Acting on the Signs and Solutions of Financial Distress

Hospitals and health systems who address financial problems proactively are in a better competitive position to meet the demands of today’s healthcare marketplace for higher quality care at lower costs, as well as more consumer choice and greater transparency.

 

The signs of hospital financial distress may seem obvious in retrospect, but recognizing them before it is too late and choosing from available solutions requires recognizing the signs of problems early and identifying solutions.

New Forces Create Financial Challenge

It is well known that healthcare spending has grown at an unsustainable rate in recent decades. In the wake of the 2007-09 financial crisis and passage of the Affordable Care Act, the healthcare marketplace has begun to drive down payments, stress value over volume, and encourage comparison shopping by consumers.

“We are moving to value-based and retail models for healthcare,” says Anu Singh, managing director, Kaufman, Hall & Associates, Skokie, Illinois. “Increasingly, healthcare is characterized by payer and purchaser demands for higher quality, lower cost, and elimination of low-value types of care, as well as by more consumer choice and greater transparency.”

To succeed, hospitals and health systems need to get more business savvy, Singh says. “We need to make fundamental changes to our business model, and this requires not only new ways of thinking but significant investment.” But for hospitals that are in some degree of financial distress, it will be difficult if not impossible to make these investments, he says, and they are likely to find themselves falling further behind the financially sound organizations. “Every hospital and health system has found gaps in their strategies for dealing with the changing marketplace, and the gaps are huge for the lower-capitalized, weaker, poorly positioned organizations.”

Singh points to the fact that of the stand-alone, not-for-profit hospitals for which data are available, 44 percent had credit ratings of BBB or lower in 2012, compared to only 15 percent of system-affiliated hospitals. “There are many other facilities for which data are not available that find themselves at the same or greater level of distress. These stand-alone community hospitals are the ones that will face increased financial pressure because of the emerging macroeconomic environment,” Singh says. Unfortunately, some of those hospitals may not be aware of the danger signs. Singh and his collaborators are dedicated to helping identify and deal with the key issues these organizations are facing.

Early Signs

Once the distress signs begin to grow and a hospital’s strategic position is compromised, it is very difficult to stop the financial and operational decline, says Matt Robbins, vice president, Kaufman, Hall. “This creates a vicious cycle: financial difficulties lead to reduced access to capital, which makes it hard to maintain facilities and technologies, which results in physician and patient dissatisfaction and loss of profitable business lines, which in turn creates more financial stress.”

The erosion of long-term viability can happen suddenly—for example, due to loss of a defined group of specialty or primary care providers, Robbins says. “But more often than not it builds slowly over time, and when it becomes apparent it can be too late.” The sooner the organization recognizes the warning signs and acts appropriately to address them, not only will there be more options available, but the quality of the strategies will be more palatable. The longer the organization waits, the less time and flexibility will be available.

Some of the early signs include persistent negative cash flow; an increased debt-to-cash flow ratio; greater reliance on supplemental or one-time revenue sources; working capital build ups; and failure to account for softer, contingent liabilities. The latter category includes things like deferred capital expenditures, post-employment benefits, pension termination payments, inter-company loans, severance/unemployment pay, and medical malpractice tail liability—items that are not always reflected on the balance sheet. Other markers of distress include the following:

Market/competitive advantage

• Market share erosion
• Loss of service lines
• Ineffective network access
• Failing clinician support

Operational

• High operational costs
• Inefficient, inflexible cost structure
• Contribution margin challenges
• Lack of fit between facility and the type of care delivered

Community-focused

• Dwindling political/civic support
• Challenges in fundraising efforts
• Poor brand/quality perception

Financial

• Working capital, illiquidity spikes
• Inability to fund investments
• Overreliance on financing sources
• Breaches of bond covenants
• Reduced market essentiality

When a hospital begins to experience these signs of financial distress, the following key issues are likely to emerge.

Strategic position in local market

• Erosion of long-term viability
• Illustrative markers of distress
• How essential the hospital is in this market
• The viability of the hospital’s payer mix

Governance

• Fiduciary duties: duties of care, loyalty
• Solvent versus insolvent
• Ownership and sponsorship
• Governmental/regulatory issues (e.g., tax-exempt status, charity care obligations, charitable trust doctrine, etc.)

Operating performance

• Revenue quality decline and negative cash flows
• Severe working capital build ups
• Cost structure required to produce positive cash flow

Balance sheet

• “Softer” and contingent liabilities add to overall leverage
• Key triggers include defaults, renewals, changes in funding
• What resources exist to enable a turnaround?

