S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Health Carecorporate model has fallen into disfavor in recentyears, a number of the largest systems have thislegacy structure. While the corporate parent may ormay not have significant resources of its own, thebulk of the value-producing assets are not directlypledged to the debt. However, various internalarrangements allow the parent to collect moneyfrom constituent members to pay debt service.While this type of legal structure gained popularityin the mid-to-late 1990s for larger not-for-profithealth care providers, and is currently in disfavor, ithas been successfully time-tested in many otherparts of the U.S. corporate debt market.Standard & Poor’s ratings incorporate analysis ofthe legal documents; however, these security agreementsplay a secondary role in gauging and ratingan obligor’s ability and willingness to repay debt.Standard & Poor’s credit analysis always begins bylooking through obligated group structures to theposition of the organization as a whole regardlessof the specific pledge being provided. In some casesminor rating adjustments can be made for non-obligatedentities that are appropriately ‘ring-fenced’from the main obligated entity. This is discussed inmore detail within our senior living criteria.Standard & Poor’s expects that some credits willcontinue to use the unsecured GO structure or oneof its many variations, especially if its legal structureis already established in the market. The flexibilityof these documents must be matched by wisegovernance and sound management as fundamentalchanges in corporate assets can, and often do, havea profound impact on credit quality. Standard &Poor’s active and ongoing surveillance of thesecredits monitors the impact of additions, and moresignificantly, deletions of affiliates.Required covenantsIn general, Standard & Poor’s is comfortable analyzingthe concept of an unsecured GO pledge.However, to provide effective bond security, severalfeatures, outlined below, strengthen the obligor’scredit rating and legal and security arrangements.Credit rating: Credits issuing under an unsecuredGO pledge typically are rated ‘A+’ or better.Although Standard & Poor’s stated earlier that thisstructure by itself would not negatively affect a rating,lower-rated credits often do not have the creditcharacteristics necessary to prove to Standard &Poor’s that they can effectively manage under alooser legal structure.Senior debt: The unsecured GO debt typicallyremains the senior debt security for the entirehealth care system. To preserve the senior positionof this debt, Standard & Poor’s expects clearlydefined limits on senior liens outside this structure.As a benchmark, senior liens up to 25% of longtermdebt; unrestricted fund balance; or net property,plant, and equipment will be allowed in the documents.Access to cash: Senior corporate officersshould be able to quickly upstream cash and liquidinvestments without limit from constituent members.Rate covenant: The system as a whole, includingany contractual affiliates, should maintain arate covenant of at least 1x principal and interestcoverage of maximum annual debt service. Failureto meet this test should generate an independentconsultant’s report to the system’s governing bodyand senior management.Designated affiliate modelThe unsecured GO pledge also includes the conceptof designated or restricted affiliates. This model ismore like traditional legal structures, as it seeks tomarry the freedom of the unsecured GO pledge withsome of the characteristics of the more traditionalobligated group structure. Under this variation of theunsecured GO model, the parent, which remains theonly entity promising to pay, seeks to move the creditanalysis and the key legal covenants from the systemas a whole to a narrower subset of the system,namely restricted or designated affiliates. These affiliatesare bound to the parent either through ownershipor contract. In either case, however, the parenthas a clearly established mechanism to upstreamfunds for debt-service payments if necessary.A key difference between this structure and traditionalobligated groups is enforceability. As a result,although the designated affiliate model appears tobe structured like a more traditional joint and severalobligation, and within the system it essentiallyis a joint and several pledge, it actually cannot bedirectly enforced as such by bondholders. Rather,bondholders must rely on the parent’s obligation toenforce its internal documents. As a result,Standard & Poor’s legal analysis of the designatedaffiliate model will mirror that performed for pureunsecured GO pledges.One potentially troubling aspect of the designatedaffiliate model is the ability of the parent to designateand undesignated affiliates almost at will. Intheory, the parent could undesignate enough affiliatesso that the credit is fundamentally changed. Whilegenerally considered highly unlikely, this has thepotential to threaten management’s ability to repaydebt. In these cases, some simple additions to thepreviously stated requirements should be in place.Typically Standard & Poor’s sees at least 1xrate covenant calculated on the entire systemaudit, not just the credit group. In addition, theresults of contractually designated affiliatesshould be included within the rate covenantcalculation. If violated, this test will providethe board of directors and bondholders with avaluable independent assessment of managementand current operations. As always,160 Standard & Poor’s Public Finance Criteria 2007