1 Distressed Healthcare Current Trends Thomas M. Barry William P. Smith Robert C. Yolland June 8, 2012 1

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Distressed HealthcareDistressed Healthcare

Current TrendsCurrent Trends Thomas M. Barry

William P. Smith

Robert C. Yolland

June 8, 2012

1

2Copyright 2012. All Rights Reserved.

Your Players This Morning

Thomas M. Barry – Hammond Hanlon Camp LLC: an investment banker focusing on healthcare change in control

transactions.

Robert C. Yolland – Franklin Advisors: an institutional

investor focusing on hospitals.

William P. Smith – McDermott Will & Emery LLP: a

lawyer and trailing economic indicator.


Program

Healthcare Challenges: Last Year and Today. Current Issues in Healthcare M&A: Realities and

Activity. Current Issues in Hospital Finance: Front and Back. Current Issues in Long Term Care: Parable of The

Clare. Prognosis. Appendix A: CCRCs As Special Problems Appendix B: Recent CCRC Bankruptcy Sales


Biggest Healthcare Stories of 2011

1. Challenges to Affordable Care Act.

2. Debt Ceiling Effect on Reimbursement.

3. Accountable Care Regs. Released.

4. Payors and Providers Mix It Up.

5. For Profits Buy.

6. Tenet-CHS.

7. Non-profits Buy.

8. Physician Employment Rises.


Biggest Healthcare Stories of 2011, cont.

9. Increased Scrutiny of Hospital Tax-Exempt Status.

10. Fraud Prosecutions Balloon.

Source: Becker’s Hospital Review, 11/06/11


Biggest Healthcare Stories of 2012 (so far)

Supreme Court Reviews Affordable Care Act. Aggressive Anti-Trust Review. Long Term Care Reimbursement. CCRC Tailspin. Not So Happy Valley. Debt Ownership As Leverage Comes to

Healthcare.

h2cllc.comHealthcare Investment Banking

HAMMOND HANLON CAMP LLC

The Realities of Healthcare


Healthcare Investment Banking 8

Current incentives are contributing to unexplained and/or unintended variation in health care quality and cost

FFS rewards episodic intervention: throughput, ancillary utilization, radical autonomy and leveraging for rates

Promotes ‘coopetition!’

No “accountability” for patient management:

– Best measurable outcomes

– Referring to the appropriate level of care

– Cost effectiveness

– Coordination of care/team care

– Standardizing around best science

– Team performance

– Patient responsibility

The Current Model is Fractionated



National Healthcare Expenditures per Capita vs. Life Expectancy at Birth(1)

We Spend Too Much and Do Not Get Enough in Return

(1) OECD Health Data 2011; Dataset includes most recent information available (2008, 2009 and 2010 data)

Rest of OECD

U.S.



Cumulative Changes in Health Insurance Premiums, Workers’ Contribution to Premiums, Inflation and Workers’ Earnings(1) (1999 Index)

…But it Cannot Last Forever

(1) Kaiser/HRET Survey of Employer-Sponsored Health Benefits, 1999-2010; Bureau of Labor Statistics



Inpatient vs. Outpatient Volume(1) (1990 Index)

Volumes are Becoming Less and Less Inpatient Centric

(1) “Trendwatch Chartbook 2011: Trends Affecting Hospitals and Health Systems” American Hospital Association, Avalere



Two Not for Profit Health Care Systems:

One: an old and respected health care provider. Among other activities operates a long term managed care plan, no debt, large endowment, profitable

Two: an old and respected health care provider: operates a long term care facility: no debt, large endowment, profitable

The two serve the same geographic market

New Legislation:

The State in which the two operate is mandating enrollment for “dual eligibles”

The Impact:

The long term managed care plan will more than double in size, profitability and value in the next 12 months

The long term care facility plans to be sold since it is concerned it will no longer be able to deliver its normal brand of quality care

Winners and Losers: The Impact of New Legislation on Two Health Care Organizations



