Financial and Bond Services for Hospital Market

Financial Advisory &
Acquisition Services

Market Segment Brief

October 2008

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Table of Contents

Quick navigation -Hover over blue page and ctrl-click

EXECUTIVE SUMMARY ............................................................................................................4
PROLOGUE ...............................................................................................................................6
OVERALL DESCRIPTION .........................................................................................................7
Implementation – Strategy & Posture .........................................................................................8
External Factors - Largely Beyond the Enterprise’s Control........................................................8
Internal Factors - Conditions Effecting the Enterprise’s Overall Performance.............................8
COSTS .......................................................................................................................................9
BUYERS, USERS ......................................................................................................................9
BENEFITS RETURNS .............................................................................................................10
HEALTHCARE MARKET..........................................................................................................10
Market Size and Growth:...........................................................................................................10
Consensus: It’s A Complicated Time for Healthcare But It Will Continue To Do OK.................12
Hospital Performance – Plateaus for the Strong; Declines for the Weak...................................12
Hospital Bond Rating Volatility Tracks Financial Performance..................................................13
Mergers & Acquisitions .............................................................................................................13
General – Steep Decline in Activity...........................................................................................13
Healthcare – Strategic Buyer’s Market......................................................................................14
FUTURE TRENDS ...................................................................................................................14
HEALTHCARE .........................................................................................................................15
Top Six Healthcare Challenges Will Intensify............................................................................15
Recession Will Have A Mild Effect On Healthcare.....................................................................16
Healthcare Financial Managers Remain Calm..........................................................................16
Hospital Affiliations Up..............................................................................................................17
VENDORS ...............................................................................................................................17
OVERSIGHT & INFLUENCE ....................................................................................................19
Regulatory ................................................................................................................................19
Associations..............................................................................................................................20
Appendix A................................................................................................................................21
A Primer--Tax-Exempt & Non-Traditional Debt Instruments......................................................21
Bibliography..............................................................................................................................23

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EXECUTIVE SUMMARY
Historically low interest rates, narrow Total Acute Care Bond Up/Downgrades
credit spreads, and a flat yield curve that (Fitc h 2008 Report)

began peaking in 2006 fueled the
hospital bond market’s estimated $50 40
billion performance in 2007. Thus far, in
2008 available information suggests 30
bond market contraction with
approximately 100 overall healthcare 20
provider deals having been underwritten,
10
averaging $138 million in size and
totaling $14 billion. Despite this plunge 0
from record-setting days to the current 2002 2003 2004 2005 2006 2007 2008
financial turmoil, healthcare remains
clear-headed and is anticipating its usual
challenges intensifying; the effects of the Total Healthcare M&A Deals Trending
recession on it being mild; low
800
confidence in the bond markets
persisting; and increasing opportunities
for strategic acquisitions by the strong 600
being a popular strategy. 410 523 534 489
400 423
Those holding the financial reins at
hospitals are dealing with many trans- 200
departmental issues leaving little
bandwidth to handle the details of 0
transforming their capital positions or 2003 2004 2005 2006 2007 2008
handling merger and acquisition
activities—enter the financial advisory firm. Working with the board and financial
leadership, these advisory firms provide the expertise and finesse to evaluate a
hospital’s dynamics and then plan and execute a strategy that gives the funding
sources, bond rating services and Market Share - Capital Advisory Services
underwriters a favorable view of a [1985-2007 Total Deals Value (Billions $)]
hospital’s credit worthiness. For the
median hospital, these firms produce a
value of $1.6 million for each 100 basis
points in average borrowing costs Ponder & Co
avoided. 48%
Killarney
Three of the top five healthcare financial Group Kaufman Hall
advisory firms are part of larger national 3% 24%
Public
firms with the remaining two being Shattuck Financial
growing stand-alone, privately held Morgan Mgmt.
firms. The leading firm claims twice the Keegan 20%
number of deals as the next two closest 5%
competitors—the fourth and fifth place
firms halve this amount again. These firms account for an estimated 10% of the
total bond underwriting for healthcare provider organizations; tend to be involved
in deals that average smaller in size ($54 million verses $138 million for all of

Page 4 of 25


healthcare): and have created a twenty-two year collective average of $5.54
billion/yr.