Restructuring options

• Nature of the core underlying business
• Value of non-core assets
• Analysis of options inside/outside bankruptcy process
• Communication to key stakeholders

Fiduciary Duties of Board and Management

Once financial distress is recognized, the hospital governing board and officers must be clear about their fiduciary duties, says Mark Cody, partner in the Chicago office of Jones Day. They must act with due care, in good faith, avoiding conflicts of interest. “Although this may seem obvious, what is not always apparent is to whom those duties are owed,” he says.

Fiduciary duties are owed to the enterprise, which, in a solvent corporation, includes corporate members or shareholders. For an insolvent corporation, the duties remain to the enterprise, but what constitutes the enterprise expands beyond the corporate members and shareholders to include a broader range of stakeholders such as debt holders or other creditors.

In addition, the practical application of the fiduciary duties will vary depending on whether the hospital is for-profit or not-for-profit, public or private, religious or community-based. If sale or closure is an option, the possible role of the state’s attorney general will need to be considered.

“Management and governing boards are sometimes in denial, or they may feel pressure from various stakeholders—such as community leaders or groups, religious sponsors, vendors, bond holders, etc.—to continue the traditional mission of the hospital in traditional ways,” says Jeff Kapp, a partner in Jones Day’s Cleveland office. It’s important not to be distracted and to think clearly about various options and duties in light of the early warning signs.”

Surviving in the new environment usually requires new capabilities such as enhanced care management, assuming risk, and retail strategies, among many others. Organizations that are unable to develop these capabilities may find their strategic options diminished and, in some cases, may find themselves considering bankruptcy.

Balance Sheet Problems Versus Business Problems

The fundamental task is diagnosing whether the distress is merely a balance sheet issue or one that results from external factors in the hospital’s market environment. If the former, the solutions could include financial and capital infusion, asset sale (merger/acquisition), or restructuring through the bankruptcy process.

On the other hand, if broader market-related issues predominate, the solution may not lie in traditional financial mechanisms. In fact, a recent study reported in hfm magazine showed that although cost containment efforts may gain the respect of rating agencies, conventional efforts to avoid bankruptcy are often ineffective. Instead, a serious re-examination of the organization’s competitive position needs to be undertaken. This involves answering some basic strategic questions, such as:

• What is our core business?
• How essential is this facility to the overall market?
• What are our most and least valuable service lines?
• Are there realistic opportunities for growth?
• What are the key physician/clinician dynamics?
• Can collaboration offer more than competition?
• Is bankruptcy in our future, or are there other options?

The Solution Set is Multi-Faceted

The first step is to determine and address the immediate source of the financial distress, says Kapp. “You must also have a clear understanding of the relevant internal and external factors before finalizing and implementing a solution. Each situation presents a different set of facts and circumstances, and there are many combinations of short-, medium-, and long-term structures to consider.”

Balance sheet issues can be addressed through avenues that have always been around: capital infusion, loans, debt assumption, and asset sale or merger. What is newer, harder, and more creative are the partnerships involving service agreements, joint ventures, joint operating agreements, and the like.

There are geographic differences at work as well, says Amy Edgy, a partner in Jones Day’s Washington, D.C. office. For example, the options available to small community hospitals in the rural south, or in a state that has not expanded its Medicaid program, will be different than those of hospitals in other markets.

In addition, many successful hospitals that used to have some reliable source of funding through state mechanisms or other sources are now finding that asset combination will be necessary if capital support is not enough, says Singh. “There’s a heightened tension between liquidity and capital that didn’t exist in the past because we weren’t as severely challenged as we are today.”

Today, there is waning interest in acquisition of distressed hospitals, whereas in the past, many systems grew for the sake of scale when issues relating to particular markets were not too important to their strategies. “There’s a lot more thought being put into programmatic elements related to individual markets,” Singh says. “As a result, there’s not always going to be ‘cash on the barrelhead’ to rescue a distressed hospital.”

Managing Today’s Challenging Marketplace

Today’s challenging healthcare marketplace requires that hospitals and health systems maintain solid financial performance to invest in new care models, technology, and various assets. Business savvy healthcare organizations that recognize the early warning signs of financial distress will have a wider array of options to address challenges and meet the needs of new markets.

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J. Stuart Showalter, JD, MFS, is a contributing editor for HFMA.

Interviewed for this article: Anu Singh is managing director, Kaufman, Hall & Associates, LLC, Skokie, Ill.

Matt Robbins is vice president, Kaufman, Hall & Associates, LLC, Skokie, Ill., and is a member of HFMA’s Massachusetts-Rhode Island Chapter

Mark A. Cody is partner, Jones Day, Chicago, Ill.

Jeffrey L. Kapp is partner, Jones Day, Cleveland, Ohio.

Amy Edgy is partner, Jones Day, Washington, D.C.