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C APITAL F UNDING A N OVERVIEW OF THE FUNDING PROCESS Presented by: Ross Sinclaire & Associates July 25, 2013 Kentucky HFMA Summer Institute.

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Presentation on theme: "C APITAL F UNDING A N OVERVIEW OF THE FUNDING PROCESS Presented by: Ross Sinclaire & Associates July 25, 2013 Kentucky HFMA Summer Institute."— Presentation transcript:

1 C APITAL F UNDING A N OVERVIEW OF THE FUNDING PROCESS Presented by: Ross Sinclaire & Associates July 25, 2013 Kentucky HFMA Summer Institute

2 Ross, Sinclaire & Associates, LLC TABLE OF CONTENTS Introduction Interest Rates Recent Developments Capital Funding Sources Typical Bond Structure Fixed Payer Swap Overview What is a Bond Rating? Why are Ratings Important to Issuers? Why are Ratings Important to Investors? Who Issues Bond Ratings? Rating Agency Scales Investment Grade Bonds Speculative Grade Bonds Rating Distribution Rating Medians Rating Ratio Definitions Chart of Borrowing Costs Rating Process How Do Rating Agencies evaluate Issuers? What Information is Used in Determining a Bond Rating? How Long Does a Rating Last? How to Improve Your Bond Rating Do I Need a Bond Rating? Typical Steps in a Transaction Financing Participants Contact Information

3 Ross, Sinclaire & Associates, LLC Introduction This presentation is meant to accomplish the following items: Provide an overview of the current economic environment Establish an understanding of various financing mechanisms available to healthcare providers Provide basic outline for the decision making process required to obtain the lowest cost of capital and the optimal capital structure 1

4 Ross, Sinclaire & Associates, LLC Interest Rates Bond Buyer 20 Year General Obligation Bond Weekly Index – 20 Year History 2

5 Ross, Sinclaire & Associates, LLC Interest Rates (Continued) Bond Buyer 25 Year Revenue Bond Weekly Index – 20 Year History 3

6 Ross, Sinclaire & Associates, LLC Interest Rates (Continued) Ten Year Treasury Rate – Six Month History 4

7 Ross, Sinclaire & Associates, LLC Interest Rates (Continued) 5

8 Ross, Sinclaire & Associates, LLC Interest Rates (Continued) SIFMA Municipal Swap Index Yield – 10 Year History 6

9 Ross, Sinclaire & Associates, LLC City of Detroit - Bankruptcy Market Reaction – Rates generally unchanged since bankruptcy had long been expected. City Ramifications – Yields of future debt expected to increase if access to capital markets is possible. Ratings Downgrades Moody’s Investor’s Service has issued many downgrades in the recent weeks, including the City of Chicago Reasons include more stringent analysis as well as the weakened economy. Economic Comeback Dow Jones Industrial Average, S&P 500 and NASDAQ at recent highs. Federal reserve may pare back their quantitative easing policy. Unemployment rate lower, though still historically high. Recent Developments 7

10 Ross, Sinclaire & Associates, LLC Debt Limit House speaker John Boehner indicated a clash with the White House and Senate over raising the US debt ceiling. Senate leadership and White House signaled that anything outside of a clean increase will not be accepted. Home Prices US home prices increased 7.3% in year through May. Real estate pricing rising with employment. Limited supply and increases mortgage rates may be slowing growth. Quantitative Easing to slow in September Ben Bernanke will trim the Fed’s monthly bond buying by $20 billion to $65 billion in September. Fed to begin to moderate the pace of bond buying near year end. Recent Developments 8

11 Ross, Sinclaire & Associates, LLC Capital Funding Sources Gifts – can include gifts from individuals or corporations, community gifts or grants. Capitalized Leases – can be used for many items including equipment and technology Long-Term Debt (Bonds) – can include both tax-exempt and taxable obligations, bank loans, fixed and variable rate obligations, and private placements. 9

