Premature prognosis? Hardly. The U.S. healthcare system has reached a precarious tipping point, the culmination of decades of spiraling healthcare costs. Despite many attempts during the past 30 years to enact reform and control costs, the financial ecosystem that links up clinicians, hospitals and health systems, and insurers is clearly unsustainable. Past cost-control initiatives have not kept pace with the continued cost increases because of changing demographics, expensive new medical technologies and ever-longer life expectancies.

U.S. healthcare costs now account for more than 17% of GDP, up from 12% in 1990. Annual spending today averages about $7,000 per person. And now baby boomers have officially begun their slow march onto the rolls of Medicare, the government health insurance program covering everyone age 65 and older. These 78 million Americans born between 1946 and 1964 are expected to boost Medicare enrollment from 45 million in 2010 to 64 million by 2020.

That so-called tipping point seems more and more like a breaking point for the U.S. healthcare system.

The Accountability Cure

With the nation’s healthcare system facing economic crisis, legislators passed a historic healthcare reform act in March 2010 to address the spiraling costs. To bend the cost curve, one measure encourages the creation of accountable care organizations (ACOs). The ACO model ties reimbursements for medical providers to two key components: strict adherence to quality metrics, and reduction in the total cost of care for a defined population of patients.

While ACO may be a new term for many, in truth the healthcare industry has been moving away from traditional “fee for service” relationships toward quality-based reimbursements for some time. Pure fee-for-service reimbursement is going away. In some markets the rate of change is faster than in others. But most payers are seeking to base a significant percentage of payments on performance.

The ACO model is understandably attractive to organizations that pay for healthcare. This is especially true for health insurers, which are squeezed between the demands of large employers to reduce premiums and those of providers concerned about diminishing revenues. But while payers are embracing ACOs’ transfer of risk to providers (especially in California, where assumption of clinical risk by providers is still prevalent), most providers are not nearly as enthusiastic, and few have adopted the model.

Many healthcare providers argue that the uncertainty around ACOs makes it difficult to buy into the model, which in most cases requires a significant financial investment to ensure success. The cost of implementing technology, reorganizing physician practices and instituting performance measurement systems can be substantial.

In particular, providers make the following arguments:

• There is far too much uncertainty in the guidelines on ACOs issued by the Centers for Medicare & Medicaid Services (CMS). Hospitals are being asked to reorganize and invest in a system that is not clearly defined.
• Providers are not proficient with the new regulations because the legislation is new and they haven’t fully digested its actual and implied changes.
• The current legislation applies only to Medicare and Medicaid (a joint federalstate health insurance program for the poor) patient reimbursements, a sizable but still limited portion of the entire population.
• It may not make sense to invest in updated systems with the real chance that healthcare legislation may be repealed under a new administration.
• The ACO model may not actually save hospitals money. In part, ACOs reduce costs by lowering demand for unnecessary procedures. Providers worry that lower demand will cut into their bottom lines.

All of these arguments have merit. But they miss the point that the ACO model includes approaches that providers should adopt regardless of the specifics of future payment models. Providers that don’t start making these changes soon will find themselves at a competitive disadvantage.

Because of changing demographics, the payer mix is shifting, with a higher proportion of patients qualifying for Medicare and Medicaid. Whether or not ACOs become a model for the health system at large, it seems inevitable that the future reimbursement model for CMS-qualified patients will be based on pay for performance. As a result, providers need to begin standardizing best clinical practices, support disease prevention, reduce overutilization and take responsibility for medical outcomes. Those that do not will likely see declining reimbursements.

Achieving these things requires much closer alignment of physicians and providers than is found in most healthcare systems today. Physicians need to work toward the same objectives that hospitals do: reducing the length of hospital stays, minimizing resource consumption and improving outcomes. What’s more, physicians from different specialty areas must work more closely with one another to improve the outcomes for patients who need to be treated by several specialties. These strategies are not incremental changes for physicianprovider relations in many healthcare systems but transformative ones in an already embattled industry.

One Goal, Mulitple Approaches

It is becoming clearer by the day that most healthcare providers must start implementing elements of the ACO model. Early adopters can also gain the favor of consumers and advocacy groups seeking quality and price transparency.

The ACO model holds physicians and hospitals jointly responsible for improving quality and reducing costs. Yet it is up to both groups to determine how best to achieve the goals. For instance, hospitals can lower the cost of treatments by standardizing a “proven” best practice. One group of South Carolina hospitals, for example, embarked on a program of evidencebased care and reduced the rate of mortality from acute myocardial infarction from 12% to less than 5% in the first year.

Providers can reduce costs and improve outcomes by helping patients look after their health. Some providers are educating patients and giving them incentives to do that. For instance, an Alabama program in 2004–2007 to help diabetics manage their condition reduced their emergency room visits by half.

Another way to reduce healthcare costs is to steer patients away from unnecessary hospital visits altogether. That requires establishing the local primary care clinic — not the hospital — as the core of the healthcare delivery system. Recent studies have shown that a patient-centered medical home model benefits both patients and medical staff, giving patients more one-on-one time with a physician, improving caregiver cooperation and providing more preventive care.

Hospitals can improve efficiency, too, by better managing complex patients — that is, those with more than one condition. Studies have shown that patients in hospitals employing hospitalists — attending physicians for individual patients — tend to have shorter stays, especially in cases requiring close clinical monitoring or complicated discharge planning. Most of these changes require strong clinical integration: primary care physicians, specialists, nurses and hospitals coordinating their activities to improve outcomes for every patient.

Better Quality, Lower Costs

Baptist Health, a San Antonio, Texasbased five-hospital system with 1,741 licensed beds, was an early participant in a CMS-sponsored Acute Care Episode Demonstration (ACE Demo) project, a Medicare program launched in 2009 that pays participating hospitals a lump sum for hospital and physician services.

The goal of ACE Demo is to give hospitals and physicians the right incentives to improve quality and lower the cost of care for 28 cardiac and nine orthopedic diagnosis-related groups of illnesses.

In the first year, Baptist consolidated vendors and reduced the costs of implants by 15%, from $6,000 to $5,000 per case. Baptist tracked 22 CMS quality metrics, of which a subset was used to calculate savings to be split equally between the physicians and the system. By the beginning of 2011, the program had saved Baptist $4 million, and hundreds of thousands of dollars had been paid out to physicians and patients in shared savings.

In addition to savings, Baptist reported dramatic improvements in patient care and quality, including:

• Quality at or approaching 100% for all metrics
• Improved physician alignment
• A shift toward evidence-based practice
• Higher physician satisfaction

Despite many providers’ cautiousness about ACOs, Baptist and other health systems are demonstrating real savings and quality improvements by following the precepts of an ACO model. As with Baptist, that means getting the hospital and doctors in formerly segregated clinical disciplines to work closely to produce better outcomes at lower cost for every patient. Such strong collaboration around patient outcomes is referred to in medical shorthand as clinical integration. And clinical integration depends on two factors: better alignment of physicians and the ready availability of clinical data, on both individual patients and populations.

Physicians Take The Lead

A few health systems, such as Kaiser Permanente and Cleveland Clinic, employ the majority of their physicians. As a result, it is easier for them to get hospitals and physicians working toward the same goals. But for almost everyone else, getting physicians who aren’t employed by a hospital system to buy
into standardized processes will be a major challenge. Still, it is possible.

Let’s look at how one health system is getting its hospitals and independent physicians on the same page.

Consider the success of the Henry Ford Health System (HFHS), which was once a closed system consisting of the Henry Ford Hospital, the 1,300-doctor Henry Ford Medical Group, and a fully owned health insurer, Health Alliance Plan. But in recent years, HFHS has built or acquired four community-based hospitals, creating relationships with many physicians who are not part of the medical group. The challenge for HFHS: How can it partner with private-practice physicians and those employed at other hospitals? Many of these physicians want to remain independent and do not want, for example, to participate in the education and teaching requirements of the medical group.

HFHS began looking at how to increase clinical integration back in 2009. The initial motivation was not healthcare reform. Rather, large local employers expressed to Health Alliance Plan their desire to engage with a highperformance network. HFHS leadership realized that if it could integrate physician groups and thereby reduce medical costs and improve quality, it would have something attractive to offer the broader marketplace.

Eighteen months later, the hospital system has the entity in place: the Henry Ford Physicians Network (HFPN). To date, the physician network includes all Henry Ford Medical Group physicians, hospital-employed physicians and almost 200 independents.

Engaging the physicians early in the process and letting them lead it were critical, according to Matt Walsh, HFPN’s vice president of operations. The board of HFPN has 15 members, of whom 13 are physicians. Walsh believes that physicians agree quickly to the core tenets of clinical integration — partnership and value creation through improved quality and efficiency — because physicians intrinsically believe in these principles. Payer contracting is another matter, however. The dollars and fee schedules quickly engage the interest and concern of all stakeholders. Careful development of a management structure that builds trust in this area is critical.

