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Debt financing in the care sector

Debt financing within the care sector

 This article first appeared in Care Management Matters, November 2016.

 Q. There’s lots of talk about debt financing within the sector (specifically term loans) and the risks associated with this method of finance. What can I do to protect against these risks?   

A. Rachel Brown, Senior Associate, Druces.

 It has recently been reported that Britain’s care home sector is under threat due to mounting financial pressures. Several reports have focused on the use of debt financing within the sector (particularly term loans) and concern about the high levels of debt carried by businesses.

What is debt finance?

The concept of debt finance is relatively simple. The business seeks external finance from a third party (normally a bank) and agrees to repay the loaned sum, together with interest, within a specified period of time. The loan will typically be secured against an asset (normally a property).

Debt finance is an attractive method of finance for businesses of all sizes and it can be used for a variety of purposes. One of the key benefits of debt finance is that it does not affect ownership of the business. It is also a flexible method of raising finance and can be tailored to meet both short- and long-term funding needs.

Most businesses require some method of finance during their lifetime and debt finance can provide a solution for a variety of funding needs. For example, a business may require additional funds to cover capital expenditure, to make an acquisition, or to grow its market share. Additional finance may also be required to resolve a short-term cash flow issue.

Added to this, the overall cost of obtaining debt finance is, typically, less than the overall cost of equity finance.

Why is it criticised? 

Since the financial crisis in 2007, there has been wide spread criticism of the way banks have lent money to businesses, particularly where money has been lent to smaller businesses and the finance for a business has been underpinned by security on physical assets. The care sector has been a particular point of focus because businesses within the sector have traditionally used debt finance as a way of raising additional funds and debts have been secured against properties, often homing vulnerable people. The collapse of Southern Cross, which many attributed to its business model and the fact that it was carrying high levels of debt, has also attracted the media’s attention and led the Care Quality Commission to take on responsibility of market oversight for large providers in the sector to prevent a similar situation arising.

Despite recent criticism, debt finance remains an accessible and flexible method of finance for care businesses.

What are the risks?

Using debt finance exposes a business to a number of risks. The main disadvantage of debt finance is the business’ obligation to repay the loan, together with interest. The business is in effect borrowing money against its future profits. This leaves the business exposed to risks that its future profits may not be sufficient to enable it to meet the required repayments on the debt and it may not be able to pay its debts as and when they fall due. If the terms of the loan provide for variable interest, the business will also be exposed to increases in interest rates.

Using debt finance may also place restrictions on the business’ future activities and impact on its future planning. Lenders often require borrowers to enter into covenants which restrict the business’ operations and its ability to materially alter its business model during the loan period. These covenants are designed to protect the interests of the lender and can be extensive. The borrower may be asked to enter into negative covenants restricting it from doing certain things (often related to assets, cash flow, control of the business and liabilities). Equally, the borrower may also be asked to enter into positive covenants, which require it to take positive steps to comply with the terms of the loan (for example, reporting to the lender on performance of the business, or any changes within the business).

‘Overuse’ of debt finance can also expose a business to several additional risks. If a business is carrying high levels of debt, it may find that high repayment obligations negatively impact on its cash flow and increase its vulnerability to adverse economic conditions. If repayments are too high, the business may struggle to maintain a sufficient level of working capital to meet its debts as and when they fall due. It may also find its growth is stifled.

Owners and operators should be mindful of these risks when reviewing existing arrangements and considering new finance options.   

 What steps can be taken to protect against these risks?

There are a number of steps that owners and operators can take to manage a business’ debt levels and to protect against some of the risks associated with debt finance.

Providers should make sure they understand, and are familiar with, the terms of any loan. Particular attention should be given to the covenants section. Owners and operators should also keep compliance with these covenants under regular review.

If, for any reason, it becomes apparent that the business will not be able to comply with the covenants, legal advice should be sought promptly. The lender should also be notified promptly and, ideally, before a default occurs, so that the business may be able to renegotiate terms with the lender (such as lengthening the loan period to reduce the amount paid, or negotiating a repayment holiday).

Make sure the business has a good debt recovery policy and debts are chased promptly. This will assist with cash flow. It will also enable providers to identify potential bad debtors and take appropriate action. Debt collection methods vary depending on whether the outstanding fees relate to privately funded residents or local authority funded residents. Legal advice should be sought on the most appropriate method of collecting debts, if required.  

Make sure the business has an efficient costs management system in place. A good costs management system enables operators to plan ahead and stop the business from overspending. It also allows providers to monitor revenue, profit and the overall performance of the business. In turn, this enables them to identify what steps can be taken to increase revenue and profit for the business, as well as identifying potential opportunities for growth and expansion.

If the business experiences cash flow difficulties, prompt action is required. Most businesses experience cash flow difficulties at some point during their lifetime and, generally, the quicker it is acted upon, the easier it will be to resolve those issues.  

Revisit the business strategy and make sure it is realistic. Particular attention should be given to cash flow forecasts and the business’ repayment obligations.

Review the business’ finance model and make sure it is suitable. Businesses within the care sector often have complicated, multi-level finance models. In some cases, this is appropriate; however, an overly complicated finance model can act as a hindrance and make it difficult for providers to effectively manage costs. A range of different finance models are available and it is advisable to seek professional advice on the suitability of existing models.  

Review the business’ property portfolio. Businesses owning property will find it easier to raise finance and may be offered better terms. Providers should also be mindful of the fact that lenders are increasingly concerned about the age and condition of any property offered for security. Businesses with older, non-purpose-built properties may find it harder to obtain finance because lenders tend to be more willing to lend to businesses that can offer security against a good quality, purpose-built asset.

Keep abreast of any changes in the market. Providers should also ensure that the business is adequately prepared for any upcoming changes which are likely to affect cash flow. Particular attention should be given to changes affecting staff costs (such as the National Living Wage), which tend to make up a large proportion of a business’ costs in the sector.

Ensure that the business is achieving high levels of regulatory compliance. Businesses achieving this will be able to charge high fees, increasing cash flow and profits within the business. Lenders are also increasingly concerned about compliance issues. Businesses with compliance issues may find it harder to obtain finance, or negotiate terms with lenders on existing term loans. Providers who embrace regulation and achieve high levels of compliance will, generally, find it easier to obtain finance and obtain an advantage over competitors.

What is the future of debt finance?  

Businesses within the care sector have faced a number of challenges over the last few years, including cuts to local authority funding, increased competition and increased regulation. Some businesses may have found it a challenge to maintain cash flow and profitability levels. Recent criticism of debt financing within the sector has led to changes within the lending market and this creates an additional challenge for businesses. However, the healthcare sector remains one of the largest in the country and it continues to attract high levels of private investment. Many lenders are looking to increase lending within the sector over the next few years, albeit subject to stricter lending criteria. Debt finance will remain an attractive method of finance for many within the sector and businesses who adapt their model to respond to these changes will, inevitably, find it easier to use debt finance effectively. 

Have you used debt financing for your business? Share your thoughts online at www.caremanagementmatters.co.uk Subscription required.

Rachel Brown is Senior Associate at Druces LLP.

r.brown@druces.com

 

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