12 Ross, Sinclaire & Associates, LLC Capital Funding Sources - Gifts Pros Extremely cost effective Not required to pay back funds No reporting requirements No issuing process Cons Highly unreliable Susceptible to economic shifts Highly competitive 10

13 Ross, Sinclaire & Associates, LLC Capital Funding Sources – Capital Leases Pros Low issuance cost Ease of issue process Little to no reporting requirements Ease of access Cons Only available for certain items Relative high interest cost Little structure flexibility 11

14 Ross, Sinclaire & Associates, LLC Capital Funding Sources – Bonds Pros Flexible Structure Relative low interest cost Most projects eligible Cons Issuing process can be cumbersome Reporting requirements Increases entity debt 12

15 Ross, Sinclaire & Associates, LLC Bank Loans, Private Placements & Bank- Qualified Bonds Bank Loans Commercial Bank Loans in the form of real estate or equipment term loans. Available from local and national banks. Interest rates can be fixed or variable rate. Typically banks will only finance for a limited period, usually up to 10 years. Private Placements Tax-Exempt bonds can be placed with local or national banks. Can be sold to one or several banks. Offering documents distributed only to interested parties. Financing terms can vary. Bank-Qualified Bonds Available to issuers that issue less than $10 million in one year. Banks can deduct 80% of purchase and carry cost. Issue must be designated bank-qualified. Offering documents distributed similar to non-bank-qualified bonds. 13

16 Ross, Sinclaire & Associates, LLC Bank Loans, Private Placements & Bank- Qualified Bonds(continued) Issuance Soars do to expiring letter of credits. 14

17 Ross, Sinclaire & Associates, LLC Fixed Payer Swap Overview Synthetic fixed rate debt is an alternative to traditional fixed rate debt. Issuer receives floating and pays fixed against floating rate note. Swap can also be executed today with the rate protection to begin at some point in the future (“Forward Starting Swap”). Forward Starting Swap allows the client to take advantage of currently low variable rates while having interest rate protection in the future. IssuerBank Bonds Issuer pays floating rate plus loan spread Issuer receives floating rate index from the Bank Issuer pays fixed rate to the Bank When these indices don’t match, the issuer is not perfectly hedged. 15

18 Ross, Sinclaire & Associates, LLC Typical Bond Structure Credit- Enhanced Letter of Credit Bond Insurance USDAUnenhancedRatedNon-Rated 16

19 Ross, Sinclaire & Associates, LLC Typical Bond Structure – Credit Enhanced Letter of Credit Provides issuer with rating of letter provider Typically cost prohibitive Difficult to obtain Bond Insurance Provides issuer with rating of insurance provider Possibly not cost effective Few Insurers left to utilize USDA Loan through the department of agriculture Guaranteed by federal government agency Difficult to obtain 17

20 Ross, Sinclaire & Associates, LLC Typical Bond Structure – Credit Enhanced (continued) Letter of Credit Provider has obligation to make principal and interest payments in the event the borrower is unable to make payments. Cost is generally derived from credit profile of issuer. Issued for limited terms, typically 3-5 years, and can be renewed. Low supply of banks willing to issue new letter of credits. 18

21 Ross, Sinclaire & Associates, LLC Typical Bond Structure – Credit Enhanced (continued) Bond Insurance Credit enhancement that guarantees investors will be paid even if the issuer cannot make it’s principal and interest payments. Cost is determined and be part of the initial bond sale. Historically common, recently insurance providers have been scarce. 19

22 Ross, Sinclaire & Associates, LLC FHA Section 242 Mortgage Insurance Must work with FHA-approved lenders. Program is available to fund new facilities, acquisitions and/or the renovation and updating of current facilities. Enables issuers to borrow with AAA or AA bond ratings. FHA insured loans are non-recourse - the loans are backed solely by the borrower’s real estate and other assets. Interest rates are fixed up to a 25 year term. May borrow up to 90% of the value of the project. Issuer must be an acute care hospital that derives less than half of revenues from non-core services. Three year average operating margin must be positive and must have debt coverage ratio of at lease 1.25 for the last three years. 242/223 program allows the refinance for existing bonds. Re-activated in 2013, allowing for 100% refinancings to be possible. Must meet minimum eligibility requirements. Debt service coverage must be 1.40 for the last four years. Typical Bond Structure – Credit Enhanced (continued) 20

