Capital Finance. Changing Structures

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1 2013 Capital Finance The first in a series of four Executive Insight Reports from Bank of America Merrill Lynch produced in collaboration with HealthLeaders Media Changing Structures

2 Perspective: Capital Finance 2013 promises to be another year of transformation for the healthcare industry. As executives prepare for the realities of healthcare reform and continue to ride economic ups and downs, they face some challenges but also profound opportunities. To equip you for this changing healthcare market, Bank of America Merrill Lynch and HealthLeaders Media have partnered to bring you unique insights, ideas, and strategies to help you better understand the landscape of healthcare economics and finance. In the coming months, look for special surveys and reports on the new Executive Insight Center at HealthLeadersMedia.com, a valuable new reference center providing groundbreaking research, thought leader analysis, and executive roundtable discussions. This first Executive Insight Report, featuring expertise from around the industry, brings you further insights into the results of HealthLeaders most recent Buzz Survey, focused on capital funding. The results of this proprietary survey of healthcare executives from across the industry show that reform and the threat of sequestration of federal funding remain significant drivers of capital investment as providers prepare for their impacts. Healthcare organizations are prioritizing: investing more in information systems and IT infrastructure, and cutting back in some cases on things like facilities. The research also shows that there is no single dominant funding source. Providers are finding many different ways to put together their financing puzzle, depending on their capital priorities such as the borrowing need and related costs, interest rates, and debt maturities. The following pages provide more valuable data and detail. Our clients have shown increased focus on preparing their organizations whether they are the acquirer or the acquired. To provide further insight on positioning your organization should an acquisition or partnership opportunity arise, the April edition of the Executive Insight Report will focus on industry consolidation. I hope the fresh perspectives presented by HealthLeaders Media and Bank of America Merrill Lynch are valuable as you guide your organization through the changing landscape of healthcare. Here s to a healthy, prosperous John Hesselmann Senior Vice President, Specialized Industries Executive Bank of America Merrill Lynch 2 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

3 Healthcare reform is driving providers capital investments just as much as it s driving operational and clinical changes, according to a recent survey of industry executives. At the top of the list is health information technology to generate the data they need to improve performance, followed by facility upgrades to stay competitive. But many are depending on investment income first to pay for those improvements. A recent capital funding survey conducted by HealthLeaders Media revealed that while the bond market is still, by a slim margin, the favorite primary funding source, only one out of three survey respondents intend to use bonds as a primary source of capital in the next two to three years, and 44% don t expect to tap that source at all (climbing to 50% among C-level executives). About 30% intend to rely on investment income as a primary source of funding for Kerri Schroeder Senior Vice President and Credit Products Executive for specialized industries Bank of America Merrill Lynch capital projects, and another 38% look at it as a secondary source. Uncertainty is causing some of our clients to be cautious about their investments and their overall debt load, says Kerri Schroeder, senior vice president and Credit Products executive for Specialized Industries at Bank of America Merrill Lynch, which sponsored the survey. PRIORITIES FOR CAPITAL INVESTMENT: What are your organization s top three priorities for capital investment in the next 12 to 18 months? Healthcare information systems (including EMR) and IT infrastructure 68% 66% Upgrades to existing facilities 47% 47% Process improvements for operational efficiencies Merger, acquisition, or other partnership 33% 36% 45% 47% Clinical technology 22% 32% New facilities Funding for pension, benefits, or self-insurance Compliance with safety codes No capital investment planned in the next 12 to 18 months 6% 9% 6% 7% 6% 9% 26% 28% n Total n Senior leaders Multi Response 3 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

