If you hospital or system has a bank letter of credit expiring in 2011, here are some practical tips on how to go about the process.
How Much Variable Rate and In What Form
Letter of credit renewal is a good time to review your capital structure and reassess whether variable rate debt is at levels appropriate for your organization’s risk tolerance and objectives. You can then decide between LOC-backed debt and alternative variable rate structures such as direct placements are more indicated. Hospitals can take renewal as an opportunity to stress-test the capital structure using financial risk simulation to project the impact of various interest rate scenarios. This should be done not just on liabilities, but on the entire balance sheet, including investments. Risk modeling is the only way to make decisions based on the risk-adjusted cost of debt. You should avoid lumping variable rate debt in a single category: not all debt is created equal, and rating agencies now differentiate by put type and term-out.
A comprehensive stress-test should factor in swaps and interest rate hedges. If swaps were used to fix the coupon and a fixed rate refunding is considered, a termination analysis needs to be performed because if left in place, their cost of carry will add several percentage points to your borrowing cost. Termination is also typically costly due to large negative “mark to market” values in today’s rate environment.
Alternative variable rate structures help capture the benefit of low short term rates without the put and remarketing risk common with LOC’s. These structures include bank tax-exempt loans and direct placements and have grown in popularity as many banks have exited the LOC business after being downgraded. The $30 million cap per borrower on Bank Qualified loans has reverted back to $10 million per issuer so banks now price them on a taxable basis, but short term rates are so low that the difference is negligible.
To RFP Or Not
If you’ve decided to keep your LOC-backed debt in place, you must now determine whether to confine negotiations to the existing bank, or expand your search to other banks.
We generally recommend expanding the search. The first reason is basic risk avoidance: you do not want to proceed based on positive feedback from your bank, only to find out at the eleventh hour that their terms are unattractive. The lending environment is volatile and banks seldom commit for long periods of time, so “warm and fuzzy” feelings do not always translate into an acceptable commitment at renewal time. Early renewal may help avoid this situation, but requires prematurely giving up on what is often lower existing LOC fees. In some cases however, an early renewal is required to avoid the debt being classified as current by auditors. Time is on the bank’s side, the longer the hospital waits, the fewer the options. If your bank appears lukewarm or slow to respond, expanding the search may be the only safe option.
The second reason is that competition among banks is good. More proposals almost always result in lower pricing and better terms. We yet have to see a bank refusing to renew or bumping up their pricing because the hospital decided to seek additional proposals.
The third reason is that multiple proposals can provide valuable information hard to obtain by other means. It’s hard to tell how competitive your bank is without getting quotes from other banks. Terms shared by colleagues and other providers may not be applicable to your hospital.
RFP Best Practices
Once the decision is made to seek additional proposals, some hospitals struggle between doing a formal RFP vs. a less formal process. An informal process may appear to give the hospital more control, but in reality, a formal RFP allows the hospital much more control over the exact scope and format of the information requested, making the side-by-side comparison easier. Another benefit of the formal RFP is that banks are more likely to mobilize and provide a timely written response than with an informal request. Avoid rushing to send out an RFP. You can bet banks will not get together to make sure their proposals are easily comparable. Instead, invest the time with your financial advisor to spell out your specific requirements and preferences, and draft an RFP in a format that is consistent with current banking practices. This will pay for itself in the evaluation process.
The next step is to develop a clear timeline based on current LOC expiration, auditor cycle, and a target closing date which provides enough time for all necessary board approvals and a Plan B. Six months may seem like a long time, but will provide for an orderly process and enough cushion for other options if responses don’t meet objectives.
Decide on a single point of contact for handling all communications. Traditionally this is the role of the financial advisor. Keep in mind that each bank will have a single point of contact who will diligently consolidate all intelligence gathered in discussions with your hospital. If you don’t have a single point of contact on your end, you may be at a disadvantage in the negotiation process.