Page 5 of 25


PROLOGUE
Since the early 1990s, a hospital’s access to traditional sources of capital--bonds, bank loans,
philanthropy and equipment leases--was relatively easy. These debt instruments fueled
strategies for healthcare systems to scale up aggressively by buying physician practices,
increasing corporate girth through merger and acquisition, cutting deals to grow their integrated
delivery networks and investing in the latest revenue producing technology. However,
healthcare has been experiencing a tightening on these common funding sources over the last
decade that has illuminated a widening gap between hospitals in strong financial health and
those who are not. The effects of this trend include:

• The total amount and mix of capital accessed from traditional sources has dropped—bank
loans have decreased and leasing has become more popular.
Capital-Intensive
• The percentage of hospitals defined as having broad
Challenges
access to capital has declined.
• Conversely, the percentage of hospitals with limited Changing Competitive
access to capital rose more sharply. Landscape
• Rising Costs of
• Operating margins for both hospital types has also Delivery
declined—more so for limited-capital-access hospitals. • Aging Facilities
• Hospital M&A
Much of this movement between these two groupings is
• Alternate Site
attributed to a host of capital-intensive challenges that
Competitors
keep healthcare’s financial landscape in flux. Coupling a
mixture of these challenges with the current rocky • Referring Physician
economy makes it hard to find an acute care enterprise of Relations
any substance that has not seen its equity holdings and • Declining Philanthropy
access to capital suffer. For example, the University of
Pittsburgh Medical Center generates approximately $7 IT Requirements
billion/yr with a revenue growth of 12% CAGR in revenue • Major Legacy
during 2003-07.1 Yet despite this track record, it was not Upgrades
able to stop a 99% drop in its investment income during • EMR & Clinical
the second half of 2007. 2 This type of drop has not only Systems
raised the common concerns about budget, but, more to • Siloed Systems
the point, liquidity issues that add to the challenge of Integration
accessing debt instruments to survive and grow the • Compliance (SOX,
business. HIPAA)

Today, most hospitals are surviving, in part, by trafficking Employee Issues
in a plethora of debt instruments (See Appendix A). To • High Turnover Rates
remain debt worthy, consensus states that hospitals need • Limited Skilled Talent
to return to the basics by focusing on what matters most to Pool
the capital markets—robust cash flow, a strong balance
sheet and strong returns from capital, quality and safety Reimbursement
initiatives. It is also thought that with the future earnings Pressures
potential of hospitals always being challenged and choices • Uninsured
• Declining

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for accessing capital becoming more sophisticated, the need for guidance to negotiate a
tortuous list of options will exist.

This report will focus on financial advisory services that help acute care enterprises prepare for
and manage access capital funding sources.

OVERALL DESCRIPTION
Financial advisory firms and practices that are focused on helping health systems access
capital typically provide expertise and services that include:

Planning for Capital Access:
• Define financing goals and needs
• Analysis of current credit and debt capacity
• Risk analysis and articulation
• Staging for market conditions
• Develop a clear understanding of the financial strategy with the board

Transaction Implementation:
• Provide detailed knowledge of financial products to be used
• Negotiate fees and interest rates to pay underwriters
• Complete appropriate legal and credit documentation and filings

Continuing Surveillance:
• Monitor for developments in financial products markets; e.g. security provisions, interest
rates and regulatory requirements
• Monitor for opportunities to reduce interest costs or turn a profit like terminating a swap

Derivative Services:
• Advise and negotiate structure, terms and financing on exchanging one type of debt
instruments (e.g. fixed interest payments) for another type (e.g. floating interest payments)
• FAS 133 Reporting: the standard for financial reporting of derivatives and hedging
transactions since 2001

Investment Management Services:
• Act as an independent investment advisor to manage funds that include:
• Project or construction funds
• Reserved funds for debt service
• General corporate funds
• Board-designated funds

Merger & Acquisition Services:
• Provide oversight and management for all steps of the acquisition and divestiture process
• Value healthcare assets
• Negotiate the terms and conditions of buying or selling of business assets

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Implementation – Strategy & Posture
Overall, the funding sources, bond rating services and underwriters want to see
that hospital management and the board have a clear strategy. The advisory
firm must assure that in planning a strategy numerous external and internal
dynamics are evaluated including: 3
External Factors - Largely Beyond the Enterprise’s Control
Reimbursement for Services:
• Tightening reimbursement continuing for the foreseeable future
• Quality-based pay-for-performance requirements negatively impacting payment

“Graying of America”:
• Demographics of Americans ages 65 and older will increase by 19 million between 2000 and
2020—how will the hospital handle the volume?

Regulation:
• Increased scrutiny of tax-exempt status and community benefit
• Increased transparency through stricter reporting requirements

Consumerism:
• Health care consumers want access to high-quality care at reasonable costs
• Hospitals will need to invest in meeting the market’s needs or loose share

Internal Factors - Conditions Effecting the Enterprise’s Overall
Performance
Operating Performance:
• Costs, margins, bad debt, accounts receivable, financial ratios, plant condition and other
incomes are among the metrics used to assess financial strength, performance and liquidity
of the enterprise.

Competitive Posture:
• Market share, competing hospital services, patient volume, community perception and
breadth of services are used to assess an enterprise’s attractiveness to a patient population
and ability to capture share.
• The demographic fit with offered services and strength of the local economy assesses
growth potential over the long term.
.
Governance & Leadership
• Pivotal to organizational performance is planning for executive succession; board
composition and involvement; and oversight and accountability of leadership coupled with
long-term strategic, financial and capital planning.