23 Ross, Sinclaire & Associates, LLC Typical Bond Structure – Unenhanced Rated One or more rating agencies perform a through analysis of the issuing entity and assign a rating Higher ratings allow for lower rates Ratings process can be difficult and time intensive Non-Rated No rating agency involved May require higher interest rates Possibly preferred if expected rating determined not cost effective May make market access difficult 21

24 Ross, Sinclaire & Associates, LLC Typical Bond Structure – Unenhanced (continued) May be utilized by both investment grade and non- investment grade issuers. Sold on the credit profile and characteristics of the borrowing entity. Collateral typically provided in the form of a pledge of the organization’s revenues and a lien on trustee-held reserves – including a debt service reserve fund. May also require a first mortgage and lien on real estate assets as well as additional security and covenants. 22

25 Ross, Sinclaire & Associates, LLC What is a Bond Rating? A Bond Rating is an independent assessment or opinion of the ability of an issuer to honor their financial obligation to make interest and principal payments. It is associated with purchase and holding a particular bond. It assesses relative credit risk. Ratings indicate likelihood that the obligation will be paid. In essence, a local government's bond rating is the government equivalent of your personal credit score or credit rating. The higher the rating means the less likely an issuer will default. 23

26 Ross, Sinclaire & Associates, LLC Why are Ratings Important to Issuers? They are independent verification of their credit worthiness. They allow the issuers to “tell their story.” They are a marketing tool that can be used to attract investors. The higher the rating, the lower their borrowing costs. Provide potential investors with an unbiased opinion regarding their ability to meet obligations. Higher Rating = Lower Cost 24

27 Ross, Sinclaire & Associates, LLC Why are Ratings Important to Investors? Investors rely on ratings as an indicator of the risk of default for a particular bond investment. The ratings influence the price and the yield of a bond both in the primary and secondary market. The rating provides investors with a comparative ranking between bonds that would otherwise be impractical or impossible for them to get with their own resources. 25

28 Ross, Sinclaire & Associates, LLC Who Issues Bond Ratings? Moody’s Investors Services 1909 – John Moody published a book of Railroad Investments that included concise analysis of their relative investment quality. Standard & Poor’s Corporation 1860 – Henry Varnum Poor began supplying European investors with financial with financial information on their holdings in the developing infrastructure of America. Fitch Ratings 1913 – John Knowles Fitch published “Fitch Bond Book” and other books on financial markets. Fitch is credited with introducing the AAA through D rating system now used. 26

29 Ross, Sinclaire & Associates, LLC Rating Agency Scales Credit Ratings Moody's S & P Fitch Highest Quality Credit Rating Levels AaaAAA High Grade / High Quality Aa1AA+ Aa2AA Aa3AA- Upper Medium Grade A1A+ A2AA A3A- Minimum Investment Grade Baa1BBB+ Baa2BBB Baa3BBB- Speculative Grade Ba1BB+ Ba2BB Ba3BB- B1B+ B2BB B3B- Highly Speculative Grade Caa (1,2 or 3) or CaCCC (+,-) CC or C Imminent default or in default CSD or DRD or D 27

30 Ross, Sinclaire & Associates, LLC Investment Grade Bonds Highest Grade – AAA These bonds are judged to be of the best quality. They carry the smallest degree of risk. Interest payments are protected by an exceptionally stable margin and principal is secure. The issuer’s capacity to meet its financial obligation on the bond is extremely strong. High Grade – AA These bonds are judged to be of high quality by all standards. Margins of protection may not be as large as in AAA securities. The issuer’s capacity to meet its financial obligation on the bond is very strong. Upper Medium Grade – A These bonds possess many favorable investment attributes. Factors giving security to principal and interest are considered adequate. Although these bonds are somewhat more susceptible to the adverse effects of changing economic conditions, the issuer’s capacity to meet its financial obligations is strong. Medium Grade – BBB The bonds lack outstanding investment characteristics and have speculative characteristics as well. Adverse economic conditions are more likely to lead to a weakened capacity of the issuer to meet its financial commitment. 28

