Key Considerations for Health Care Equipment Leasing in Today's Market

The health care industry is going through a period of unprecedented change and uncertainty due to the slow-to-recover economy, tight credit markets, increasing costs and health care reform. These challenges are substantial and are expected to continue well into the future as health care reform unfolds. We know that major health care policy changes create winners and losers, as the Balanced Budget Act of 1997 demonstrated. The impact of recent health care reform legislation will be much broader.

In the midst of this turbulence, health care continues to be a very capital-intensive industry. Health care providers, including hospitals, physician practices, skilled nursing facilities, long-term care, home health care, labs, imaging centers, etc., must not only maintain their existing facilities, but also keep up with continuous advances in medical equipment and information technology (“IT”) if they hope to stay competitive. However, providers' access to capital for equipment purchases is being restricted, making leasing an attractive option for capital-starved and cash-strapped health care organizations. For leasing companies, this is clearly good news. While there are a number of complexities to operating in the health care leasing arena, there also are more than ample opportunities. Those leasing companies that are proactive in mitigating certain industry risks have an opportunity to be very successful in this space.

Health Care Equipment Leasing

Historically, health care equipment financing has been provided by: 1) manufacturers' captive finance arms; 2) financial institutions; 3) bonds; and 4) third-party financing and leasing companies. Today, however, access to bank financing and the bond market for equipment financing has been restricted, forcing a shift to other options for financing.

While the percentage of health care equipment and technology leased has ranged between 12% and 15% over the past few years, this appears to be on the rise. Equipment and technology commonly leased include imaging systems, clinical lab equipment, diagnostic equipment, financial and clinical information systems, networking equipment, communications systems and electronic health records (“EHR”).

Generally, the financing companies are very flexible in structuring financing deals as loans or leases, to meet the customer's needs. Operating leases are particularly attractive for medical equipment that must be updated or replaced frequently, allowing for use of the equipment without ownership and return of equipment at the end of the lease. Leases often provide a less expensive form of financing due to tax and other considerations. In addition, leases can often be structured so that they are off-balance-sheet and are paid for from operating dollars rather than capital dollars. This is an advantage for providers that either need the additional borrowing capacity for other needs or are otherwise precluded from adding debt due to debt covenant restrictions. However, off-balance-sheet accounting treatment is likely to end sometime in the next few years due to proposed changes in the accounting rules. Tight credit markets have forced many U.S. hospitals to shift their limited capital resources away from equipment investment and to infrastructure. This shift may have stalled the growth of health care equipment leasing. This shift appears to have begun prior to the financial meltdown of 2008. A recent Healthcare Financial Management Association's (“HFMA”) Healthcare Financial Pulse survey found that 68% of respondents stated that a strategy used to reduce costs in 2009 was the reduction of capital spending. This is important because capital spending in health care can only be deferred for so long before it becomes a necessity. Release of this pent-up demand for new equipment should drive future growth in equipment leasing.

Challenges Facing the Health Care Industry

In the United States, the health care industry represented approximately 17% of GDP in 2009. According to the Centers for Medicare & Medicaid Services, it is estimated that this will increase to 19% by 2019. There are a number of reasons for the anticipated increase. First of all, as the baby boomers continue to grow older and the birth rate continues to decline, the average age of the U.S. population is expected to increase. By certain estimates, the number of Americans age 65 or older and eligible for Medicare will grow to more than 70 million within this generation. The population age 85 and older will increase by almost five times to 19 million by the middle of the 21st century. According to a U.S. Census report, the median age in the United States has grown from 34 in 1994 to 35.5 in 2000 and will grow to an estimated 39.1 by 2035. As older individuals are more prone to chronic health conditions, they also have a higher relative cost in terms of per capita health care spending.

The recent economic turmoil that has battered the financial markets has taken its toll on the health care industry. Many of the traditional financing options that the industry has relied on in the past ' bonds, banks, finance companies, private equity, venture capital, real estate investment trusts, private philanthropy and grants ' are no longer available or only available in limited amounts and/or under unfavorable arrangements. At the same time, rising costs, lower reimbursement rates, shrinking demand for elective procedures, higher levels of charitable care and bad debt, and increased scrutiny of tax-exempt hospitals are putting a near buckling strain on health care systems. Systems throughout the country have been forced to re-examine their business plans, defer capital spending and cut costs.

