Successfully Managing Opportunities in Healthcare Asset-Based Lending

Applying the "Five Cs of Credit"

MICHAEL COILEY OF CIT CORPORATE FINANCE, HEALTHCARE, DISCUSSES SOME OF THE AREAS THAT YOU SHOULD CONSIDER AS YOU EVALUATE THE HEALTHCARE SECTOR AND THE CHALLENGES THAT EXIST IN LENDING TO THIS SECTOR.

There is not a day that goes by without some news about healthcare, whether it's modifications to the Affordable Care Act (ACA), a shifting and consolidating market of service providers or altering the "fee for service" model, among others topics. Healthcare accounts for 18% of GDP (projected to increase to 20% by 2022) and, as such, represents a growing sector of the economy and should also signify an expanding loan market during this period.

While we are all individual "users" of healthcare, do we understand it enough to deploy capital in the form of senior secured loans? As assetbased lenders, do we really appreciate the risk that we are being asked to take by lending into this sector? This brief article using the "Five Cs of Credit" outlines some of the areas that you should consider as you evaluate the healthcare sector and some of the challenges that exist in lending to this sector.

Capacity: Like most specialized sectors, healthcare has an abundance of acronyms and terms that are utilized in each sub-sector, such as "ADC," "PPD," "RUGS," "CON," "ALOS" and "case mix," among others. Do you understand the impact these items have on the financial statements? Can you "speak" the same language as your borrower in the critical diligence phases as you evaluate the sufficiency of their cash flows? If you are transacting with a business that relies on payments from Medicare/Medicaid, do you understand the impact of sequestration and do you have a view on the potential for future reimbursement rate reductions or regulatory changes? Do you have a process to follow the recommendations of the Medicare Payment Advisory Commission ("MedPAC"), an independent agency that advises the U.S. Congress on issues affecting the Medicare program whose recommendations may provide a basis for assumptions in your financial forecasts?

Capital: Corporate structures in healthcare asset-based lending (ABL) are complex in certain sub-sectors given the legal landscape; therefore, it is critical to understand the full level of capital investment by your borrower and at which legal entity the borrower's equity is located. Is there shared risk? Unlike traditional commercial and industrial (C&l) ABL, there is a higher percentage of service providers in healthcare ABL, so the level of infrastructure investment to support the business tends to be a little lower. As such, it's critical to understand the business' prospects, its earnings retention practices, its liquidity profile and to undertake a "real" cash flow analysis (not EBITDA cash flow), as items such as CHOW (Change of Ownership) or certain state Medicaid payment practices can quickly alter liquidity.

Character: To state the obvious, avoiding the bad guys is the secret to a long life in this industry. While a healthcare asset-based lender seeks many of the same attributes as a C&l asset-based lender, there are two areas of concern that merit increased focus: fraud and abuse, and the regulatory processes of the Centers for Medicare and Medicaid Services (CMS), which administers the Medicare and Medicaid programs. In FY2013, the U.S. Government's healthcare fraud prevention and enforcement efforts recovered a record-breaking S4.3 billion from individuals and companies. The Obama administration has certainly focused on recovery, as their combined five-year effort has recovered $19.2 billion, almost double the previous five years. Healthcare has the potential to be very confusing, which can create room for a fraudster seeking to take advantage of a knowledge gap between the parties. Background checks here are not perfunctory and an asset-based lender should be looking for signals. Common sense, trusting your gut instincts and full-cash dominion are additional weapons. Another concern is CMS. Is your borrower engaged in ongoing disputes or disagreements with CMS that may have arisen through audits (e.g. overpayments)? Are they being cited for quality of care issues? Ongoing battles with CMS or its agents, which could take years, could be a harbinger of troubles, and when you combine concerns about Medicare's recoupment rights, it can get interesting.

Conditions: Regulatory decisions, historic sector challenges and the general economy are all focus areas. To explore a little deeper, we'll use the durable medical equipment sector (DME) as an example. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (MMA) had a significant impact on this sector that is now being felt. The MMA established the competitive bidding program that was implemented in 2011 (so lenders did have forward-looking warning signs). Some non-healthcare lenders who did not understand the DME sector or the potential impact of the MMA found themselves with borrowers who suffered serious cashflow deterioration. Another example is skilled nursing facilities (SNFs), more commonly known as nursing homes. The 1997 Balanced Budget Act dramatically altered the reimbursement rules and had the unintended consequence of driving many operators into bankruptcy; (today, this sector is again under scrutiny to ensure appropriate reimbursement levels). The asset mix and cash flows of SNFs are relatively straightforward, but there are nuances that a lender who is active in the sector appreciates. For example, understanding the timing of invoices and the lumpy nature of receipts creates the need to lend on "unbilled A/R," and your portfolio teams need to follow any CHOW impacts as well. As shown by the examples of these two sectors, understanding the industry, its history and potential legislative impacts on borrowers' real cash flows are all necessary to avoid problems. MedPACcan provide an early "warning" signal on which sectors might have future rate cuts. Furthermore, having portfolio specialists who understand the tenets of ABL within a focused healthcare discipline allows those professionals to highlight potential issues (inclusive of your client's ongoing regulatory compliance) before they become big problems and take appropriate action.

