Pending union with UM Health fails to spare Sparrow Health from downgrade

University of Michigan Health’s pending acquisition of Sparrow Health — which brings an infusion of $800 million in financial support but not a backing on debt — fell short of staving off a downgrade due to Sparrow’s battered balance sheet.

The affiliation agreement — struck Dec. 8 and expected to close in the first half of 2023 — will make UM Health Corp. the sole corporate member of Sparrow and provide it with capital and operational support but the revenues and debt of the two systems will remain separate.

“The university will commit a total of $800 million in capital contributions to Sparrow over an eight-year period for capital expenditures and specific programmatic investments,” reads a Friday notice posted on the Municipal Securities Rulemaking Board’s EMMA website. “If the transaction is consummated, the revenues of Sparrow and its controlled affiliates and UM Health Corp. are anticipated to remain separate and each health system will be obligated to repay its respective outstanding debt.”

Moody’s on Friday cut the Sparrow Obligated Group rating to A3 from A2 and warned of the potential for further downward action by assigning a negative outlook. The system has about $414 million of outstanding debt.

“If completed as currently contemplated, the affiliation will help fund capital expenditures, which would help preserve Sparrow’s balance sheet if it is able to stabilize operations, and could benefit financial performance through economies of scale and other operating efficiencies,” Moody’s said. “The magnitude of potential benefit is not currently known and the affiliation has not been incorporated into the rating.”

The downgrade “reflects the magnitude of operating losses in fiscal 2022 resulting in negative cash flow. Operating losses together with unrealized losses on its investment portfolio, has translated to a 22% decline in Sparrow’s unrestricted cash/investments position since the beginning of the fiscal year,” Moody’s said. The decline leaves the system short of meeting a debt service coverage covenant.

Sparrow’s wounds stem from strains felt across the not-for-profit hospital sector from materially higher labor costs, inflationary expenses, and higher length of stays that result in unreimbursed costs but they have cut more deeply into Sparrow’s balance sheet metrics than peer institutions. Sparrow expects a recovery in fiscal 2023 with contracted rate increases and the annualized impact of a reduction in force.

“The downgrade and negative outlook assume Sparrow will obtain forbearance or a waiver on its debt service coverage test for fiscal 2022,” Moody’s said. Another downgrade could follow if the acquisition falls through or the system fails to obtain forbearance agreement or waiver on debt service coverage tests.

The 126-year-old Sparrow operates five hospital locations in Lansing, Carson City, Charlotte, Ionia and St. Johns. The system includes an employed physician practice and a health plan. Several of the hospitals were recently added to the obligated group.

The five-hospital UM Health will become a $7 billion organization with more than 200 care sites across the state with the transaction expanding its presence from the southeast to cover the middle region of the state. It furthers the university’s goal of expanding into a statewide health system.

The two systems have partnered through an affiliation agreement since 2019 for pediatric services.

On Nov. 23, S&P Global Ratings downgraded the Sparrow Obligated Group to A-minus from A and placed it on CreditWatch with negative implications.

“The downgrade reflects our view of a multiyear trend of accelerating operating losses that have continued through the nine-month interim period ended Sept. 30, 2022,” S&P analyst Kay Sifferman said in a release. “The CreditWatch placement reflects our view that there is a one-in-two chance we could further lower the rating within the next 90 days pending review of certain strategic initiatives provided by management.”