March 21, 2006
Mr. Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
100 First Street, N.E.
Washington, D.C. 20549
RE: Vanguard Health Systems, Inc.
Form 10-K for the Fiscal Year Ended June 30, 2005
Filed September 13, 2005
File Number 333-71934
Dear Mr. Rosenberg:
Vanguard Health Systems, Inc. (“Vanguard” or “the Registrant”) is hereby responding to comments of the staff (the “Staff”) of the Securities and Exchange Commission (the “Commission”) contained in the Staff’s letter dated March 8, 2006 related to the above-referenced filing.
We have recited the comments of the Staff in bold type below and have followed each comment with Vanguard’s response. Capitalized terms used but not defined herein have the meanings ascribed thereto in the Form 10-K.
Item 7. Management’s Discussion and Analysis of Financial Condition… page 42
General Trends, page 46
Accounts Receivable Collection Risks Leading to Increased Bad Debts, page 47
1. Provide to us in disclosure type format agings that include more detailed
information with the “Insured” payor classification such as Medicare,
Medicaid, managed care, and other. Further explain to us why you are
unable to provide this information in a format that agrees to what you
include in your financial statements.
In response to your comment, the Registrant supplementally provides the information set forth in Attachment I to this letter. Vanguard revised the accounts receivable aging totals to reflect manual contractual allowances for unbilled accounts. However, Vanguard is unable to provide accounts receivable aging reports that reflect deductions for manual contractual
1
allowances for those billed patient accounts where our information systems only allow contractual discounts to be applied to patient accounts at the time payment is received. Vanguard does not believe that this additional information is useful because the primary collection risk relates to uninsured patient accounts and patient accounts for which primary insurance has paid but patient deductibles and co-insurance portions remain outstanding.
Critical Accounting Policies, page 50
Revenues and Revenue Deductions, page 50
2. Please explain to us in greater detail the amount of contractual allowance
estimates that are not generated at the time of billing. Please provide us in
disclosure-type format whether or not these are the estimates discussed in the
next paragraph related to your “final third party settlements.” If not, also
provide us in disclosure-type format the amount of these estimates,
quantification of changes in the estimate for each period presented and a
sensitivity analysis based on reasonably likely adjustments that might be
made to these estimates as of the latest balance sheet date.
In response to your comment, the Registrant supplementally provides the following response. Vanguard manually calculates contractual allowances for unbilled patient accounts at each balance sheet date and for instances in which information system limitations prevent the recording of contractual adjustments directly to the patient account at the time of billing. Otherwise, our information systems post the estimated contractual adjustments directly to the patient accounts at the time of billing and reduce the outstanding balances included in our accounts receivable aging schedule. All contractual deduction estimates are adjusted to actual upon receipt of payment.
As of June 30, 2004 and 2005, manual contractual allowances were approximately $95.9 million and $152.1 million, respectively. Due to system limitations, Vanguard is unable to determine total system posted contractual adjustments applied to outstanding accounts receivable. Vanguard is also unable to determine the variance between both manual contractual allowance estimates and system posted contractual adjustments recorded as of June 30, 2004 and 2005 and the ultimate contractual adjustments recorded upon payment of those accounts. Vanguard can only determine the variance for individual patient accounts and therefore does not believe that a meaningful sensitivity analysis can be provided.
The manual contractual allowances do not include estimates for final third party settlements, the changes in which are separately disclosed.
Allowance for Doubtful Accounts and Provision for Doubtful Accounts, page 51
3. Please provide us the following information in disclosure-type format to
help us evaluate the adequacy of your disclosure:
2
a. Quantify and analyze the reasonably likely effects that a change in
estimate of unsettled amounts from 3rd party payors as of the latest
balance sheet date could have on financial position and operations.
In response to your comment, the Registrant supplementally provides in disclosure-type format the information set forth in Attachment II to this letter.
b. If you have amounts that are pending approval from third party
payors, please provide the balances of such amounts, where they have
been classified in your aging buckets, and what payor classification
they have been grouped with. If amounts are classified outside
self-pay, tell us why this classification is appropriate, and provide the
historical percentage of amounts that get reclassified into self-pay.