We’re often asked how many banks should be invited to submit proposals. Our answer is as many as you can find and prequalify. Prequalification consists of eliminating banks who are unlikely to respond for various reasons (out of footprint, different credit requirements, insufficient rating, etc). You should avoid overzealous prequalification as it may result in a smaller list than optimal.
Make sure you send the RFP to the right person within each bank. We see some RFP’s sent to the wrong relationship manager without a heads up call. This is a sign that the borrower is either going through the motions without a true interest in getting proposals, or the advisor has not put the time into identifying the proper parties. Do not assume that an RFP sent to anyone within a bank will quickly find its way to the right representative, particularly with larger institutions. By the time the right person receives the package, the bank may not have any time left to respond. Make sure your advisor is making the calls and tracking down recipients before the RFP is sent out.
Include all banks who have expressed interest in the past. Get independent advice on which other banks to add. Expect some banks will not respond at all.
There are no set rules for format and content, but a minimum, the RFP should clearly state the requested amount, key terms, and deadline for responses. Two weeks is considered standard, but 3 to 4 weeks may be better if more banks are involved. Don’t assume that banks have access to your audited financial statements or rating reports; include all relevant information as a convenience to them and to keep the timeline to a minimum. Stamp the RFP as confidential and keep boilerplate language out, it may look impressive but you’re not the federal government. In most cases, banks know you don’t have to go with the lowest bid and you have the right to pull the plug anytime.
Here are the typical major elements of a request for proposals for a bank letter of credit:
- hospital single point of contact
- deadline for responses
- face amount
- upfront fees
- annual fees
- closing fees including legal counsels
- termination pricing
- bank’s right of consent to additional debt
- renewal terms
- acceleration or term-out clause
- material adverse changes or “MAC” language
- covenants and disclosure requirements
- other required business and lending capacity for the hospital
How to Evaluate Responses
If the RFP was properly drafted, the evaluation is the easy part, so long as you are familiar with bank letters of credit. If your advisor has direct experience working for an LOC bank, this will come in handy.
It’s important for the hospital to understand the different levels of commitment between proposals. If a proposal does not say it is binding, it isn’t. Look for “subject to’s” such as credit committee approval, and make sure they are captured in the side-by-side comparison.
A standard RFP evaluation technique is to assign a ranking to each item and a weight based on the hospital’s internal preferences. For example, if your biggest concern is renewal risk, the facility term and renewal will receive the highest weight. The weighted total can then be used to rank each proposal.
We recommend that unless a bank group is required, the hospital’s initial evaluation results in selecting a shortlist of 2-3 banks for a final round of discussions and an opportunity to adjust terms. Keeping more banks in play can be a distraction and can detract from the ultimate objective: picking a bank with enough time to close or go to Plan B.
It’s fair to say that LOC pricing has increased significantly from what it was before the recession, and terms have gotten more restrictive. That is why rating agencies are much less excited about LOC-backed variable rate than they used to be. Keep in mind that pricing is only one piece of the puzzle, and it is renegotiable later. We routinely help hospitals adjust pricing midway through an LOC’s term based on changes in the lending environment and/or the hospital’s financial performance. Don’t think you’re stuck with the pricing you negotiate. Other terms may be harder to renegotiate.
Waiting until the last minute is the most common mistake we see and is of particular concern this year given the huge volume healthcare LOC’s up for renewal. If your board needs convincing, there is some frightening information out on what some predict will be a perfect storm. This should help get everybody going before it’s too late. Remember that time is not on the hospital’s side.
Other common mistakes to avoid include:
- relying on your existing bank’s verbal promises. In today’s lending environment, too many things can change too quickly. Trust, but RFP. Even if your bank is willing to renew, their terms may be sub-par and you’ll never know unless you solicit additional proposals.
- underestimating the true cost of switching your other banking business. Banks used to have brief discussions about treasury, cash management, and bond underwriting. Now they want firm commitments for transitioning including specific timetables. This can be costly, disruptive, and may limit the hospital’s flexibility to shop its financing options for the best terms.
Properly planned, LOC renewal can be a great opportunity to keep your organization on solid financial footing and your cost of debt low for the next several years.