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The European health care securitization sector was one of most active for restructuring activity in 2005
and this is expected to continue into 2006. Ongoing underlying cash flow growth is likely to fuel further
debt issuance, including value taps, as well as further consolidation (particularly in the fragmented care
homes sector), strategic disposals, and ownership changes.
The sector is substantially controlled by venture-capital sponsors seeking to reap investment returns,
while new investors seek investment opportunities, attracted by the growth prospects for the sector. We
maintain ratings in nine transactions — totaling approximately £2.56 billion of rated debt — incorporating
the acute care, psychiatric care, and care homes sectors. With one exception (Craegmoor Funding No.2
Ltd.), rating trends were either stable or positive over 2005. All transactions are U.K. based.
Strategic Disposals
Over the past year, the ultimate parents in the two rated transactions in the U.K. private acute care sector,
GHG Finance Ltd. and UK Hospitals No. 1 S.A., both undertook strategic disposals to reposition their
businesses and/or monetize rising asset values.
In July 2005, the primary participant in the UK Hospitals No. 1 transaction, British United Provident Assoc.
Ltd. (BUPA), sold nine weaker, non-core hospitals for approximately £85 million. Sale proceeds, plus
existing retained cash, were used to repay all £120 million of outstanding floating-rate notes at the
October 2005 interest payment date. The ratings were affirmed, as the prepayment of debt more than
offset the loss of EBITDA (for further information please refer to table 1).
We also affirmed the ratings on GHG Finance's notes in July 2005, following the disposal of BMI Health
Services Ltd., which involved outsourced occupational health care and screening contracts. The business
had a limited impact on the group's activities and was generating minor EBITDA and cash flow losses.
The ratings in the transaction had previously been affirmed in April 2005 following the group's disposal of
its Partnerships in Care unit (for further information please refer to table 1). Although this action was
considered negative for the overall credit profile of the transaction, we were able to affirm the ratings
because we were still comfortable that the alignment of interests between noteholders and equity was
maintained. The affirmation was principally due to both the transaction benefiting from a high level of
funded equity at the outset and to the increased sustainable value in the remaining acute business, which
had achieved substantial growth since closing in 2001.
A further mitigating feature of the disposal actions by both GHG Finance and UK Hospitals No. 1 was that
both transactions were materially deleveraged: floating-rate notes were repurchased, as in other
refinancing actions, because this is less costly in the current interest rate environment.
In affirming the ratings on GHG Finance's notes, we maintained that it is possible for proposed changes
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to a transaction to modify its creditworthiness but for the ratings to remain unchanged. This depends on
the ratings assigned at the outset, or may be due to the negative consequences affecting investors in a
way that the ratings do not address. The rating scale introduces thresholds to what is a continuous
spectrum of risk, so between thresholds there are situations where the risk level can increase or decrease
without warranting a rating change. Further details on this topic are provided in "Rating Affirmations And
Their Impact On Investors" (see "Related Articles").
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Strong Transaction Performance
We will continue to monitor changes in the strategy of the U.K.'s National Health Service (NHS) to make
greater use of private sector acute care providers, which may result in increased risk to rated private
sector health care operators, including price and margin erosion. The top-tier rated acute care hospital
operators have maintained good underlying cash flow growth, despite higher business risks and the
impact of strategic disposals undertaken in 2005. Strategies with respect to increased partnering with the
NHS are evolving cautiously.
In the fragmented U.K. nursing home sector, we expect there to be further consolidation and ownership
changes, which should facilitate increasing operator efficiency and profitability. The increasing elderly
population and currently stable industry environment — with constrained supply and rising bed rates —
are attracting increased transaction activity, principally from venture-capital sponsors. Businesses are
being purchased at high earnings multiples (well over 10x current EBITDA). Although our present view of
the prospects for U.K. care homes is generally favorable, we expect that bed rates will grow more slowly
than in recent years, while further gains in occupancy will also moderate. We note that there has been
cyclicality in supply and performance in the sector in the past, and consider that this could recur. Falls in
occupancy and slower fee growth, together with staff costs, are key factors that determine industry
performance and profitability. Even if revenue growth remains robust, operators will continue to face the
challenge of managing high fixed staff costs. Although wage levels and inflation for care homes staff are
relatively low, high staff turnover rates, ongoing training requirements, and the use of agency staff where
there are labor shortages can drive up costs faster than revenue increases, potentially affecting operators'
profitability.
Transaction performance in the care homes sector has been stable to positive. The majority of ratings
were affirmed in 2005, with two exceptions. The underlying ratings on the class A notes in the Craegmoor
Funding No.2 transaction were placed on CreditWatch with negative implications in October 2005, which
reflected continued underperformance (see table 1). Also in October 2005, the ratings on the junior notes
in the Care Homes No. 2 and Care Homes No. 3 Ltd. transactions were raised to 'BBB+' from 'BBB',
reflecting overperformance.
Overall, the care homes transactions we rate reflect the capacity of nursing home operators to pay rents,
which provide the sole source of income for servicing the notes. Since these real estate-based
transactions closed, the business model underlying the structures has changed, with an increasing shift
from a diverse pool of tenants to an owner-operator model as defaulting tenants were acquired by the real
estate owners. The transition has led to transactions being increasingly exposed to the owner-operators'
business risks. These risks have been offset by the benefits of consolidation, which has placed the assets
in the hands of more creditworthy and efficient tenant-operators. This, along with improved industry
fundamentals, has contributed to the relative overperformance of the real estate-based transactions since
the stress period of 2001-2002. Our view is that these transactions now require additional cushion due to
their increased exposure to operator risk, which limits further upgrade potential at this time.
Although the health care sector continues to benefit from higher growth potential than many other
securitization sectors over the three to five year visible time horizon, there is a significant degree of
operating leverage and management intensity in this sector. These factors generally manifest themselves
in more conservative structures than seen in more mature or less operating-intensive securitizations.
Total debt as a multiple of starting EBITDA, for example, has ranged between 4x and 6x, while LTV ratios
on recent transactions, excluding the Care Homes transactions, have generally been between 65% and
80%. In addition, risk capital and equity have tended to be higher, at between 12% and 30% of
sustainable value. Margin stresses in the early years of a transaction test its ability withstand up to a 50%
decline in margin. Restricted payment tests for the release of dividends may continue to be set at higher
thresholds, ranging between 1.3x and 1.7x free cash flows after minimum maintenance capital
expenditure and taxes in current transactions.
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Table 1
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Table 1
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Table 1
Table 2
Table 3
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Table 3
Related Articles
• "Stability Remains For Corporate Securitization Ratings Despite Ongoing Restructuring"
(published Jan. 16, 2006).
• "UK Healthcare Securitization Craegmoor Remains On CreditWatch Negative" (published Dec.
22, 2005).
• "Presale: Talisman-2 (Priory) Finance PLC" (published Dec. 6, 2005)
• "Transaction Update: Care Homes No. 2 Ltd. And Care Homes No. 3 Ltd." (published Oct. 10,
2005).
• "Transaction Update: Tiara Securities Issuer B.V. and PHF Securities No. 1 Ltd." (published
Sept. 9, 2005).
• "Transaction Update: UK Hospitals No. 1 S.A." (published July 27, 2005).
• "Bulletin: Ratings On GHG Finance Ltd. Unaffected By Disposal Of BMI Health Services Ltd."
(published July 11, 2005).
• "Rating Affirmations And Their Impact On Investors" (published April 20, 2005)
• "Bulletin: Ratings Affirmed On GHG Finance Ltd. Notes Following Partnerships in Care Sale"
(published April 12, 2005).
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