BANKRUPT!

The industry's been hammered but will adapt and survive

THERE ARE THREE WORDS THAT CURRENTLY SEND SHIVERS through the nursing home industry: leverage, labor, and litigation. The last two, labor and litigation, will become increasingly problematic as staffing shortages worsen and plaintiffs' lawyers continue on the warpath. Excessive leverage, however, has already done considerable damage to the sector, a once-promising business that in the mid-1990s captured the eye--and capital--of Wall Street.

Because the nursing home industry is largely a real estate business, there has always been an "acceptable" amount of leverage would have been foolish not to take advantage of, especially given that most state Medicaid programs reimburse facilities for a portion of their debt.

But as the health care side of the industry came to the fore with the rush into subacute care and the entry into such Medicare-dependent businesses as contract therapy and pharmacy, corporate borrowings rose to unacceptably risky levels, especially considering that Medicare was about to undergo a major overhaul. In fact, "acceptable leverage" has taken on a whole new meaning since the new prospective payment system took effect on July 1, 1998.

In the past 18 months, four publicly traded nursing home chains--Unison (now Rain Tree) Healthcare, NewCare Health, Vencor, and Sun Healthcare--and two large privately owned companies--The Frontier Group and Texas Health Enterprises--filed for Chapter 11 bankruptcy protection, five of them since June. More filings are expected by the end of the year. On the other hand, even though this group includes two of the five largest nursing home companies, Vencor and Sun, the total number of nursing facilities operated by these star-crossed six represents less than 6 percent of all nursing facilities in the country.

As contradictory as it sounds, the current rash of bankruptcy filings may actually be good for the industry, at least in the long term. If Vencor's proposed restructuring terms (an effective $900 million in debt reductions) are any indication of what the other large chains may be able to accomplish, the estimated reduction in debt for all of the companies expected ultimately to file could exceed $3 billion. This will certainly strengthen their financial condition, which, in turn, will enhance the perception of the industry as a whole. Second, lenders have already become more conservative in their financing programs, which will result in fewer bankruptcies in the future as well as a better screening process for potential borrowers.

Lastly, the lesson of these bankruptcies has reverberated far beyond the companies themselves. HCFA and Congress are now very much aware that crucial mistakes were made in designing the PPS, mistakes which ended up removing twice as much money from the Medicare system than had been intended. Investors, both public and private, are acutely aware that the nursing home industry is a complicated health care business subject to higher levels of risk than expected, and one that can change dramatically by legislative fiat. And everyone's learned that leverage can turn lethal when, based on demographic trends, a sector is characterized as high-growth when, in fact, its occupancy levels are being pounded by competition from assisted living operators, and its profits eroded by fines and damage awards.

So who's really getting hurt from the wave of nursing home chain bankruptcies? Despite what some federal and state agencies would like you to believe, it is rarely the residents in these companies' facilities, for whom reorganization in most cases has served to negate rather than confirm their fear of winding up on the street. No, the real losers are the unsecured creditors, such as bondholders and bank lenders that do not have a secured interest in the real estate. In Vencor's case, the banks reduced their loan amount by $200 million and the bondholders lost all of their $300 million in principal in return for shares in the reorganized company. The biggest losers, however, are the existing shareholders, who have basically lost everything.

In the summer of 1999, when news of the financial woes of the industry had reached a fevered pitch, state health departments were put on alert by Washington to be on the lookout for a deterioration in the quality of care. The feds also advised local authorities to develop contingency plans for the transfer of patients when "bankrupt" nursing home companies were forced to close their facilities. Unfortunately, there was little the industry has been able to do to combat these irresponsible scare tactics. While it is true that some very old, low-occupancy, and inefficient facilities will be closed, the reality is that the number will be quite small. Out of the approximately 800 nursing homes controlled by the six companies that have declared bankruptcy so far, only a few are slated for closure, and in most cases, these should have been closed years ago and the bankruptcy only made it easier to accomplish.

The regulators have demonstrated a woeful misunderstanding of the financial dynamics of the nursing home industry. As a case in point, Sun, which filed for bankruptcy protection in October, leases 54 nursing homes from Omega Healthcare Investors. Omega, a real estate investment trust, has agreed to take back four poorly performing facilities. On the other hand, Sun's other 50 nursing homes have a cash flow coverage ratio (before management fee) of 2.0x rent. Quite obviously, these homes are profitable and Sun's financial woes are due to other problems. Will quality of care suffer at these facilities? Not when the company needs to continue to generate this level of cash flow.

Many people in the industry believe that the current financial distress of the larger chains will be a wake-up call to Washington. In fact, the pending bills, while providing some relief, won't reverse the damage already done to the big chains. What's more, because the problems related to PPS have been most acutely felt by the big chains, they have led some in Congress to question whether PPS needs much fixing at all as it applies to smaller companies, many of whom have, in fact, seen some financial benefits from PPS.

The current round of bankruptcies will, however, have some long-term ramifications for the nursing home industry. First, the initial public offering market will continue to be closed to the industry for at least two to three years. (The last IPO was in July of 1997). The credit markets will remain relatively tight for the next two years as well, but the lessons learned will be forgotten more quickly than in the equity market. Furthermore, there will be a huge asset re-shuffling, rivaling Beverly Enterprises' divestiture of 400 nursing homes in the early 1990s, as the companies in Chapter 11 decide which facilities to sell off.

This period of uncertainty may also be the first step in a re-positioning of the nursing home business as a whole. The disparate impact of PPS on the big versus small providers may result in a realignment of for-profit nursing home owners into two different lobbying groups, one representing the large chains and the other the smaller companies and mom-and-pops. Meanwhile, battered by low occupancy, decreased reimbursement and increased regulatory pressures, rising labor costs, and mounting litigation, not to mention competition from assisted living and home health care, nursing homes of every size will need to redefine their market niche.

Whatever happens, it is important to remember that at some point in the future there will he a shortage of skilled nursing home beds. The current round of bankruptcies may be a setback for the industry, but nursing homes will always serve a market niche.

Stephen M. Monroe is a partner with New Canaan, Connecticut-based Irving Levin Associates. He is the editor of The SeniorCare Investor.