In the last few months, bank direct placements have replaced public offerings as structure of choice for many hospitals looking to minimize issuance costs. Beyond favorable economics, CFOs need to understand how placements are different.
What Are Bank Direct Placements?
Bank direct placements are similar to publicly-sold bonds in that they are issued for new money or refunding purposes on parity with other senior tax- exempt debt, and they can be structured with a fixed or variable rate coupon. However, unlike publicly-offered bonds, direct placements are sold directly to a single bondholder, generally a bank or other financial institution with a large balance sheet. The bank holds the bonds to maturity.
The single investor status of a bank direct placement provides some key benefits, but also creates certain limitations.
Benefits of Direct Placements
There are a few reasons why direct placements are looking attractive to hospitals right now:
- Low coupon. Eager to put their balance sheets to work, banks are pricing direct placements aggressively, to say the least. It’s not unusual for direct placements to be priced at credit “spreads” (the premium charged over an index such as Libor to compensate for credit risk) close to half of what public bond markets require. No telling how long this will last, but for now, saving 80-100 basis points by going the direct route is attracting many takers.
- No middleman. Without multiple investors to round up (as is the case with public offerings), bond underwriters are out of a job. This takes underwriting fees and expenses out of the equation, the single largest component of issuance costs.
- No rating agency. In the public markets, bondholders demand a much higher coupon for unrated issues. Banks do not require direct placements to be rated. This doesn’t mean a hospital without any existing bond ratings will find a bank willing to do a direct placement. Rather, it means the direct placement itself does not require a rating, so agency presentations and fees are eliminated.
- No debt service reserve fund. We don’t know why bondholders in the public bond markets want to lend 10% more to a hospital, just to get it back if payments are missed, but they do. Banks have no such requirement. This lowers the size of the offering and eliminates the potential for negative arbitrage on investing the debt service reserve fund.
- Less disclosure. Appendix A, the narrative section which bulks up official statements for the benefit of investors and is largely driven by regulators’ concerns for widows and orphans, is out. The banks are considered big boys who can do their own homework. This cuts on legal fees and time to closing.
The low coupons, absence of underwriters and rating agencies, and limited disclosure all translate into significant time and cost savings for direct placements. So what about limitations?
Limitations of Direct Placements
There are some drawbacks to direct placements worth noting: shorter maturities, smaller maximum offering size, additional business requirements. Tax exempt direct placements also involve tax risk. Finally, documents must be carefully reviewed, particularly outs provided to the bank.
- Shorter final maturity. A typical placement features a 20 to 25-year amortization with a 5 to 10-year balloon. Some go out to 15 years, all depending on credit quality. Public underwritings on the other hand routinely go out 30 to 40 years and fully amortize without a balloon. The shorter amortization of direct placements doesn’t hurt maximum annual debt service and debt service coverage ratios much, but the large balloon creates significant renewal/refinancing risk. A typical 10-year balloon will be around two-thirds of the original par amount. The borrower must decide if this risk can be managed. Many hospitals have said yes, but more conservative boards may determine that access to the debt markets in 7 to 10 years is too much of an unknown, particularly with larger placements.
- Size limit. Placements are not syndicated like public offerings, which can theoretically handle unlimited par amounts. For most banks, $60 to $80 million is the upper limit, although this varies depending on the institution’s single-credit concentration limits and the hospital’s credit quality. This is clearly more of a concern for borrowers with larger needs.
- Additional business requirements. Banks want the “whole relationship” and are aggressively looking to pick up other fee business. This can include treasury, cash management, deposit and trust accounts, purchasing cards, etc. Many hospitals select a bank based on coupon and terms, only to find out way later in the process that unreasonable strings are attached. The cost and distractions of switching banking relationships cannot be ignored and should be another criteria in the selection process. A written description of requirements with proposed timeline for implementation is not something most banks volunteer, but always a good idea to ask for so it can be negotiated early on.
- Tax risk. Unlike public offerings, direct placements documents contain language that bump up the coupon should the tax-exempt interest collected by the bank become taxable due to changes in the tax code. Most hospitals view this as a minute risk with limited practical consequences in today’s low interest rate environment, but tax exemption is being debated in Congress and this risk needs to be evaluated.
- Material adverse changes language. MAC language is an out for the bank to call the bonds if a change materially and negatively affects the business, financial condition, or operations of the borrower. Publicly-sold fixed rate bonds contain no such language. In some cases, MAC clauses were so vague that auditors would require an amendment or threatened to classify the placement as short-term debt. Hospitals must carefully review this language to avoid giving an unconditional “put” to the bank.
Bank Direct Placements Are Negotiated!
Hospitals must keep in mind that direct placements are negotiated instruments and that unlike public offerings, terms and covenants can vary significantly among banks. In the public bond markets, terms are more standardized and predictable, in part because the same institutional investors end up as bondholders from one deal to the next and not one can exact unusual terms. Not so with direct placements. This can put the hospital at a relative negotiating disadvantage, particularly if the bank has more experience with the structure as is often the case. This is where getting third party advice with hands-on experience can add significant value.
With the above considerations in mind and a thorough understanding of all risks involved, bank direct placements can provide an attractive alternative to traditional bond financings for hospitals looking to minimize upfront fees and lower their cost of funds.