In Kaufman Hall’s recently published 2023 State of Healthcare Performance Improvement report, we asked participants two questions regarding debt covenants:
- Did your organization encounter debt covenant challenges over the past 12 months?
- Does your organization foresee debt covenant challenges over the next 12 months?
Nearly one-quarter (24%) of participants responded “yes” to the first question. This was no surprise, given that 2022 was the worst year financially for not-for-profit hospitals since the pandemic, primarily driven by the high use of expensive contract labor and the Omicron outbreak.
That number grew to an astounding 34% for the second question. Just over one-in-three participants responded they will either fail to make their covenants or they will come very close (a “near miss”).
Covenants are binary: you either make them or you don’t. Making your covenants is like pole vaulting: all an athlete has to do is crest right over the bar without touching it. Coming within a hair’s distance is okay. Then you advance to the next round where the bar is reset at a higher level.
Unlike in pole vaulting, the covenant requirements in most debt structures remain the same and are not set higher and higher every year. That said, given how much harder it will be for many hospitals to make their covenants per the response to the second question, one could indeed infer that the bar has been set higher.
When hospitals borrow debt in the public market or via direct lending, they make numerous promises to their investors and lenders. The most important promise is to repay the debt, in full and on time, through final maturity or at redemption. To ensure that debt repayment, hospitals agree to produce income available for debt service that exceeds a required level, typically anywhere from 1.10x to 1.25x. Other covenants may include days cash on hand or a debt-to-capitalization covenant.
Just “getting by” on covenants does not build a pathway of financial sustainability. Near misses are more concerning to ratings analysts than actual misses because there is very little margin for error. At their very core, ratings measure “headroom” to the covenants, which is expressed through gradations of risk on a rating scale. Typically, a covenant breach requires the use of an external consultant to develop an immediate plan to eliminate the financial shortfalls and position the hospital to comply the following year. With a “near miss,” the need to find a solution to create greater distance to the covenant may not seem as urgent. The hospital lives to fail another day.
What is also surprising about the 34% of survey respondents who foresee covenant challenges over the coming year is that it is incongruent with the improving trends documented in Kaufman Hall’s October National Hospital Flash Report. Through September, the year-to-date operating margin median index reported a positive 1.4%, continuing the improvement that began in January and a sharp reversal from the deep operating deficits incurred throughout 2022.
So what does this tell us?
First, we are by no means out of the woods. Labor will remain a challenge as the pipeline of nurses remains thin and demand remains high, leading to escalating pressure on salaries and benefits. A new boldness of unions to strike also sets an ominous tone for expense management. Second, while many hospitals report that they are maintaining good market share, many also report that the payer mix has shifted. Medicare and Medicaid now outpace commercial volume, which pressures top-line revenue growth. Each of these factors contribute to uncertainty on the durability of the current improvement. What is certain, however, is that the claims on that margin are unrelenting. That dollar will have to stretch pretty far to cover capital (unless debt is used for longer-lived assets), pension contributions, annual principal payments, and the ability to set some of the margin aside to maintain liquidity.
Covenant violations are time consuming, expensive, and should be avoided. Investors have long memories, too, and eventually organizations will return to the debt market to fund their long-term capital needs. Living close to the edge and just clearing the covenants is not sustainable either. Thorough financial planning should be employed to understand the causes of a covenant miss—or near miss—and build a durable financial plan that creates ample headroom to the covenants. That will help your organization pole vault over the covenant bar with greater certainty and a winning game plan.