In response to your comment, the Registrant supplementally provides the information set forth in Attachment II to this letter. Vanguard is unable to determine the balances of accounts pending Medicaid approval for historical periods but will monitor such amounts for future annual reporting periods.
c. Specify what you mean by “a pre-determined number of days” in
reference to reserving the 100% of the receivable balance.
In response to your comment, the Registrant supplementally provides the following response. As noted in Attachment II to this letter, Vanguard reserves all accounts aged greater than 180 days subsequent to the discharge date. Vanguard adjusts its estimate of the allowance for doubtful accounts as necessary based upon the results of a quarterly hindsight calculation.
Insurance Reserves, page 51
4. Please provide to us in disclosure type format a discussion that provides
greater insight to the quality and variability of these estimates. In your
proposed disclosure, you should supplement the current disclosure by
addressing the following:
–How accurate management’s estimate/assumption has been in the past,
quantify changes in estimate in each period;
–Whether the estimate/assumption is reasonably likely to change in the
future; and
–Evaluate the sensitivity to change of critical accounting policies.
In response to your comment, the Registrant supplementally provides the information set forth in Attachment III to this letter.
Consolidated Financial Statements, page F-1
Notes to Consolidated Financial Statements, page F-10
3
1. Merger Transaction, page F-10
5. Please tell us why it was appropriate to value the ownership interest in
Holdings by anyone other than by Blackstone at fair value, as it appears that
the other investors held residual interests. In addition, please tell us how you
have satisfied the monetary test in recognizing all interests owned by
Blackstone, MSCP and other investors at fair value. Refer to paragraphs
2(b) and 3(c) of EITF 88-16.
In response to this item, the Registrant supplementally provides the following responses.
Fair Value Test
The ownership interests of Blackstone, MSCP and Baptist Health Services in Holdings were valued at fair value. The ownership interests of management investors were recorded at the predecessor basis as noted in paragraph four of the footnote. This conclusion was based on the information in the following table.
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| Oldco |
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| Holdings |
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| Amount | % | Amount | % | ||||||||||
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Investment by Management Investors in Options |
| $ | 141.1 |
|
| 11.5 | % |
| $ | – |
|
| 0.0 | % |
Investment by Management Investors in Shares |
|
| 188.1 |
|
| 15.4 | % |
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| 119.1 |
|
| 15.8 | % |
Investment by Management Investors in Equity |
|
| – |
|
| 0.0 | % |
|
| 5.7 |
|
| 0.7 | % |
Investment by Blackstone |
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| – |
|
| 0.0 | % |
|
| 494.9 |
|
| 65.6 | % |
Investment by MSCP |
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| 824.3 |
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| 67.6 | % |
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| 130.0 |
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| 17.2 | % |
Investment by Baptist Health Services |
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| 66.5 |
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| 5.5 | % |
|
| 5.0 |
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| 0.7 | % |
$ | 1,220.0 | 100.0 | % | $ | 754.7 | 100.0 | % | |||||||
As indicated in the table, the residual interest of Baptist Health Services is less than 5 percent of Holdings and is valued at fair value according to Section 2.b.i.a of EITF 88-16. The residual interest of MSCP represents greater than 5 percent but less than 20 percent of the residual interest in Holdings and is valued at fair value according to Section 2.b.i.b of EITF 88-16. Further, MSCP and Baptist Health Services are not a part of the Holdings control group as defined in paragraph 1.c.iii. of EITF 88-16 as they are not members of management and their residual interests in Holdings are less than their investment in Oldco. Therefore, as required by Section 2 of EITF 88-16 and because the monetary test did not result in any further limitation, the residual interests of these continuing shareholders are valued at fair value.
4
Monetary Test
The information supporting the monetary test required in paragraph 3 of EITF 88-16 is reflected in the tables below.