Hospital Governance

Many Independent Providers

Systems are Evolving

(1) “Trendwatch Chartbook 2011: Trends Affecting Hospitals and Health Systems” American Hospital Association, Avalere

2,0442,941



The “Big” Guys are Not Really That Big

(1) Revenue numbers are for most recent year availableSource: CapitalIQ; Audited Financial Statements

Top 10 Largest U.S. Hospital Systems(1) ($ millions) % of Total

Health System Revenue % of Spend

U.S. Veterans Affairs Department $50,015 1.9%

HCA 32,506 1.3%

Ascension Health 15,564 0.6%

Community Health Systems 13,626 0.5%

Dignity Health 9,839 0.4%

Catholic Health Initiatives 9,632 0.4%

Tenet Healthcare 9,584 0.4%

Sutter Health 8,777 0.3%

Providence Health & Services 8,082 0.3%

Universal Health Services 7,500 0.3%

Top 10 Hospitals

6.4%

The top 10 largest hospital chains represent only 6.4% of total national healthcare expenditures



How Do We Get There?

Redesign Business Model

ScaleHorizontal and Vertical

Integration

ConsolidationPayors and Providers

Working Together



Current State Future State

Current vs. Future State of Healthcare

Cost and Quality Opaque

Cost Shifting – Pricing Differential

Expensive and Inefficient

Fragmented Providers

Fee For Service / Utilization Driven

Inpatient Centric

Transparent and Consumer Focused

Rate “Normalization” / Revenue Pressure

Achieve Greater Value

Consolidated and Integrated

Value Based, Outcomes Driven

Distributed / Outpatient



And Then a Miracle Happens…



So What’s Next?

HospitalsPhysiciansPayors

Integrated Delivery System With Scope and Scale

Data & Information Underwriting

Capability

Coordinate &

Deliver Care

Care Delivery -

Infrastructure Capital



The emerging success model will require transformational change and impose new risks on hospitals. Successful hospitals and health systems will need to possess or develop:

– An “essential” market position and growth strategies to drive revenues and achieve critical mass

– Integrated physicians to support quality and cost initiatives

– Ability to demonstrate value proposition to employers and payors - measurable quality and cost effectiveness

– Alignment with other providers to enable patients to be managed seamlessly across multiple care sites

– Sophisticated IT and care management infrastructures

– Access to capital to fund overdue and increasing capital expenditure requirements

– Medical technology and telemedicine

– Effective management and governance

The New Model for Survival



Partnership and Consolidation Activity



Announced Hospital and Health System Transactions

Distributions of Transactions by Ownership Model

M&A activity was high in the late 90s, and is rising again today, as the current healthcare model takes its toll on profitability and margins

M&A Activity

Source: Irving Levin Associates, Inc. and H2C

Relatively High Margins / Minimal

Legislation

1995 2000 20122011

51%

14%

7%

28%22%

20%

31%

27%

55%

7%3%

36%

65%12%

8%

15%

NFP-NFP FP-FP NFP-FP FP-NFP



Recent M&A Activity: Publicly Traded For-Profit Acquirers

Acquirer Target Strategic Rationale

Scale New Market

Value Asset

Scale Expansion

Consolidate Industry

Scale Demographi

cs

Geographic Expansion

Scale In-Market Specialization

Scale New Market

Value Asset

Geographic Expansion

Specialization

Branding Strategy

Consolidation

Service Line Expansion

Scale New Market

Value Asset

(Rejected)



Need for scale and market strength driving activity

– Weak market and financial positions driving independent hospitals to find partners

– National multi-hospital systems with single facilities in unfavorable markets facing need to prioritize

• Significant activity among Catholic systems, including facility “swaps”

– Strong regional systems acquiring independent hospitals to improve market position

– For-profit hospital management companies – both publicly-traded and privately held – are extremely acquisitive

Analysis of Recent Transactions: Trends



Substantial capital looking for investment opportunities in the healthcare sector

