Three months after the moratorium on surgical hospitals enacted by the passage of the Medicare reform bill last November, and at least six months after the bankruptcy of financing company DVI Corp., the industry still is trying to cope with this one-two punch. Those whose surgical hospitals were not under development as of Nov. 18, 2003, found that their plans have been summarily halted; the developers of projects that made it through the gauntlet are now hoping their financing can stay the course, too.

"Some of the projects under development will continue forward, but those facilities that weren't under development as defined by the Prescription Drug and Medicare Improvement Act of 2003 have been put on hold, so it has pretty much stopped everyone in his or her tracks," says Brett Brodnax, senior vice president and chief development officer at United Surgical Partners International. "We will also see organizations trying to modify the model a little so that the project is not considered a specialty hospital but more of a whole hospital. The technical rules aren't established and they won't be for some time, so it comes down to a legal opinion about what the legislation actually means and whether developers are comfortable about moving forward with their projects if they think they have met the intent of the new law."

Experts in development and financing are noticing that an already-tightening market is becoming increasingly challenging. The easiest lenders, such as banks and equipment-financing sources, are becoming more watchful, and the most stringent lenders, including third-party developers, are now holding the purse-strings with a death grip.

"It's definitely getting harder to finance certain healthcare facilities," Brodnax adds. "If your project is not under development right now it would be close to impossible to get funding. It will continue to be difficult because the surgical hospital industry is a risky business to be in right now, since the future is so unknown."

It's not all doom and gloom, however. With the general economy endeavoring to improve and medical entrepreneurs poised to work as many loopholes in the Medicare reform act as they can, the outlook isn't as glum as it could be in the first two quarters of 2004

"A lot of financing continues to be driven by the development of outpatient facilities and I don't think there's a lot to stop the model," says Randy Fuller, the hospital segment manager for GE Healthcare Financial Services, who is responsible for monitoring emerging trends in the hospital industry and developing new financial products and services to meet customer needs. "The margins still remain fairly healthy, at least from the perspectives of the clients and customers that we talk to. As long as that continues, development is likely to continue in both rural and urban settings.

Surgical hospitals were singled out for the moratorium, but we think that it is not the end of the story. There's likely to be scrutiny on these things from CMS, and perhaps some changes to the reimbursement system that would level the playing field, if you believe that surgical hospitals are receiving an outsized reimbursement pop from Medicare. We see the surgical hospital model as being under pressure and we are being cautious about the business we do with that segment of that market."

GE is not alone in this respect, as most financiers have set the bar higher when it comes to due diligence, especially in the wake of the DVI bankruptcy. Before the DVI fallout, Brodnax says money had been flowing relatively well and that most lenders were competing to put their money to work in the ambulatory care industry. The level of equity required was minimal, non-recourse financing was fairly easy to secure, and due diligence received less scrutiny. Today, in a post-DVI world, Brodnax says, the money flow has slowed, lenders are increasingly risk-adverse, the level of equity is at least 30 to 40 percent, and non-recourse financing is much harder to find for everything except equipment. Brodnax adds that the fundamentals of due diligence are more important than ever before, and that lenders are more likely to involve principals as well as many partners in their negotiations over deals

"The companies that are providing financing on these kinds of projects are doing more significant due diligence and doing more homework than they had done previously, which ultimately will be better for the industry," he explains. "They will finance projects that will hopefully make it, as opposed to projects that don't. The DVI bankruptcy hurt the industry but I think it will create a more solid foundation from which to work in the future."

Brodnax adds, "Financiers are scrutinizing projects more closely than they have in the past. They are looking at things like competition, how the local hospital is going to respond to the new project, and whether or not there is an alternative use for the project. In other words, if it doesn't work, could someone else come in, pick it up and do something else with it? Lenders are being picky about these types of criteria."

Lenders are also looking at:

• Commitment on the part of investing physicians (including verifiable case volume estimates)

• Location of the project relative to referring physicians, population centers, partner offices and local hospitals

• Solidification of non-compete agreements

• Overall market fundamentals, such as demographics, market growth and payor mix

"Patient demographics is important but the real driver of the deal is finding a group of high-quality physicians who will support your center," Brodnax adds. "You need the patient population to make the center work, but the physicians ultimately will drive the business."

Brodnax says that would-be developers should begin the financing process early, so that the financing term sheet is solid upon the closing of syndication. The group's business plan and proforma package should be strong yet conservative, and reflect research into the potential pitfalls. Monthly financials for an entire year should be forecasted, and working capital needs determined. And if personal financial guarantees are required, physicians should be ready. Above all, Brodnax says, investors should be poised to address pertinent market dynamics, competition and reimbursement issues.