4 DRIVERS OF CAPITAL INVESTMENTS: How influential are each of the following in driving your organization s capital investments in the next 2-3 years? n Major influence n Minor influence n Not an influence Changes to healthcare reform laws 65% 23% 12% Sequestration of federal funding 50% 33% 17% Merger, acquisition, or other partnership 45% 20% 35% An economic downturn 43% 41% 16% Local competitor moves 37% 42% 21% An economic upturn 21% 50% 29% Some popular capital investments, like information technology, aren t suited for incurring long-term debt, Schroeder says. Part of the equation has to be balancing the term of financing with the useful life of the investments you re making. Others, like mergers or affiliations between not-for-profit entities, may not require much up-front capital because they merely pool the resources of the organizations involved. Part of the equation has to be balancing the term of financing with the useful life of the investments you re making. An unsettling future By an overwhelming margin, changes to healthcare reform laws were the biggest driver of capital investments among survey respondents, with 65% saying they were a major influence and another 23% citing them as a minor influence. (The corresponding figures were 69% and 14% among C-level executives and other senior leaders.) Half of all respondents say the sequestration of federal funding will be a major influence on their investments if the government s deficit controversy can t be resolved, though senior leaders are slightly less worried, with only 47% ranking sequestration as a primary concern and 22% saying the prospect doesn t influence their investment plans. Money will be tight no matter what, says Schroeder. Sequestration is a concern for hospitals and a 2% 4 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

5 cut in Medicare funding would not go unnoticed by anyone, but the reality is that there will likely be funding cuts and entitlement reforms passed in order to balance the federal budget, and they may be more far-reaching than sequestration, she says. As providers think about a more difficult environment and shifting of reimbursement away from fee-for-service toward value-based or population-based payments, they re trying to wring out as much cost saving as they possibly can. Investing for change The leading investment by far is in information technology. In the next months, 68% of respondents said IT and IT infrastructure investment were a top priority. Part of that enthusiasm is due to A note on the survey The Capital Funding Buzz Survey polled members of the HealthLeaders Media Council, a group of executives from healthcare provider organizations. A total of 125 completed surveys were included in the analysis; 58 of those were from senior leaders (C-level executives, partners, board members, and principal owners). Hospital executives represented 41% of the respondents, and 23% were from integrated delivery systems. Another 18% were from physician organizations. The majority (69%) were from nonprofit organizations. Respondents were asked three questions in all, regarding their organization s top three priorities for capital investment in the next months, the factors driving those investments, and the likely sources of funding for them. The margin of error for a sample size of 125 is +/-8.8% at the 95% confidence interval. the federal meaningful use program, which has earmarked billions of dollars in incentive payments for providers who use IT in certain mandated ways, and in 2016 is scheduled to start penalizing non-users by curtailing Medicare payments. But Schroeder says the IT investment would or at least should be made regardless of the federal program. What they re getting back is certainly helpful, but the bigger driver is to manage efficiency in the organization as they look at physician alignment strategies, managing length of stay, quality of care, and so on, she says. Healthcare IT is helping support those initiatives. Schroeder says the recession has delayed many facilities upgrades, making this category the second most popular for capital investments over the next months. Process improvements and mergers are in third and fourth place. All four of the top categories reflect efforts to deal with the changing reimbursement environment. Top of mind is how to invest to bend the cost curve and manage the revenue cycle as reform gains traction, she says. Fundamental shift As providers grow by mergers and acquisitions, they will gain the ability to leverage economies of scale, greater negotiating power with insurers, and more fluid access to capital markets, Schroeder says. But providers of all sizes will see their reimbursement squeezed, and will have to address fundamental changes in the way care is measured and paid for. Everyone will have to work through the waste in their systems and become more efficient, Schroeder says. The only ones ahead of the game are integrated systems that are both providers and insurers, because they have more control over the end to end process. n 5 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

6 EXECUTIVE SPOTLIGHT North Shore-Long Island Jewish Health System is the nation s third largest nonprofit secular health system, operating more than 6,000 beds in 16 hospitals that serve Long Island and three of New York City s five boroughs. Its medical group is the sixth largest in the country, with more than 2,400 full-time physicians. Its annual operating budget is more than $6.7 billion. In recent years it has been recognized for high-quality care by the National Quality Forum, The Joint Commission, the Healthcare Association of New York State, and U.S. News and World Report. Despite its solid position today, North Shore-LIJ, like all providers, is making capital plans in an environment of uncertainty. Below, CFO Bob Shapiro talks about some of the issues and how North Shore-LIJ is approaching them. Capital priorities We are primarily investing in three areas: health information technology; facility upgrades; and mergers, acquisitions, and other partnerships. We d be doing these even if there were no major changes coming in how care is delivered and paid for, except that we are putting more emphasis on acquisitions. We acquired Lenox Hill Hospital in Manhattan a year and a half ago and we re expanding ambulatory services there. Robert S. Shapiro Executive Vice President and CFO North Shore-Long Island Jewish Health System Manhasset, N.Y. CAPITAL INVESTMENTS FUNDING SOURCES: Please indicate if each of the following funding sources will be a primary source, a secondary source, or not a source for your organization s capital investments in the next 2 to 3 years. n Primary Source n Secondary Source n Not a Source Bond market 33% 23% 44% Investment income 30% 38% 32% Commercial loans 22% 26% 52% Philanthropic donations 18% 44% 38% Venture capital 12% 14% 74% 6 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