31 Ross, Sinclaire & Associates, LLC Speculative Grade Bonds Distinctly Speculative Grades - BB & B The future of these bonds cannot be considered as well assured. These bonds face exposure to adverse business or economic conditions which could lead to an issuer’s inadequate capacity to meet its financial commitment. Predominately Speculative Grades - CCC and below These bonds are of poor standing. Such issues may be in default, or there may be elements of danger with respect to principal or interest. These bonds are vulnerable to nonpayment, and are dependent upon favorable economic conditions for the issuer to meet its financial commitment. 29

32 Ross, Sinclaire & Associates, LLC Rating Distribution *Information from Standard and Poor’s Rating Service 30

33 Ross, Sinclaire & Associates, LLC Rating Medians *Information from Standard and Poor’s Rating Service 31

34 Ross, Sinclaire & Associates, LLC Rating Ratio Definitions 32

35 Ross, Sinclaire & Associates, LLC Chart of Borrowing Costs 33

36 Ross, Sinclaire & Associates, LLC Rating Process Bond Issuer requests that a rating company determine a rating. Financial Advisor & Bond Counsel submit financial plan draft legal documents for review. Rating Company forms an analytical team that: o Gathers information sufficient to evaluate risk to investors who might own or buy a given security o Develops a conclusion in committee on the appropriate rating The Rating Committee then issues a rating decision based on the report of the analytical team. The new rating then is monitored over time and adjusted as appropriate to reflect changes in the probability the issuer will default. 34

37 Ross, Sinclaire & Associates, LLC How Do Rating Agencies evaluate Issuers? Finances Debt Position EconomyManagement Bond Rating 35

38 Ross, Sinclaire & Associates, LLC How Do Rating Agencies Evaluate Issuers? (continued) Debt PositionFinances Financial Operating History o 3-5 years of audits o Significant deviations o General trends Stable revenue streams Expenditure Items Liquidity Financial feasibility of project Utilization and payor mix Budget vs. actual Debt Burden Debt service as a % of budget Amortization schedule Future borrowing plans and capital needs Variable rate exposure Operating procedures Profitability 36

39 Ross, Sinclaire & Associates, LLC How Do Rating Agencies Evaluate Issuers? (continued) ManagementEconomy Growth trends General population Diversity of employers and taxpayers Proximity to ancillary services Competing facilities Socio-economic indicators o Wealth indices o Demographics o Unemployment rates Long-term planning & predictability o Strategic planning o Financial & budgetary policies Growth management o Balancing operating & capital needs o Cost estimate accuracy Continuity Community support Physical plant conditions 37

40 Ross, Sinclaire & Associates, LLC What Information is Used in Determining a Bond Rating? Publicly available data including past official statements and financial statements. Fiscal policies and procedures utilized by the issuers including budget processes. Market data, e.g., bond yield trends, trading volume, data on bond price spreads. Economic data from industry groups, associations or bodies. Data from agencies, such as central banks or regulators. Books or articles from academic sources, financial journals, news reports. Discussions with expert sources in industry, government, or academia. Data that may come from meeting or conversations with the debt issuer including local property assessments, population and other local information. 38

41 Ross, Sinclaire & Associates, LLC How Long Does a Rating Last? A Bond Rating can last until the final maturity of the bonds rated or until such bonds are refunded or called. An initial rating on a bond issue is subject to change if the rating agency deems necessary. Rating agencies may withdraw ratings due to insufficient information or other issues with the status of the bonds including default situations. Each new bond issue must be rated even if other bonds issued by the issuer have been rated. Issuers are not required in any way to obtain a rating from a certain agency or multiple agencies. 39