Walsh advises health networks moving toward greater clinical integration to communicate to physicians how it benefits them. For the independent physicians in HFPN, those advantages include continuing medical education, performance feedback, and access to best practices and affordable information technology tools and support. All these give physicians opportunities to improve their practices and create access to future contracting opportunities. As more and more physicians realize that fee-for-service reimbursement will fade into the past, such benefits become important incentives.

Data Reveals Opportunities For Improvement

The collection and processing of data are also critical to better clinical integration. First, integration of services for each patient is much more effective if there is a patient-centric health record — an electronic health record, or EHR. Second, if healthcare systems are proceeding to a full ACO model, they must report performance metrics to CMS to share the savings benefits beginning in 2012. Most important, it is impossible for hospitals to know where to make improvements without knowing their current performance.

Norton Healthcare is a five-hospital, 500-physician, 100-location Kentuckybased nonprofit healthcare system. Long before the acronym ACO made its way through the halls of Norton Healthcare’s Louisville headquarters, the healthcare system was bullish on using data to improve its services. It has long shared performance data with the public. On its Website, it publishes performance metrics for more than 600 quality criteria, each benchmarked to national averages.

Impending healthcare reform was one reason Norton started moving toward greater clinical integration. But it also wanted to leverage its skills in data collection and usage.

As Steven T. Hester, M.D., senior vice president and chief medical officer, explains, “We have much more data than we did 20 years ago, and we can use the data to find opportunities. Everyone always thinks they are doing well, but until you can show them data on how they compare with their peers, internally and externally, they don’t know how well, or where the opportunities for improvement might lie.”

Given the breadth of data available to Norton physicians, the organization can influence a wide range of quality indicators. As an example, Hester explains how the hospital can focus on reducing the length of stays. “We have specialists who work with hospitalist groups on how they manage care,” he says. “We can give them data that compares their indicators with their peers on, for instance, readmissions or length of stays. This information is key to helping them understand how to move patients through the system. Consider a neurosurgery patient. His specialist may be in the operating room and not be able to discharge him until the end of a busy day. But now the hospitalists see where the bottleneck is and can keep the process moving without having to wait for the specialist to be free.”

Comparing practices has been important in just about every industry. Healthcare is no exception. As Hester points out, “Benchmarking data is critical. Clinicians need to see where they sit versus others in the community, both within their own health system and outside.”

This cannot be done manually, at least not for any meaningful length of time. Every health system with several hospitals, hundreds of physicians and thousands of patients needs to report dozens of metrics and monitor hundreds more. That requires information technology. Norton has made, and continues to make, significant investments in IT for clinical data collection, processing and reporting.

As Baptist and others have demonstrated, there are financial and quality benefits from organizing as an ACO. Clinical integration brings a range of benefits, including the following:

• Higher quality and efficiency through better-coordinated care
• Improvements against pay-forperformance measures
• A more collaborative relationship with medical staff, leading to higher physician loyalty
• Greater physician support for hospital initiatives

Despite such benefits, healthcare providers trying to migrate toward an ACO model must overcome significant barriers:

• Uncertainty about the future of healthcare reform. No institution relishes investing significant capital in projects without a clear mandate. The possibility of wholesale changes to current reform legislation creates uncomfortable ambiguity for executives.
• The complex task of technology implementation. History is littered with the debris of large healthcare IT projects, and IT challenges in healthcare seem no smaller than they were 20 years ago.
• The challenge of managing change and gaining the trust of physicians. Private-practice doctors are often inherently distrustful of hospitals. It takes time and effort to convince physicians that their needs will be heard during times of reorganization.

The most powerful ways to overcome these barriers are engaging physicians early and giving them leadership roles in which they can shape the future organization. It is especially important to involve physicians who are influential and believe in the change. In addition, identifying very early in the process what data is needed and putting in place the systems to collect and report it is vital.

The ACO Advantage

Given the inevitable migration from the fee-for-service model toward reimbursement on outcomes, health systems should not wait for the future of healthcare reform to arrive definitively. Whether or not the current version of reform or of ACOs survives, greater clinical integration will soon define the higher-performing health systems.

The ACO model’s core tenet of greater clinical integration is simply good patient care and good business. It reduces costs and improves quality in an industry that badly needs both. What’s more, for organizations willing to commit to the hard work of quality measurement and clinician alignment, there is the prospect of first-mover advantage. Patients are acting more and more as healthcare consumers; they, too, are advocating for quality, efficiency and transparency.

For providers, there’s really no reason to wait.

Common Issues

Causes of poor care include lack of universal coverage and/or inadequate capacity of the healthcare system, creating uneven access to care, and gaps in quality from the underuse, overuse or misuse of care or services. Rising costs leave an increasing number of people without coverage and/ or access to care, and often restrict the services they are allowed access to. Numerous studies support the fact that underuse of effective services is a huge problem.

Indeed, people who would benefit from services — be they preventive in nature (such as screening for colon cancer) or helpful in controlling the symptoms or progression of a chronic disease — receive those services only half as often as they should. Similarly, with respect to overuse, many studies have shown that 30% to 50% of services offer no value to the individual receiving them. In fact, in some of these cases the individual is more likely to suffer harm than benefit. While there is less information to support the incidence of misuse, this dimension of poor quality also contributes significantly to the challenge of providing quality care. These gaps in quality can be linked to specific problems within the healthcare system. They include (in no specific order of importance):

• Flawed payment methodologies
• Information gaps relative to patients’ health needs in planning and at the point of service
• A lack of or diffuse accountability for results
• Fragmentation of the care delivery system, with poor coordination or communication between caregivers
• Little experience in collaborating between organizations

All of these have contributed to the complexity of the healthcare system and make it difficult for providers, not to mention patients, to navigate. While these system issues are responsible for the gaps in quality, other forces are the major drivers of costs. The three major factors driving the unsustainable trends in healthcare costs are aging populations, resultant increases in chronic diseases such as diabetes, cardiovascular conditions and cancers, and the proliferation of new technology. In addition, it is clear that compensation methods for providers are a major enabler — if not an absolute driver — of current cost trends.

Solutions

Managing Chronic Disease

While nothing can be done about the aging of populations, we can certainly do a far better job of preventing or managing chronic diseases. There is great promise in care redesign via patient-centered medical homes (PCMH) or advanced primary care models (which I will discuss later). That said, the most promising results in fostering improved health behaviors in individuals are coming from efforts such as the Robert Wood Johnson Foundation’s Aligning Forces for Quality (AF4Q) initiative, which helps providers, individuals and communities in the United States redefine their roles and responsibilities and work together to deliver more effective healthcare. Such programs work because much chronic disease stems from individual decisions about behaviors — diet, exercise, smoking, and seeking proven effective preventive services such as cancer screenings.

One example: In 1994 Brazil launched the Family Health Program, which is now the world’s largest community-based primary healthcare program. Under this program, teams of at least one physician, one nurse, a medical assistant, and four to six trained community health agents delivermost services at community-based clinics. They also make regular home visits and conduct neighborhood health promotion activities. Between 1999 and 2007, hospitalizations in Brazil for ambulatory-care-sensitive chronic diseases, including cardiovascular disease, stroke and asthma, fell at a rate almost twice that of hospitalizations for all other causes. In municipalities with high Family Health Program enrollment, chronic disease hospitalization rates were 13% lower than in municipalities with low enrollment, when other factors were held constant.

Accountable Care Organizations

In the United States, there is considerable interest in a new approach to managing care — accountable care organizations. ACOs are seen as a way to provide better-quality care at lower costs. The need for more accountability in caring for patients is clear. Unfortunately, there is too much talk about the organizations that will do it and not nearly enough about what accountable care looks like when done well. Providing accountable care means using a specified amount of money to maintain or improve the health of a defined group of people. Health insurance companies have had this responsibility for some time. Unfortunately, the contractual relationships with the providers, as well as the payment systems and/or methodologies, have not transferred this accountability effectively. While some insurers have put payment systems in place to reward providers for better outcomes, in large part providers have been rewarded for delivering volumes of services without regard to cost. The healthcare reform enacted in the Netherlands in 2006 goes a long way toward addressing this problem. The new system uses a combination of regulation and an insurance equalization pool run by the state to transfer responsibility. Insurance companies are mandated to provide at least one policy that meets a government-set minimum standard level of coverage, and all adult residents are obliged by law to purchase this coverage. Insurance companies receive funds from the equalization pool to help cover the cost of coverage and compensate for different risks presented by individual policy holders; insurance premiums cannot be based on health status or age. Patients dissatisfied with one insurer have an opportunity to choose another at least once a year. As a result of this system, health insurers are effectively responsible for the health

of a self-selected population. Because it is built around a fixed price, they have every incentive to keep that price down and deliver better outcomes. In a 2010 study, the Netherlands’ healthcare system was ranked first in a comparison with systems in Australia, Canada, Germany, Great Britain, New Zealand and the United States.

