Ross Johnston - Aged Care Guild

21st December 2012

Ms Kerrie Westcott By email Director Department of Health and Ageing Legislation Section Transition Branch Ageing and Aged Care Division MDP 550 GPO Box 9848 Canberra ACT 2601

Email: [email protected]

Dear Ms Westcott, Implementing the Living Longer Living Better aged care reform package

Overview of proposed changes to the Aged Care Act 1997 and related legislation Please find enclosed our response to your “Overview of proposed changes to the Aged Care Act 1997 and related legislation – November 2012” document.

Firstly, we would appreciate your clarification about the consultation process regarding these important legislative changes. It appears as though the Department of Health and Ageing may be pre-empting decisions by the Minister before receiving full advice from ACFA. In short, we are concerned that DoHA may be short-circuiting the process established by the Minister under the Interim Operating Framework. We are seriously concerned about the lack of consultation and short time frames in this process.

The Guild have provided substantial support to the reform process to date, effecting these amendments ahead of the process leads us to question the integrity of it.

Could you please clarify the timing of the overall reform process timing to us?

Our responses are as follows: Part Two

Resident Fees; Page 20, paragraph 3 Do these arrangements extend to Extra Services places?

We have built and developed Extra Service facilities around receipt of bonds in high care and specific services as defined in their benchmark list.

Our business model is based on the provision of the Benchmark List Services to all residents to enable us to coordinate staffing and to manage expenses. Some of these costs are spread across the resident population and cannot readily be discontinued without added expense.

We note residential aged care facilities have very structured staffing which cannot be adjusted readily (notice to employees under awards re shift changes etc.).

Whilst we encourage the provision of choice to residents, we believe extra service facilities should be excluded. Part Three

Resident Care – flexibility and choice in paying for accommodation costs Page 23, paragraph 7 - 8

Removing a Providers ability to choose how they are able to charge for their rooms (i.e. bond or periodic payment) exposes them to significant financial risk.

If Providers are not in control of replacing like for like (bond for bond), the financial consequences of residents choosing periodic payments will be significant.

The following is an extract from a Guild letter to ACFA dated 21st November 2012; We agree with this recommendation broadly but not on the basis that the current method is utilised.

Through the introduction of the “choice of preferred payment option” providers lose the ability to control their income and cash flows.

Under the current legislation, residents have a right to elect whether to pay a lump sum or periodic payment for an accommodation bond. Specifically, section 57-17(1) of the Aged Care Act 1997 provides that:

"A care recipient may elect that an *accommodation bond is to be paid, in whole or in part, by periodic payments." The difference between the current legislation and the proposed legislation in relation to the method of accommodation bond payment, is that the resident's election right is preserved for 28 days. Whilst section 23.84 of the User Rights Principles 1997 currently provides residents with a cooling off period in relation to the resident agreement:

"The resident agreement must comply with the following requirements: (b) the agreement must provide that is, within 14 days after signing, the care recipient or his or her representative tells the provider, in writing, that the care recipient wishes to withdraw from the agreement:

i. the agreement becomes void; and

ii. the care recipient is liable for the fees and charges payable for any period when the care recipient was in the residential care service under the agreement; and

iii. the provider is liable to refund any other amount paid by the care recipient under the agreement." The proposed 21 day period operates more as a choice of payment period as opposed to a cooling off period. The 21 day period after entry will prevent providers from only offering a place where they know that the resident will be paying a lump sum bond, because the payment method is not elected by the resident until 21 days after entry. We note also that the default position is a periodic payment.

In relation to extra service places, approved providers have been able to take accommodation bonds since November 1999. The manner in which an accommodation bond is charged by approved providers for an extra service place is regulated in the same way non-extra service places are regulated (please see above). The basis of investment in new Extra Services facilities was based on provider’s ability to choose to accept an Accommodation Bond.

Currently the equivalence is determined using a rate of interest that is more aligned to a debt rate. As changes in bond cashflows are funded by providers using their available sources of funding, a pricing mechanism that utilises the approved providers Weighted Average Cost of Capital (WACC) would be more appropriate. Note that this would need to be notionally adjusted to a pretax WACC to reflect the pre-tax nature of the funding.

If we are to lose the ability to decide on the way we choose to manage our cash flows it is our view that an appropriate return on funds invested is required. An appropriate return is the Weighted Average Cost of Capital for a typical Approved Provider. If the equivalence methodology was only a debt rate, then we would not support consumers having choice of paying a lump sum or a periodic payment. The logic that supports this is that if there was a material outflow of lump sum bonds for whatever reason (typically expected to be based on macro economic events (such as illiquidity in the housing market)) that an Approved Provider would be better able to secure debt funding if there was a margin between the cost of short term funds and amount of the periodic payments. If that short term funding (from outflow of bonds) became permanent, then further equity could be injected into the business, with a consequent reduction in the debt level and long term funding of the bond outflow being funded at the WACC.