The consolidation of health care providers is a growing trend, driven by limitations on access to capital, mandates on quality-of-care and survival due to pressure on the bottom line. While the current challenges must be acknowledged, the opportunities that exist in this industry are nearly limitless when you consider the demand for health care services and the priority on quality care.

Health care reform has created a great deal of uncertainty, which is contributing to the difficulties in obtaining financing for the industry. The major effect of recent legislation on health care providers is that 32 million Americans who previously did not have medical insurance will soon be covered. The estimated $1 trillion cost of health care reform will be paid, in part, from anticipated reductions in the cost of health care delivery and reduction of current reimbursement rates to providers and insurers. Health care reform also places a major emphasis on pay-for-performance and quality-of-care initiatives that will likely come with a high price tag. It remains to be seen whether the positive impact of having more insured patients will offset the effect of reduced reimbursement rates and the added strain on the already stressed health care delivery system, in which cost containment has never been achieved.

What does all this mean for health care equipment leasing? Providers will need to take advantage of technological advances in order to contain costs and achieve the efficiencies needed to compete in this environment. At the same time, the uncertainties in the marketplace make it very difficult for hospitals to make the large capital expenditures associated with these technological advances. Leasing will be a very attractive way for many health care providers to acquire the use of necessary equipment.

Demand for Technology Drives New Leasing Opportunities

Advancements in medical technology and IT are occurring at a phenomenal rate. Investment in health care infrastructure and equipment is expected to keep pace with the overall growth in health care expenditures. In some markets, the pressure to have the “latest and greatest” equipment is extreme.

Moreover, mandates to improve quality of care and patient outcomes drive a need for using the best diagnostic and treatment technology available in the marketplace. In addition, it can be a major marketing advantage to have the most current imaging or diagnostic technology. Keeping pace with technological advances is also a major selling point to attract and retain the best physicians. Health care IT, which covers a broad spectrum of administrative and clinical data management, is increasingly viewed as a key contributor to quality patient care. State-of-the-art IT can help reduce errors while at the same time lower the total cost of care delivery through reductions in labor, lengths of stay and unnecessary diagnostic testing. A major component of IT spending will be for EHR.

EHR is an especially challenging requirement for many hospitals and is a major opportunity for financing and leasing companies. Implementation of EHR has been mandated by recent legislation and is considered a key to improved quality of care and future cost containment. Once it is implemented, providers are expected to receive a very positive return on their investment, but getting there will be costly and will require a significant commitment on the part of management. Kathleen Sebelius, Secretary of Health and Human Services, recently stated that “Only 20 percent of doctors and 10 percent of hospitals use even basic electronic health records.” This statement underscores the significant investment that will need to be made in EHR, much of which will require financing or leasing.

Financing Trends

Given that many health care lenders have exited the market over the past few years, and access to the tax-exempt bond market has been interrupted, many providers are scrambling to secure any type of financing they can. Banks are somewhat restricted by the legislative and regulatory environment and are under pressure to improve the quality of their loan portfolios. While commercial lending activity has been on the rise in the first half of 2010, terms and covenants are more restrictive than before the economic downturn.

In response to this tighter lending environment, many health care providers are reserving their available lines of credit for term loans, cash-flow loans and major infrastructure projects. The limited borrowing capacity available from banks and the issuance of bonds are generally not being used for equipment financing. This provides financing and leasing companies the opportunity to provide financing as loans or leases, depending on the specific circumstances and needs of the provider. One clear advantage of leasing is that it can allow providers to have all of the competitive advantages of the most recent technology, without taking on incremental balance sheet debt.

Many third-party health care financing and leasing companies have fallen victim to their own lack of access to capital and have gone out of business in recent years. For those financing companies that are well capitalized and continue to write new business, market conditions are improving and the reduction in competition has allowed them to improve their portfolios. The finance arms of major health care equipment manufacturers have become a primary means of equipment financing and leasing. Given the rapid technological advances, these leases are being structured with shorter terms that allow for replacement with the newest model. This can be a win-win for the manufacturer and the health care provider. In another encouraging sign, leasing companies have not seen a material increase in delinquency rates in health care-related leases, despite issues in the overall economy as well as industry-specific concerns.

