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West Penn-Highmark Breakup Drama Puts Bonds on the Brink

This Pittsburgh drama mixes the intrigue of a daytime hospital TV soap and the rough-and-tumble of a Steelers football game.

The troubled West Penn Allegheny Health System’s abrupt rejection of a $475 million affiliation offer from its would-be white knight, insurer Highmark Inc., has triggered lawsuits, countersuits, accusations of personnel raids and harsh glare from rating agencies.

West Penn’s 2007 issue of $737 million of health system revenue bonds — rated double-B then and since lowered — made it one of the largest junk-bond issuers in the municipal marketplace.

Highmark, a Blue Cross Blue Shield insurer that serves about five million health-plan members in Pennsylvania, West Virginia and Delaware, sued in Allegheny County to prohibit West Penn from talking with other suitors. West Penn retaliated with its own lawsuit on Tuesday. Amid all this, officials from the two companies have spoken by phone about possibly reviving talks.

Should the latest round of talks fizzle again, West Penn, unless it finds another white knight, may have to file for bankruptcy.

West Penn, the second-largest hospital network in western Pennsylvania, reported a loss of $88 million through the first nine months of fiscal 2012. Its predecessor organization, the Allegheny Health, Education and Research Foundation, filed a $1.3 billion Chapter 11 case in 1998 after a series of bond downgrades in what was by far the biggest health-care bankruptcy filing at the time.

A repeat Chapter 11 filing — bankruptcy wonks call it “Chapter 22” — would resonate far beyond the Steel City.

“If there’s another bankruptcy, it will be monumental. A filing by the same credit in health care would roil the markets. It would be event-breaking,” said Lisa Goldstein, a senior vice president for health care at Moody’s Investors Service.

Bank of America Merrill Lynch, in a commentary headlined “Mayhem on the Monongahela,” called the impact of the deal cancellation “immediate and dramatic,” noting that long bonds with a 5.35% coupon maturing in 2040 that had been priced at 85 on Sept. 27 fell to 72 the next day.

All three major bond rating agencies have placed West Penn under review. Fitch Ratings and Standard & Poor’s rate the system B-plus and B-minus, respectively, while Moody’s assigns its Caa1 rating.

The details, characters and moving parts in this drama include an insurer looking to compete in a regional health care market dominated by the University of Pittsburgh Medical Center; an extramarital affair; a public fistfight over the affair; the subsequent firing of a fist-fighting, philandering chief executive that changed the dynamic of what had appeared to be a done deal; and reports in the Pittsburgh media of insurrection by some West Penn doctors demanding that their board embrace Highmark.

West Penn has accused University of Pittsburgh of “predatory tactics” that include a raid on top doctors.

The health care competition in Pittsburgh is “just unbelievable,” said Alan Schankel, a managing director at Janney Capital Markets in Philadelphia.

The University of Pittsburgh Medical Center dominates the scene and the Highmark-West Penn affiliation was to have made the pair more competitive.

“They’re the biggest health care organization in Pennsylvania and one of the biggest in the country,” Schankel said of UPMC. “This merger or affiliation or whatever you want to call it with West Penn would give [Highmark] a chance to compete head to head.”

Eva Thein, an analyst with Fitch, sees the Pittsburgh competition as deep-rooted. “I don’t know why the competition had to get this intense. I think personalities have had something to do with it,” she said. “You have companies with long histories and deep ties to the communities.”

One Pennsylvania health care administrator, speaking anonymously, still thinks the Highmark-West Penn affiliation will materialize. “West Penn can’t afford to do the deal but it can’t afford not to. Highmark can’t afford to do the deal and can’t afford not to,” he said.

According to B of A Merrill, breaking up or even closing West Penn is unlikely. “We do not believe that the non-UPMC competition has sufficient wherewithal to take on the financial burden, and UPMC would probably be prevented from doing so on antitrust grounds,” the bank said.

The backdrop is the financial downfall two decades earlier of a group built out from what had been a western Pennsylvania jewel, Allegheny General Hospital.

“The story of Allegheny General Hospital’s transformation from a single prosperous hospital on the North Side to a statewide 14-hospital chain buried under a mountain of debt is full of twists and turns,” the Pittsburgh Post-Gazette wrote in a six-part series in 1999. “The hospital was victimized by bad judgment, overarching ambition and maybe even some bad luck.”

In the 1980s, the lucrative, patrician Allegheny General evolved into the expansionist Allegheny Health, Education and Research Foundation. Old-money names dotted the board of Allegheny General’s hierarchy. Its chairman was William Penn Snyder 3d, patriarch of a family that made millions in the iron and steel industry for which Pittsburgh is widely known. Allegheny General in the late 1980s was among 40 hospitals with a bond rating of Aa.