Reconciliation to | ||||||||
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| Oldco |
| Holdings |
| Cash |
| Total |
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| |||||||
Management Stock Options |
| $ 141.1 |
| $ – |
| $ – | $ – | |
Management Shares Owned |
| 188.1 | 96.6 | 22.5 | 119.1 | |||
Management Equity Incentive Units in Holdings | – | – | 5.7 | 5.7 | ||||
MSCP Shares Owned | 824.3 | 130.0 | – | 130.0 | ||||
Baptist Health Services Investments | 66.5 | – | 5.0 | 5.0 | ||||
Blackstone Equity | – | 494.9 | – | 494.9 | ||||
Other cash sources | – | 1.6 | – | – | ||||
Incremental debt | – | 496.9 | – | – | ||||
Total consideration | $ 1,220.0 | $ 1,220.0 | $ 33.2 | $ 754.7 | ||||
Monetary consideration | ||||||||
Blackstone Equity | $ 494.9 | |||||||
Incremental debt | $ 496.9 | |||||||
$ 991.8 | ||||||||
Total Consideration | $ 1,220.0 | |||||||
Monetary consideration as a % of Total Consideration | 81.3% | |||||||
6. Please provide to us in disclosure type format a more detailed discussion of
how the equity capitalization and financing relate to the $1.22 billion and the
$1.97 billion discussed in the first paragraph of this note. Include the
amounts of the proceeds used to complete the transaction at the top of page
F-11. Also include a purchase price allocation that allows us to better
understand how these amounts were reflected in your financial statements.
In response to your comment, the Registrant supplementally provides the information in disclosure-type format set forth in Attachment IV to this letter.
* * *
5
Regarding the comments received from the Commission and the responses thereto, Vanguard acknowledges that staff comments or changes to disclosure in response to staff comments do not foreclose the Commission from taking any action with respect to the filing and that Vanguard may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States. Additionally, Vanguard acknowledges that it is responsible for the adequacy and accuracy of the disclosures set forth in its filings with the Commission.
Please feel free to call the undersigned at (615) 665-6005 with any questions regarding these filings or responses.
Sincerely,
/s/ Phillip W. Roe
Phillip W. Roe
Senior Vice President and Chief Accounting Officer
Attachments
6
Attachment I
The following table provides a summary of our accounts receivable by age since discharge date for significant payer classes as of June 30, 2003, 2004 and 2005 (in millions).
June 30, 2003 | 0-90 days | 91-180 days | Over 180 days | Total | ||||
Medicare | $ 41.4 | $ 3.5 | $ 2.2 | $ 47.1 | ||||
Medicaid | 23.6 | 7.0 | 4.3 | 34.9 | ||||
Managed Care | 91.2 | 18.0 | 10.4 | 119.6 | ||||
Self Pay(1) | 32.6 | 28.6 | 7.1 | 68.3 | ||||
Other | 13.9 | 4.0 | 2.2 | 20.1 | ||||
Total(2) | $ 202.7 | $ 61.1 | $ 26.2 | $ 290.0 | ||||
June 30, 2004 | 0-90 days | 91-180 days | Over 180 days | Total | ||||
Medicare | $ 50.4 | $ 3.0 | $ 2.6 | $ 56.0 | ||||
Medicaid | 20.8 | 5.9 | 4.1 | 30.8 | ||||
Managed Care | 105.8 | 17.4 | 8.4 | 131.6 | ||||
Self Pay(1) | 38.7 | 35.3 | 10.2 | 84.2 | ||||
Other | 11.8 | 2.7 | 1.6 | 16.1 | ||||
Total(2) | $ 227.5 | $ 64.3 | $ 26.9 | $ 318.7 | ||||
June 30, 2005 | 0-90 days(3) | 91-180 days(3) | Over 180 days | Total | ||||
Medicare | $ 63.0 | $ 5.5 | $ 2.3 | $ 70.8 | ||||
Medicaid | 31.9 | 12.1 | 7.3 | 51.3 | ||||
Managed Care | 140.8 | 21.2 | 10.1 | 172.1 | ||||
Self Pay(1) | 45.1 | 45.4 | 10.0 | 100.5 | ||||
Other | 17.8 | 6.0 | 1.8 | 25.6 | ||||
Total(2) | $ 298.6 | $ 90.2 | $ 31.5 | $ 420.3 | ||||
____________________ | ||
(1) |
| Includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the primary payer. |
(2) |
| The total accounts receivable balances reflected on these tables differ from the net accounts receivable balances as stated on the consolidated balance sheets for those respective periods because the balance sheet accounts receivable amounts are reduced by manual contractual allowances for certain billed patient accounts and for cash payments received but not posted to patient accounts, whereas those deductions are not reflected on the aging reports. |
(3) |
| Includes accounts receivable balances for the recently acquired Massachusetts hospitals. |
Attachment II