Collateral: No need to define this for an asset-based lender, or is there? Estimated net value (ENV), liquidation rates, non-assignability, concentrations, self-pay, 180 days and double lockboxes are all in the vocabulary of a healthcare asset-based lender. Quite a few healthcare ABL clients have a borrowing base that is "A/R only," however, that is where some of the complications and differences start.

Terms like full dominion are forgotten in middle-market C&l ABL today, but it's not so in the healthcare ABL sector. Most traditional healthcare ABL shops require full cash dominion, but there are some areas of focus:

I Utilizing a double lockbox set-up is appropriate given the Medicare anti-assignment provisions. Presuming the lender has filed the proper UCCs, the lender is perfected in the identifiable cash proceeds of Medicare receivables. Thus, once Medicare pays the provider (typically into a lockbox account), the lender is perfected, even though they may not have control of that account. A second lockbox is typically set-up with lender control that receives automatic sweeps from that first lockbox on a predetermined basis (typically daily). As such, while the borrower does control the initial lockbox account and can alter the sweep instructions (which should be a default in your agreement), you should be at risk for only one day of Medicare cash receipts.

I Do you have a view on ICD-10 (International Classification of Diseases) and have your clients invested in preparing for this transition? ICD10, the code used to report medical diagnoses and inpatient proce- dures, is slated to replace ICD-g on October 1, 2014. Invoicing using DRGs (diagnosis-related groups) would be based on the DRG assigned, using the new ICD-10 codes. Is your client ready? Are fiscal agents, insurance companies and other payors ready? The American Hospital Association, in a February 19, 2014 hearing to the National Committee on Vital and Health Statistics, has warned that "testing only one week in March is not adequate." The net impact is that ICD-10 could cause a major cashflow problem for clients if anyone in the stream of payments is not ready. Some healthcare companies have commented that they "would be surprised if this would be implemented without any issues"; "we expect that their (payors') readiness will be all over the map" and ICD-10 is "like a mini Y2K."

I Do you know what a bundled payment is? Picture a general contractor who receives all the monies for a contract and distributes to its sub-contractor. A bundled payment is essentially an episode payment; however, the services may be performed by different parties, so they "share" in the delivery, but the payment is made to the general contractor. A bundled payment pilot was created under the ACA for 2013. How will the bundled payment be distributed to providers of care or even providers that don't provide care but share in the gains and losses? There are many lenders who are following this pilot as it could certainly lead to new challenges when financing healthcare providers, especially in the healthcare ABL sector, as full dominion is an important lending safeguard.

In the healthcare sector, advancing up to 150-180 days is not out of the ordinary (but be sure you understand the subsector into which you're lending). In addition, while there are typical dilutive items, such as bad debt losses and unauthorized deductions from A/R, healthcare ABL treats them differently. Healthcare asset-based lenders track the cash received divisible by eligible A/R, and the resultant ratio is called a liquidation rate (or ENV). To calculate a healthcare borrowing base, you multiply the eligible A/R by the ENV and then by the advance rate.

I Each sub-sector can work very differently. For example, the drug distribution business could have reserves for chargebacks, distribution fees, Medicare/Medicaid reserves and rebates, combined with an industry standard return policy that will materially impact A/R availability.

I C&l asset-based lenders always struggle with concentration issues, but that is, generally, not the case in healthcare ABL. You need to understand the sub-sector to ensure proper structure to gain that concentration comfort. Two examples: if you are in the distribution segment, it's not uncommon to have three large distributors as your main customers where your client's sales staff is targeting the end customer with the product "pulled through" the channel, or a 70% Medicare / Medicaid concentration in a SNF.

Common Sense, often called the sixth "C" of credit: At the end of the day, does all the information that you have reviewed correspond with the discussions you have had to date? Does your lending institution truly understand and appreciate the risk that they are being asked to undertake? The most seasoned lenders are always ready to share a story where they trusted their gut instinct by walking away.

The healthcare sector is both exciting and challenging. It is an expanding part of the economy and, combined with the Affordable Care Act's focus on increasing the number of insured lives, it should represent a solid lending sector. However, there are risks. For example, while "stroke of the pen" risk exists in government reimbursement related sectors, a properly structured healthcare ABL transaction should provide loan protection. Sector knowledge, staff expertise, systems and execution capabilities are critically important for successfully lending to healthcare companies. Anyone can lend money. The important question is: Can you get it repaid and will you know when to act to head off a potential problem? tsl

Michael Coiley is managing director for CIT Corporate Finance, Healthcare, and is responsible for providing both financing and strategic solutions to clients in the healthcare sector. He also serves as first vice president of the Commercial Finance Association.