Starting with the purchase of the Philadelphia-based Medical College of Pennsylvania in 1986, Allegheny ballooned into a behemoth. The chief executive at the time, Sherif Abdelhak, expanded through acquisitions in a Philly market perceived as even more cutthroat than Pittsburgh’s.

But debt spiraled and in the mid-to-late 1990s, reports of financial problems, opaqueness and siphoning of money among groups were rampant.

“Debt-rating agencies such as Moody’s Investors Service had a difficult time grading each group, since it was hard to know how the fiscal and operational health of one group affected the others,” the medical journal Health Affairs wrote. It cited internal subsidies, hidden internal cash transfers, and raids on hospital endowments, in addition to the out-of-control debt.

After would-be acquirer Vanguard Health Systems backed out of a deal, AHERF placed all of its Philadelphia hospitals and some of its health care facilities in bankruptcy on July 21, 1998. At the time it was the biggest nonprofit health care system failure ever.

West Penn emerged from the demise of AHERF and sold $430 million of bonds in 2000 to finance its creation. It issued $752 million in 2007 through the Allegheny County Hospital Development Authority, at the time the largest junk-bond deal.

“When AHERF restructured in the market and issued debt, Moody’s never rated it investment grade,” said Goldstein.

A 2008 Moody’s special commentary on the AHERF bankruptcy cited the need for strong governance and oversight of management, disciplined growth strategies, and better financial disclosure of all operations. Newer challenges for health care providers, according to Moody’s, included a weaker national economy, weak state economies causing increased charity care and bad debt expenses, and operating risks associated with the opening of major construction projects for many hospitals and health systems.

On Nov. 1, 2011, Highmark and West Penn announced a preliminary agreement for their affiliation. The companies intended to create a 501(c)3 parent organization, one part health-care insurance unit, the other the provider’s business unit. The deal needed various approvals, including that of the Pennsylvania Insurance Department, or PID.

Highmark infused West Penn with some needed cash, which helped the latter reopen its emergency department in Pittsburgh’s Bloomfield neighborhood, and renovate Forbes Hospital in Monroeville. Highmark pumped $200 million in equal parts loans and grants of what was expected to be a $475 million infusion.

Kenneth Melani, Highmark’s CEO since 2003, was a significant business and political player. “[Melani] probably would have gotten the PID to do the approval earlier,” said the Pennsylvania health care administrator.

But Melani was gone in April, two weeks before the PID’s public hearing on the deal. Highmark’s board fired him after he got into a public fistfight with the husband of his girlfriend — she also works for Highmark — in suburban Oakmont. Prosecutors filed defiant trespass and simple assault charges but later dropped them after Melani agreed to attend anger-management classes.

“I was dropped like a hot potato by everybody in Pittsburgh,” Melani, his right eye swollen shut from the fight, told Pittsburgh’s Tribune-Review soon afterward.

William Winkenwerder, a former assistant secretary of defense for health affairs in the George W. Bush administration, replaced Melani. Whereas Melani saw bankruptcy as disruptive to staff at a system where he once interned, his successor took an outside view and saw nearly $1 billion in debt that he didn’t want to assume.

Clearly the deal landscape changed with the new CEO’s arrival.

“You see more of this type of thing in the corporate world than in municipals, although health care is more of a hybrid model. You don’t see it much in the muni world,” Schankel said.

Winkenwerder on Aug. 30 told West Penn’s board that he wanted the hospital system to file for bankruptcy protection before sealing the deal. West Penn called off the deal on Sept. 28, prompting the latest litigation crossfire.

Highmark, meanwhile, took a brief time-out from its West Penn scrum to announce an affiliation deal with Saint Vincent Health System of Erie, Pa., 125 miles north, on Oct. 16 for $65 million. In June it announced an affiliation with Jefferson Regional Medical Center in Allegheny County’s Jefferson Hills, offering $75 million to Jefferson’s foundation plus an assumption of $200 million of debt.

West Penn’s options are limited, according to Fitch’s Thein.

“West Penn needs to explore other relationships or repair this one to secure its long-term viability,” she said.

“There is a theme in health care, and I’ve written about this several times: Bigger is better, unless you’re tucked in-between a pair of mountains with no competition,” Schankel added.

Schankel pointed to New Jersey, where Moody’s lowered the rating on St. Peter’s University Hospital’s $166 million of outstanding bonds to junk-level Ba1 from Baa3. St. Peter’s competes against the more lucrative Robert Wood Johnson Memorial Hospital in the Garden State.

“Not every deal is borne out of very strong synergies. If there are any storm warnings out there, due diligence should be heightened,” said Anthony Sabino, a law professor at St. John’s University. “That’s a big chunk of change and the folks who hold the current bonds have a right to urge West Penn to ratchet up the due diligence and see if the deal can be done.”

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