As we have articulated above the bond cash flows are a significant multiple of our free cash flows and our capacity to fund and repay additional bond cash out flows is limited.

The introduction of bonds in high care at this time in the industry where ebitda’s have dropped by circa 4% of revenue (due to increasing expenses and no COPO increase this year) are of little assistance to providers. At this time providers require revenue to increase returns and meet escalating expenses and increased exposure to bond cash flows at the same time as introduction of resident choice in terms of payment method increases our risk around cash flow. That would be reflected in the WACC that would be determined.

From a Guild perspective we hold circa $1.75 billion in bonds If this was to shift ten percent unfavourably (this could happen over twelve months) given the magnitude of the cash flows and the relatively short stay of residents this would place significant financial stress on our organisations. In the current market it is very difficult/impossible to raise equity to fund this, leaving only our available debt capacity to fund the cash outflows. As gearing levels increase, equity will eventually need to be raised in a market where values will continue to decline directly as a result of Living Longer Living Better performs proposed herein. If this is to be changed, the “periodic payment” rate should be a Weighted Average Cost of capital so providers can at least repay the debt over time.

We note the 21 day period proposed herein differs from the period nominated by ACFA of 28 days.

The default position for Providers as a result of a resident electing to do nothing is a Period Payment.

We have attached an extract of a paper provided to ACFA on 21st November for your information.

This is referred to as Attachment 1 (page 5). Paragraph 9 – Removal of bond retention amounts

The removal of retention amounts from providers is a punitive step without replacement of these revenues.

Currently retentions are circa $4,000 per annum.

Providers annual revenues for a bonded room are circa

 High Care (ES) $80 - $100k per annum

 Low Care $30 - $50k per annum

The retention removal amounts to

 High Care (ES) 4% – 5% of operating profit

 Low Care 7% – 13 of operating profit

Providers have no capacity to mitigate this loss of income from other income sources. This will place significant duress on all providers with bonds, particularly the smaller facilities with bonds. We note retentions held by the Guild amount to $22 million of income per annum currently.

It is our view that if these changes (resident choice of Accommodation Payments, bond retention and opt in/out services) are to be implemented all of them should be grandfathered for new residents entering care after 20th April 2012.

Yours sincerely

Ross Johnston Chief Executive Officer Regis Aged Care Pty Ltd

For and on behalf of the Aged Care Guild Attachment 1

Market Attractiveness and Weighted Average Cost of Capital (Rate of Return)15 November 2012

Background Guild members operate 20,000 aged care beds with replacement value of $5bn

Executive Summary  The WACC for top quartile private operators in aged care is in the range of 12% to 15% for a mature facility and 17% to 20% for a development facility

 This is an appropriate premium to regulated telecommunications returns at 11%

 At 12.5% and with building & land cost of $250,000 the required return is $31,250 per year

 This level cannot be sustained by government and must be supported by private payments

 Bonds have been a fair and effective private funding mechanism for the last 15 years

 Bonds allow private wealth created by favourable government tax concessions on residential housing (no capital gains tax, no annual property tax) to be used to fund aged care beds

 Bonds priced above construction costs in wealthy areas are supporting government

 objectives by partially cross subsidizing concessional beds

 Very material capital allocation decisions have been made over the last 15 years based on bonds at market rates. Capping bonds will permanently raise the industry cost of capital

 Annual bond retentions are an important, privately funded, source of income. Their removal indirectly shifts up to $3,876 per bonded bed of annual funding risk to taxpayers ($150m)

In response to the government funding and accommodation bond proposals:

 Bonds should continue to operate at market rates and be allowed over a national average of 70% of all residential aged care beds (varying by region based on demographics)

 30% of beds would then retain concessional characteristics (supporting policy objectives and an increase from an existing average of 23% of concessional places nationally)

 Bond retention should continue to be allowed in its current form and subject to the current cap (maximum 5 years of bond retention). Any move away from this should be funded by government income. The Guild’s combined bond retention is around $22m per annum.

WACC Overview The high and low WACCs of an operator in the top quartile are constructed as follows:

Case Low High Risk Free Rate 5.7% 5.7% Equity Market Risk Premium 6.0% 6.0% Equity Beta 1.1 1.1 Cost of Equity Pre Specific 12.3% 12.3% Risk Small Company Risk 4.0% 5.0% Premium Industry Specific Risk 0.0% 1.0% Premium Cost of Equity Post Specific 16.3% 18.3% Risk Cost of Debt 8.0% 8.0% Corporate Tax Rate 30.0% 30.0% Post Tax Cost of Debt 5.6% 5.6% Debt to Equity Ratio 35.0% 25.0% Weighted Debt Cost 2.0% 1.4% Weighted Equity Cost 10.6% 13.7% WACC (mature site) 12.5% 15.1% Development Risk Premium 5.0% 5.0% WACC (development site) 17.5% 20.1%

These WACCs are an appropriate premium to the published WACCs of regulated utility, telecommunications and airport companies. A premium is justified for the additional operating risk in aged care (see further below). Simply put, if Telstra is issued a regulatory WACC of 11.35% by the ACCC for its universal service obligation (2008), then the WACC in residential aged care is at least 12.5% and realistically closer to 15.0%.

