Strategies for Accomplishing New Development or Major Capital Projects

One of the focal areas of my consulting practice/work is assisting health care organizations in accessing sources of funding (securing financing basically) for major projects and/or new development.  Given the state of the economy, most specifically the capital markets over the past eighteen months, getting funding for capital projects and/or development has been challenging, though not impossible.  Terms are definitely not as good (rates, covenant restrictions, and length or term of the obligation) and lending sources are far more credit adverse than two years ago.  Health care, although the defaults have been low, is an eclectic industry for most traditional lenders and their lack of specialization or knowledge makes them deal “shy”.  Even lenders with health care technical experience are more cautious and requiring far more information and deal due-diligence than say, two years or so ago.

Approaching a major capital project (expansion, remodeling, equipment replacement, etc.) or a new development (addition or new facility) is a daunting task and if any of the cost involves securing financing, below are some strategies or tips for project analysis and due diligence that I have found are virtual necessities to secure financing.  Obviously, this information does not supplant the credit worthiness of the organization doing the borrowing or in other words, bad financial ratios equals bad terms or today, no credit.

  • Completion of an Internal Rate of Return analysis at “current” market cost’s of capital.  The analysis needs to include sensitivity adjustments/tests as well.  If the project is such that the expenditure will not add revenue (major equipment or even some remodeling projects), the Internal Rate of Return analysis uses assumptions of savings and depreciation expense as the source of “revenues”.  In other words, you begin the first phase by using a life-cycle cost analysis as the means to produce the “net inflow” assumptions (savings, etc.) for the IRR. 
    • Much of health care, especially the reimbursed and clinical segments is very much a fixed-revenue prospect.  I see providers get caught all the time trying to justify remodeling and even down-sizing projects as “revenue improvements” and it doesn’t fly.  It is possible to produce or to generate new or improved “cash inflows” from these types of projects but creating assumptions for this improvement and the resulting new inflows requires careful thought and impartial analysis.  Suffice to say that if the project involves remodeling or down-sizing, getting to the point of improved net inflows as a result of the project means something had to change on the expense side (especially again, if the bulk of the revenue related to the project is fixed reimbursement), efficiencies have to be clear and demonstrable, and/or the use of the remodeled or down-sized space is for a new product or service line that will generate incrementally higher revenues or reimbursements per patient day.
    • On new developments or expansion projects, the largest mistake I see made is around the assumptions of occupancy and revenue generation.  The assumptions used need careful analysis and should be weighed against comparable provider/market experiences whenever possible.  This is critical in the sensitivity testing portion of the IRR – stressing and testing the new revenue assumptions.  Some very important revenue assumptions cues are;
      • Reimbursement rates and the corresponding revenue assumptions need to fit the current legislative and policy trends.  For example, health care reform just passed and Medicare is looking at $500 plus billion in cuts.  Medicaid is another issue and state budgets and forecasts of rate cuts or rate stability are an issue.  Don’t use assumptions that don’t follow the present health policy issues.
      • Dramatic changes in payer mix and product line mix are unlikely to occur as rapidly as I see providers try to project.  If for example, your payer mix has been predominantly Medicare, some Medicaid and some private insurance (65/25/10),  it may change dramatically for a new development in a new market location but not for an addition to an existing location.  In reality, just by “building it”, they won’t “naturally come”.  Marketing strategy is the key to this change but in the analysis, the assumptions of any major revenue changes as a result of a project need to be smoothed.
  • Capital Budgeting techniques and analysis need to be performed for major equipment replacement or infrastructure improvements.  Alternatives to the project need to be reviewed and financial analysis of the costs and operating impacts of each alternative need to be completed.  Again, interest rate/cost of capital assumptions, even a cost of cash assumption (investments of internal cash v. cost of debt), need to be integrated into the analysis.  Lenders want to see that the provider has thoroughly evaluated analytically, the alternatives for each proposed capital project.
  • Benchmark your project against like projects and your numbers against industry ratios.  There are a number of sources for industry ratios by health care segment from Fitch, to trade associations, Ziegler, BB&T, etc.  I typically will add comments and a brief discussion of salient differences when the ratios and results are positive or negative to industry standards.  I also like to incorporate a pre and post project re-cap.
  • Discussion and information on Market and Industry Trends is important for lenders to understand how the project fits into the overall market, into your organization’s position within the market and where the organization views the project in light of current industry trends.  Remember, the policy landscape is quite volatile and lenders are aware of the volatility.  Explanations of a thorough understanding of this volatility and how the project and organization plan fits in light of this trend is imperative in order for lenders to have a grasp of  the organization’s project management and financial and strategic management capacity. 
    • Market discussions should focus on where the organization ranks competitively within a market area, where the organization’s target market is, how that market is changing, and how the project responds to the market needs, its market position, and to the changing demands within the market location.  I also like to incorporate sales advantages, competitive advantages, quality information (as pertinent), customer satisfaction information, and any commentary on competitors.
    • Industry trend discussions focus on what is happening in the industry and how the project relates to these trends and why.  If the project is for example, an infrastructure improvement (roofs, mechanical systems, etc.), it is entirely appropriate to discuss the average age of physical plants in the industry, deferred maintenance and or average capital spending trends, etc.  If the project is an addition, the discussion should focus around meeting customer needs, new products and services that will be delivered and how completing the project either keeps the organization up-to-date with industry advances or propels it ahead of the pack. Other industry information that is important to discuss is;
      • Major health policy trends such as reimbursement rates, new regulations or requirements (e.g., mandates for sprinkler systems in SNFs), and as applicable, changing patient/customer needs.  It is important to relate these trends to the project and as much as possible, across the anticipated horizon that covers the length of the credit.  For example, if reimbursement changes may positively or negatively impact the organization’s cash flow, a frank discussion of this impact is necessary along with how the organization is planning to address the impact.  The impact, of course, plus the organization’s assumptions of impact on the project and the organization should be incorporated in the financial analysis.
      • Industry information regarding payer mix trends, length of stay, service utilization, labor costs, etc. may or may not relate to the project but whenever it does, I like to point it out and moreover, discuss briefly the relevance and the distinctions.
  • For New Developments market and demand studies are critical.  I like to see demand studies that test demand at given prices, not just global demand.  Global demand assumes price doesn’t matter or location and service-depth is less relevant and in reality, it may be the difference between success or lack of success.  Although a bit esoteric, I am even in-favor of incorporating a bit of “central place” or “location” theory in my market and demand analyses.  This type of analysis looks at key project characteristics or specifications and analyzes how strongly they are met or reinforced by the development location.  For example, if proximity to a certain referral source is a key project specification, I’d analyze this in relationship to market size and perhaps, existing referral patterns. I’d then look at the cost of development and location (site) in relationship to the requirement that the location is proximal to a referral source.  In some cases, the cost of development may be to such a degree greater that an alternative location actually becomes preferrable from a financial feasibility stand-point.  Finally, market analysis needs to define the primary markets, the competitors within the markets, the socio-economic condition of the market location (population growth, income/wealth, age,education, etc.) and the market trend.  I will also address factors that may positively or negatively affect the project’s completion and revenue assumptions (occupancy/lease-up, etc.).

 As daunting as the above may sound, it is nearly a pre-requisite to access capital for large capital projects and/or new developments at acceptable terms (again, assuming the general financial profile of the organization is solid).  While each project is different necessitating more analysis in one area and less in another and each organization is different, I’ve found that lenders today prefer more on-point discussions, even if they seem trivial, than less.  Building a solid case, financially and strategically, for the project is critical in order to achieve success in the capital markets and frankly, in order for the project to achieve the organizational objectives.

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