In my decades as a ratings analyst and now as an advisor, I continue to hear the criticism that rating agencies are slow to upgrade and quick to downgrade. Let’s unpack this statement and look at the facts.
The first concept is “slow to upgrade.” The data would indicate that this is true, given that downgrades typically exceed upgrades annually. Before upgrading a rating, the rating committee must be confident that better financial performance is sustainable, debt service coverage is improving, and liquidity levels will be maintained or increasing. Showing that sustainability may take consecutive quarters or years, depending on each hospital’s situation. It is up to management to put forth a compelling case, supported by data, as to why better performance is achievable in the face of industry headwinds.
While the number of upgrades were lower during the pandemic than the preceding years, all three rating agencies upgraded not-for-profit hospital ratings during and after the crisis. About half of the rating upgrades in 2023 reflected improved financial performance, stronger debt service coverage, and affordable capital plans. Undoubtedly, the upgraded hospitals provided detailed multi-year financial projections which gave the rating committee a line of sight on financial results despite the murkiness of healthcare’s crystal ball. Assumptions supporting the forecast reflected solid planning with an in-depth understanding of local economic, competitive, and reimbursement challenges, underscored by strong leadership and governance that provided clear direction. There was no secret sauce behind the upgrades but excellent financial planning that any investor would look for from a well-run enterprise.
The balance of the rating upgrades reflected structural or legal changes driven by mergers, whereby a lower-rated hospital (say, Baa1 or BBB+) joined the legal borrowing group of a higher rated system (say, Aa3 or AA-), known as member substitution. The rating committee determined that there was no diminution to the higher rating, and the rating was upgraded to Aa3 or AA-. In other cases, the Aa3/AA- health system guaranteed the debt of the lower-rated hospital with no downdraft on the guarantor’s rating, and the higher rating was assigned. Some would dismiss these upgrades as “mechanical,” but they represent a strategic decision by management to find a partner and remain sustainable for the long term. In no way is that a mechanical decision.
The second concept is “quick to downgrade.” There is no doubt that the hospital rating distribution has drifted downward in recent years given labor costs and a slow return of volume. Downgrades exceeded upgrades by over 3-to-1 in 2023.
But what about the speed of the downgrade? This one is harder to call. When performance starts to weaken, rating analysts must determine if the lower results are an aberration or represent a new, permanent level of performance. Rating agencies are then tasked with moving the rating down to reflect this new lower level. In the best-case scenario, rating downgrades are preceded by a negative outlook or a watchlist action, but this step is not required. All three rating agencies have downgraded from stable outlooks when a new lower level of performance is forecasted, or debt escalates and impairs balance sheet and coverage measures.
When a hospital’s financial performance starts to unravel, it can do so quickly. The rating must move quickly as well, and sometimes by several notches. Rating agencies have stated that they will not forbear ratings or hold off on a downgrade because of the financial repercussions a downgrade may cause. They are entrusted by investors to put the rating where it needs to be, even if it triggers an acceleration. So, yes, in some cases the rating is downgraded quickly.
This brings me to a final, related point: rating agencies are often accused of not extending benefit of the doubt. On this I say absolutely false. The rating agencies have extended tremendous benefit of the doubt to the industry, most recently with the pandemic and now with Change Healthcare’s cyberattack, by taking a measured case-by-case approach. Furthermore, investors have told the rating agencies that they don’t want ratings moving up and down but rather that the agencies “rate through the cycle.” The number of annual affirmations would suggest they are indeed meeting this request, and nothing says benefit of the doubt like a rating affirmation.
There is some truth to the “slow to upgrade, quick to downgrade” statement, but it is grounded in the realities of what ratings are intended to do, which is to reflect the rating agency’s best assessment of an organization’s performance for the investor community. Upgrades must be earned, and downgrades must be assigned when financial performance deteriorates significantly (and sometimes quickly). A more accurate statement would be “slow to upgrade, quick to downgrade, typical to affirm.”