Reimbursement Mix:
• The percentage of patients covered by state, federal and commercial insurers and the
breakout for managed care, co-pay, self-pay and uninsured care offers insight to revenue
source and planning for leaner future reimbursement.

Page 8 of 25


Physician alignment
• Number of physicians, their specialties, certifications, general satisfaction and aging
indicates the strength of the hospital-physician relationship.
• Hospital must have planning to balance physician needs with the communities to offset
contraction in reimbursement and expansion of physician ventures that preempt hospital
revenues.

The end result of this planning is the creation of a “We want to make sure
favorable credit worthiness profile for the funding sources that management and
that includes leading bond rating services (Fitch, Moody’s, the board have a clear
Standard & Poor’s). These ratings rank the likelihood of strategy that runs out for
hospitals to default on a bond issue; provides guidance on five to 10 years.”
the level of risk associated with investing in the hospital; or Jeff Schaub
facilitates the ability of hospitals to access the debt market Sn. Director
—the higher the rating the lower the cost of capital.

COSTS
Total costs are dependent on duration and extend of services or a percent of total bond
transactions. A basic costing may look like:4

Financial Advisor (based on bond size):
$2- $4 Million $20,000
$4- $7 Million $36,000
$7- $10 Million $50,000

Issuer:
Fee On All Bonds: 0.25%

BUYERS, USERS
The ultimate buyer of Financial Advisory Services is the Board Member Experience Criteria
Board of Directors for the acute care enterprise. The
Financial & Business 63%
board is typical composed of relevant stakeholders, such
Strategic Planning
as the medical staff and those from the community, and 49%

represents different skill sets critical to the hospital’s Public Relations 33%

success. This general composition of the board means Academic Training 31%

that there will be varying competencies about accessing Quality Mgmt. 26%

capital through a variety of debt instruments. To Other Boards 26%

compensate for this, the formation of a Financing Safety & Quality. 19%

Committee is typical and includes board members with Fund Raising 15%

knowledge of capital financing and key hospital personnel Clinical Practice 13%

that includes the CFO and CEO. Conflict Mgmt. 11%

The overall composition of the board is of utmost importance due to bond-rating agencies
(Fitch, Moody’s) increasing their examination of the board’s composition more closely. A board
that has the correct balance of knowledge and experience to achieve the financing mission
garners a more favorable evaluation and thus, positively effects bond ratings.

Page 9 of 25


Finally, the size of the healthcare organization matters. With payer and case mixes being
similar, those organizations with more than $2 billion in revenue typically perform better than
smaller organizations. This stronger profile makes it easier for them to secure funding and
typically indicates a more aggressive growth path that would require advisory services. 5

BENEFITS RETURNS
The role of those holding the financial reins of a hospital have changed. As exampled, the CFO
used to be focused on balancing the books and achieving some type of revenue. Today, the
stakes are much higher. Price transparency, pay for performance, regulatory compliance and
quality are blurring operational lines and health systems need a much more diverse person
interacting with all departments including those who are actually providing the patient care.

As their reach is extended by these conditions, financial leaders have to expand their
knowledge base and resources as well. It is the addition of a financial advisory services that
provides the periodically needed bandwidth, transactional expertise and surveillance that
speeds access to capital at the lowest cost--failure to do so can become expensive

With today’s higher borrowing costs and complexity of transactions, timing a hospital's
borrowing needs and the types of debt it has previously utilized weighed against what’s wise for
the hospital now is the basis of all benefits. The simplest of examples tell us for each increase
of 100 basis points in average borrowing costs the annual interest expense for the median
hospital would increase by $1.6 million.6
HEALTHCARE MARKET
Market Size and Growth:
(NOTE: Due to most firms being privately held and the Total Acute Care Bond Up/Downgrades
(Fitc h 2008 R eport)

highly niche nature of this service, publicly available
market data on the capital access advisory services 40
market is insufficient to construct estimates that are 30
anything more that rough at best.)
20

Market Size: 10

• The leading top five capital access advisory 0
firms are involved in an estimated 10% of the 2002 2003 2004 2005 2006 2007 2008

total bond underwriting for healthcare provider
organizations.
• The twenty-two year collective average of bond deals completed by these
five firms is $5.54 billion/yr.

• The top five firms tend to be involved in deals that average smaller in size
($54 million verses $138 million) than those handled by the large financial
bankers.
• The average deal size was roughly the same among the top five vendors.
• The leading firm claims twice the number of deals as the next closest
competitor—the third and fourth place firms halve this amount again.

Market Growth:

Page 10 of 25


• Bond rating agency’s empirical growth projections indicate that, despite
healthcare’s general lag in responding to gyrations of the economy, this
market will continue to see slowing growth from the highs of early 2007.
• “Flight to Quality”: The strongest financial performers with the highest
bond ratings will lead the list of those organizations seeking additional
funding to grow and modernize their system while those of lesser strength
will find funding difficult to attract.

2007 saw a continuation of hospital finance directors taking advantage of historically low
interest rates, narrow credit spreads, and a flat yield curve that began peaking in 2006.