Our ability to collect the self-pay portions of outstanding receivables is critical to our operating performance and cash flows. The allowance for doubtful accounts was approximately 22.0% and 24.0% of accounts receivable, net of contractual discounts, as of June 30, 2004 and 2005, respectively. The primary collection risk relates to uninsured patient accounts and patient accounts for which primary insurance has paid but patient deductibles or co-insurance portions remain outstanding. We estimate the allowance for doubtful accounts using a standard policy that reserves 100% of all accounts aged greater than 180 days subsequent to discharge date plus a pre-determined percentage of accounts receivable due from patients less than 180 days old. We adjust our estimate as necessary on a quarterly basis using a hindsight calculation that utilizes write-off data from the previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. We also monitor cash collections and self-pay utilization. We believe that our standard policy is flexible to adapt to changing collection and self-pay utilization trends and our procedures for testing the standard policy provide timely and accurate information. Significant changes in payer mix, business office operations, general economic conditions or healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates and significantly affect our future operations and cash flows.
We classify accounts pending Medicaid approval as Medicaid accounts in our accounts receivable aging report and record a manual contractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state. We have historically been successful in qualifying approximately 60% of submitted accounts for Medicaid coverage. In the event an account is not successfully qualified for Medicaid coverage, we reclassify the account to self-pay and reverse the estimated contractual discount. We then include the account in our estimate of the allowance for doubtful accounts.
Attachment III
Given the nature of our operating environment, we are subject to professional and general liability and workers compensation claims and related lawsuits in the ordinary course of business. Effective June 1, 2002, we established a wholly owned captive subsidiary to insure our professional and general liability risks at a $10.0 million retention level. We maintain excess coverage from independent third party insurers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. We self-insure our workers compensations claims up to $1.0 million per claim and purchase excess insurance coverage for claims exceeding $1.0 million. The following tables summarize our professional and general liability and workers compensation reserve balances as of June 30, 2004 and 2005 and our total provision for professional and general liability and workers compensation losses and related claims payments during the years ended June 30, 2003, 2004 and 2005, respectively.
Professional | |||||
and General | Workers | ||||
Liability | Compensation | ||||
(In millions) | |||||
Reserve balance: | |||||
June 30, 2004 | $ 40.9 | $ 7.8 | |||
June 30, 2005 | $ 50.5 | $ 12.7 | |||
Provision for claims losses: | |||||
Fiscal Year 2003 | $ 17.6 | $ 6.9 | |||
Fiscal Year 2004 | $ 22.0 | $ 8.3 | |||
Fiscal Year 2005 | $ 18.8 | $ 11.3 | |||
Claims paid: | |||||
Fiscal Year 2003 | $ 7.4 | $ 3.1 | |||
Fiscal Year 2004 | $ 7.6 | $ 6.4 | |||
Fiscal Year 2005 | $ 9.2 | $ 6.4 | |||
We use an independent actuary to estimate our reserves for professional and general liability and workers compensation claims. Each reserve is comprised of estimated indemnity and expense payments related to: 1) reported events (“case reserves”) and 2) incurred but not reported (“IBNR”) events as of the end of the period. Management uses information from its risk managers and its best judgment to estimate case reserves. Actuarial IBNR estimates are dependent on multiple variables including our loss exposures, our self-insurance limits, geographic locations in which we operate, the severity of our historical losses compared to industry averages and the reporting pattern of our historical losses compared to industry averages, among others. Most of these variables require judgment by the independent actuary and changes in these variables could result in significant period over period fluctuations in our estimates. We adjust these reserves from time to time as we receive updated information. During fiscal 2005, due to changes in historical loss trends, we decreased our professional and general liability reserve related to prior fiscal years by $3.6 million and increased our workers compensation reserve related to prior fiscal years by $2.0 million. Given the fact that we have operated our hospitals for relatively short periods of time, we expect that additional adjustments to prior year estimates may occur as our reporting history and loss portfolio matures.