Patient-Centered Medical Homes

There is mounting evidence that the efforts to develop patient-centered medical homes (PCMH) or advanced primary care practices are making significant progress in delivering quality care. A PCMH practice is accountable for defined elements of care for a specific patient population. Reimbursement models differ among PCMH models, but there is movement away from fee-forservice reimbursement. The Colorado Clinical Guidelines Collaborative, a nonprofit coalition of health insurance plans, physicians, hospitals, employers, government agencies and other entities working together to improve healthcare in Colorado, recently instituted a PCMH pilot. The pilot was initially set up with 16 family medicine and internal medicine practices, representing a total of 17 sites. Health insurance plans, large employers, key hospital groups, physician societies, the Colorado Department of Public Health and Environment, and the University of Denver Health Science Center were also involved in the implementation and operation. The outcomes, both financial and clinical, are impressive, and include a return on investment of 3:1 and a 22% decrease in emergency room visits, for example, at one health plan.

Information

What information will be needed for each population of patients is a key issue and will take a lot of effort to decide. The local or regional disease burden will be unique to each area’s population. So decisions on which services are needed and how they should be delivered should reflect the needs of the population, the values and priorities of the region, and the capabilities of the region. Local stakeholders should have much more say about how resources should be allocated than should a central resource like the U.S. government health program administrator Centers for Medicare & Medicaid Services (CMS) in Washington or a health department authority in some state capital.

When discussing accountable care organizations, policymakers should ask to whom and for what these organizations are accountable. It is not enough to understand what care they will be required to provide. It must also be very clear who will be responsible for making sure that care is provided well and adequately. Of course providers will answer to CMS about Medicare enrollees, but there needs to be similar accountability to state, local and regional stakeholders for both Medicaid and commercial enrollees.

Technology

While technology has been an incredible tool in advancing healthcare, it is only a means to an end. Healthcare will remain a relationship “business” where the trust and relationships between people set the stage for better results. Current payment systems and policies have encouraged the rapid and sometimes premature adoption of new technologies. In the United States, where more than 30% of Medicare spending is devoted to highly technical care during the last few months of life, many individuals could benefit from more discussion about how to approach care decisions at this time.

Clearly the coordination of care and communication will be enabled by technology such as electronic health records and health information exchanges. Understanding the needs of patient populations will require information technology new to many organizations. Physician groups and hospitals have previously not needed to profile the populations of patients they serve in order to understand the disease burden the population carries. Predictive modeling tools to identify those patients at highest risk of experiencing an adverse event will allow the allocation of resources to help avert those situations. In 2001 health insurance provider BlueCross BlueShield of Tennessee (BCBST) began applying predictive modeling techniques to member health and claims data in an effort to improve both the delivery and the quality of care. BCBST first used these techniques to make sense of mountains of clinical information and to pinpoint clusters of diagnoses, procedures and patterns of illness. Having this information allowed for the deployment of specialized service programs, such as promoting the use of beta blockers, enhancing medication compliance and coordinating care. This allowed them to avoid disease progression while providing a high level of patient support, which in turn drove down costs by reducing the amount of acute care these patients needed. Today BCBST has a sophisticated data warehouse and business analytics operation. It can, or will shortly be able to, serve up analytics to major consumers, deliver individual history and predictions to members, give near-real-time performance management, and capture structured and unstructured information.

Regional Planning

In the United States, regional health planning authorities have played an important role in helping to allocate resources. In New York these regional authorities were mostly eliminated in the late 1980s and early 1990s. One of the few that remained active and effective was in Rochester. Six years ago, the state put together the Berger Commission to make recommendations about downsizing health system capacity across New York to better reflect the actual healthcare needs of each region. The only region that didn’t require any downsizing: Rochester. France recently undertook a similar effort that underscored the importance of regional planning. It rationalized eliminating service duplication and excess capacity according to the needs of regional populations. In both cases the emphasis on understanding the region’s capabilities and its population’s needs led to rational decision-making. In the United States, population health assessments such as the recent work published by the University of Wisconsin Population Health Institute can be used as a basis for assessing the overall health needs of groups within a specified geographic region. Once the geography has been defined and the health needs of the population have been carefully delineated, the next important task is determining the workforce needed to provide the requisite services. The right mix of caregivers — primary care physicians, specialists, nurses, pharmacists and other professionals — will depend on both the population’s health needs and the chosen care delivery model.

New Roles

Both the teamwork within the primary care practices and the coordination of care between primary care physicians, specialists and other providers speak to the need to have clearly defined roles and responsibilities within the systems of care. New roles for care coordinators, health educators, community case workers and clinical informatics experts will all be important building blocks as we better understand the gaps in the care system and how best to close them.

Co-Opetition

The inevitable decrease in total resources available for healthcare means that countries, states and regions will have to learn how to do more with less. Here is where the concept of “co-opetition” comes into play. Many investments can be made — particularly in the area of IT — in which competitors or nontraditional partners may find that investing together lets them lower costs and increase collaboration while continuing to preserve a strong basis for competition. Some regional health information organizations, such as the Western New York Clinical Information Exchange, are good examples of this. Seven competing healthcare organizations in the Buffalo region have joined to create a dedicated information system that preserves the ability of the individual organizations to compete on the use of their own data. Areas that can strike a balance between collaboration and competition will enjoy a significant advantage in the resourceconstrained future.

Conclusion

To ensure maximum value for the resources invested in healthcare, several things must happen: Accountability needs to be defined; data systems and standards have to be established for tracking populations’ health needs as well as for evaluating the success of interventions; new roles must be defined, with teamwork and communication more important than ever before; and new skills must be brought to bear, not the least of which is the ability to collaborate across previously impenetrable boundaries. Only by doing these things can we bring people the healthcare they deserve, at a price they can afford.

Even if the perfect system could be divined by selecting the best from everywhere, implementing it anywhere would range from painful to impossible. The large number of stakeholders in any country’s healthcare system — patients, providers, government, insurers, regulators — plus the fact that healthcare is an emotionally charged issue means that change is never easy.

But there are some lessons that each country can learn from others, including what developed countries can learn from developing ones about the necessary role of government and the pivotal role of local communities. To focus on some of these lessons, FTI Consulting convened a roundtable of healthcare experts chaired by Mark Malloch-Brown, FTI Consulting’s Chairman, Europe, Middle East and Africa.

In conversation with him were Michael W. Cropp, M.D., President/ CEO, Independent Health; Anne-Toni Rodgers, Payer Capability, Regional Lead — Europe, AstraZeneca; Meg Guerin-Calvert, Vice Chairman and

Senior Managing Director, Compass Lexecon; Vicky Pryce, Senior Managing Director of FTI Consulting’s Economic Consulting practice; Liz Shanahan, Senior Managing Director, Health & Life Sciences, Strategic Communications, FTI Consulting; and Dan Corry, Director, Economic Consulting, FTI Consulting.

Mark Malloch-Brown: I feel I perhaps know less about this subject than anyone else here today. But I was involved in running large international public-development organizations for a decade at a time when communicable diseases and the absence of healthcare investments in developing countries were as salient a pair of development issues as you could find. So I will press you during this discussion to not forget the 2 billion people at the bottom of the economic ladder in our solutions for healthcare coverage worldwide. Meg, what are the underlying drivers for change in healthcare?

Meg Guerin-Calvert: The single greatest challenge for developed economies is the proportion of GDP going for healthcare expenditures in virtually every country. In general, for major Organisation for Economic Cooperation and Development countries it’s somewhere between 8% and 16%. As we have moved through the financial crisis, the rate of economic growth in many countries has slowed or stalled, yet the rate of healthcare expenditure has not. As a result, the proportion of overall GDP consumed by healthcare in many countries is increasing. Depending on the importance of public sector funding, a very high proportion of government budget is allocated to healthcare. And despite that level of spending, certain countries, such as the United States, believe that quality and access achieved do not meet expectations. Those are substantial challenges.

Vicky Pryce: The developing world, where population growth is high, faces huge pressures to provide any kind of sensible healthcare system. At the same time, in some of those countries the emerging middle classes are looking for much more than just the basics.

Michael W. Cropp, M.M.: The cost of care relative to the value created is an increasing challenge that is emerging in every country. Everyone is or should be grappling with how we can afford to provide care for the entire population and get the maximum value. It is quite simply the cost of doing business as a nation, and it has huge economic implications.

Malloch-Brown: Since this is a global challenge, what lessons can we learn from each other? China, for instance, has made good progress against smoking through social marketing. It didn’t have fully developed healthcare options available. Can other countries learn from such successes?

Cropp : I think so. I just visited France, where government statistics show the country spends 11% of its GDP on healthcare. France has compelling statistics to suggest the results are worthwhile. For example, I was struck by the percentage of money spent on the physician component of healthcare overall, and that pharmaceutical spending is overrepresented relative to the United States; hospital expenditures are too. But smokingrelated cancers aside, France stacks up exceedingly well on most of the mortality measures, such as deaths related to diabetes and heart disease.