• The $27.1 billion produced overall by healthcare in the "Hospitals that have
first half of 2007 showed a 40.1% increase over the been issuers over a long
same period a year earlier most of this growth was in period of time have
the first quarter.7 generally seen that over
• Combined issues, which include refundings and new a 20-year period, the
money, rose 125.2% to $10 billion from 2006's first lowest cost of capital
half.8 has been in variable-rate
• Straight new-money issues fell by 3.6% from the debt."
2006 period.9 Ken Kaufman
Founder
• Refundings increased 70.4% to $6.3 billion
compared with the same period in 2006.10
• Hospitals issued more than $15 billion of fixed-rate debt verses $11 billion of variable-
rate.11
• Variable-rate long bonds increased 2,267% from $125 million in 2006 to nearly $3
billion in the first half of 2007.12

Hospital Funding:
• Up through September 2008, available information
October, 2008
suggests that around 100 overall healthcare bond deals
... because of the lack of
have been underwritten.13
liquidity in the market
• These provider bond deals total $14 billion,
...hospitals have been
averaging $138 million.14 postponing plans to sell
• Banner Health, the largest non-profit system in the new bonds to fund capital
US, closed the largest deal thus far at $917 million.15 improvements such as
• Although data is incomplete, the market could slow to renovations and new
half its previous growth spike and size until more building....
favorable liquidity returns. Lisa Martin SVP
Moody’s HC

Leading Hospital Financial Advisory Services:
• During the 1985 to January 1, 2008, there were 2,270
transactions (103/yr) accounting for $122 billion ($5.54 billion/yr) in funding among the top
five identified leading capital access advisory vendors.
• The average transaction was for $53.7 million.16
• VHA’s current vendor Ponder & Co claims the lion’s share with an average forty-six deals
per year through 2007.

It is anticipated that the severe dislocation in the bond market will presumably ease as
government interventions take hold and market confidence returns. However, prudence
Page 11 of 25


dictates that, even in the event of effective government intervention, future credit and liquidity
facilities from banks to support new issues will be more difficult and more costly to obtain for the
near future.

Consensus: It’s A Complicated Time for Healthcare But It Will Continue
To Do OK
The agreement over a litany of anticipated negatives precipitating a slowing in
healthcare’s bond market activity is matched by a sense of calm about the low
impact they will have on the sector.

Most of the last decade found hospitals enjoying a market with high liquidity that easily
facilitated borrowing at affordable costs. However, the current financial crisis is producing an
emerging consensus about what hospitals can do and expect over the short term:

• Many are delaying plans to sell new bonds to fund capital improvements.17

• Bad debt will grow due to the weakening economy forcing companies to shift costs in the
form of higher deductibles and co-pays or eliminating employee coverage all together.18

• The tighter economy and anticipated tax hikes will cause higher-income patients and
community supporters to be less inclined to make charitable donations to their local
hospital.19
• Hospitals that implemented a strategic plan requiring back-end borrowing may be stuck with
very large investments that they financed on lines of credit--expecting to refinance these
lines is not going to be as easy as before.

Still, top bond-rating agencies see hospitals financial performance in 2008 continuing to
stabilize or moderately decline from 2007, despite a weaker economy and negative effects on
patient volumes and revenues.20

Hospital Performance – Plateaus for the Strong; Declines for the Weak
Hospitals with high bond ratings are seeing a leveling of financial performance
while those with rating of “BBB” or lower are scaling back.

A Sept. 25, 2008 special report by a leading bond rating % Community Hospitals With Negative
agency and based on audited financial data from 270 T otal Margins
hospitals and systems for fiscal 2007, excluding specialty 35

and those with significant municipal support, found:21 30

25
• After several years of stable and improving financial
20
performance, acute care hospitals are experiencing a
plateau.22 15

• Those with bond rating of “A” or higher are showing 10
the strongest performance, even though there is a
5
slight decline in profitability during 2006-07.23
0
1998 1999 2000 2001 2002 2003 2004 2005 2006

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• Most notably is a downward financial performance trend in the lower end of the investment
grade bond scale (“BBB” and lower). 24
• These enterprises tend to be more volatile due to their smaller size and thus are limited
during contracting negotiations due to limited economies of scale. 25
• They are also experiencing eroding profitability that is resulting in reduced capital
investments.26
Hospital Bond Rating Volatility Tracks Financial Performance
The number of upgrades and downgrades are at parity, but look for upgrading—
especially for “BBB+” or above rated bonds-- over the next two years.