i
The independent actuary provides a best estimate of IBNR using statistical confidence levels deemed adequate by the actuary. Using a higher statistical confidence level would increase the estimated reserve. The following table illustrates the sensitivity of the reserve estimates at 75% and 90% confidence levels.
Professional | |||||
and General | Workers | ||||
Liability | Compensation | ||||
(In millions) | |||||
June 30, 2004 reserve: | |||||
As reported | $ 40.9 | $ 7.8 | |||
With 75% Confidence Level | $ 44.5 | $ 8.4 | |||
With 90% Confidence Level | $ 48.6 | $ 8.9 | |||
June 30, 2005 reserve: | |||||
As reported | $ 50.5 | $ 12.7 | |||
With 75% Confidence Level | $ 54.4 | $ 13.1 | |||
With 90% Confidence Level | $ 60.2 | $ 13.6 | |||
ii
Attachment IV
On September 23, 2004, affiliates of The Blackstone Group (“Blackstone”), a private equity firm, purchased a majority equity interest in VHS Holdings LLC (“Holdings”), which became the principal stockholder of Vanguard Health Systems, Inc. (“Vanguard”) in a merger transaction (the “merger”). Pursuant to the merger agreement, the former holders of Vanguard shares received $1.22 billion, net of debt repayments, transaction costs, tender premiums and consent fees and the redemption of payable-in-kind preferred stock. The transaction was valued at approximately $1.97 billion prior to transaction fees and expenses.
Subsequent to the merger, Blackstone beneficially owns approximately 66% of the equity interests in Vanguard through its subscription and purchase of approximately $494.9 million aggregate amount of Class A membership units in Holdings and common stock of Vanguard.
Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively, “MSCP”), the Company’s previous private equity sponsor, contributed $130.0 million and management (along with certain other investors) contributed approximately $124.1 million by contributing shares of Vanguard common stock and/or utilizing cash proceeds from the merger to purchase Class A membership units in Holdings. These stockholders, on a combined basis, beneficially own approximately 34% of the equity interests in Vanguard. Certain members of management also purchased $5.7 million of the equity incentive units in Holdings.
Vanguard accounted for the transaction as a purchase under the guidance set forth in Emerging Issues Task Force Number 88-16, Basis in Leveraged Buyout Transactions, (“EITF 88-16”). Under EITF 88-16, the transaction was deemed to be a purchase by new controlling investors for which Holdings’ interests in Vanguard were valued using a partial change in accounting basis. In effect, the membership units of Holdings owned by the management investors were valued using predecessor basis, while the membership units of Holdings owned by Blackstone, MSCP and other certain investors were recorded at fair value.
