The composition of Boards of Directors, Investment Committees and management teams change and evolve constantly. Our regulatory environment and political leadership seem to be in a constant state of flux. Amid this backdrop, however, there is one constant companion that leaders of healthcare organizations may depend on—uncertainty.
Uncertainty creates opportunities for those leaders who approach it thoughtfully and manage risks strategically. Or, as John Milton famously stated, “Luck is the residue of design.” In healthcare, leaders are hailed as visionaries when they capitalize on opportunities presented by uncertainty and changing times. Even the most visionary leader, however, can’t take advantage of these opportunities without meticulous planning and responsible stewardship of financial resources.
Today, healthcare organizations increasingly face uncertainty on so many fronts. Margins continue to compress and growth, if any, has slowed significantly for many organizations. Uncertainty also exists with interest rates. How many Board members have been “certain” that interest rates would surely rise any day now—for the last five years? Even if interest rates do rise, should you pay off debt? The answer isn’t so cut and dry.
Healthcare organizations must understand the total cost of maintaining debt, both direct cost (interest payments, ratings agency fees, etc.) and indirect cost (management time, balance sheet risk of leverage, etc.). Equally important, of course, is opportunity cost. Maintaining debt may be just the lever that enables your organization and its leadership to be visionary. The following discourse outlines a summary of notable considerations.
Cost of Borrowing
What is the true cost of borrowing money? There are both direct and indirect costs that must be borne by any institution that borrows money. Some of these costs apply to bank debt, while others apply to debt issued to the public or via private placement. The direct costs may include ongoing interest expense, the cost of issuing the debt in the first place (which can take many forms, including fees paid to bankers, regulatory agencies, etc.), the fees levied by ratings agencies, the relative impact of issuing taxable versus tax-exempt debt and more.
Furthermore, indirect costs contribute to the total cost. The amount of management’s time and attention consumed is certainly one of the primary indirect costs. The same may hold true for a Board of Directors. While debt (in any form) represents an important decision for the organization, it is a means to an end, not an end in itself. Excessive focus on the organization’s debt (Is now the time to refinance? Is now the time to retire our debt? If not now, when?) can be counterproductive and may divert attention from the real strategic considerations that should serve as the primary focus of the Board’s attention.
Liquidity/Availability of Capital
Human behavioral heuristics, such as “recency bias”, encourage us to assume that recent events are repeatable, projectable and represent the normal state of affairs. In other words, if stocks returned 8% last year, they will continue to return 8% this year and in the future. Given how often most Boards and leadership teams experience turnover these days, most organizations don’t benefit from the wise counsel of those individuals who have “been through the wars.”
How does this relate to debt and financial resources? Many assume there will always be debt available as needed and when needed. That belief is wrong and even more costly than the belief that we can effectively “time” interest rate changes (so let’s retire or refinance our debt now). Maintaining debt is costly but maintaining liquidity (“dry powder”) can be invaluable. Having that capital available for a strategic investment can have an enormous impact, or in some cases an existential impact, on a healthcare organization.
Some individuals view renting a home as a waste of money, as renting does not build equity in the home. Others view renting as an expense, but a useful expense that affords flexibility and enables the renter to capitalize on buying opportunities as they may arise. A healthcare organization’s debt is not materially different; it begs for a simple cost-benefit analysis and should be considered as one component of an overall strategic plan.
Investment Opportunities/Opportunity Cost
In addition to the direct and indirect costs of debt, the opportunity cost warrants careful analysis. In periods of low investment returns, every organization compares the direct cost of debt to the investment returns. Nearly everyone seeks to avoid negative arbitrage (for example, borrowing money that costs 5% annually and investing in securities that return 3% annually).
Perhaps surprisingly, even negative arbitrage can be productive for an organization if debt allows the organization to quickly take advantage of strategic opportunities that would otherwise not be possible. Of course, positive arbitrage (borrowing at a lower rate than the investment rate of return) is even better. The key to making a prudent decision is comprehensive analysis of the investment opportunity, its financial and strategic impact to the organization and the likelihood of the desired outcome.
Strategic investment opportunities in healthcare or any other industry might involve acquisitions, joint ventures, facility expansion and other growth initiatives. Healthcare continues to evolve and change at breakneck speed. Sometimes even the most visionary leaders don’t anticipate major opportunities but more often, the leadership and Board have extensively discussed and analyzed the major strategic opportunities. The financial resources needed to act on these opportunities and the timeframe within which the capital will be needed should be an integral part of that discussion.
Financial investment opportunities are also an important, though less existential consideration. With some capital typically not needed by the organization for a very long time, there may be investments in less liquid or illiquid investments that can offer meaningful incremental returns. This illiquidity must be analyzed from multiple perspectives, including overall liquidity (days’ cash on hand), credit rating implication and so on. Furthermore, these financial investments can enhance the organization’s chances of positive arbitrage while awaiting the more significant strategic investment opportunities.
While debt is only a means to an end, it remains a critical tool that may enable healthcare organizations to grow. As detailed above, carrying debt requires the organization to incur costs, both direct and indirect. Yet, the organization should also weigh the opportunity cost of not carrying debt. These decisions can dramatically impact the organization’s ability to progress and thrive.