42 Ross, Sinclaire & Associates, LLC How to Improve Your Bond Rating Establish “rainy day” and budget stabilization reserves – memorialize these practices with written policies. Review economic and revenue trends to identify potential budget problems and take corrective action as needed. Prioritize spending and establish contingency plans for budget shortfalls. Develop a formal capital improvement program and a debt affordability model. Incorporate pay-as-go financing in capital plans and operating budgets. 40

43 Ross, Sinclaire & Associates, LLC How to Improve Your Bond Rating (continued) Anticipate the impact of capital and operating budgets in a multiyear financial forecast. Establish benchmarks and priorities through workshops. Establish and maintain effective management systems & financial controls. Consider the affordability of actions and plans before they become a part of the budget. Have a well-defined and coordinated economic development strategy. 41

44 Ross, Sinclaire & Associates, LLC Do I Need a Bond Rating? Does your capital plan call for long term bond issuance? Would a bond rating be economically beneficial? What is your estimated or current bond rating? See us to help answer these questions and any others If deemed appropriate we will complete a benchmark ratings analysis & provide other insight regarding possible ratings. 42

45 Ross, Sinclaire & Associates, LLC Typical Steps in a Transaction Evaluate capital needs and financing source. Assemble financing team o Includes financial advisor and/or underwriter, bond counsel and others mentioned previously. Develop a financing plan and schedule o Type of sale Negotiated, Competitive, Private Placement or Bond Pool o Structure Source of repayment Amortization Schedule Serial vs. term bonds Bond covenants Credit Enhanced vs. Unenhanced 43

46 Ross, Sinclaire & Associates, LLC Typical Steps in a Transaction (continued) Draft documents o Authorizing resolutions/ordinances o Feasibility studies o Trust Indentures/Agreements o Notices to bondholders/insurance companies/trustee o Preliminary Official Statement o Preliminary Blue Sky Due Diligence o Compliance with Rule 15c2-12 Marketing 44

47 Ross, Sinclaire & Associates, LLC Underwriter – Dealer which purchases a new issue of municipal securities for resale Trustee/Paying Agent/Registrar – Financial institution which acts in a fiduciary capacity for the benefit of bondholders in enforcing the terms of the bonds and responsible for transmitting payments to bondholders and maintaining records of the registered owners of the bonds Insurer – Company which provides credit enhancement (for example, guaranteeing payment of principal and interest on the bonds Financing Participants Issuer/Borrower – A state, political subdivision, agency, or authority that borrows money through the sale of bonds or notes Bond Counsel – Attorneys retained by the issuer/borrower to give an expert and objective legal opinion with respect to the validity of bonds and other subjects, particularly the federal income tax treatment of interest on the bonds Financial Advisor – Consultant who advises an issuer/borrower on matters pertinent to an issue, such as structure, timing, marketing, fairness of pricing, terms, and bond ratings 45

48 Ross, Sinclaire & Associates, LLC Financing Participants (continued) Credit Enhancer – Bond insurer, commercial bank, or other financial institution issuing an insurance policy or a supporting letter of credit in order to improve an issue’s credit rating Liquidity Provider – Commercial bank or other financial institution entering into a standby bond purchase agreement or issuing a standby letter of credit in order to improve an issue’s credit rating Rating Agency – Organization which provides publicly available ratings of the credit qualities of securities Issuer’s Counsel – Attorneys representing the issuer Disclosure Counsel – Attorneys serving as the principal drafters of an issuer’s disclosure document Underwriter’s Counsel – Attorneys representing the underwriter in connection with the purchase of a new issuer of municipal securities 46

49 Ross, Sinclaire & Associates, LLC Contact Information Ross, Sinclaire & Associates 325 W. Main Street, Suite 300 Lexington, KY Toll Free: Fax: Joe Lakofka – Dwight Salsbury – Bryan Skinner – 47


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