i
The following table summarizes the sources and uses of funds to finance the merger (in millions):
Sources: |
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| Amount |
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Senior credit facilities(1): | |||||
Term loan facility | $ 475.0 | ||||
Revolving loan facility | – | ||||
Issuance of 9.0% senior subordinated notes(2) | 575.0 | ||||
Issuance of 11.25% senior discount notes(3) | 124.7 | ||||
Cash equity contribution by Blackstone | 494.9 | ||||
Rollover equity contribution by MSCP | 130.0 | ||||
Rollover equity contribution by management and certain other investors | 96.6 | ||||
Cash equity contribution by management and certain other investors | 22.5 | ||||
Cash equity contribution by Baptist Health Services(4) | 5.0 | ||||
Cash equity contribution for purchase of equity | |||||
incentive units by certain members of senior management | 5.7 | ||||
Vanguard cash on hand | 38.3 | ||||
$ 1,967.7 | |||||
Uses: | |||||
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Purchase price of Vanguard equity | $ 1,220.0 | ||||
Redemption of Payable In Kind Preferred Stock issued in | |||||
connection with the acquisition of MacNeal Hospital | 28.6 | ||||
Repayment of Vanguard's existing senior credit facilities | 300.0 | ||||
Repurchase of substantially all of Vanguard's outstanding | |||||
9.75% Notes and payment of related tender premium and consent fees(5) | 349.2 | ||||
Payment of fees and expenses related to the new senior | |||||
credit facilities, the 9.0% Notes and the 11.25% Notes | 41.6 | ||||
Payment of capitalized merger-related fees and expenses | 28.3 | ||||
| $ 1,967.7 | ||||
____________________ |
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(1) The new senior credit agreement governed senior secured term loan facilities of $800.0 million, of which $475.0 million was | |||||
(2) Vanguard issued and sold $575.0 million of 9.0% senior subordinated notes due 2014 (the “9.0% Notes”). | |||||
(3) Vanguard issued and sold $216.0 million aggregate principal amount at maturity ($124.7 million in gross proceeds) of 11.25% | |||||
(4) Baptist Health Services made its $5.0 million cash equity contribution from some of the proceeds of the conversion of its 8.18% | |||||
(5) Vanguard had outstanding $300.0 million of 9.75% senior subordinated notes due 2011 (the “9.75% Notes”). | |||||
ii
The following table sets forth the merger purchase price allocation under EITF 88-16 including a reconciliation of such purchase price allocation to the merger fair value detailed above (in millions).
Cash | $ 86.9 | |||
Accounts receivable, net | 235.3 | |||
Prepaid expenses and other current assets | 64.8 | |||
Property, plant and equipment | 795.8 | |||
Goodwill | 820.0 | |||
Intangible assets | 79.4 | |||
Other assets | 61.9 | |||
Total assets acquired | 2,144.1 | |||
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Current liabilities |
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| 191.4 | |
Debt | 5.1 | |||
Other liabilities | 93.2 | |||
Total liabilities assumed | 289.7 | |||
Allocated purchase price | 1,854.4 | |||
Predecessor basis limitation under EITF 88-16 | 113.3 | |||
Fair value of net assets acquired | $ 1,967.7 | |||
Vanguard incurred $96.7 million in stock compensation expense in connection with the merger related to the payment to stock option holders under its various former stock option plans as calculated under the provisions of Accounting Principles Board Opinion No. 25 for option grants prior to July 1, 2003, and under Statement of Financial Accounting Standards No. 123 for option grants on or after July 1, 2003. Vanguard incurred debt extinguishment costs of $62.2 million in connection with the merger representing the write-off of loan costs under the 2004 senior secured credit facility and related fees of $16.6 million, tender premiums and consent fees of $50.2 million and a $4.6 million credit for the recognition of the remaining deferred gain under an interest rate swap agreement related to the 9.75% Notes. The Company capitalized $41.6 million of fees and expenses related to the execution of the new senior secured credit facilities and the issuance of the 9.0% Notes and the 11.25% Notes on the merger date.
Vanguard also incurred costs of $51.6 million directly related to the merger, of which $23.1 million, $0.2 million and $23.3 million is reflected as merger expenses on the accompanying consolidated statements of operations for the predecessor period July 1, 2004 through September 22, 2004, the successor period September 23, 2004 through June 30, 2005 and the combined year ended June 30, 2005, respectively. The remaining $28.3 million is included in goodwill on the accompanying consolidated balance sheet as of June 30, 2005 as set forth by the provisions of Statement of Financial Accounting Standards No. 141. The table below provides a detail of the merger-related costs (in millions).
iii
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| Merger |
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| Goodwill |
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Advisory fees |
| $ | 10.0 |
| $ | 4.0 |
Legal and accounting fees |
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| 1.4 |
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| 3.8 |
Transaction completion fees to Blackstone and bonuses to management |
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| 6.1 |
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| 20.3 |
Bridge loan commitment fees |
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| 5.3 |
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| – |
Other |
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| 0.5 |
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| 0.2 |
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| $ | 23.3 |
| $ | 28.3 |
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iv
