Specialty healthcare requires a unique financing structure to ensure a
successful venture. Knowing where to start and arming your center against the common financial
pitfalls is half the battle – as well as the ultimate payoff.
The money is out there, interest rates are currently decent, and terms can be
quite reasonable. In fact, the current financial outlook for ambulatory surgery
centers (ASCs) is excellent, according to Peter Myhre, president of Chicago,
Ill.-based MarCap Corp. “Customers have numerous finance options in the
lending market and the experienced lenders that focus in the ASC market should
be able to provide a variety of finance alternatives to choose from.”
You just have to know where to look and how to access the best deals.
Before courting any kind of deal, rule No. 1 shared by the experts is the
resounding, “You must understand your financial needs.”
“Understanding the costs includes having a good plan in place that projects
the tenant improvement costs, equipment costs, and working capital needs over a
couple of years period so that you can control and measure as you are going
along, how you are doing against that plan,” advises William M. Karnes,
cofounder and chief financial of- ficer of Westchester, Ill.-based Regent
Surgical Health.
A solid, detailed, in-depth pro forma is critical to this understanding, adds
Chris McMenemy, vice president of Columbia, S.C.-based Ortmann Healthcare
Consultants. “You must have accurate estimates of how much revenue the center
can expect for at least the first three years,” she recommends. “And, just
saying I think I’ll have about 2,000 procedures is not good enough. You need
to look at your current caseload, analyze how much of it will be transferable to
the center, and know how managed care contracting will affect the transfer of
cases and the amount of revenue you will receive. You must know your
construction costs, your equipment costs, your annual expenses, and your working
capital needs. Only with this information in hand will you be able to adequately
project your financing needs. If the amount that is financed is inadequate, real
problems will arise. And, if too much is financed, you will pay more than is
necessary in interest expense,” she points out.
Karnes says the most common pitfall he sees is that people simply have very
poor projections. “They don’t have the ability or model that allows them to
understand how much money they need to open a center. They miss on the tenant
improvement dollars, they don’t get good bids from their subcontractors, they
miss on the equipment, they don’t plan upfront what they are going to need for
every room; the key equipment needs. Probably the thing they miss the most is the soft
costs: the legal fees, the consulting fees, the permit fees, any accounting tax
fees to get the amenity up and running.
“The solution is,” he offers, “is you have a good predictive model
which allows you on a monthly basis to determine what your inflows and outflows
are going to be. You get good estimates from your general contractor on your
construction costs and upfront you identify your equipment needs. Then, build a
cost estimate of those so you don’t get big surprises and the money you think
you have for working capital is eaten up by either construction or by equipment.”
Todd Tidmore, managing director of Addison, Texas-based Med- Capital Group,
agrees that clients often overlook including all of the true costs into their
budget when building a new center. He points out that unless one obtains real
estate financing on an ongoing basis, there are many “norms” that could be
missed. He explains, “For example, what is the normal loan to value? What
really is a good interest rate for this type of project? What are the true
options? The considerations vary widely depending upon the objective of the borrower.
I would recommend that the borrower truly identify what their objective is.
For example, is the interest rate the most important component of the financing
I am seeking, or is it loan to cost, or recourse, or lower equity?”
Karnes says that unless you have a good manager who can project these things
for you, oftentimes you are not going to have the ability to understand the
connivance they have put into place and what that is going to mean. “You then
run the risk of defaulting on your loan in the first few months of operation
because you don’t meet the coverage covenant or you don’t meet the working
capital covenant that will be in the loan,” he says.
Shopping around for lenders also is vital. Tidmore says people don’t really
explore all their options, and McMenemy points out that not getting proposals
from several lenders is a real problem that occurs regularly.
She says clients who have a good relationship with a particular bank may feel
that approaching this “friend” will give the best results. “It’s possible that it will, but that’s not a fact that can be depended
upon,” she points out. “Unfortunately, too often the ‘local bank’ is
more likely to be conservative in its terms and its guarantee requirements.
Looking at national as well as local options is wise,” she adds.
Karnes advises against the local banks because of their lack of niche
knowledge of the ASC industry. He says proper structuring of a loan for an ASC
differs greatly from what most banks will normally offer.
He explains, “In most cases, your local business is a good financing source
and they may give you the best pricing because you have your home mortgages with
them and you have other business relationships with them, but they may not
understand the surgery business. One of the things that people miss is they don’t get a lender that
understands the business; therefore they don’t get a loan structure that is
reflective of the start up of the business. If they do not understand it, they
are not going to structure that loan in a way that is best for that center. They
are going to expect that when you complete construction, you are going to start
paying them.