At the same time, recent actions by the U.S. government have elevated a commonly held concern among financing institutions that are active in the health care market ' the fear of the unknown. The current administration has taken steps toward making affordable, quality health care available to everyone, the impact of which is not entirely understood by the financial world at this point in time. As the landmark health care reform legislation is implemented, the risk exists that the changes could have a negative impact on lessors under the premise that anything that reduces the ability of providers to invest in equipment is also potentially bad for the leasing companies.

To mitigate this risk, leasing companies must closely evaluate how the recent legislation is affecting the segment of health care that it operates in, and stay closely attuned to new legislation. For example, the impact on an acute care hospital may be very different than it will be on a skilled nursing facility. Some leasing companies are waiting to enter or expand into the marketplace until there has been some history with the impending legislation and its impact. This opens up opportunities for leasing industry leaders who have done their homework.

Conclusion

The health care industry has not been immune to the recent U.S. financial crisis. It has seen its share of closures and bankruptcies as a result of unemployment, investment losses and tightening credit markets, much like other industries. However, the health care industry will not sink as low and is expected to recover more quickly than other industries. The demand for health care services ' from the changing demographics to the mandate for improved quality of care ' will require advanced technology that will drive substantial growth in capital spending for the foreseeable future.

Given the limited access to capital funding that is expected to continue, leasing arrangements will become a more attractive option and, in some cases, may be the only option available. The health care industry represents a substantial opportunity for leasing companies, but it is not without risk. To mitigate this risk, it is critical to understand the economics of health care and to closely monitor the government's increased participation in the industry and the corresponding uncertainty this creates.

[IMGCAP(1)]

[IMGCAP(2)]

Scott B. Davis is a partner in Grant Thornton LLP's Corporate Advisory & Restructuring Services practice, and is located in the Charlotte office. Davis has more than 25 years of experience assisting underperforming businesses in the areas of strategic change, litigation and forensics. He currently serves on the team that holds the role of Chief Restructuring Officer of Saint Vincent's Catholic Medical Center in its Chapter 11 bankruptcy, and is responsible for the disposition and sale of all assets. Phillip J. Robinson is a director in the Corporate Advisory & Restructuring Services practice of Grant Thornton LLP, and is located in the Phoenix office. His focus is the health care industry, where he advises hospitals and other providers who are experiencing financial and operational challenges.

The health care industry is going through a period of unprecedented change and uncertainty due to the slow-to-recover economy, tight credit markets, increasing costs and health care reform. These challenges are substantial and are expected to continue well into the future as health care reform unfolds. We know that major health care policy changes create winners and losers, as the Balanced Budget Act of 1997 demonstrated. The impact of recent health care reform legislation will be much broader.

In the midst of this turbulence, health care continues to be a very capital-intensive industry. Health care providers, including hospitals, physician practices, skilled nursing facilities, long-term care, home health care, labs, imaging centers, etc., must not only maintain their existing facilities, but also keep up with continuous advances in medical equipment and information technology (“IT”) if they hope to stay competitive. However, providers' access to capital for equipment purchases is being restricted, making leasing an attractive option for capital-starved and cash-strapped health care organizations. For leasing companies, this is clearly good news. While there are a number of complexities to operating in the health care leasing arena, there also are more than ample opportunities. Those leasing companies that are proactive in mitigating certain industry risks have an opportunity to be very successful in this space.

Health Care Equipment Leasing

Historically, health care equipment financing has been provided by: 1) manufacturers' captive finance arms; 2) financial institutions; 3) bonds; and 4) third-party financing and leasing companies. Today, however, access to bank financing and the bond market for equipment financing has been restricted, forcing a shift to other options for financing.

While the percentage of health care equipment and technology leased has ranged between 12% and 15% over the past few years, this appears to be on the rise. Equipment and technology commonly leased include imaging systems, clinical lab equipment, diagnostic equipment, financial and clinical information systems, networking equipment, communications systems and electronic health records (“EHR”).

