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To Buy, Borrow or Lease?

November 1, 2007
by David Raths
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As hospitals look to acquire high-priced equipment, creative financing deals get more and more attractive.

Perhaps nowhere is a gifted chief financial officer more crucial than in the art of hospital construction and equipment financing. Studying their organization's financial history, savvy CFOs work to understand what they can afford and how a capital project fits into a larger organizational strategy.

Capital investment is the lifeblood of Baptist Health System of Alabama, a nonprofit four-hospital, 1,700-bed chain in the Birmingham metropolitan area. And Greg Johnston, vice president of finance, says there's always intense internal competition for limited funds.

Part of his job is making sure the hospital is getting the best deal on expensive equipment such as picture archiving and communication systems (PACS) and arranging financing deals.

"Because we're non-profit, one option is tax-exempt bonds," Johnston says. But one problem is matching the length of bond maturity to the lifecycle of the asset. "The underwriter won't give you a 30-year bond on an asset with a lifespan of five to seven years," he says, adding that sometimes it's possible to combine payments for equipment into bonds for construction renovations.

On some deals, Baptist has worked with Irving, Tex.-based Voluntary Hospitals of America. The hospital alliance arranges tax-exempt financing and allows its members to access funds from its borrowing, Johnston explained. One advantage of working with a company like VHA is lower issuance costs (one set of bond attorneys and underwriters), reducing the overall borrowing costs for each hospital. Another advantage is access to pooled funds (a single bond issue at a relatively low principal might not be economical). Finally, VHA can get lower interest rates, because the credit risk is not related to a single hospital.

With diagnostic imaging equipment leading the way, healthcare is one of the fastest-growing equipment leasing markets, according to the Washington, D.C.-based Equipment Leasing and Finance Association (ELFA). The healthcare equipment financing market is projected to exceed $8 billion in 2007, according to a study performed in 2005 by ELFA and R.S. Carmichael & Co. Inc. (White Plains, N.Y.).

Lenders who specialize in medical equipment say they try to offer as much flexibility to hospitals as possible. "We seek to understand what the objective of the hospital is from a clinical, technical and financial standpoint and match the loan options to their needs," says David Sook, vice president of Cleveland-based National City Healthcare Finance. "With PACS, the state-of-the-art technology changes rapidly, so they may want to do an operating lease, where the lender assumes the risk of technological obsolescence," he says. "It's just like a car lease."

Some hospitals have decided not to purchase or lease equipment, and instead have turned to an application service provider (ASP) model, in which they pay an outside vendor per radiological study.

"The typical PACS costs around $3 million," says consultant Gary Reed, president of Lebanon, N.J.-based Integration Resources Inc., which helps hospitals with PACS implementations. "And the typical lifespan of these systems is seven years. Well, you know computer systems ­— seven years is old. But with a fee-per-service model, when new technology comes along, you'll get the advantages of it immediately."

Baptist hasn't used an ASP model for PACS, but it has for some ultrasound equipment that the organization decided wasn't going to get enough use to justify purchasing. "If you tightly manage utilization," Johnston says, "it can be a very efficient way to purchase services."

No matter what type of equipment is under consideration, Johnston says, Baptist executives turn to MD Buyline, which offers an online subscription-based database on medical capital and informatics purchasing, including information on what other hospitals have paid.

"Our materials management people live and die by that," Johnston says. "In fact, we have a requirement that it must be used on any capital equipment purchase over $25,000."

Construction financing more complex

Financing equipment deals is one thing. Arranging bond financing for hospital expansions or new buildings requires another level of sophistication. CFOs of larger health systems usually have experience with bond markets, but smaller and rural hospitals often need help with the process, according to Mark Baumgartner, managing director of Milwaukee, Wisc.-based Ziegler Companies Inc.'s healthcare investment banking division. "They're not sure what they can afford and you have to go back and study their financial state historically," he says. Hospitals have to make a business case for expansion by projecting the monthly cash flow that's going to support debt services.

CFOs face a bigger challenge if their hospital or health system has issued debt and stumbled financially in the past. "That's an interesting conversation to have with the CFO," Baumgartner says. "It may not be the organization's fault. It may be market dynamics or changes in reimbursement. But the market cares very much about that issue," he says. "If you've already been downgraded, you should think twice about trying to sell more debt. It will affect the interest rate you get. In certain circumstances, you may not be able to sell that debt at all."

One of the hottest trends in new construction financing is monetizing older office buildings. "Twenty years ago, many hospitals built satellite buildings and doctors' offices using precious capital," Baumgartner says. "Now that capital is even more precious and capital budgets are stretched even more."

CFOs see those older buildings as saleable assets, and real estate investment trusts (REITs) and investment groups are buying them up, he says, adding, "Hospitals are getting out of the real estate game."