“Pick a lender that knows the ASC business — the leaps and lags in terms
of cash flow, the contracting aspects that drive a lot of the receivables. What
we’re seeing is there are a lot of good lenders. There are a lot of people that understand our business and are good, solid
lenders and have well-structured financing terms.
“A good industry lender will say first of all we will accrue the interest
during the construction period, we’ll build it into the loan so you don’t
have to come out of pocket for interest while you’re not generating any cash.
Secondly, for the first three months, there are no payments and perhaps for
months three to six, or four to six, you pay interest only. Then in month seven,
you begin amortization of the principal balance of the loan, over the term of
the loan. They will structure like this because they understand that this center
is not going to generate any cash for the first three or four months and it will
be spending cash to pay for salaries while waiting for collections.”
That said, ASC entrepreneurs also must understand they have to give to get.
Equity — one small word, but a giant consideration. The amount of equity a
group of physicians presents at the onset of courting financing is what may very well make or break the deal.
“Banks are not equity partners,” Tidmore explains. “They are not
suppliers of equity, they are suppliers of debt.”
Karnes agrees, adding, “People think that they can borrow all the money
that they need to do the deal because they are great doctors, they have a great
historical track record of patient flows and people are going to look at that
and want to do business with them and that’s true, but unless you have enough
equity in the transaction, you’re going to run out of cash.”
Simply put: “Raise more money,” advises Robert S. Goodman, CHE, managing
partner of Westampton, N.J.-based Mansfield Group LLC. Goodman says he always
goes in with a base assumption that his clients are going to try to raise
somewhere in the neighborhood of 25 percent equity. “We know what lenders are
looking for, so this way you’re borrowing around 75 to 80 percent. The closer
you get to 70 percent, the better the structure will be. More specifically, I
mean the guarantee structure. If you put in say 30 percent equity you have a
shot at maybe getting nonrecourse financing meaning a no guarantee transaction.
At 20 percent, it’s not likely.”
Equity also commits your partners to the deal, Karnes points out. “If someone has written a check for $50,000 they are much more aware of
costs in terms of the types of equipment they are buying, they are much more
aware of revenue needs in terms of bringing their patients to the center, than
if they had a $5,000 investment which is more meaningless to them. An equity
commitment cements you to the deal,” he asserts.
Another aspect that comes into play is the level of guarantee. “Sometimes
people don’t want to put at risk what needs to be put at risk in terms of
cash, equity, and oftentimes guarantees,” Goodman states.
Karnes explains that if you personally guarantee the whole loan, you’re
going to get a lower rate than if you only guarantee half the loan or none of
the loan. “And if there is a guarantee, the lenders that understand the
business generally let the guarantee burn off or go away over a 12 to 24 month
time period if you meet your projections,” he explains.
McMenemy on the other hand advises against such structures “Joint and
several guarantees on the loan is a term that should be avoided in any financing
contract,” she asserts. She offers considerations that should be put in
perspective before agreeing to such a deal. “If the value of the loan is $1
million, and there are five investors, each might expect to be responsible for
only one-fifth of the loan or $200,000. If the loan requires joint and several
guarantees, then each investor is ultimately responsible for the entire loan.
Additionally, if an investor tries to get financing for a different project, a
credit report may show that the investor is already in debt for $1 million,
rather than the $200,000 portion.”
Myhre says the amount of personal guarantees required by a lender can range
from zero percent to 100 percent of the loan amount. “The client really needs to think through what it would do if something
goes wrong. It is easy to assume things will work out, otherwise why proceed at
all? Unfortunately, all projects do not work out as planned. Personal guarantees
can kick in, in a worst-case scenario. This involves going beyond the legal confines and safety of typically a
limited liability company, and pursuing the personal assets of an individual
owner.
“The client should consider multiple options as to the level of personal
guarantees required,” he advises. “If guarantees are required, they should
be several rather than joint. Several guarantees divide the total guarantee
amount up between the individual owners. Joint guarantees takes the path of
least resistance and pursues the wealthiest guarantors first.”
McMenemy advises looking at pre-payment penalties. “The ASC will want the
flexibility of being able to pay off the loan at its convenience,” she points out. “It is not unusual for some penalty to exist, but it’s
important that the facility is not completely barred from paying off a loan or
refinancing a loan. Who would have thought 10 years ago that interest rates
would go as low as the norm was just a few months ago? The ASC needs to be in
the position to take advantage of changing market rates as well as greater than
anticipated profitability that could lead to early payoff of the loan.”