Generally, the financing companies are very flexible in structuring financing deals as loans or leases, to meet the customer's needs. Operating leases are particularly attractive for medical equipment that must be updated or replaced frequently, allowing for use of the equipment without ownership and return of equipment at the end of the lease. Leases often provide a less expensive form of financing due to tax and other considerations. In addition, leases can often be structured so that they are off-balance-sheet and are paid for from operating dollars rather than capital dollars. This is an advantage for providers that either need the additional borrowing capacity for other needs or are otherwise precluded from adding debt due to debt covenant restrictions. However, off-balance-sheet accounting treatment is likely to end sometime in the next few years due to proposed changes in the accounting rules. Tight credit markets have forced many U.S. hospitals to shift their limited capital resources away from equipment investment and to infrastructure. This shift may have stalled the growth of health care equipment leasing. This shift appears to have begun prior to the financial meltdown of 2008. A recent Healthcare Financial Management Association's (“HFMA”) Healthcare Financial Pulse survey found that 68% of respondents stated that a strategy used to reduce costs in 2009 was the reduction of capital spending. This is important because capital spending in health care can only be deferred for so long before it becomes a necessity. Release of this pent-up demand for new equipment should drive future growth in equipment leasing.

Challenges Facing the Health Care Industry

In the United States, the health care industry represented approximately 17% of GDP in 2009. According to the Centers for Medicare & Medicaid Services, it is estimated that this will increase to 19% by 2019. There are a number of reasons for the anticipated increase. First of all, as the baby boomers continue to grow older and the birth rate continues to decline, the average age of the U.S. population is expected to increase. By certain estimates, the number of Americans age 65 or older and eligible for Medicare will grow to more than 70 million within this generation. The population age 85 and older will increase by almost five times to 19 million by the middle of the 21st century. According to a U.S. Census report, the median age in the United States has grown from 34 in 1994 to 35.5 in 2000 and will grow to an estimated 39.1 by 2035. As older individuals are more prone to chronic health conditions, they also have a higher relative cost in terms of per capita health care spending.

The recent economic turmoil that has battered the financial markets has taken its toll on the health care industry. Many of the traditional financing options that the industry has relied on in the past ' bonds, banks, finance companies, private equity, venture capital, real estate investment trusts, private philanthropy and grants ' are no longer available or only available in limited amounts and/or under unfavorable arrangements. At the same time, rising costs, lower reimbursement rates, shrinking demand for elective procedures, higher levels of charitable care and bad debt, and increased scrutiny of tax-exempt hospitals are putting a near buckling strain on health care systems. Systems throughout the country have been forced to re-examine their business plans, defer capital spending and cut costs.

The consolidation of health care providers is a growing trend, driven by limitations on access to capital, mandates on quality-of-care and survival due to pressure on the bottom line. While the current challenges must be acknowledged, the opportunities that exist in this industry are nearly limitless when you consider the demand for health care services and the priority on quality care.

Health care reform has created a great deal of uncertainty, which is contributing to the difficulties in obtaining financing for the industry. The major effect of recent legislation on health care providers is that 32 million Americans who previously did not have medical insurance will soon be covered. The estimated $1 trillion cost of health care reform will be paid, in part, from anticipated reductions in the cost of health care delivery and reduction of current reimbursement rates to providers and insurers. Health care reform also places a major emphasis on pay-for-performance and quality-of-care initiatives that will likely come with a high price tag. It remains to be seen whether the positive impact of having more insured patients will offset the effect of reduced reimbursement rates and the added strain on the already stressed health care delivery system, in which cost containment has never been achieved.

What does all this mean for health care equipment leasing? Providers will need to take advantage of technological advances in order to contain costs and achieve the efficiencies needed to compete in this environment. At the same time, the uncertainties in the marketplace make it very difficult for hospitals to make the large capital expenditures associated with these technological advances. Leasing will be a very attractive way for many health care providers to acquire the use of necessary equipment.

Demand for Technology Drives New Leasing Opportunities

Advancements in medical technology and IT are occurring at a phenomenal rate. Investment in health care infrastructure and equipment is expected to keep pace with the overall growth in health care expenditures. In some markets, the pressure to have the “latest and greatest” equipment is extreme.

Moreover, mandates to improve quality of care and patient outcomes drive a need for using the best diagnostic and treatment technology available in the marketplace. In addition, it can be a major marketing advantage to have the most current imaging or diagnostic technology. Keeping pace with technological advances is also a major selling point to attract and retain the best physicians. Health care IT, which covers a broad spectrum of administrative and clinical data management, is increasingly viewed as a key contributor to quality patient care. State-of-the-art IT can help reduce errors while at the same time lower the total cost of care delivery through reductions in labor, lengths of stay and unnecessary diagnostic testing. A major component of IT spending will be for EHR.

