Hospitals require a 3-pronged response to potential covenant violations

The financial shocks of COVID-19 are the strongest most healthcare organizations have ever experienced.

In early March, all three major rating agencies revised their outlooks for not-for-profit hospitals to negative. In April, we found that hospitals’ outpatient revenue fell 49%, inpatient revenue dropped 25% and operating EBITDA margins fell 174%. As for the future, the pace and degree of volume return are unknown, leaving hospitals struggling to chart a clear path to financial recovery.

These shocks are evident in the disruption hospitals are seeing in their balance sheets, starting with the initial scramble for liquidity and progressing to serious questions about debt and capital structure.

As the next possible result of COVID-19’s financial hit, we may see hospitals violating debt covenants. America’s hospitals should make it a top priority to avoid this destabilizing effect. And for organizations that are facing violations, immediate and tailored action is necessary, not only to mitigate violations, but also — in some cases — to avoid even more dire consequences.

Initial Assessment

In the time of COVID-19, most hospitals are carefully cataloging each financial covenant, including what and where each covenant resides and when and how each is tested. It is essential for any healthcare providers that find themselves in a position of violating covenants to be able to develop and implement a recovery plan.

For some organizations, a baseline situation analysis, or a deeper dive, will show that the hospital will meet its Master Trust Indenture (MTI) and bank covenants or that any possible violation is fairly easily resolved. Any organization facing potential covenant violations should immediately begin to develop a plan for recovering expense and enhancing revenue so that when it enters discussions with external parties, the plan is already well underway and demonstrating results achieved and cash flow implications for the organization.

Hospitals facing covenant violations fall into a range of situations requiring different degrees of intensity in their resolution.

For hospitals with sound levels of debt and capital structure, the mitigation strategy for violations could be fairly straightforward if addressed promptly. However, for hospitals that are over-leveraged, in need of debt relief or facing even more difficult financial challenges, a broader and more vigorous solution is necessary.

3 Directions of Attack

For many hospitals, covenant violations are a symptom rather than a cause of existing challenges that are being exacerbated by COVID-19. Treating the symptoms as well as the underlying causes requires a three-direction attack.

Mitigating violations. Hospitals facing covenant violations should assess options for addressing the problem, including:

• Developing a revenue strategy
• Instituting expense controls
• Harvesting investment gains
• Engaging in negotiations
• Restructuring debt restructuring
• Calling in a consultant

In any case, the organization should be timely in communicating with stakeholders, including board members, rating analysts, bondholders and banking partners, with a clear explanation of the exact nature of the violation and specific remedial plans. It is essential to begin this work immediately, given that margin improvements must be identified and implemented before improvements can be realized on the income statement.

Improving performance. Reworking cost structure and enhancing revenue performance are foundational parts of a holistic solution for most organizations facing balance sheet challenges and covenant violations. In many cases, debt holders will require a plan improving performance as part of any agreement to hold back covenant violations. The more detailed these plans are, the greater the organization’s ability to demonstrate the positive effect on the its financial plan.

Performance improvement can focus on the following key areas:

• Workforce, including productivity, overtime and structures and processes that support the current labor complement
• Non-labor expenses, including medical and surgical supplies, pharmaceuticals, purchased services and other expenses associated with delivery of care across the organization
• The revenue cycle, including short- and intermediate-term opportunities to improve margin
• The physician enterprise, including opportunities to improve practice management, patient access and scheduling, provider productivity and compensation and non-provider staffing
• Clinical redesign, including opportunities to drive clinical transformation and reduce clinical variation
• Service distribution, including a review of all clinical programs/services to ensure the delivery model is effective and efficient and meets the needs of the communities the organization serves
• Operating model, including a systemic evaluation to streamline corporate overhead functions and the reporting structure to enhance future decision-making

Rethinking strategy. When organizations face the type of significant financial challenges that COVID-19 has created, they should consider the continued relevance of existing strategies and how a range of strategic options may influence their ability to best serve their communities moving forward.

For some organizations, that means identifying any changes in strategy required to maintain independence. Each organization will need to honestly assess what gaps in operational or strategic capabilities exist, and whether it can address those on its own. Alternatively, executives will need to consider whether a partner would help fill these gaps more quickly and effectively.

If the organization considers a partnership, it should understand the potential formats and structures, many of which may not require a change of control. Decisions regarding what type of partnership relationship to pursue should be guided by the gap analysis. As the number of gaps grows, the need for more fully integrated arrangements increases.

The Risk of Waiting

When faced with a rapidly emerging and unpredictable situation, a natural instinct is to wait for the chaos to subside before acting. However, waiting can allow financial problems to get quickly out of control as revenues continue to track behind budget and as options to remedy the situation diminish. Far better is to get out in front of the situation while the organization still has all its options.

The financial upheaval that COVID-19 has brought requires that hospitals take immediate action, even while the pandemic and its effects are still playing out. By acting immediately, an organization will be better prepared for an unpredictable near-term future and will retain the greatest possible flexibility in dealing with whatever challenges lie ahead.

COVID-19 has placed unprecedented pressure on hospital leaders. The leaders that most effectively guide their organizations through this time will be those who can simultaneously manage these pressures while taking the best steps toward future success.