– New private-equity backed hospital management companies formed to pursue acquisitions and / or joint ventures, many with a focus on not-for-profit facilities

– Increased funding for those already operational

Non-cash mergers have become the primary transaction structure utilized by not-for-profits

– Financially sound hospitals facing substantial capital requirements and reduced access to capital

– Governing boards’ preference to retain not-for-profit status

– Governance rights and capital commitments in lieu of cash

– Regional systems merging to create super-regionals

Analysis of Recent Transactions: Trends


Hospital Finance: Investor Concerns

ACA makes Future Reimbursement Difficult. Medicare Under Pressure – 2024 Is Not Far. States Are Struggling Affecting Medicaid. Falling Utilization. Little to No Revenue Growth. Physician Acquisitions – Movie Wasn’t That

Great the Last Time. Strong Getting Stronger; Weak Weaker.


Hospital Finance: Investor Concerns, cont.

Ratings Compression: Single Site Close to Multi-Hospital Systems.

Pension Expenses. Swap Issues. Yield Compression. Direct Placements Return to Hospitals. Supply Leads to Weakening of Legal

Structures.


Hospital Finance: Back End

Search for Capital Partners: St. Vincent’s I & II West Penn - Highmark

PE Rides to the Rescue: Vanguard – Detroit Medical Center Cerberus – Caritas Christi create Stewart Bayonne; Hoboken; Christ

Regulators Rule: Cheboygan & Peninsula. Default As Leverage To Augment Structure.


Senior Living: Parable of The Clare


CCRC Endowment Structures

Typically a partially refundable payment at entrance, combined with monthly service fees.

Continuum of Care. Early Sales Pay Down Early Maturities. Rise in Unit Values Repay Long Term Debt. Little to No Equity From Sponsor. Often “Mission Driven” Non-Profit Sponsor.


Fully Refundable Presales – Aren’t

Clare "pre-sale" (aka: fully refundable deposit) rate

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

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90.0%

100.0%

3/31

/200

6

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9/30

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6

11/3

0/20

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1/31

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3/31

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7

5/31

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7

7/31

/200

7

9/30

/200

7

11/3

0/20

07

1/31

/200

8

3/31

/200

8

5/31

/200

8

7/31

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9/30

/200

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11/3

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08

1/31

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3/31

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5/31

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9


Result

Occupancy Freezes at 31%. Arguments Over Entrance Endowments.

Exposes Cracks Among Lenders. Working Capital Evaporates. Regulators “Concerned”. Publicity Does Not Augment Marketing.


Intermediate Solutions

2010: Exchange Offer Gives Equity Fix: Fixed Convert to A/B Structure Variable Agree to Convert When L/C Expires Effect Is Equity Fix and Covenant Relief Lasted Seven Months

2011: Covenant Relief: Loosen Strictures; Add Working Capital Lasted Four Months


Final Solution

Chapter 11 on November 15, 2011. Sale Held April 12, 2012. Plan Confirmed April 27, 2012. Recovery: 21% for Debt; 100% for Residents;

Zero for Trade and Sponsors. Concessions by Landlord. Strategic PE Buyer. Repeated In Multiple Jurisdictions. Big CCRCs Still Struggling.


CCRC Results To Date

A never-ending string of amendments (and fees) for the “healthy”.

Some Refinancing with Fixed Debt. Hope and Schmuck Notes Abound. 363 Sales to Distressed PE Buyers. Little Creativity. Lender Revolt Brewing Relative to Resident

Recoveries.


Prognosis:

Mission Focus: Do You Want to Be In This Business?

If You Mark It Down, They Will Buy. PE Has the Dough; Does It Have the Exit? Given Time, Non-profits Will Play. Litigation Seems More Likely Than Recent

Past. He Who Has The Gold, Rules.


APPENDIX A:Why Are CCRCs Special Problems? CCRCs are being affected by several forces:

-falling personal net worth;-dislocation in housing markets; and-contraction in commercial debt markets.