Anne-Toni Rogers: Many people are taking note of what’s being done by the United Kingdom’s NICE [National Institute for Health and Clinical Excellence]. But while most of the focus is on technology appraisals of drugs and devices, the way they developed clinical guidelines was quite clever. NICE funded the Royal Colleges and the professional associations to produce the guidelines, so the guidelines were being produced for the professionals by the professionals. That has made the guidelines much more likely to be widely adopted. Therefore they are likely to have a greater impact on healthcare overall.

Malloch-Brown: How transferable are practices? Can you easily take them from one country and implement them in another?

Dan Corry: It is very difficult to make sound cross-country comparisons on health expenditure; even if we did have the right figures, would that persuade us that if something worked for France or the United States or wherever, we should change our system to match? I think that’s very questionable. Each system has evolved over a long period of time, which creates significant inertia that makes it very tricky to completely change it. And there may be reasons that it works in one country and not in another. Another challenge for policymakers is that it’s very hard to say what the right answer really is. As economists, we like to know we’ve done our analyses and econometrics so we can tell you the right answer. But in healthcare there are so many complications that make it very, very hard to model well. But progress is being made. So you’re seeing proposals in the United Kingdom for changes in health that some people are convinced would work. Yet there’s another set of people — just as genuine, just as clever — who don’t think they will work. And the public is sitting there thinking, “What’s the right answer?”

Guerin-Calvert: Looking behind the successes to understand the sources of improvement is critical. I would agree with your sense that sound analytics are important tools. In addition, there needs to be a way to measure and track on a common basis.

liz Shanahan: I agree that healthcare systems can learn from each other, but analytics and metrics are not sufficient on their own to drive change. The way the learnings are communicated, cognizant of cultural differences, will also be pivotal to their success.

Rodgers: There are structural issues in the way, too. In Europe, technology that’s been around for 30 years could enable patients to be treated at home. But they’re not given the choice because the system rewards physicians for providing care at a medical office or hospital. For example, there is hardly any home-care dialysis in Germany, as compared to the rest of Europe, possibly because German physicians are rewarded for owning and running the treatment centers.

Malloch-Brown: France is a fascinating example to me because I believe that French health statistics are entirely driven by red wine consumption. And let me add that most of the FT I Consulting leadership would agree. But joking aside, there’s a serious point here: Many French policy leaders argue that there are broad lifestyle issues involved. This is, after all, a country that has championed a kind of quality-of-life index where work-lifestyle balance is a key issue.

Rodgers: I think lifestyle issues are very relevant, and you don’t only see differences between countries. There’s actually strong regionalization within France, and you see incredibly different statistics across the regions, as indeed you do in other countries.

Cropp : That is a very important point. We see tremendous variations in the United States as well. Even though Buffalo might have a culture very similar to those in Pittsburgh and Cleveland, the differences in health statistics are dramatic. When you trace the underlying drivers, they often relate back to chronic diseases and simple personal choices about exercise, eating and smoking.

Guerin-Calvert: In the United States there has been extensive study of the drivers of spending on Medicare [the U.S. government health insurance program covering everyone age 65 and older], looking at not just cost but also utilization — for example, the use of inpatient services vs. preventive care or the rate of readmissions. As an economist, what I find intriguing are the large variances in the utilization of services such as diabetes care, cardiac care, testing and so on across geographies. There are many factors that account for these differences, and demographics play an important role.

Malloch-Brown: How important are local structures and incentives?

Cropp : As we’ve mentioned, local conditions are very different, so there has to be local ownership and accountability to make things happen effectively. Whatever works in Buffalo may or may not work in the next community. So I’m a strong believer that local solutions must emerge in every country we’re talking about. But sometimes it’s going to require support at the state or federal level to facilitate the right dialogue. Key to effective local implementation is balanced metrics. It can’t just all be about cost and affordability. Only now is the United States beginning to go from a robust set of economic data — which is mostly complete for the Medicare population — to an almost equally robust set of quality data and a less robust data set on patients’ experience. Pulling all of that together is essential to being able to say, “Hey, they’ve figured something out in Cleveland that’s worth replicating.” And to understand what it was that made Cleveland a success. You can see from the data, for instance, that La Crosse, Wisconsin, is a very efficient area where the annual costs per Medicare enrollee are about $5,000. That’s at the bottom of the national range, which is $5,000 to $25,000. Plus, the quality of care and the patient experience are good. If you ask people from La Crosse what’s going on, they’ll tell you that as a community — of physicians, patients, faith-based institutions and others — they’ve tackled end-of-life issues. So if you live in the La Crosse area and you’re over 65, you have a 95% chance of being enrolled in hospice and only a 5% chance of dying in a facility, which is the opposite of the rest of the country. And that’s a local solution.

Guerin-Calvert: We can learn a great deal from cross-community comparisons as to what types of structures, incentives and metrics worked well to achieve desired cost, quality and access goals.

Shanahan: In the United Kingdom, general practitioners have been heavily incentivized to achieve improvements in screening and managing high-risk patient groups such as those with diabetes. The GPs have hit almost all of the relevant targets, capitalizing on the many exclusion criteria, and have been generously reimbursed for doing so. Still, it’s hard to know the true benefit, and we have yet to see the improvements in outcomes promised by these incentives.

Malloch-Brown: For healthcare systems being built in the developing world, how much of this is relevant? What would be your top lessons for someone in Chengdu, China, or wherever, which he might or might not learn from Buffalo as he starts to build a healthcare system?

Pryce: The first thing to note is the huge differences between countries in the developing world, as well as between them and developed countries. You can’t just take what works in the developed world and superimpose it on developing countries; it’s not going to work.

Rodgers: These developing markets often trust the industry more than the Western markets do, and they are keener to have partnerships. They will often accept that the industry is investing in infrastructure because they want the right medicine to go to the right patient at the right time, and they want that inward investment. In India, for example, some device manufacturers have worked with local communities to figure out how to get dialysis to a population that doesn’t have refrigerators or electricity. They’ve come up with entirely different products and solutions, because that’s what the community needs — for example, a box that delivers clean water to do the dialysis. They don’t really need to know how it does it, and they just accept that it does it. So my biggest recommendation is to capitalize on the level of trust and not start to overregulate, because the minute you do, you stifle innovation and increase cost.

Guerin-Calvert: I agree completely; you do not want overregulation. You want to rely on the market as much as possible. But you need to take a realistic look at what the market can easily provide and what things you might need to do to encourage new or different sources of funding to make that happen. By encourage, I mean new kinds of coordination, organizations coming together to exchange data and practices. Critical elements are the availability and use of data on quality, cost and other metrics.

Rodgers: If you look at what’s happened in China, you’ll see that wealthy Chinese are spending on plastic surgery and the diseases of wealth, and therefore it’s more attractive for clinicians to go into plastic surgery, cardiology, etc. For the health of the country as a whole, China needs hematologists, pediatricians and mental
health physicians — specializations that perhaps aren’t as appealing. How you regulate and how you reward the clinicians in those markets will have a big impact on how the healthcare system develops.

Malloch-Brown: We’ve talked a lot about how national and local variations make it difficult to transfer learnings from one place to another. What are some other impediments to change?

Guerin-Calvert: I have seen many industries go through transformative change, from regulation to deregulation, and in my experience healthcare is the most challenging. To make change possible will require a complex balancing of competition, government and consumer choice, combined with development of new organizations and increased coordination.

Corry: As Meg says, there are some very complicated economics, very complicated stakeholder issues in all countries, and an awful lot of emotion. People care about nothing more than health. You only have to see how every newspaper in every country wants to have a health story high up every day. So it’s a very interesting but very difficult area of policy.

Shanahan: Very few market sectors are as emotive as healthcare, and this makes it very challenging. There are clear tensions between physicians, management, insurers, pharmaceutical companies and providers. Balancing the needs and biases of each group demands a good understanding of the commitment phases individuals and groups go through, where they move from self-concern to exploration to adoption, and finally where the changes become institutionalized. This can take many years.

Corry: In addition, in most industries we think that competition is a good thing and it’ll drive down costs, but in healthcare that may not be the case. In fact, for various reasons — asymmetrical information among them — we think it may be the opposite: that more competition might lead to higher costs.

Shanahan: Dan is right. Competition vis-à-vis health is viewed differently in some countries, though not universally. There is mixed evidence of benefit, with some recent data from the United Kingdom showing that local competition has raised standards and improved patient outcomes.

Cropp: Physicians are generally smart. They want to do good, and they want to do right. But they haven’t had the right kind of accountability structure to deliver a value proposition for a defined population. So if we sit down with physicians and say, “Let’s talk about what excellent care looks like,” they’ll describe it, they’ll be consistent about it, and they’ll think they’re doing it all the time. But they don’t know what they don’t know.

Shanahan: Inertia and entrenched habits play a role here too. I’ve done a lot of work in psychiatry, where the clinical community has recognized that there is a serious problem of obesity and diabetes in the patient population. To address this, they galvanized the support of their relevant cardiology and diabetology colleagues at a European level to develop pan-European guidance. However, four years down the line patients have yet to see any tangible benefit. Wanting to do the right thing and then actually doing it require huge investments in time and education, which often don’t follow from the original well-intentioned concept.