EHR is an especially challenging requirement for many hospitals and is a major opportunity for financing and leasing companies. Implementation of EHR has been mandated by recent legislation and is considered a key to improved quality of care and future cost containment. Once it is implemented, providers are expected to receive a very positive return on their investment, but getting there will be costly and will require a significant commitment on the part of management. Kathleen Sebelius, Secretary of Health and Human Services, recently stated that “Only 20 percent of doctors and 10 percent of hospitals use even basic electronic health records.” This statement underscores the significant investment that will need to be made in EHR, much of which will require financing or leasing.

Financing Trends

Given that many health care lenders have exited the market over the past few years, and access to the tax-exempt bond market has been interrupted, many providers are scrambling to secure any type of financing they can. Banks are somewhat restricted by the legislative and regulatory environment and are under pressure to improve the quality of their loan portfolios. While commercial lending activity has been on the rise in the first half of 2010, terms and covenants are more restrictive than before the economic downturn.

In response to this tighter lending environment, many health care providers are reserving their available lines of credit for term loans, cash-flow loans and major infrastructure projects. The limited borrowing capacity available from banks and the issuance of bonds are generally not being used for equipment financing. This provides financing and leasing companies the opportunity to provide financing as loans or leases, depending on the specific circumstances and needs of the provider. One clear advantage of leasing is that it can allow providers to have all of the competitive advantages of the most recent technology, without taking on incremental balance sheet debt.

Many third-party health care financing and leasing companies have fallen victim to their own lack of access to capital and have gone out of business in recent years. For those financing companies that are well capitalized and continue to write new business, market conditions are improving and the reduction in competition has allowed them to improve their portfolios. The finance arms of major health care equipment manufacturers have become a primary means of equipment financing and leasing. Given the rapid technological advances, these leases are being structured with shorter terms that allow for replacement with the newest model. This can be a win-win for the manufacturer and the health care provider. In another encouraging sign, leasing companies have not seen a material increase in delinquency rates in health care-related leases, despite issues in the overall economy as well as industry-specific concerns.

At the same time, recent actions by the U.S. government have elevated a commonly held concern among financing institutions that are active in the health care market ' the fear of the unknown. The current administration has taken steps toward making affordable, quality health care available to everyone, the impact of which is not entirely understood by the financial world at this point in time. As the landmark health care reform legislation is implemented, the risk exists that the changes could have a negative impact on lessors under the premise that anything that reduces the ability of providers to invest in equipment is also potentially bad for the leasing companies.

To mitigate this risk, leasing companies must closely evaluate how the recent legislation is affecting the segment of health care that it operates in, and stay closely attuned to new legislation. For example, the impact on an acute care hospital may be very different than it will be on a skilled nursing facility. Some leasing companies are waiting to enter or expand into the marketplace until there has been some history with the impending legislation and its impact. This opens up opportunities for leasing industry leaders who have done their homework.

Conclusion

The health care industry has not been immune to the recent U.S. financial crisis. It has seen its share of closures and bankruptcies as a result of unemployment, investment losses and tightening credit markets, much like other industries. However, the health care industry will not sink as low and is expected to recover more quickly than other industries. The demand for health care services ' from the changing demographics to the mandate for improved quality of care ' will require advanced technology that will drive substantial growth in capital spending for the foreseeable future.

Given the limited access to capital funding that is expected to continue, leasing arrangements will become a more attractive option and, in some cases, may be the only option available. The health care industry represents a substantial opportunity for leasing companies, but it is not without risk. To mitigate this risk, it is critical to understand the economics of health care and to closely monitor the government's increased participation in the industry and the corresponding uncertainty this creates.

[IMGCAP(1)]

[IMGCAP(2)]

Scott B. Davis is a partner in Grant Thornton LLP's Corporate Advisory & Restructuring Services practice, and is located in the Charlotte office. Davis has more than 25 years of experience assisting underperforming businesses in the areas of strategic change, litigation and forensics. He currently serves on the team that holds the role of Chief Restructuring Officer of Saint Vincent's Catholic Medical Center in its Chapter 11 bankruptcy, and is responsible for the disposition and sale of all assets. Phillip J. Robinson is a director in the Corporate Advisory & Restructuring Services practice of Grant Thornton LLP, and is located in the Phoenix office. His focus is the health care industry, where he advises hospitals and other providers who are experiencing financial and operational challenges.