Results:-slower fill-up, lower occupancy rates, maturity date

structural-roadblocks, covenant violations;-increasing yield spreads;-shorter letter of credit terms given lenders’ balance

sheets; and-inability to arrange refinancing or purchase money

financing.


Conventional Financing

Market dominated by a small number of lenders. Unique underwriting set. Construction financing generally tied to entrance deposit

collateral (phased to hedge risk); take out financing tied to fill up. Current environment is gloomy:

Many lenders out of market, period! Many with workouts, causing internal strain. Appetite for new credit support or refinancing limited and, if available,

only with higher spreads. “Integrated” legal structure makes use of government financing

for a “piecemeal” approach to access more available credit (i.e. carve out SNF, AL, unit) difficult to achieve.


Bond Financing

Favorable pricing continues to be attractive. Ability to tie construction risk with lease up risk with long term

operating risk unique, especially at fixed rates! History of tax-exempt CCRC financing lead to current favored

structure of short term letter of credit backed variable rate debt and long term fixed rate debt.

However, shared collateral pledges and different aspirational goals lead to tension between variable and fixed interests.

Use of 100% debt financing leads to early stress if thinly capitalized or unmotivated sponsor.

Nature of publically traded debt leads to challenges in altering structure.

Advent of distressed debt buyers a new and untested phenomenon.


Governing Law

No comprehensive federal law on CCRCs State regulated:

Jurisdiction-specific Certain jurisdictions have more comprehensive laws in

effect (e.g., CA, FL, NC, NY and PA) Areas typically covered:

Entry Requirements Financial Solvency Consumer protection Residents’ rights Health & Safety Requirements


Regulatory Authorities

* “CCRCs offer multiple levels of health and long-term care services, [therefore] regulatory gaps and overlaps exist.”

* “Coordination of these various authorities is a persistent problem in most states.”

State Department of Insurance State Health Department; State Office on Aging; State Social Services

Department State Attorney General’s Office Statewide CCRC Advisory Boards/Councils State Long Term Care Ombudsman

*Elder Law Portfolio Series, Portfolio No. 5, Housing Options, Release #11, 5-29 (Stephanie Edelstein ed., 1999).


Examples of State Laws

Massachusetts: Mass. Gen. Laws ch. 93 § 76 Office of Elder Affairs mandates disclosure:

Facility files Disclosure Statement containing: organizational and management information; business experience; financial statements; fees; services; and copy of residents’ rights.

Florida: Fl. Stat. Ann. § 651 Dept. of Financial Services, Office of Insurance Regulation is

the principal regulator: Statutory minimum liquid reserve requirement

California: Cal. H & S Code §§ 1770-1793 Dept. of Social Services, Continuing Care Contracts Branch

regularly evaluates financial stability and mandates reserve levels

Statewide Continuing Care Advisory Committee


Stakeholders in Distressed CCRC

Sponsor and Shareholders. Manager and Required Consultants. Residents (and their progeny in a life care return

of capital model!) State (attorney general and regulatory

authorities). Institutional creditors (bondholders, trustees,

letter of credit issuer, insurer). Trade debt. Local community (watch out if your alternative

use requires a zoning change!)


Identifying Source of Problem

1. Operational – Cost overruns, occupancy, service delivery, reputational, and reimbursement issues.

2. Market – Demand side, condition (capital expenditures?), supply side.

3. Finance – Maturity date, amortization, rate increases on variable rate debt; investment losses on endowment funds; covenant (occupancy; marketing; coverage) breaches; the cost of consultants, both in cash and management distraction.

4. Management/Sponsor Attention – Single site versus multi-site; commingling of cash; dilution of time.


Solutions

1. Operational Expense control (vendors; staffing). Capital expenditures and use of endowment. Management change, component management change, or consultant

change. Rebranding. Observation rights.

2. Market Use of endowment (compare interest vs. principal). Receiver’s involvement without bankruptcy. Unit pricing. Seller unit financing or spread payments over twelve to eighteen mos. Closure or conversion of units. Rental versus ownership.