During the period from 2003 and thus far in 2008, bond Acute Care Bond Upgrade Trend
(Fitc h 2008 R eport)
volatility (ratings upgrades or downgrades) has shown: 27
30
• “A” rated bonds and higher remained the least volatile
showing little tendency to migrate. 20
• “A-” & “BBB+” exhibit a propensity for mildly moving up.
• “BBB” & “BBB-” are the most active and trend negative, 10
if they don’t remain neutral.
0
As to the up and down grading trends nine months into 2002 2003 2004 2005 2006 2007 2008
2008, the pendulum has swung back from 2006 when
Acute Care Bond Downgrade T rend
upgrades spiked and exceeded downgrades for the first (Fitc h 200 8 R epo rt)

time.
30

• The number of upgrades and downgrades are currently
at parity. 28 20

• Upgrades tend to be for large higher rated
10
enterprises with improved financial profiles.29
• Downgrades are for smaller, lower rated enterprises
0
with eroding profitability and volume losses-- 2002 2003 2004 2005 2006 2007 2008
increased debt had a small effect.30
• Upgrades will likely match or slightly lag downgrades through the next 12 – 24 months.31
• Stronger hospitals should fare better by virtue of the characteristics that got them to high
‘A’ or ‘AA’.32
• Expect more downgrades than upgrades at lower end of the investment grade rating
scale.33

Mergers & Acquisitions
The slowing of M&A activity in 2007 resulted in a restructuring that eliminated
underperforming and marginally strategic assets to create stronger regional
networks.
General – Steep Decline in Activity
• The $1.6 trillion in worldwide M&A activity thus far in the “It has taken a long time
first half of 2008 shows a 36% decline from the record for the pendulum to
set during the same period a year ago.34 swing...the market
conditions clearly favor
Page 13 of 25 the buyer...”
Jim Beecher
Publisher
Buyouts Magazine

• Activity in transactions under $500 million showed best performance with only an 18%
decline and totaling $369 billion.35
• As of late July, 2008 only 36% had hope for an improved outlook in the second half of 2008;
up from 24% in December 2007.36
Healthcare – Strategic Buyer’s Market
The implosion of the credit market in midsummer 2008 has prompted a reduction in healthcare
M&A activity--especially in those transactions with considerable real estate components. This
contraction is seen as producing two key effects:37

• Financial buyers have retreated from the market.
• These buyers seek opportunities to buy organizations and then sell equity assets like real
estate.
• Strategic buyers, who did not care to compete with
T otal Healthcare M&A Deals Trending
financial buyers and have always accounted for the
largest share of acquirers, will take advantage of the 800

current pricing deflation. 600
• Hospital pricing in 2007 showed an average price- 489
410 523 534
to-revenue multiples of 0.74x, down slightly from 400 423
the 0.75x of 2006, yet above the 2004
200
measurement of 0.61x.38
• Expect some opportunistic activity from the stronger 0
systems while the weaker unload non-strategic 2003 2004 2005 2006 2007 2008

assets.

Healthcare’s service sectors M&A advisors enjoyed a bull 2007 Healthcare Services M&A Deals
market from 2003 into 2007. Since then, overall M&A
activity declined 8% in 2007 from the record year of Long Term Care 127

2006.39 Still, the $57 billion spent in 2007 eclipsed all H ospit als 58
other years with the exception of the $90 billion in 2006.40
Labs, MR I, Dialysis 54

More to the point, the 2007 hospital acquisition activity Home Health Care 48

paralleled the activity in the overall M&A market:
Physician Groups 41

• 58 transactions totaled $8.8 billion and involved 149 Managed Care 28

hospitals accounting for 22,440 beds; a decrease from Rehab 15
the $35 billion in involving 57 transactions involving
Behavorial H ealt h 13
249 hospitals and accounting for 54,550 beds in
2006.41 Other Services 105

• 2006 included the largest transaction ever--$33
billion privatization of HCA by a consortium of private equity firms.42

FUTURE TRENDS

As of September 2008, industry observers have noted no evidence of lack of capital available,
but have seen the sources of funding shift toward strength and quality--the money is going after
deals with big-name companies. The general trends include:43

Page 14 of 25


• Lending continues to large, financially sound companies like Siemens or Chevron.

• Smaller companies with higher risk are paying higher rates due to their weaker credit status.
• The large companies with excellent banking relationships and reservoirs of credit are
borrowing and then extending credit to their channels and trading partners.

• Municipal bondholders have responded to the crisis with a huge flight to quality—high-grade
short-term issues are highly coveted right now.44
• Although the yields are up in the long end of the market, 30 years, demand is down and
that is why people are buying short term.

• The generation of money through the use collateralized debt obligation by leasing
companies has found the current market unreceptive.

HEALTHCARE
Top Six Healthcare Challenges Will Intensify
One of the more important steps for hospitals to do is establish a formal investor relations
programs that include consistent, open and honest communications with Wall Street. These
efforts will keep the capital expenditure pipeline open and full as hospitals reconfigure to meet a
variety of needs.45 A centerpiece of this program is to answer how hospitals are addressing:

Expenditure Control: For Medicare/Medicaid payors, budgetary pressures will hinder rate
increases and may lead to restructured payment programs to control costs over the long term.