To elaborate, aged care is a very labour intensive industry relative to other regulated or partially regulated assets. Labour to revenue ratios of over 65%, compared with regulated telecommunications labour to revenue ratios of around 16% (Telstra, 2012). Turnover in the industry is high at over 25% and there are ongoing wage pressures to retain clinically trained nurses and personal care staff. Aged care is also exposed to localized competition which impacts occupancy and bond pricing (compared to fully regulated companies which typically have monopolistic characteristics).

Industry Published WACC Energy 8% to 9% Telcos 11.4% Airports 10.3%

The selected WACC must then be applied to pre-tax cash flows.] The cash flows must include an allowance for recurring capital expenditures (not included in EBITDA). At a minimum, these are likely to average 1.25% of construction cost (or $3,000 each year).

Taking an average build cost (including land, stamp duty, capitalized interest, labour, materials) of $250,000 then the required annual return at 12.5% is $31,250.

A 75% percentile operator (bottom of top quartile) should be able to earn $10,000 of EBITDA. With a deduction of $3,000 of capex, this is equals $7,000 of operating cash.

The large gap between $31,250 and $7,000 cannot be bridged by government funding. The most effective way to bridge the gap is continued operation of bonds at market rates, and the continued operations of bond retentions at current levels (up to $3,850 per year).

Comments on WACC Construction Debt to Equity: Submissions have been made by other parties to the government to the effect that debt to equity ratios in aged care should be 60%:40%. This is based on an analysis of the leverage ratios of listed stock. However, the stocks used include retirement village operators that historically have been viewed as akin to property trusts and so have obtained high levels of debt. The stocks used also include larger, very liquid health care companies with ready access to additional capital through on-market raisings.

The ACCC has consistently used a debt to equity ratio of 40%:60% for PTSN and ULLS services in telecommunications. The Guild’s view is that for aged care a ratio of 30%:70% is appropriate, reflecting the higher operating risk in aged care compared with telecommunications, as well as the significantly smaller size of aged care operators compared with major telecommunications providers.

Cost of Equity: Submissions made to the government have not placed sufficient weight on the following factors:

 Small company risk premium: aged care operators are typically much smaller than ASX 100 companies (on which the typical market returns are based). They are also unlisted, which means they have low liquidity. Independent firms such as Ibbotson have historically placed small company risk premiums of 5.0% or more to reflect this risk.

 Beta: the submissions around beta at 1.0 to 1.20 compared with market of 1.0 are accurate. The beta should reflect that aged care is a very operationally intensive business, with ongoing wage pressures (from shortage of qualified nursing staff), high turnover at 25% to 35% across personal care staff and is subject to competition (occupancy pressure and bond pricing).

Risk Free Rate: Some submissions have used the current 10 year bond rate as the risk free rate. This rate is at historical lows for a host of reasons, including US Federal Reserve policies. They do not reflect the ongoing risk free rate. The more correct approach (as acknowledged by regulators in other sectors) to adopt the average rate of the 10 year bond of the last five years. This means the appropriate risk free rate is around 5.50% (rather than the current ten year bond rate at 3.00%). The alternative approach is to increase the equity risk premium (the risk free rate is low because global economic conditions are weak, and so the equity risk premium to deploy capital is higher than normal, off-setting the lower 10 year bond rates).

Cost of Debt: An average of 8.5% for top quartile operators (and over 10.0% for other operators). Some of the submissions made to the government have cited debt costs of closer to 8.0%, but these have typically not included appropriate allowances for establishment fees, legal fees, availability fees and hedging costs.

Tax Rate: Assumed at 30% in various submissions and in this analysis. Some regulators in other industries have assumed 20% tax rate, which is the effective national tax rate. However, for simplicity, 30% is used here.

Construction Risk: The WACC prepared above is based on the operator of a mature aged care site. It does not take into account construction risk, or the significant ramp up time and risk, or the occupancy risk involved in starting a new aged care centre (two years of construction, followed by two to three years of ramp up to full occupancy, typically resulting in four to five years of initially negative cash flow). The Guild’s view is that for development sites a premium of 5.00% should be added to the WACC (not included in the analysis in this paper). This results in a development WACC range of 17% to 20%. This development WACC should apply for the first five years of a new build, and then revert to the mature facility WACC of 12% to 15%.