Working capital requirements for a new ASC can be as significant in terms
of dollar requirements as each of the other categories. Working capital is that amount of money needed to pay for expenses incurred
from the beginning of the project until revenue is received. “These requirements are the least understood capital requirements
and often the most overlooked need,” warns McMenemy.
She also points out that it is often necessary to help educate both the
accountants and bankers on this subject, as the needs of the ASC can be quite
different from other businesses. “Reason being is that most businesses start functioning when they get their
certificate of occupancy from the local governmental entity,” she explains.
“The ASC on the other hand cannot start full operations until it is state
licensed, Medicare certified, and in some situations accredited.
The amount of time to go through these processes varies by state, she says,
but can be lengthy (one to four months) even if you pass all inspections the
first time around. As a result the ASC must have working capital reserves to pay
for all operational expenses for at least three to four months of operation. “When one adds the requirements up, you will find that working capital
requirements often equal or exceed the requirements for equipment or
construction,” she adds.
She continues, “If you have not properly budgeted for these needs or if
problems occur that delay the opening of your center, you may exhaust your
working capital loan. At this point, you will have to go back to the owners of the ASC and ask for
another capital call to raise the needed money or go back to your financial
institutions and refinance your previous loan. This can create a great deal of
dissatisfaction among the owners who thought they had contributed all of the
money necessary for this project and will also likely change your pro-forma
estimates a great deal and prolong the day when the center begins to start
profitable operations. It is far better to overestimate the working capital
requirements and not use the money, than to underestimate the requirement and
have to go back to your investors for more money.”
Karnes says it is pretty consistent that the thing people overlook the most
is the working capital. “One thing we always recommend is if you’re going to
borrow money for your tenant improvement or borrow money for your equipment, you
put in place a working capital line with that same financing source. So if your
equity does run out, you have $250,000 or $500,000 of bank money you can borrow
against to get to the time when collections are exceeding your payables and you
begin to generate positive cash flow.”
Nightmares concerning ASC financing can occur in nearly every facet of the
process. For example, the rush to finance is a common problem, according to
McMenemy.
“The amount spent in financing costs is huge and not taking enough time to
adequately study the options can have significant financial consequences,” she
warns. “You might wonder why anyone would rush to get financing done, but as
there are so many deadlines that have to be met in getting an ASC started that
it’s not really all that uncommon. Needing to have cash ready for a real
estate close date is one of the most common reasons for needing to rush into
financing.”
It takes a long time to complete a financing project. “Oftentimes people do
not understand there is a process you have to go through in order to get
approval and more important to sell your story in such a way to the lender that
you get the best possible structure of the transaction and the best possible
rate,” Goodman advises.
Most physicians are so busy, that it’s dif- ficult to wade through the
unfamiliar terms and sheer volume of material that must be read. McMenemy
advises having a trusted advisor.
Karnes agrees, “This is a good decision for a doctor group to make because
they get the benefit of that learned knowledge and contacts when it comes to any of these financing decisions.”
As Goodman points out, in all likelihood a local start up will involve a
group of doctors that have not before explored these types of financing avenues.
“Inexperience is a pitfall,” he asserts, and he too advises seeking help
from knowledgeable industry leaders. “Most of the management companies have
relationships with a lot of the lenders and they have kind of developed a
rhythm, if you will, and a methodology with the lender. That lender knows this
management company so when this management company brings a project to that
lender, they kind of know from experience what each other is looking for and
presenting. So there is an experience base that is helpful,” he adds.
Other last minute nightmares can include something as simple as the appraisal
process. Managing the appraisal process can play a significant role in a smooth
transaction, Tidmore points out. “Make sure the lender understands the
importance of using an appraiser that has experience in dealing with the costs
of the type of medical building that you are building,” he advises. Tidmore
explains that if the appraiser is undereducated in the true value of an ASC
facility, it can be appraised too low which can ultimately have a devastating
effect on the financing of that facility.
“What we have seen are customers that come to us after their first finance
company did not deliver the terms that were expected,” Myhre adds. “This has included an out right rejection at the last minute
which can really create problems. When you are developing an ASC, unexpected
delays can be a disaster. Your finance company should very clearly spell out the
timeframes and activities to complete a mutually agreeable proposal, due
diligence which should include a site visit, internal process to obtain credit
approval, what changes may come out of due diligence and credit committee
process, obtaining documents, potential negotiations, and funding.”
Overall, Karnes says it is the operational issues that create the most
nightmares. “Typically, the nightmares occur because operations are
functioning low after the center opens its doors,” he interjects. “Operational
issues such as it takes you longer than you anticipated to open the doors
because you don’t have a good contractor and the work isn’t done on time.
