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Fixed-Income Insights

It takes keen insight to spot opportunities in an industry struggling with consolidation, overleverage, and long-term declining patient volumes. 

With profound changes in fundamentals in the hospital sector, assessing potential investments has required intensive care. Just ask Lord Abbett research analyst Murali Ganti, who has covered the healthcare industry for more than 16 years, and specializes in the fixed-income arena across leveraged loans, high-grade, and high-yield asset classes. 

Hospitals have seen a structural decline in patient volumes since the early 1980s.1 The U.S. Affordable Care Act (also known as “Obamacare”) helped reverse some of that loss by making health care more accessible, thus, consequently, injecting millions of new patients into the system. But in recent years, both revenues and profits have fallen off, leaving some of the most acquisitive hospital companies in the lurch.

“Now we have overlevered entities, with weak operating fundamentals in a high fixed-cost business that don’t have the free cash flow-generating capability they historically enjoyed,” Ganti said. “Needless to say, their options are limited. Are these leveraged buyout candidates? Probably not. They’re already six to seven times levered, making it unpalatable for any private-equity suitor looking to add more leverage in a potential transaction. But who wants to buy a hospital in the current stressed environment? Maybe some not-for-profit hospital chains, but they have their own issues.”

In addition to all the structural problems, more and more care is being dis-intermediated away from traditional hospitals and toward outpatient facilities, thanks largely to improving technology, lower costs, and patient convenience, among other trends. As a result, patients who previously might have needed a few nights in a hospital for a procedure can now be treated and released within the day of their arrival at, say, a suburban surgical center.

“Whether it’s free-standing surgical centers, retail clinics, or so-called ‘doc in a box’ locations, that is where health care is going, and you can’t stop it, which leaves hospitals with an existential crisis,” Ganti said. “We are over-bedded as a nation, which means we need to take some capacity out of the system, but we have been very reticent and slow to do that, given a variety of factors, including local community politics.”

A Company Hooked on Leverage
One example of this existential crisis is a volatile hospital company whose debt went from investment grade to the high-yield space after leveraging itself heavily for various acquisitions. 

“Management always prioritized share buybacks over debt paydown,” Ganti said. “As of September 2017, 90% of the company’s enterprise value was debt, 10% was equity, and an outside hedge fund that owned 18% of the equity was looking to do something with its troubled investment. ”

With its substantial equity stake, the hedge fund helped precipitate a change in management and a board shakeup. But in an attempt to prevent large shareholders from buying bigger stakes in the company, management adopted a “poison pill,” in order to allow existing shareholders to purchase additional shares at a discount, thus making it prohibitively expensive for anyone else to buy the company or for the hedge fund to increase its ownership stake.

Sell or Spin?
Now the question is whether the hedge fund will try a takeover of the hospital company or accede to a spin-off of its most attractive subsidiary. “Selling that crown jewel could be good for bondholders,” said Ganti. “A spin-off would disadvantage them.”

While there are various opinions about how this boardroom drama will play out, Ganti doubts there will be any significant move until February, although the story continues to evolve.   

Against that backdrop, some active managers have favored the company’s unsecured debt, given the upside potential.   

"Spinning off a key subsidiary would be challenging, but not impossible,” Ganti said. “The hedge fund here has orchestrated such a transaction before culminating in the forced sale of a company, and it has been a mess. In this case, for a spin-off to happen, the hospital company would first need to secure IRS approval for a tax-free spin-off, before buying out the sponsor’s existing minority interest, and then renegotiating various contracts. Tax-basis issues could also complicate the matter.”

If the hospital company does spin off a key asset, equity holders most likely will benefit at the expense of bondholders. However, with so much uncertainty surrounding the timing (and feasibility) of such a transaction, some active managers are weighing whether to trim their exposure slowly as the company weighs its strategic options or figure out a way to hedge themselves by buying the equity and/or credit default swap.

What, then, would be the most likely scenario?

“Asset sales would make the most sense,” Ganti said. “Management could sell a few hospitals and use the proceeds to pay down debt. At least that would demonstrate a commitment to reducing debt. We need to see some deleveraging before a large portion of the company’s secured debt comes due in 2020. I think the company has enough runway to figure out what to do.”

Sector Prognosis
While macro headwinds continue to challenge the hospital sector, some investors have favored diversified companies with high free cash flow and low leverage, those that have the potential to do well even in the current uncertain operating environment.

“One of those hospital operators has little in the way of covenants and can issue practically any amount of debt, given its highly liquid capital structure and strong operating fundamentals,” Ganti said. “Another company, with just under 2.4 times leverage, has the potential to refinance its debt at much lower rates once it returns to a full investment-grade rating.”

In any case, volatility likely will continue, given the continuing quest to repeal all or portions of Obamacare, despite three unsuccessful attempts. No matter what form the ultimate legislation takes, Ganti believes it will most certainly be negative to providers. President Trump's recent executive order was not altogether unexpected, but it is still a material headline negative for the hospital space.

 

1 Volume declines have been further exacerbated by shifts toward value-based care, the advent of high-deductible plans, the growth of observation status and improving technology.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds, including a higher risk of default.

High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

This article is being provided for informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described above.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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