7 We are approaching two-thirds of the way with our electronic medical record infrastructure. We ve gotten federal meaningful use dollars from that. It s a little early in the process to be benefitting in respect to the analytics, but having the EMR in place will be very important for care delivery in the future. We re not an old health system, but some of our buildings were built back in the 1950s and 60s and they re in need of normal rehab. We also feel that we need to upgrade at our five tertiary campuses. We believe that the decision-makers for healthcare in the future will be looking at two things: first, clinical quality, and second, the experience of being in the hospital. Updated facilities, private rooms, and quiet areas are all very important to patients. They re looking for hospitals that are more like a hotel and less like a dormitory. We recently put up a new wing at Long Island Jewish Medical Center for surgical services and obstetrics. People love the quiet there, and that s going to pay off down the road. Drivers of investment When we look at how Medicare Recovery Auditors are denying payment going after short stays in hospitals, or certain DRGs that they feel should be handled on an ambulatory basis rather than inpatient we see that we have to make major changes in our assumptions about how we re going to be paid and how we need to document the care we give. And you can t ignore the growth in Medicare expenditures and beneficiaries as the baby boomers age. We have to change how we deliver care as payers move away from fee-for-service. Updated facilities, private rooms, and quiet areas are all very important to patients. Sequestration [of federal funds] is a time bomb that no one wants to see go off. I ll be an optimist and say that they ll figure out some rational way to solve [federal budget issues], but we re developing plans to deal with whatever they throw at us. We want to go down the path of being an insurer. Even if this is just like the 1990s, where there was a lot of talk and no action on changing the payment model, we feel that a population health approach being both the insurer and the provider is the right way to go. And if this time is the real change, we re going to be prepared. But it s not easy to make that decision. New York is a highly regulated insurance environment. We don t have the balance sheet to handle the risk from being an insurer. Our first step is a product that we offer with UnitedHealthcare, and the next step is to partner with others to create an insurance company or acquire an existing one. Sources of capital We get our money from three primary sources: borrowing from the bond market (either taxable or tax-exempt depending on how we use the funds), cash generated from operations, and philanthropy. We have a very disciplined cash allocation process: We borrow only what we can afford. We have a $200 million bond issue planned for 2013, but we haven t decided whether it will be 7 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material

8 tax-exempt or taxable. If we decide to use it for brick and mortar, we may go tax-exempt, but if it goes for acquisitions, we ll do taxable bonds. The activity that we ve had expanding our physician practice will hit its peak this year. I m happy to say that the donor climate has improved over last few years. On average, we raise $80 $100 million a year in philanthropy. We have a mix we get a few very large donations every year, but the mid-level donations are our bread and butter. We did see a drop during , but it s been coming back over 2011 and We feel donations are going to get better over the next several years. Now that we re in Manhattan, some donors view us differently. They agree with what we re trying to do. n I m very concerned about any rewrite in the tax code. It would be a hit for us if charitable deductions were reduced or eliminated. Bank of America Merrill Lynch is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., member FDIC. Securities, strategic advisory, and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation ( Investment Banking Affiliates ), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp., all of which are registered broker dealers and members of FINRA and SIPC, and, in other jurisdictions, by locally registered entities. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. are registered as futures commission merchants with the CFTC and are members of the NFA. Investment products offered by Investment Banking Affiliates: Are Not FDIC Insured * May Lose Value * Are Not Bank Guaranteed Bank of America Corporation. 8 Bank of America Merrill Lynch I Capital Finance Changing Structures Sponsored Material