Health care borrowers are having a harder time with loan covenants the past couple of years, mostly because cost pressure and government relief went the wrong way at the same time. Many borrowers are struggling, and the result is a lot more of them coming close to or breaching the covenants in their loan documents.
The covenant breaches aren’t only from a few borrowers in a few markets, as was true during the first year of the pandemic. Now it’s a sectorwide problem, and it’s usually the same two covenants: debt service coverage ratio (DSCR) and days cash on hand (DCOH). For some, breaching a covenant is a certainty and it’s not a question of ‘if’ but of ‘when’.
Always know where you stand on covenants, and always assume problems will take more time than you think to fix. The last thing you want to do is to be surprised when you breach or approach a covenant breach. Planning ahead is the key to getting a system out of breach without causing a crisis. In this article, I’ll cover what you need to know to keep tabs on your covenants, how to organize your process, and what to do if you find out you’re heading for a breach.
Where You Stand on the Key Covenants
Find out what the main credit covenants are and whether you have a cushion. Keep your covenant numbers right in front of you where you can update them every month. In many cases that will involve forecasting, but even if you don’t forecast (which you should!) you can at least keep a running tally of where you stand on the key covenants.
The first place to look is the master trust indenture (MTI), but also look at any recent loan agreements because they could have added new terms or covenants. The covenants you actually have may be buried in a side document you didn’t even know existed. Supplemental indentures, covenant agreements and leases may create or change the terms of the loan’s covenants. Read everything.
The trick is in whose numbers count. Many covenants are measured on the numbers of a certain group of obligors, which may or may not be identical with the borrower. That may mean the obligated group, the whole system or whatever group the borrower chooses. Your lease may bind a subsidiary, a single hospital or the whole group. Know what your covenants cover before it counts.
Many covenants test a system’s numbers every three or six months, but other periods are not unheard of. See your master indenture or loan agreement. Usually the borrower has to give the bank a set of financials after the end of the period covered by the test, often at the same time as quarterly or annual financials. In some credit covenants the loan doesn’t default immediately when the test is failed.
DSCR and DCOH can tell you a lot about how a hospital or health system is doing, so let’s take a closer look at both.
DSCR is typically income available for debt service divided by debt service, which may be the past year’s actual figure or maximum annual debt service. The DSCR tests your ability to cover a full year’s payments with the income your hospital or system generates. The higher the DSCR, the better.
DCOH is a measure of liquidity that gives you a picture of how long a hospital or system can keep paying its bills without making any money. The formula for DCOH is unrestricted cash and investments divided by operating expenses on that same date, times 365.
Covenants serve a real purpose and that makes them important. First, they assure investors the hospital can repay the bonds. Second, they let the bond holders demand repayment before you go into bankruptcy. If a breach is coming, you should tell the investors, if it’s true, that breaking the covenant is not the same as missing a payment.
You Still May Have Some Options
If your projections show you heading toward a covenant breach, you still may have some options.
Time is your friend and running out of time is not. The clock is running when you think a breach is coming. The more time you have, the more options you have.
First, the best fix is usually the same for any health system and it’s an operational fix, not a financial fix. That means raising revenue or cutting expenses, so start there. It takes time to make money or stop losing money, so start the operations work now.
Find out whether you have options on your DSCR and DCOH formulas, such as a system or obligated group basis, assumed interest rates or amortization for balloon or variable rate debt, and other options. Maybe the numbers are better over six months than over a year, or maybe the obligated group looks better than the whole group. You never know till you try.
You probably should reduce the denominator or raise the numerator if you can. Most ratios work with either end of the equation.
If your test uses the obligated group, start now on getting the weaker members out and getting the strong ones in, because the tests to see who’s in and who’s out often look at the last year’s numbers.
If a DSCR is based on maximum annual debt service, find out how to reduce that number. If you have long term debt or a balloon payment, figure out what it would take to restructure that debt in a way that the covenants won’t get worse.
If you have a loan with the current year formula, consider making the current year’s debt service look better, for example through a refunding, a defeasance escrow or reclassifying debt as short-term. This can be tricky, but if you can do it it can be a big help.
If you have an unrealized gain on a debt or investment, you may be able to sell that security and realize the gain. You may also be able to delay a loss until after the period covered by the covenant test, or classify it as extraordinary where possible.
Health care borrowers hit by COVID or strikes often assume there’s no way to avoid a covenant breach. That’s not always true. Some debt agreements let the borrower miss the covenant test because of an event outside its control, usually called an act of God, a natural disaster or a strike. Check your loan agreement to see if there’s a force majeure clause. If there is, do the math to see whether the hospital or system would have met the covenant but for the pandemic or strike costs. Showing that may help you defend a technical covenant breach without a technical default.
A new lender can help refinance current debt with a structure that may let you get rid of your covenant problem. It won’t be cheap, but it might be the best choice you have. Likewise, you may be able to change a capital lease to an operating lease. If you can do a big capital project with an operating lease the payment may be expense, not debt service. Sometimes a hospital or system can get access to needed equipment through a sale-leaseback. Bringing in new money is good, and paying down old debt is better.
The interest rate environment over the last few years was extremely kind to healthcare borrowers, and many of them took advantage of it. A lot of debt was issued, but not all of it was used. Many systems still have project funds available, which they may not be using because the project was cancelled, shrunk, finished or shifted to another hospital. The good news is that you got low interest rates to finance an important project. The bad news is that now you don’t need the project, or your priorities have changed. If you can think of a higher-priority project that will use the project fund that much faster, then there is a case for redirecting the proceeds to a more current need. Keep in mind that tax-exempt bonds have a limitation on where they can be spent and how long you can borrow the money. First, you can’t spend a dollar outside the geographic area approved in the TEFRA notice. Second, the weighted average maturity of the bonds that finance it can’t exceed 120% of the projects’ weighted average useful life.
Event of Default
It helps to know when you have a breach and when you have a default. You need to know what your debt is and who holds it. With a bank or private placement lender, you know who to call. Then at the other end of the flexibility spectrum are public bonds, where the greatest number of participants mean the most risk of an impasse, since a waiver means reaching a majority of holders and involving the issuer and trustee.
A soft default means the borrower is below its target, but not so far below its target as to trigger an event of default. Depending on the debt agreement, this may involve hiring an independent consultant. If a bank holds the debt, it may waive that step. The lender may let you choose the consultant, but it has a veto power, or the bank may require that they, not you, pick the consultant. With public bonds, the borrower generally picks the consultant. The consultant reviews the borrower’s operations and finances to see what solutions are feasible. Its report usually lands with the master trustee, and bondholders may see it too.
Reaching a hard default is a major watershed event in the relationship between lender and borrower. On DSCR, if you fall below 1.0 you’re generally in an Event of Default unless bondholders waive it, though some documents look for several years in a row below that line.
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