Rodgers: As spending on pharmaceuticals moves increasingly toward prevention or lifestyle conditions, such as vaccines or even obesity, a challenge I see is the length of time to payback. The budget may go up now, but the real economic benefit is in 30 or 40 years. So people see the budget going up, and they may object to
their money being spent on antiobesity therapies, even though in 30 years the benefit to the public balance sheet may be substantial.

Malloch-Brown: We’ve talked already about the importance of local structures and incentives to making implementation successful. Are there any other things that can help overcome those barriers?

Rodgers: Education is critical. The original purpose of NICE was to drive innovation because U.K. doctors were some of the slowest to adopt new technology, and access to treatment varied by postal code. As I recall, when NICE looked at taxanes for breast cancer, only two out of 10 women who could benefit got access to the
medication. Within eight weeks of NICE saying these women should have access, it had gone up to eight out of 10. It’s also important to educate young people. All the evidence shows that educating the young drives change. Recycling was a good example. And it’s as true of doctors. When you’ve introduced change in clinical guidelines, for example, you might find that the consultant who’s been in practice for 30 years isn’t following them, but the junior doctors are all trained to work within guidelines now and are doing so. There’s also a role here for pharmaceutical companies to communicate directly with patients, which is one of the things the European Union has been trying to effect for about four or five years now. Patients want to communicate with the people who have data on their products. But it’s been continually blocked by member states who are afraid “communication” is going to turn into advertising prescription drugs on TV.

Cropp : Key for me is that we think beyond organizational boundaries and figure out how to bring various organizations and parties together to collaborate. I’ve started two nonprofit organizations in our community. One brings different parties together to create a culture of health in the community by looking at behaviors and helping individuals make choices and reinforce those choices across the community. The other is a regional health information organization through which all the health information in our community flows. We need competition to spur innovation, but I am sure we also need more collaboration in order to affect the cost/benefit ratio for healthcare.

Shanahan: Patients and consumers can be major drivers of change, and the growth in social media has removed many barriers. New data show that 70% of consumers now get their health information online, and doing so has increasingly become an interactive experience, with consumers asking each other for advice and guidance on their treatments/interventions. Given that their patients are armed with this knowledge, physicians often have little choice but to change.

Malloch-Brown: What do you all think is the role of innovation in helping us make progress?

Shanahan: I think a major challenge for innovation, particularly for the pharmaceutical industry, is the relentless pressure on costs, reducing medicines to no more than a cost base rather than an investment in patient health. Almost every new medicine or health technology has been developed by the commercial sector. If governments and healthcare providers continue to drive down reimbursement and undervalue these innovations, where will the hundreds of millions of euros that are required to develop new medicines and technologies to treat or prevent conditions such as Alzheimer’s come from?

Cropp: There’s another challenge too. According to the Institute of Medicine, it takes 17 years from the time when something’s proven to be effective to its finding its way into everyday use. With the profusion of new technology has come an implementation/innovation gap that could be better managed. So while there might be an innovation gap at the front end [in developing new therapies], you could argue that there is a bigger gap when it comes to getting proven technology to reach and have an impact on the broader population.

Malloch-Brown: To wrap up, it’s clear that there’s value in this iterative global knowledge exchange around what works, which is not just one approach. The point was made that some of the most interesting broader public health interventions are learned from developing countries that couldn’t rely on fully developed hospital systems. Second, we should not defer to markets alone, but also have a kind of strategic hidden hand. A 20-year view of where the shortages are is key. An example of that is the World Health Organization’s big push this year on noncommunicable diseases. It is an astonishing fact that obesity is now a bigger global problem than famine. So I think there is a sense that we’ve started to create a little bit of a global public policy health debate, which helps set some priorities. Finally, we’ve seen that structures, incentives and collaboration locally are essential to effective implementation.

From a patient’s perspective, all care is local and personal. But healthcare is a global industry, so declining resources and physician shortages in one country may be acutely felt in others. In the United States, almost 25% of the 680,000 practicing physicians were born or trained in other countries, and some of those physicians are heading home, lured by higher salaries. To take one example, more than 1,200 physicians will be recruited from around the world to staff a $1.3 billion public-private enterprise sponsored by the government of Kuwait, which has the resources to pay very well.

Such market-driven shifts in medical manpower come on top of demographic trends that could also lead to imbalances. In many developed countries, older doctors are preparing to retire just as those nations’ aging populations need more and more care. But solutions to physician shortages aren’t likely to come from cash-strapped government health ministries. Rather, private enterprise, well-funded and free to innovate, will increasingly fill the gap.

More than Government can do

Poland is a good example of a nation where entrepreneurs are adding capacity to a system that has struggled to keep up with demand for medical services. Two years ago, the government delivered all of the country’s healthcare; there were waits of six months or more for some surgical and diagnostic procedures.

But because the government lacked the resources to develop enough specialty care capacity, it began to aggressively engage private industry, physicians and investors to develop and run such healthcare enterprises. Now, medical specialty facilities are springing up, both in cities that had lacked healthcare services and in densely populated areas where there haven’t been sufficient physicians and hospital beds. Many of the new clinics are single-specialty facilities — for orthopedics and cardiology, among others — that have been able to leverage specialized staffs and equipment to achieve stellar clinical outcomes.

For investors in both the operations and real estate of healthcare, meanwhile, such ventures often provide substantial returns. Specialty clinics in two cities in western Poland aim to earn more than 20% for the investors who own the real

estate (comparable projects in the United States routinely see returns in only the high single digits and low teens). In just two years, 7% of Poland’s specialty care has been privatized, and the government projects — probably incorrectly — that within another four years, 40% of such care will be delivered privately.

India, in contrast, has a long history of private healthcare, which now accounts for 80% of all medical expenditures and the majority of new enterprises. Government-run facilities are vastly overcrowded and have a reputation for delivering substandard care. India continues to struggle with access to care: There are only 1.5 hospital beds per 1,000 people, compared with 2.5 beds in China, 3.2 in the United States and 8.3 in Germany. Meanwhile, the rapid growth of India’s middle class has led to escalating demand for higher-quality medical services.

Until two years ago, there was just one comprehensive diabetes clinic to serve the 7.5 million people in Chennai. (India has the world’s highest prevalence of diabetes, which affects 50 million people.) That meant many cases went undiagnosed until complications had set in. A newly planned diabetes clinic, ambulatory surgery center and hospital in Chennai, funded by a group of investors that includes physicians, an insurance company and real estate developers, will help meet that demand. Soon many patients will be diagnosed earlier and will be better able to manage this condition.

These new facilities are marketed to those who can afford to pay for care out of pocket (only 6% of Indians have private insurance), employers offering employee benefits, and state governments seeking to meet their social mandate through the provision of private insurance to citizens. It’s possible that as more patients with private insurance or the ability to pay flock to new private clinics and hospitals, the government will be able to redirect its resources to providing care for the poor.

Stretching technology

Using private equity to finance medical services is only one solution to providing greater access to healthcare. Another approach, undertaken by the owners of the Aravind Eye Care System in India, is to use technology more effectively. As part of its mission, the nonprofit eye institute serves the poor in rural areas, but rather than send an ophthalmologist to small villages, it dispatches a mobile kiosk and a technician to take digital photos of villagers’ eyes and record their symptoms. Then an ophthalmologist can use that information to make a diagnosis and determine whether treatment is required. Because of its strong reputation, 40% of Aravind’s patients pay for care, enough to allow it to subsidize care for the rest of its patients.

Integrating less expensive providers (such as nurse practitioners and physician’s assistants) with physicians can also reduce costs without sacrificing quality of care. Technicians can be trained to take patients’ blood pressure, for example, and nurses can handle many aspects of routine patient care. Telemedicine and other digital technologies can help mitigate the physician shortage by connecting patients with medical consultants in another locale or even another country. But governments and private payers have to be willing to create a regulatory environment and payment schemes that support such entrepreneurial solutions. How, for example, should providers in Turkey be paid to diagnose a patient in Algeria? And how will liability for careor misdiagnosis through digital and telemedicine consultations be handled? Without answers to such questions, digital technologies may fall short of their considerable potential.

The health dividend

Private healthcare enterprises may also eventually upend conventional reimbursement practices that reward providers for treating patients and performing procedures rather than for keeping them well. The publicprivate integrated health maintenance organization that the Hammes Company and FTI Consulting are involved with in Kuwait will charge a single annual premium to cover all care that a patient may need. Organized as a public company, the HMO will own its hospitals and clinics and employ its own physicians, helping it manage costs and boost quality of care while enhancing the return on investment.

In Kuwait the expatriate population will have only one HMO choice, but in other countries patients may choose among HMOs, private insurance and other private enterprises, all competing on the quality of their care. It seems reasonable that in integrated systems such as HMOs, in which the enterprise collects a premium and provides care, owners will decide which resources will be allocated to treatment and promoting good health. For example, if yoga is proven to keep patients healthy — and to make them less likely to require highcost treatments — then offering yoga classes will make good business sense. Crisis, too, can be the mother of invention, and the global health system is close to a crisis point. It’s time to let the entrepreneurial process work to improve healthcare for all.