Operational issues such as you have the wrong case mix or you have a lot of low
reimbursement cases and you built an expensive center or you bought expensive
equipment and you can’t cover the costs because your reimbursements are too
low. You don’t have enough doctors. You try to do it with three or four doctors thinking that others will come
later. You don’t attract those other doctors and your revenue is not enough
from those doctors to pay the costs of that facility.
“Or, you sign the wrong contracts,” he continues. “You sign a lot of
low reimbursement contracts thinking it is going to drive volume. It does draw volume, but your staff costs and your supply costs are high and
your reimbursements per case are low and you can’t cover your costs.”
Whatever the issue, Tidmore points out that honesty is always the best
policy. He shares an example of when last October he had a client who was not
honest about his financial position and had filed bankruptcy two weeks before
closing on a deal.
“He could have gone to jail had the lender been a federally insured
institution,” Tidmore asserts. “You have got to be honest with all of your
documentation on a project because through the review process, they will find
out. You have to realize you will have to really bear your financial soul to any
lender.”
Constructive Considerations
In June 2004, the New York state Health department fined Saratoga Hospital
$10,000 for the construction and financing of an ambulatory surgery center (asc)
in Saratoga springs citing inappropriate state authorization.¹ “We found it
appropriate and necessary to fine Saratoga Hospital for what we determined to be
the hospital’s inexplicable failure to adhere to well-established state
regulations regarding the financing and construction of the project,” asserts
New York’s state health commissioner Antonia C. Novello, Md, MPH, DRPH, in a
press release.
The state investigation determined that Saratoga Hospital incurred additional
debt and closed on the financing of the project without appropriate state
authorization when constructing the new asc. The state found amendments related
to the cost and financing of the original 2002 certificate of need (con)
proposal for the construction of the asc.
The original application submitted to the department for consideration
projected a cost of $10.3 million; however, subsequent estimates by the hospital
determined that the project cost would total more than $12.8 million when
construction was completed. in addition, significant restructuring of
refinancing components of the project loan occurred, extending the terms of the
mortgage to 30 years. The terms of the loan, “which far exceeded state
standards,” included a deferral of principal payments and the refinancing of
both operating and equipment expenditures for a 30-year period. The state does
not allow 30-year mortgages for capital projects, the state department reports.
In addition to the fine, the hospital was required to submit a written Plan
of correction (Poc). as part of the Poc, the department imposed restrictions on
future debt financing of capital projects by Saratoga Hospital, including
mandatory accelerated payments on loans — citing that the requirement will “help
balance the excessive terms of the financing in this enforcement case.”
In the press release, novella continues, “While there was a clear need for
this expansion it was a critical error to fail to gain the necessary approvals
to carry it out. Healthcare providers across the state are fully knowledgeable
of New York’s rules governing the approval process for con applications and,
frankly, there is no excuse for a breach of those requirements.”
However, William M. Karnes, cofounder and chief financial officer of regent
surgical Health, says sometimes when put in perspective, such fines are a
necessary evil.
He explains, “The problem is that construction costs have accelerated
recently. We are in close to a full employment economy. There have been some
drains on materials for rebuilding the areas affected by the hurricanes, so we’re
seeing pricing inflation. We are also seeing that most of the states have construction costs that are
two or three years out of date. So the combination of more recent inflationary cost increases plus
construction costs that are out of date have caused a lot of pressure on the
tenant improvement side of con budgets.
“Almost every project that i am aware of has trouble with their con budget
in terms of once you get into construction, you inevitably find a few things
that you didn’t count on and you have to enhance the building; you have to add things to the building you didn’t anticipate.
A tight budget becomes a very difficult budget and people do go over and they
get fined.”
Karnes says you have to put the fine into perspective. “If you are building a three or four or (operating room) center, you may be
spending $1.9 to $2.5 million for tenant improvement work — not including
equipment, just improvement to the space. So, $10,000 isn’t a lot of money in relation to $2.
million. it is difficult to control the budgets because I think they are too
low to begin with. recent pricing inflation, which is affecting both labor costs
and equipment and supply costs, is going to be a continuing issue. What needs to
happen is the con boards need to reflect current construction costs not dated
construction costs.”
The other question is do you delay your project by going back to the con
board and trying to get a variance at such a crucial time. “When you have a
multi-million dollar project that is running and you have run all the costs; you’ve
let interest carry on your loan and you may be paying rent on your space —
think of the costs you are incurring every month to handle those things,”
Karnes advises. “if you wait or stop to go back to get a variance on the con,
it may not make any sense because you are accruing too many other costs that are
eating you up. once you have a construction project up and running, you need to
continue because there are just too many negatives to slow the process.”
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