particularly in bond insurance, of having proposals from several bond insurers. Bond insurers are increasingly competitive. The hospital should look to the financial advisers and/or underwriters to give it a general analysis of then various bond insurers. All AAA rated credits are not alike in pricing, and all bond insurers are not rated AAA. The hospital and its counsel can also learn from financial advisers and underwriters generally how flexible particular bond insurers are on particular points.
Responding to Proposals. When a hospital receives multiple proposals of insurance, perhaps the only easy comparison between them is in price. The hospital then runs the risk that the low bidder will ultimately prove to be unsatisfactory because of the insurer's insistence on financing and operating covenants that the hospital finds burdensome. While the hospital cannot string along multiple insurers indefinitely, it may wish to keep the second lowest bid "in reserve" until it has a handle on the operating covenants the low bidder will require.
Negotiating With the Low Bidder. Once the hospital has the low bid and believes it has selected an insurer, it should press ahead quickly to negotiate the actual terms and conditions of the commitment, i.e., identify precisely what financing and operating covenants the insurer will require. The insurer sets these conditions out in a commitment letter, but there is frequently room for negotiation. Once the hospital has gone so far down the road with bond insurance that it cannot easily retreat (such as mailing of a preliminary official statement that names the bond insurer), the hospital essentially has no leverage to negotiate operating covenants with the insurer.
Operating Covenants. While commitment letters generally list required operating covenants, they are frequently subject to negotiations. Upon the recommendation of underwriters and financial advisers, hospitals frequently have their bond counsel produce financing documents that have the "loosest" possible financial and operating covenants. There then follows a negotiation process in which the insurer requests changes in those basic documents and may or may not insist on all of the operating covenants in precisely the form set forth in the commitment letter. The hospital and its counsel should press ahead with this process as quickly as possible after the initial decision on insurers is made. Otherwise its ability to go to another insurer is lessened.
Utilizing Financial Advisers and Underwriters. A financial adviser is frequently important as a mediator between the hospital and a credit enhancer. Hospital and its counsel should look to the financial adviser to provide a realistic understanding of what changes the bond insurer will or will not accept. Similarly, the existence of credit enhancement frequently changes the relationship between the hospital and the underwriter. In a normal transaction, the underwriter will frequently insist on operating covenants that it believes appropriate. With credit enhancement, the underwriter generally become an ally of the hospital in negotiating with the credit enhancers, since the underwriter generally doesn't care what operating covenants exist in a credit enhanced transaction (even though the Securities and Exchange Commission thinks it should).
Particular Types of Covenants. Credit enhancers have a variety of views on the operating and financial covenants that they require. The most common ones include:
Rate Tests. These are standard. It is important to have a flexible "out" that provides the hospital with the ability to avoid "default" if it drops below a required coverage so long as the hospital hires a consultant and follows all of the consultant's advice as to operations. Nonprofit hospitals should also have provisions that recognize that their ability to comply with rate covenants may be affected by tax code requirements for continuation of tax-exempt status.
Restrictions on Debt. These are frequently the most significant restrictions for hospitals in credit-enhanced transactions. In recent years, greater flexibility has become common, and the insurer's willingness to be flexible likely will reflect both the creditworthiness of the particular hospital and the insurer's current appetite for business. The chief financial officer of the hospital should undertake actual calculations as to the amount of debt that the hospital would be able to incur under the debt restrictions proposed by the credit enhancer.
Transfer of Assets. As hospitals engage in increasingly complicated corporate structures and affiliation agreements, insurers (as well as other lenders) are increasingly concerned on restrictions on the amount of asset transfers that hospitals can transfer to other entities. Again, it is prudent for a hospital and its counsel to consider particular expansion and other plans that the hospital may want in the future in light of such tests.
Credit Enhancer Consents. Credit enhancers frequently require that they consent to particular actions by the hospital. The hospital sometimes find that such consents cannot be obtained or obtainable only at some kind of cost. Hospital should insist on a standard of reasonableness in such consents.
Counsel Fees. Hospital and its counsel will want to be specific on whether there will be a separate payment for counsel to the insurer and whether there is a cap on such amount.
1 AFTER THE HOSPITAL RECEIVES THE COVENANTS PROPOSED BY THE INSURER OR OTHER CREDIT ENHANCER AND ITS COMMITMENT LETTER, HOSPITAL PERSONNEL AND COUNSEL, THE FINANCIAL ADVISER AND UNDERWRITER SHOULD MEET TO DETERMINE WHICH OF THE COVENANTS ARE TRULY IMPORTANT TO THE HOSPITAL AND WHICH ARE NOT. DON'T WASTE YOUR TIME AND LEVERAGE FIGHTING OVER RESTRICTIONS THAT WILL NOT PRACTICALLY AFFECT YOUR OPERATION. CONCENTRATE ON WHAT'S IMPORTANT.
2. IF YOU ARE USING A MASTER INDENTURE OR DOING SUPPLEMENTAL BONDS, PUT THE COVENANTS THAT YOU DO NOT LIKE IN THE SUPPLEMENTAL INDENTURE SO THAT THEY WILL DISAPPEAR IF THE ENHANCED BONDS ARE
REFUNDED OR PAID OFF.