The root causes of this disparity range from government corruption to a lack of access to clean water and electricity to shortages of medical equipment and clinical acumen. Addressing these myriad issues is daunting. Yet, since 2004, Developing Health Globally™, an initiative from GE , has been combining product resources, engineering expertise and best practices drawn from business to create holistic “enterprise solutions” for health facilities in Africa, Latin America and Southeast Asia. Through DHG, GE has invested $40 million in more than 100 hospitals and clinics in 13 countries, an effort that has affected an estimated 4.8 million lives. In the process, the company has also created a model for addressing the global health crisis — a model that’s driven by innovations in planning, implementation and sustainability.

What’s the problem?

The first step in this approach is to define the needs of each country by working with local ministries of health. Tim Reynolds, project and infrastructure consultant for Assist International, has been involved in DHG projects in Cambodia, Ghana, Honduras, Rwanda and other countries. “GE starts with a countrywide assessment of selected hospitals to determine the specific equipment needs of each facility,” says Reynolds. “How many beds and patients does it have? How many surgeries and deliveries per month? What are the mortality rates? Is it lacking power, water or communications infrastructure?”

A typical blueprint for improving a hospital may include an ultrasound machine, patient monitors, incubators, an X-ray machine and sterilization equipment, though gauging the needs of a particular facility requires a holistic understanding of local conditions. Air-conditioning units, for instance, a creature comfort in the developed world, might be essential to keep an operating theater sterile in a hot, buggy, humid area. And water filtration systems that can be cleaned manually are better than those depending on expensive, difficultto- replace cartridges.

Once needs have been established, GE teams create appropriate equipment configurations for local conditions. Assist International, a nonprofit humanitarian organization with more than two decades’ experience in the developing world, gets the gear to the hospital, where GE engineers and specialists install the units and train local clinicians. This approach has already had an impact, with infant mortality rates dropping by about 40% at six DHG sites in Honduras. And in Rwanda, referral rates from outlying hospitals to the hospital in the capital, Kigali, plunged from 42% to 3% with no spike in mortality, a sign that the
remote facilities were better able to handle cases on their own.

Learning to think outside the box

But this delivery model isn’t only about getting up-to-date equipment and basic user training where it’s needed. The model also aims to bring medical expertise to the countries in which DHG operates. Rachel Moresky, an emergency physician and assistant professor at Columbia University’s Mailman School of Public Health, directs the Systems Improvement at District Hospitals and Regional Training of Emergency Care (sidHART e) program, another GE partner. Since 2009, sidHART e has run training programs for doctors and nurses at district hospitals in Ghana. Using GE - donated equipment, sidHART e trainers teach medical providers to use available resources to treat cases locally rather than automatically referring patients to more advanced facilities in distant cities.

For example, a district hospital may have an ultrasound machine but not a CT scanner. Though ultrasound is used most often in obstetrics cases, physicians working with sidHART e trainers learn how to employ that technology to see whether traffic accident victims, for example, have internal lacerations. Those who don’t have complicated injuries can be treated on-site, slashing costs and making care more immediate. Integrating equipment donations with training in clinical acumen, Moresky says, is essential to creating sustainable improvements in care.

Engineering sustainability

Of course, modern medical machines are of little use if they’re not working, and according to the WHO, at least half of the laboratory and medical equipment in “resource poor” settings is partially or completely out of service at any given time. To improve on that dismal statistic, GE has partnered with Engineering World Health, a nongovernmental organization based in the United States, to implement a threeyear training program for biomedical equipment technicians in Cambodia, Ghana, Honduras and Rwanda. Local technicians are taught more than 100 basic technical assistance and troubleshooting skills, and they learn to make creative use of whatever resources are available. They might take the bulb from a car’s headlight to fix a lamp in an operating theater, for example, or use the plastic liner from the inside of a bottle cap and a standard sewing fastener to fashion a reusable pad for an electrocardiograph machine. Equipment that’s beyond repair can be cannibalized to keep other machines in working order.

To gauge the impact of such training, the Duke University Department of Biomedical Engineering, which partners with EWH, recently conducted a study of the biomedical engineering technician training program in Rwanda that involved 10 hospitals and more than 500 pieces of essential medical equipment. On average, the study found, equipment in hospitals in which technicians had been trained by EWH was 54% more likely to be in service than was equipment in hospitals whose technicians had not yet undergone the training. In addition, trained technicians were 27% more likely to be able to resolve problems with the medical equipment. The ultimate goal is to make the training sustainable, allowing the current generation of technicians to teach the next.

“As in most developing countries, our needs are many in terms of human resources, equipment and financial resources,” says Agnès Binagwaho, minister of health in Rwanda. “The GE program has been very helpful in terms of medical equipment maintenance and the training of local personnel to keep that equipment operating. The program has provided crucial support for our district hospital initiative, which focuses on delivering high-quality medical care as close as possible to where people live. Ensuring that medical equipment in these district hospitals is available and operating is very important to the success of this program, and the GE training initiative has dramatically improved equipment availability.”

Such gains could be duplicated in many other regions with similar needs, suggests Robert Malkin, a co-founder of EWH, who believes the broader engineering mind-set that drives the seemingly simple techniques put to use in the Developing Health Globally program could have a far-reaching impact. “Situations in the developing world look very different to an engineer than to the average person,” Malkin says. “We’ve seen the kinds of solutions engineering has brought to the developed world, and now that kind of innovative thinking is being translated into advances for the developing world as well.”

(A model of health promotion in Rwanda and other developing countries, the GE-sponsored program is attacking the scourge of preventable maternal and infant deaths.)

Executive compensation does not simply mean base salary; it is the total remuneration an upper-level manager receives in a corporation. This typically includes benefits such as bonuses, deferred and restricted stock, vesting periods, pensions and perquisites, as well as terms of employment including performance metrics, clawback provisions, and golden parachutes.

A Real Opportunity to Improve Incentives

Today’s situation risks more than bad public relations for public companies: there is a danger of missing out on an opportunity to improve incentives for top managers to increase the long-term value of their enterprises. Taking advantage of this opportunity has major ramifications not only for corporate stakeholders, but for society in general, as it has the potential to create more productive, durable, and valuable companies.

There is a real need to bring a dispassionate analysis to executive compensation and go beyond the superficial caricatures of unbridled greed. Economics can help by shining a light on the purpose of a corporate form of organization and the costs and benefits of comparative mechanisms for aligning executives’ behavior with shareholders and the broader stakeholder community. Keep in mind that well-constructed executive compensation packages are necessary but not sufficient for long-term value creation. 

Recognize the Objective

What is the goal of a corporation? Maximizing the long-term total enterprise value of the firm has long been understood as the chief corporate mission. Simply put, this means expanding the organization’s market reach or improving real productive capacity. Establishing a culture of long-term value creation entails gaining the loyalty and commitment of all constituencies, including employees, suppliers, and the wider community. The key challenge for management is to create the corporate vision, strategy, and tactics to unite and guide all constituents. So much depends on the stock of trust and flow of honest information.

Aligning Interests

A corporation needs to ensure that executive leaders’ incentives are aligned with shareholder interest in long-term value creation. Unlike owner-managers of small firms, executives at large enterprises often have only a small portion of their own equity at stake. However, this disparity leads to a gap in their interest as the “agent” looking after the interest of the “principals” (e.g. shareholders and debtholders). What’s more, they have an information advantage over principals, which can give rise to a serious conflict of interests and accountability problems. The economics of principals and agents helps organize thinking about how the structure of the CEO’s compensation will affect managerial behavior in pursuit of the objectives of the firm’s various stakeholders.

The principal-agent relationship is difficult and costly to maintain effectively over the long run, which means it is critical to take advantage of alternative alignment forces and mechanisms such as government regulation to monitor against fraud and accounting manipulation. In addition, the market for corporate control offers outside active investors and strategic companies a way to act as a disciplinary force against managers who do not maximize the value of their firms and stray too far from their shareholders’ interests. But recent events suggest that this discipline has limitations, especially in the recent era of overvalued equity.

The Role of Corporate Governance

Corporate governance is a mechanism for aligning principal-agent interests and incentives, encouraging accountability. How does it accomplish this? Corporate governance seeks to reconcile the relationships among the CEO, board members, stockholders, and the outside financial community of analysts, bondholders, and other creditors by clearly assigning responsibilities, measuring performance, and rewarding or penalizing managers in line with their impact on the firm’s long-term value creation.

There are some convincing examples that the sine qua non of a well-run, healthy company is effective coordination of the terms of executive compensation with the corporate governance function: rules, monitoring, and other incentives promoting effective relationships among important constituencies. Corporate governance, in theory at least, serves as a kind of “check and balance” for a corporation to ensure that executive compensation packages attract and retain the right people, hasten the departure of the wrong people, and provide incentives for high performance.