Chief among those talking points should be the Medicare reform act and its impact on ambulatory care and related healthcare sectors. According to Fuller, under the provisions of the act, Medicare reimbursement for freestanding ambulatory surgery centers would be reduced by 1 percent, effective in April, and there would be no increase in the rates for 2005 through 2009. The Government Accounting Office (GAO) will continue to study payments to ASCs with specific comparison to the payments and costs of similar procedures performed in a hospital setting. The secretary of the Department of Health and Human Services (HHS) will create a new reimbursement scheme to be implemented no later than Jan. 1, 2008. Fuller says that investors should also bear in mind that the Medicare act passed last November closes for 18 months the Stark law exemption which allows physician ownership of whole hospitals; physicians would be allowed to continue their ownership interest in specialty hospitals already in operation or under development as of Nov. 18, 2003.

"I think people are cautiously optimistic," Fuller says about the passage of the Medicare reform legislation. "I think a lot of physicians were able to dodge a rate cut because of this bill, but then there are others being targeted for reduction. ASCs and DME (durable medical equipment) are the primary ones, and I think those are two sectors that have had a lot of scrutiny, particularly the DME side for their outsized profits. I think we are still hearing the industry reacting to the legislation as good news. People are fairly bullish on the outpatient sector; 'Development is continuing' is what we are hearing from the industry. I think the more worrisome thing for the sector is a few years out when they redesign the reimbursement system and looking at what impact that will have on the sector overall."

As the shakedown from the new legislation occurs, many in the industry suspect there will be a greater differentiation among the many models of healthcare delivery in the outpatient industry.

"I think most people in the know have been able to differentiate between the surgical hospital moratorium and other issues for ASCs," Brodnax says. "We have not seen the ASC business slow down (because of the moratorium); if anything, I think it will pick up because the folks that were contemplating surgical hospitals may back up and decide to do ambulatory surgery centers instead."

It's all about the risk. ASCs and surgical hospitals, despite being a proved model in most sectors' minds, are highly specialized and remain high-risk enterprises akin to movie theatres, and thus garner higher rates - often between 11 percent and 14 percent.

"With Greenspan saying the fed rate isn't going to move anytime soon, I don't see the rates getting a lot worse or a lot better," Brodnax observes. "If the country is doing well, you will certainly have more entrepreneurs that feel there is an opportunity to build a business and make money. If they have ready access to capital to build the business, you will definitely see more movement and more guarantee behind the ASC business. However, I still think lenders are skittish about surgical hospitals because although there are about 100, most of them have not been in existence very long,"

Brodnax adds. "The long-term outlook for surgery centers, even though many of them are doing well, is still unknown. That unknown creates risk and that in turn creates more difficult financing possibilities. If something goes bad, you may do something different with an ASC; the fear is with a surgical hospital, it's a single- purpose facility and there's not much you can do with it if it doesn't work - except have someone else come in and manage it, and try to turn it around and make it work."

When it's time to approach a lender about equipment financing, Brodnax says, would-be developers should be able to differentiate a good deal from a mediocre one. For example, a competitive deal would consist of a seven-year term, with a seven-year treasury plus 300 basis points, 100 percent non-recourse, plus a 10 to 15 percent margin and secured by equipment. A poor deal would be hallmarked by a term of under five years, with a seven-year treasury and greater than 550 basis points. Credit support would come from up to 90 percent of equipment and the rest would consist of guarantees or equity.

And when it comes to working capital, Brodnax says a good scenario has receivables pre-funded with little to no guarantees, and when accounts receivable (AR) builds up, it covers the loan by at least 125 percent. The term should be three to five years and the rate should be similar to that for equipment. A so-so working capital loan has a term of two to three years and 50 percent to 100 percent guarantees with burn-offs and a trigger to release a portion of the guarantee after the AR build-up. A poor working capital arrangement has a term of a year, with a 100 percent guarantee and no release of this guarantee when AR builds up.

One of the absolutes of development and financing may lie in the hiring of a second or third party who can assist investors with constructing their deals.

"I may be a little biased, but if someone does not use a management or development company, they will quickly learn all the ways that they can make mistakes," Brodnax says. "If you bring someone in who has made all of the mistakes, has experience and expertise, they can help get you to market faster and hopefully avoid the pitfalls many of us have experienced over time."