• Healthcare costs for workers and employers will increase by an estimated 5.7% in 2009, the
same rate as 2008.46

Decline In Cost Shifting: The commercial payer sector is seeing its ability to shift costs to the
insured impeded by flattening prices.

• 59% of U.S. businesses plan to increase employees’ deductibles, copays or out-of-pocket
spending limits.47
• Nearly half are encouraging enrollment in high deductible/lower premium health plans.48
• 19% want to offer a consumer-directed health plan.49

Rising Costs For New Projects: Profitability will be negatively impacted by increasing capital
costs from new projects and the rising cost of borrowing.

The Business Physician: As physicians continue to compete with hospitals, alignment
strategies with them will ascend to being a top priority.

Consumerism Rises: Community and patient Reimbursement Gap: Actual Cost v.s.
Medi/Medi Under Payment (billions)
empowerment will bring demands for investments that $30
foster improved transparency, quality, safety and
community benefit. $25

$20

$15

Page 15 of 25 $10

$5
$0
2000 2001 2002 2003 2004 2005 2006

Uncompensated Care: the current economic slowdown and resulting unemployment is
escalating the movement by employers to reduce benefits costs and thus driving up co-pays
and deductibles.

• The percentage of individuals with employment-based health benefits decreased from 68%
in 2000 to 62% in 2006.50

• As of September 2008, the nation’s short-term acute care hospitals (STACHs) have reported
almost $124 billon in uncompensated care costs over the last five years.51
• More than 20% of uncompensated care Medicare cost reports have not complied fully
with reporting requirements.52
• Not-for-profit hospitals have 4.8% of uncompensated care costs.53

Recession Will Have A Mild Effect On Healthcare
With the exception of credit being tight, a recession lasting through 2009 is anticipated to
produce a mild effect on the healthcare sector. The most visible change will be a spike in the
health spending/GDP ratio primarily due to a shrinking economy and the costs of providing
healthcare growing at 9.6% in 2009; down from 9.9% in 2008.54 A retrospective analysis of the
past six recessions to see how a slowing economy might affect healthcare showed:55

• The health industry is not as closely linked with the rise and fall of business cycles—it takes
at least a one or more years for the effect to show up, if at all.

• A medical price [inflation adjusted Medical Consumer Price Index (MCPI)] tends to rise
where the general CPI declines usually during or towards the end of a recession.

• National Health Expenditures (NHE) and the Net Cost of Private Health Insurance (PHI)
do not always fall during a recession.
• NHE increased during the 1970, 1974, 1980, 2002 recessions and tended to decline
about one or two years after.
• PHI increased during 1970, 1974, and 2002 but declined during 1980, 1982 and 1990
recessions.

• The number of uninsured does not track well with the ebb and flow of a recession—rising
with some recessions and sinking with others.56

Healthcare Financial Managers Remain Calm
The sub-prime crisis has lead to a near complete disintegration of two bond instruments
accessed extensively in the past by hospitals--Auction-Rate Securities (ARS) and the Variable-
Rate Demand Bond (VRDB) market. The impact on hospitals has been significant.

• Auction-Rate Securities (ARS), no longer a favorite of hospitals, saw a nearly complete
destruction thus far in 2008.57
• 33% to 50% of all hospitals are in the auction rate market and everyone with this type of
debt has had problems--these rates could not possibly be supported for long. 58

Page 16 of 25


• Healthcare enterprises with these types of instruments started the process of
restructuring to move their debt out of this troubled market to VRDBs, fixed-rate bonds,
and other forms of debt in March and April 2008.
• Some have structured this debt with built in protections; for others, fast rate increases
as high as 17% have been levied. 59
• The ARS breakdown spread into the Variable-Rate Demand Bond (VRDB) market in
some specific situations.

Even with this much violent churning in the market, a late September 2008, analysis of
healthcare financial manager’s attitude highlighted that they were concerned, but confidently
waiting for the waters to calm. Observations included:60

• Despite Lehman and Merrill's problems, variable rate bonds trading, popular among
hospitals, had barely been affected.
• Managers were worried about the interest rates on their bonds, particularly auction-rate debt
that have moved up to double-digits.
• One of the primary concerns centered on the paper they currently held and the resultant
challenge to determine what mix of debt they should carry.
• The more financially fit health systems and hospitals trying to acquire smaller ones were not
struggling to find financing to do so.
• Activity within the private equity investors market continued to be brisk.