Dealing With Short-Termism

A significant part of the problem in executive compensation can be traced to how compensation packages evolved and became more closely tied to short-term stock prices. For example, pay plans have tended to move away from using fixed salaries. Compensation plans are now concentrated in stock options. And deferred stock and stock purchase options, which tend to vest over short time periods, are common. Moreover, options are typically tied to short-run publicly traded stock prices. The table overleaf shows the recent trend of executive compensation increasing in the form of equity.

Of course, CEOs are supposed to be paid for performance, but this shift in the make-up of compensation packages has led to some unexpected consequences: it has skewed managerial decisions to favor the short term and created a marketplace hothouse of overvalued equity. 

The introduction of stock options and restricted stock grants with such features as short-term vesting periods seemed to be the panacea for aligning shareholder and manager interests. Equity compensation soon evolved into the greatest portion of total executive compensation. Simultaneously, its growth facilitated a climate where information became less reliable, although superficially more plentiful, making it increasingly difficult for analysts or investors to make reliable decisions – for example, financial analysts underestimated Microsoft’s quarterly earnings 41 out of 42 times, according to an SEC investigation and cease and desist order in 2002. 

Imagine the CEO of an international engineering and construction company wrestling with whether to bite the bullet and overhaul the firm’s engineering software and invest in an even more costly three-year employee training program. If implemented, the costs of the investment could impact earnings and the company’s share price, affecting the CEO’s various stock options and restricted stock share over the next three years. Delaying the investment may benefit the value of the CEO’s personal stock options, but the longer he waits, the greater the decline in long-term company and shareholder value as his engineers continue to fall behind.

Linking Compensation and Corporate Governance

So, what can this analysis tell us about the present controversy over executive pay packages? Is the controversy symptomatic of a real problem, or an unfortunate matter of timing and appearances? What is clear is that executive compensation and corporate governance are inextricably linked and substantial effort and cost are required to better align incentives and reduce opportunism of all corporate stakeholders – top executives, board chairs and members, stockholders, debtholders – and the financial community.

The seminal idea behind the use of restricted stock grants and stock options was to enhance the performance of managers, or make “pay for performance” a reality in the corporate world. But the situation was still far removed from the ideal of all responsibility and the fruits of performance concentrated in the owner-manager. Granting stock options or restricted stock shares that vested quickly or over short time-horizons contributed nothing toward managers having “skin in the game.” (Private equity, hedge funds, LBOs and other similar entities have largely solved the “skin in the game” problem in the way that managing partners are compensated.)

It soon became clear that grants of stock options and restricted stock were not free of cost to companies and were also failing to have the desired effect of making top management more vested in companies’ long-term goals. In response, a number of corporations began to require CEOs to purchase and hold stock with after-tax dollars or variants with similar effects. Some companies that exchanged cash bonuses, grants of options or restricted stock for their longer-term equivalents include ADC Telecommunications, Arkla, Avon, Baxter, Black & Decker, Clorox, EKCO and General Mills. FTI Consulting will be monitoring the performance of these companies and others that adopt similar compensation strategies over the coming years.

There are other examples of large corporations changing the way in which they incentivize their leading talent. The CEO and COO of fuel wholesaler World Fuel Services have introduced compensation plans with equity grants that vest only after five years or more and the CEO is reported by Forbes.com to have two-thirds of his personal wealth tied up in stock in the company. Meanwhile, energy holding company PG&E Corporation uses an earnings-per-share hurdle to set its bonus for its CEO. To receive the full amount, the CEO must also meet customer and employee satisfaction targets.

The president of upscale retailer Nordstrom, who happens to be a descendant of the company’s founder, receives a portion of pay in performance shares that vest three years after they are granted and only
if total shareholder return is positive and above the average among retail peers. His shareholdings in his company have an approximate worth of $60 million.

Changing Corporate Culture

Building a culture of responsibility and accountability is essential to address issues around executive compensation. Greater transparency and credible, independent checks and balances are the minimum requirements to regain shareholder and broader stakeholder trust. Companies should also put in place a system that identifies potential conflicts of interests and implements countervailing measures. These include:

• Avoid the inherent risk of hiring the same compensation firm for the rank-and-file employees and the CEO or other top managers.
• Implement a set of measures to monitor accounting and other reporting practices that suggest weaknesses in corporate governance.
• Do not provide multi-period compensation packages.
• Carefully monitor CEO and financial analyst relationships.
• Establish an independent compensation committee composed of board members without CEO participation.
• Commission financial analysis of compensation packages with alternative scenarios and expected outcomes in terms of attraction, separation, and incentives.
• Limit to only the CEO and certain top executives the grant of options and deferred stock, and with these, make every effort to establish true estimates of costs to the company and their impact on the CEO and firm value.

As a critical component of corporate governance, executive compensation must constantly strive to align the incentives of top managers with shareholders and broader stakeholders. As the value added by management is difficult and costly to measure, monitor and verify, this is a complex and challenging undertaking for which much is at stake.

Clearly, ensuring effective measurement and monitoring of the value added by top management is complex and costly but, equally, it is essential for protecting stakeholders and increasing long-term total enterprise value of the firm.

According to the 2009 Survey of Credit Underwriting Practices, the U.S. Comptroller of Currency’s annual bank poll, 96% of the banks polled expected credit risk in their middle market loan portfolio to increase over the next year. The same poll had 67% of banks tightening their middle market underwriting standards this year, the most since the poll’s inception.

Middle market lending picked up smartly in the last quarter of 2009 but remains far below the levels of the mid-2000s. With money center banks focused on larger clients and relationship banking, and many regional banks still capital-constrained by poor loan performance, it’s unlikely that middle market lending will return to these volumes any time soon.

One thing is clear: middle market companies seeking bank loans need to be prepared for a limited appetite for leverage, tighter financial covenants, lower advance rates, shorter tenors, and higher spreads than in recent years. Above all, reluctant lenders are looking for another “C” from potential borrowers:

Credibility

While the balance of power between borrowers and lenders has shifted, borrowers should remember that they are far from helpless bystanders. Here are some of the key issues that bank underwriters are most focused on in evaluating a middle market financing:

Collateral Is King – Right now, collateral is crucial and most senior debt will be secured. Companies with tangible assets of determinate and material value are in a far more favorable position than those with fewer tangible assets. Valuing collateral is also a key issue, as real estate and some types of equipment have been severely depressed over the past year. Those seeking financing should go into bank negotiations with a clear understanding of the value of those assets to be pledged, preferably verified by a third-party source.
Remember that assets are only useful as collateral if they can be controlled by a lender in the event of default and subsequently monetized in a timely and cost-effective manner. 

Evidence of Quality Management Is Crucial – Often overlooked, this factor is of paramount importance in the underwriting process. Banks need to be comfortable with a management team’s qualifications and character. Banks are also scrutinizing managerial performance, since in many cases this provides an extreme data point. Management should have answers to the following questions when approaching lenders for financing: How have revenues held up in this downturn? How were costs kept in line with falling sales? How was working capital managed in the face of the recession?

Ensure Your Financial Data Is of the Highest Quality – The integrity of the borrower’s accounting information is critical. Financial statements must be audited, and controls must be strong. Demonstrating the internal control systems in place should be part of a presentation to lenders, as emphasizing the reliability of the company’s financial reporting systems can go a long way in mitigating any skepticism.

Understand the Role of Projections – Lenders generally expect a sluggish economy to impact the financial performance of middle market companies to a greater extent than large firms, negatively affecting cash flow and staying power. For this reason, upbeat projections are greeted skeptically and it is up to the borrower to convince lenders that realistic economic conditions are incorporated. Management should be prepared to provide detailed support for their projections and underlying assumptions. Even if banks accept these projections as reasonable, financing is unlikely to be provided at anything greater than a senior debt-to-EBITDA ratio above three times.

Use Scenario Analysis – Borrowers should have a firm understanding of a worst-case scenario and a detailed plan to deal with it. Many private equity firms started undertaking scenario planning in early 2008. This planning enabled sponsors to reduce the amount of additional equity injected when refinancing. In 2009, one large European private equity firm was able to refinance more than $1.5 billion of debt with additional equity of less than $10 million. Management should follow suit and prepare a line-by-line plan of how costs will be cut and debt will be serviced if sales fail to meet expectations. In the same vein, management should evaluate potential liquidation scenarios as banks will certainly need to understand them thoroughly.

Understand Your Industry – Traditionally, attractive industries for underwriters are those with low cyclicality and low technology/obsolescence risk because cash flows are more predictable. This downturn has spared few industries, but the risk of obsolescence and the intensity of competition continue to be heavily scrutinized in the underwriting process. Additionally, due to the renewed reluctance of banks to underwrite cash-flow loans for middle market borrowers, companies in asset-light industries such as software, technology, and services may find it more difficult to obtain financing, particularly if there is more than one lender. Those seeking financing should have a firm understanding of their industry, and be prepared to make a strong case to lenders on its attractive aspects, while explaining the company’s plan to mitigate risk from its negative elements.

