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Understanding the Capital Formation Process

[By Calvin W. Wiese CPA MBA]

Almost every bond issue has security provisions. Usually the security for bond holders is described in the bond indenture. Security for credit enhancers typically is greater than that provided bond holders and is spelled out in the agreements between the credit enhancers and the hospital obligor. Covenants are promises made between the parties and are used to describe the security provisions.

Mortgages

Mortgages on properties are not common security provisions. Mortgages, reserved for poorer credits, are considered somewhat arcane. More in favor are covenants not to encumber. The idea is to ensure that no property has a superior security interest to the interests of the bond holders. This form is less restrictive and provides more flexibility to the hospital obligor. Almost all bond issues will provide either a covenant not to encumber or a mortgage on almost all property as security for the promise to make payments.

Debt Service Covenant

Covenants based on debt service coverage are fairly common. Debt service coverage is a metric that expresses how much cash is being generated relative to the debt service of the hospital. It is, as a rule, calculated as net income available for debt services divided by annual debt service. Net income available for debt service is net income plus depreciation expense plus interest expense. Debt service is the principal and interest payments for all long-term debt. Sometimes, maximum annual debt service is used; debt service is scheduled out for each year into the future and the year with the highest amount is used. Debt service coverage is used as a trigger for various covenants. If debt service coverage falls below specified level, then provisions of covenants kick in.

The Rate Covenant

The most common covenant is the rate covenant: hospital covenants to set rates sufficiently high to ensure that debt service coverage is at least X (typically 1.10). If the specified coverage is not maintained, then the hospital promises to hire a consultant to do a study and determine what changes need to be made to achieve the specified debt service coverage.

Long Term Borrowing Covenant

Perhaps the most confusing covenants deal with additional long-term borrowing. Usually, additional long-term debt can only be borrowed when the pro-forma debt service coverage (debt service coverage including the additional long-term debt) is higher than a specified level. This limits the amount of long-term debt hospitals can borrow.

Assessment

Covenants made to bond holders are very rigid. Since there can be many bond holders, and many of them may be fairly unsophisticated, there is almost no way to get relief from them. If they are too tight, about the only means to gain relief from them is to refund the bonds. Thus, great care must be used in making covenants to bond holders. Covenants with credit enhancers can be more flexible since credit enhancers can waive covenants — if relief is needed, hospitals have the option of requesting waivers from the credit enhancers who are usually quite sophisticated and may very well find it in their interest to waive.

Conclusion

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Filed under: Health Economics, Healthcare Finance | Tagged: bond security provisions, Calvin W. Wiese, Debt Service Covenants, Hospital Bonds, hospital capital formation, Hospital Financial Covenants, Long Term Borrowing Covenants, Rate Covenants |