Hospital Affiliations Up
Competitive pressures, tightening reimbursement and the long-term demand for capital has
motivated independent community hospitals to affiliate with health systems.
• In 2007, 56% of hospitals were part of health systems—a 10% rise since 2001.61

VENDORS 2007 Long Term Municipal New Issues
Leading Firms Ranking [ (#tra ns a c tio ns )/ b illio ns ]
There any number of financial advisory services that Sourc e: T he Bond Buyer/ Sec urity Data Company

range from large financial bankers to small boutique
firms specializing in just one of the services PFM (625) $43.4

described in this report or a specific industry or First Southwest (630) $29.3
niche. However, there are only a handful of full RBC Capital Markets (244) $11.3
service financial advisory firms strictly focused on
capital access for healthcare; most are privately held; Kaufman Hall (75) $8.6

many have a strong regional presence. Three of Lamont Financial (42) $5.9
these are on this report’s vendor short list. Morgan Keegan (71) $5.7

Market leaders short list, as ranked by total value of Ponder & Co (50) $5.6

healthcare deals completed for the 1985-2007 Raymond James (5) $5.5

periods are: Kelling Nort hcross (77) $4.9

1. Ponder & Co. Market Share - Capital Advisory Services
2. Kaufman Hall [1985-2007 Total Deals Value (Billions $)]

3. Public Financial Management
4. Morgan & Keegan (Shattuck)
5. Killarney Group Ponder & Co
48%
Page 17 of 25 Killarney
Group Kaufman Hall
3% 24%
Public
proprietary information must be held in strict confidence and not disclosed to any other parties withoutFinancial
Shattuck the express written
permission of IAG LLC, San Francisco, CA 415-346-3860. Morgan Mgmt.
Keegan 20%
5%

• If the total number of deals was the criteria, Public Finance Management and Kaufman Hall
would switch rankings.

Notables:
• The American Hospital Association (AHA) has endorsed Kaufman Hall. 62
• Morgan Keegan(acquired Shattuck Hammond Partners in 2007 for their healthcare focus)
been recognized as the top municipal bond underwriter in the South Central United States
(Arkansas, Kentucky, Tennessee, Mississippi, Alabama and Louisiana) for fifteen years.63

Market Distribution of Vendors
Based on Annual Revenue When Available 1
Structure and Revenues
Vendor as available [in millions]

Ponder & Co Privately held, employee
30 years in business owned
• Ranked first in U.S. healthcare finance by dollar volume
and number of bond issues over the last 20 years, and
have helped raise more than $58 billion of debt capital
in 1,021 financing transactions.
• Prepared more than 500 capital access plans, debt
capacity and asset/liability analyses
• Advised on the terms, conditions and price of interest
rate swaps for $17 billion in the last two years
• 100 completed M&A engagements ranging from $4
million to $1.5 billion.
• Actively manage a $2 billion portfolio in fixed income
investments for clients.

Kaufman Hall Privately held
• Founded 1985
• Also offers software suite for planning, in addition to its
consulting services
• Endorsed by American Hospital Association

Public Financial Management Privately held
• Founded 1975
• A division of the PFM Group (“PFM”), that includes the
PFM Asset Management LLC
• Has advised on more than $30 billion of completed
health care transactions since 1990
• Claims to have been consistently ranked the nation's
number one financial advisor
• Very large firm; national presence

1
Source: Publicly available records
Page 18 of 25


Market Distribution of Vendors
Based on Annual Revenue When Available
Structure and Revenues
Vendor as available [in millions]

Morgan Keegan (Shattuch Hammond) Privately held
• Shattuch Hammond acquired by Morgan & Keegan in
2007
• Founded1993
• 160+ M&A transactions totaling $10.8 billion in
transaction value
• Completed $12.9 billion as underwriter, placement
agent, financial advisor on equity and debt financings
• Served as competitive bid agent on interest rate swaps
and reinvestment contracts totaling $3.4 billion
• Remarketing agent for variable rate issues of
approximately $500 million

Killarney Group Privately held
• Founded 1995
• Small shop

OVERSIGHT & INFLUENCE

Regulatory
U.S. Securities and Exchange Commission (SEC)’s mission is to protect investors, maintain
fair, orderly, and efficient markets, and facilitate capital formation. The laws and rules that the
SEC enforces governs the securities industry in the US and are based on the concept that all
investors, whether large institutions or private individuals, should have access to certain basic
facts about an investment prior to buying it, and so long as they hold it.

The SEC oversees the key participants in the securities world, including securities exchanges,
securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is
concerned primarily with promoting the disclosure of important market-related information,
maintaining fair dealing and protecting against fraud.

The most recent and notable SEC laws are the Sarbanes-Oxley Act of 2002. This legislation
mandated reforms that enhanced corporate responsibility, improved financial disclosures and
combated corporate and accounting fraud, and created the "Public Company Accounting
Oversight Board," also known as the PCAOB, to oversee the activities of the auditing
profession. Direct impact on hospitals and capital access includes hospitals posturing for bond
rating agencies by forming audit committees, in addition to finance committees in preparation
for to questions like: 64
• Does the board have a separate audit committee; what’s its role?
Page 19 of 25


• Has the hospital or health system adopted a code of conduct or code of ethics or whistle-
blower policy that allows for anonymous submission of complaints regarding accounting,
internal controls and financial matters?
• Does the hospital’s auditor routinely recommend audit adjustments? Are they reviewed by
the board?
• Which officers certify the financial statements?

Associations
The Securities Industry and Financial Markets Association (SIFMA) and its Investing in Bonds
provides a regulatory voice and information services to its 650 member firms.