Solutions, continued

3. Finance Debt exchange (but cancellation of indebtedness income). Debt restructure by forbearance. Covenant or loan terms relief and conditions. Bifurcation of debt structure. Equity infusion (manager; joint venture partner). Additional collateral, sponsor guaranty. Subdivision of facility (unbundling SNF or AL). Sale, foreclosure, deed in lieu. Bankruptcy: 363, prepacks, and plans.



4. Management/Sponsor Attention: Distraction, loss of focus, home office syndrome; Wider skill set and advisor skill set may be needed; In multi-site operations, commingling of cash can be a

likely result with difficult ramifications. Piecemeal nature of separately financed facilities tied by

common ownership or management leads to tension among stakeholders of the sponsor or parent organization.

Sponsor organization may have different agenda, whether preserving equity for shareholders, legacy for charismatic participants, or mission.



On Private Equity side, significant control rights (elect board, veto sales, replace officers) gives faster response, but lenders have been reluctant to use these techniques.

Lender observation rights, ability to approve new manager or require officer with specific skill set may be useful alternative.


Barriers/Alternatives

1. Operational Revenue Increases:

State CCRC laws (CA/FL) require advance notice to residents, resident participation in budgeting (CA) and detailed reasoning if over CPI.

Non-Core Service Curtailment: Changes to residency service agreements require advance notice and/or

approval by regulators (CA/FL). Staffing bed reductions; (Note: certain states (e.g. FL) require approval to

reduce, redeploy SNF beds to IL or “community based” SNF beds; FL has a 1:4 ratio).

Use of endowment; escrows for operations. Note – Many states require that twelve months of debt service reserves or 10% of annual operating expenses be maintained (some allow “credit” under loan or trust agreements) and that these and entrance fee escrows be lien free.


Barriers/Alternatives, continued

Management Change; Some states require notice, approval of any change in management, “structure”, “substantial” change of control; ability to revoke Certificate of Authority based on solvency review.

2. Market Contractual limitations on repricing of units. Conversion to rental (Note: CA requires disclosure and

approval of conversion of units originally designated entrance fee to rental model).



3. Finance Bondholder consent provisions. Bank syndicate consent provisions; differences in creditor

objectives and perspectives. Caution: Many state CCRC laws require advance notice (CA;

FL) and in some cases approval (CA) of any transaction, refinancing transaction or one where the regulators believe reserves are jeopardized or fees may increase.

Health Regulator or Insurance Commissioner or Attorney General restrictions or conditions on collateral foreclosure are prevalent.

Restrictions on use of escrows or endowments for operational collateral (Note: Specific state law restrictions on cross-collateralization – e.g. PA).

Cancellation of indebtedness income an unwelcome effect. Subdivision of property causes real estate and regulatory issues



4. Management/Sponsor Attention: Management Replacements, both local and home office. Management Replacements, both in whole and in part. Consultants: to assist and to police. Cash control: for fun and collateral differentiation. Consultant control: when dueling and when interfering. Consultant compromise: maintaining independence while

cooperating. Getting to the Board: is there intelligent life apparent? Multiple layers of stakeholders: my borrower’s parent’s creditors

are not my friend.


Appendix B – CCRC Bankruptcy Sales and Recoveries (last 24 months; in millions) Clare Oaks: IL $95.5; sale pending. St. Mary: OH $46; sold for $18.8. Clare: IL $229; sold for $53.5. Fairview Village: IL $56.8; sold for $28.75. Monarch Landing: IL $14; sold for $10. Sedgebrook: IL $14.3; sold for $10. Villa San Antonio: TX $36; sold for $15. Villages at Penn State: PA $34.6; sold for $18.5. Erickson: TX 20 communities sold for $365M.

Documents

1 Distressed Healthcare Current Trends Thomas M. Barry William P. Smith Robert C. Yolland June 8, 2012 1