Know Your Business – Attractive borrowers have compelling products and services, a strong brand name, little customer concentration, and highly credible management teams. Even in lean times, bank funding is usually available to high-performing companies with solid track records. Those seeking financing should know their business inside out, and be prepared to present a strong case on how the company stands apart from its competition. Unfortunately, most middle market companies currently in need of refinancing are doing so in the context of weak demand and stagnant revenues. These companies need to demonstrate how well they have been able to reduce costs and rescale their businesses to maintain margins and profitability. Management should also understand and be able to explain the company’s positioning relative to competitors in the event of a normal recovery and a prolonged downturn.

Reconfigure the Capital Structure – Banks are trying to cushion their exposure to the total leverage in a borrower’s capital structure, often requiring principals to have more “skin in the game.” Additionally, many middle market companies seeking refinancing are faced with weaker recent operating performance and more conservative covenant ratios, meaning less debt will be available to them than when the previous financing was put in place. As a result, companies may need a high equity or junior capital contribution to obtain bank debt. Personal guarantees may be required for smaller companies. In this case, the owners’ finances and credit history will be on full display and can be prepared in advance. Make-whole or capital call agreements, particularly in companies with non-public fund-held equity, may be required.

Be Prepared to Concede on Covenants – Banks are demanding tighter covenants. Borrowers should now expect tight covenants regardless of their credit history or relationship with the lender. More frequent reporting and valuation of collateral may also be required. Management should go to lenders with a willingness to accept these restrictions on any issue made in the near future, with the understanding that if the company does outperform these covenants, they can probably refinance their way out of this burden. 

Examine and Reconsider the Use of a Bank’s Other Services – A history of using the bank’s services such as treasury management or merchant services helps the company secure lending in two ways. First, it makes the company more attractive for the future fees these services will generate. Second, it frames the financing as relationship banking, based on a history of proprietary information gained through multifaceted business interactions.

Self-Help Can Help – Companies can make the process of refinancing faster and easier by undertaking their own self-diligence prior to discussions with lenders. As well as knowing their own strengths and weaknesses, companies can also prepare a thorough analysis of their operating performance, financial metrics, and collateral. It may be worth asking an external advisor to assist with this – a good advisor can bring independent analysis, industry knowledge, greater credibility, and additional manpower.

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010. 

How are Financial Markets Faring?

Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?

The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.
Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments. 

This state of high anxiety within the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

What are the Prospects for Corporate Borrowers?

Over the past two years, we have also seen a dramatic change in the composition of the lender landscape. There

are now fewer financial institutions, and those that remain are significantly more risk-averse. New paper issuance by collateralized loan obligations (CLOs), structured finance vehicles which provided so much cheap capital during the peak years, has largely dried up. Other non-bank lenders, such as hedge funds and pension funds, which also fed the leveraged loan market, have pulled back in a big way.

Traditional banks, many of which are either capital-challenged or propped up with federal assistance, are significantly more cautious lenders than previously. All told, new leveraged loan activity remains several hundred billion dollars below peak levels (see Chart A), and this decline dwarfs any buoyancy of new issuance activity in high-yield bond markets so far in 2009.

This much is clear. Big changes in the regulation of banks are coming. The effect of events over the past two years has prompted regulators in major countries to revisit rules and consider sweeping changes. The area of change most likely to affect corporate borrowers is that of capital requirements for banks.

Regulators are almost certain to introduce new rules to limit both the risks that many banks retain and the size of their asset base for any given level of capital. The message here is that banks will need to raise fresh capital just to stay where they are in terms of size. Meanwhile, loan underwriting standards are being raised, too. At best, all of this will make refinancing more challenging and expensive; at worst, over-zealous rule-making could lead to severe deleveraging and credit contraction.

Throw in the unfolding collapse of real asset values, and you have a heady cocktail likely to cause a lingering hangover. Declining residential property values, negative home equity and rising foreclosures have dominated business headlines for a while, but there is widespread belief that commercial real estate defaults are the next headline-makers.

Collateral values underlying commercial real estate debt are widely expected to drop by 35%-40% from peak 2007 levels during this down cycle. Transaction activity has plummeted and Commercial Mortgage-Backed Securities (CMBS) markets, previously a major source of real-estate finance, remain dormant, making the prospect of refinancing maturing debt without additional equity incredibly difficult.

A recent article in The New York Times (citing a widely read Deutsche Bank report) noted that “as many as 65% of commercial mortgages maturing over the next few years are unlikely to qualify for refinancing because of the drop in property values and new stricter underwriting standards.” Deutsche Bank Securities expects loss rates from defaulting real estate loans to exceed 10% of outstanding CMBS loan balances, a loss rate that would exceed the real estate crash of the early 1990s.

Until there is some persuasive evidence that the economic recovery has traction and that businesses are finally starting to expand again, markets for commercial real estate are unlikely to improve. Generally speaking, commercial real-estate markets tend to lag behind the economic cycle by at least one year.

A dearth of deal activity and depressed values in the M&A market are also impeding corporate turnarounds. There is little appetite to do deals at what might have once been considered ‘fair value,’ limiting the options of distressed corporates looking to dispose of assets to provide liquidity or refinance debt. Companies that can afford to do so are biding their time until the deal-making environment improves.

It is against this backdrop that hundreds of billions of dollars worth of leveraged corporate debt and commercial property loans will be maturing over the next five years. The ability of borrowers to meet or otherwise satisfy these upcoming obligations will depend on market-place conditions and economic circumstances outside their control, thus prolonging uncertainty in credit markets and corporate turnaround prospects.

Quantifying the Potential Size of the Refinancing Problem

An S&P study published in May showcases the scope of the future debt threat. The study analyzed nearly $4.4 trillion of U.S.-issued rated non-financial corporate debt, which included loans, notes and bonds. About $2 trillion (or 45%) was rated as speculative-grade debt, and $1.3 trillion of this total – or nearly two-thirds – was rated single-B or lower, a common threshold of ‘deep junk.’ Moreover, of the $1.4 trillion of speculative-grade debt scheduled to mature within the next five years, nearly $900 billion is rated single-B or worse. This is especially worrisome, given the ongoing difficulties of low-rated issuers in accessing credit markets despite the 2009 rally, and the materially higher default rates for issuers rated single-B or worse. The current skew of S&P’s ratings distribution of speculative-grade debt towards deep junk is one big reason why the rating agency is projecting an all-time high spec-grade default rate of 14% during this cycle, and a solidly double-digit default rate one year from now. Charts B and C show breakdowns of maturing debt by current rating and by debt type over the next five years.

For many leveraged loans, most maturities in the 2010-2014 time frame represent incredibly borrower-friendly deals originating from 2005-2007. Renewals at previous levels, terms and rates are most unlikely even for compliant, well-performing borrowers. Furthermore, a sizeable slug of these maturing loans represents LBO financings for deals that were aggressively structured and favorably priced.

In many cases, the new math simply won’t work come maturity time. Reuters LPC data indicates that some $230 billion of U.S. LBO-related term loans will mature within five years. This phenomenon is by no means endemic to the U.S.; Western European nations were also caught up in the leveraged buyout craze and the equivalent of $140 billion of LBO-related term loans will likewise be maturing by the end of 2014. 

Access to revolving credit continues to be reined in as traditional lenders seek to cut the size of new facilities, increase pricing spreads, shorten maturities and enhance collateral packages – in short, reduce their exposure to high-risk corporate borrowers. In May, Sears Holdings agreed to a bifurcated extension of its existing $4 billion asset-based revolver that was scheduled to mature in March 2010. Sears could only manage to get its lending syndicate to extend $2.4 billion of the original first lien facility by two years, despite a generous pricing margin increase of over 300 bps, a LIBOR floor, upfront fees and a BB+ rating. Now that’s risk aversion! It’s hard to believe the original ABL revolver was priced at only 88 bps over LIBOR in 2005.

The withdrawal or restriction of a line of credit can drive trade creditors and other critical suppliers to reduce their own exposures, by changing credit terms or placing riskier accounts on limit. This can intensify the pressure on a struggling company’s working capital when they are most likely to need it. In today’s new credit environment, the negotiating advantage has undoubtedly shifted back in favor of lenders, following several years when it was the borrowers that tended to call the shots. While large global companies often have access to alternative financing options or the ability to generate working capital spontaneously, those inhabiting the most precarious end of the borrowing spectrum typically have little choice but to accept more onerous terms and conditions offered by lenders.

Conservative lending practices and capital rationing by banks will disproportionately hurt small and middle-market companies, since the new emphasis on relationship banking and key accounts naturally favors the largest and most diverse clients that generate business volume and can be cross-sold an array of banking services. Middle-market borrowers are already feeling the neglect.

Patching Up the Wounded

Despite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential Fallout

For the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise. Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance. 

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic Bullets

So what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?

We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.
However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely.

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.