National Council of Health Facilities Finance Authority focuses on issues that raise the
availability of tax-exempt financing for healthcare facilities. This Council represents the
member authorities that are the tax-exempt bond issuers and does not represent specific
hospitals or healthcare systems. Since 1990, NCHFFA members have issued over $50 billion
of healthcare bonds.

Page 20 of 25


Appendix A

A Primer--Tax-Exempt & Non-Traditional Debt Instruments

Of these methods access to capital in the form of tax-
exempt bond offerings and non-traditional vehicles are the
Four Key Ways Not-for-
most common and include: profit (NFP) Access
Capital
• Bond Offerings: Most common are publicly offered tax-
• Self -Generation:
exempt bonds with fixed or variable rates are sold on the Operational cash reserves
open market by an underwriter. and flow are raised by a
• Fixed Rate Bonds: Typically a 30-year term to net increase in revenues
maturity with the rate based on the credit rating of the while dropping costs.
borrower or credit enhancements like bond insurance. • Disposal of Assets:
• Variable Rate Bonds: Unless a crediting rating of Divestiture of
AA/Aa or higher and a highly liquid financial posture nonproductive assets or
can be demonstrated, a letter of credit or bond non-core assets—like real
insurance from a bank is usually required of the estate—can yield capital
borrower. Term to maturity is shorter; can vary from and improve financial
daily to multi-year; and can be structured more performance.
commonly as: • Philanthropy: More
• Auction Rate Securities: These debt instruments mainstream than in past
are typically corporate or municipal bonds that use periods, donations of
a Dutch auction (seller and buyer demand is used “time, talent or treasure”
to set the interest rate) to reset the interest on a is part of every healthcare
regular basis. Preferred stock that uses this same financial profile.
process to set the dividend also falls into this • External Capital
category. Access : Principally debt
• Tax-exempt hospital and health system issuers in the form of bond
make up approximately 25% of the auction-rate offerings and non-
market.65
• Demand Bonds: The borrowed funds are payable upon demand by the lender;
charged interest is typically based on prevailing money market rates, like the prime
rate.
• Put Bonds: Also known as a multi-maturity bond, option tender bond or variable rate
demand obligation give the bondholder the option of requiring the bond issuer to
repurchase this security at specified dates before maturity. This may happen either
once during the lifetime of the bond (known as a one-time put bond), or on a number of
different dates. Of course, the special advantages of put bonds mean that some yield
must be sacrificed.
• Commercial Paper: An unsecured short-term debt instrument that is typically issued
by a corporation to finance accounts receivable, inventories or other short-term
liabilities. The debt is usually issued at discounted prevailing market interest rates;
only corporations with high-quality debt ratings will find buyers easily without having to
offer a substantial discount. It does not need to be registered with the Securities and
Exchange Commission (SEC) if matures before nine months—a major inducement to

Page 21 of 25


use.

• FHA Financing: Gaining some popularity recently, this is essentially a form of public
offering by the U.S. Department of Housing and Urban Development (HUD).
• FHA Section 242 loans are insured and offered to acute care hospitals to finance
constructions, remodeling, expansions or refinancing.
• It is usually a fixed rate for a term of up to 25 years from the end of construction with
variable rate swap structures often being a consideration.

• Private Placement: Raising capital via private placement is the product of selling
securities to a small number of investors such as pension or mutual funds, banks or
insurance companies.
• It can take the form of leases, loans, notes, or bonds; be taxable or tax-exempt; and
have fixed or variable interest rates.
• Because of the limited number of investors, public disclosure of detailed financials, the
need for a prospectus and registration with the Securities and Exchange Commission
(SEC) is waved.

• Nontraditional Offerings: These offerings are post 1990s when not-for-profit tax-exempt
financing was the rule of the day. Today, non-traditionals most frequently come in the form
of:

• Off-Balance-Sheet (OBS) Options: By using a method of reclassifying financing, large
capital expenditures are kept off of a company's balance sheet.
• Joint ventures, partnerships focused on research and development, and operating
leases (one of the most common forms for capital equipment).

• Real Estate Investment Trusts (REITs): These are essentially third party ownership of
the real estate that is formed to monetize the hospitals assets by selling securities on the
major exchanges.
• REITs have increasingly partnered with physician groups and other health care
enterprises to selectively develop and manage medical properties like medical office
buildings, specialty hospitals, outpatient and ambulatory treatment and diagnostic
clinics.

• Accounts Receivable Financing: A form of asset-financing where an enterprise sells or
uses its receivables--money owed by patients—in an amount that is reduced in value
based on the length of time the money has not been paid (“ageing”).

• Subordinated Securities: These are lower-rated classes of securities that bear higher
interest rates. They are sold to other investors or, in the case of securitization deals, held
by the originator.
• In the event of problems, the higher-rated (senior) securities receive payments prior to
the subordinated ones.

Page 22 of 25


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