Loan guarantees are powerful tools that can be used to finance businesses that involve a partnership with physicians, provided that there is fair market value (FMV) compensation paid for the value of services received. As recent economic turmoil has led to a tightening of credit markets, financing is becoming an ever more crucial component to develop and maintain successful healthcare businesses. This brief article introduces the concept of the loan guarantee, its use in the healthcare industry and approaches to determining the FMV of loan guarantee fees.
What is a loan guarantee? In a typical loan, a borrower will receive money from a lender, who obtains a promissory note from the borrower to repay the principal amount plus applicable interest over a set period of time. A loan guarantee involves a third party, the guarantor, who promises (i.e., the guarantee) to pay the principal and interest to the lender on behalf of the borrower in the event the borrower defaults on its obligation. It is clear from this description that the guarantor of a loan guarantee has the potential to provide a materially valuable service to the borrower. Accordingly, for the provision of such a service, the guarantor typically charges the borrower a fee for the provision of the loan guarantee.
How are loan guarantees used in the healthcare industry? Loan guarantees are used in the healthcare marketplace most commonly as a tool for facilitating the financing of a joint venture (JV) when one of the JV partners has established credit facilities. In order to avoid the time and transaction costs associated with qualifying the JV (i.e., in most cases, each of its individual members) for financing, the JV partner with lender relationships guarantees a loan on behalf of the JV. Such guarantees can have substantial value depending on the characteristics of the JV partners.
How is the FMV of a loan guarantee fee determined? Many firms provide monetary guarantees for performance through a product known as a surety bond. A surety bond is a promise by a surety (i.e., guarantor), to pay another party, the obligee (i.e., lender), in the event that a principal (i.e., borrower) fails to perform a contractual obligation. For example, surety bonds are frequently used to guarantee a contractor's performance on a construction project. Such an arrangement is analogous to a loan guarantee when the repayment of the loan is considered the contractual obligation. In exchange for guaranteeing contractual performance, the surety charges a surety fee to the principal. Such fees are typically a percentage of the monetary guarantee and paid annually. In our experience, such fees generally range from 1-5 percent of the guaranteed amount per year for low-risk principals (i.e., those with good credit) to as much as 25 percent for principals that pose very high risk (i.e., those with bad credit). Such a fee represents the approximate annual payment that a surety would require and the present value of the stream of annual surety fee payments approximates a one-time upfront guarantee payment.
To determine the FMV of a loan guarantee fee, a valuator must identify the risk characteristics of a borrower and refine the surety fee percentage to be applicable to that borrower. We believe the following characteristics to be the most relevant in this analysis:
- Venture risk based on the historical and expected performance of the JV
- Investor risk based on the creditworthiness of the borrowers (i.e., JV members)
- Agreement risk based on the specific guarantee agreement and the rights afforded to the JV investors through its operating agreement
Loan guarantee arrangements can be a powerful and cost effective tool for establishing financing for an ASC, particularly a de novo center. However, when contemplating a loan guarantee arrangement, it is essential for all participants in the joint venture to recognize the value inherent in such an arrangement and to ensure that FMV compensation is exchanged for such services.
Mr. Carr (jcarr@hcfmv.com) is a principal and Mr. Argueso is an analyst at HealthCare Appraisers. Their national practice specializes in valuation, transaction advisory, strategic and operational consulting services. Learn more about HealthCare Appraisers by visiting www.healthcareappraisers.com.