Aligning your long-term pool with your enterprise objectives, Part 2: Additional strategies for healthcare systems
Previously, we shared a holistic approach that non-profit hospital and health system fiduciaries can adopt to better align their long-term investment pool with their organizational goals. This approach involves defining one's investment objectives and setting an asset allocation based on one's risk tolerance and the needs of the overall enterprise. It allows fiduciaries to target a return in line with organizational needs, often linked to outperforming the cost of capital, while protecting their financial health during periods of market stress.
After taking these important foundational steps to align the risk and return profile with organizational needs, healthcare fiduciaries can consider additional strategies to ensure that the construction and implementation of the long-term pool is in alignment with the enterprise's finances.
1. Addressing common market exposures across the investment pool and enterprise
Given that all portfolio construction decisions are made within the context of the capital markets, it is critical to understand the types of market environments where you may need to rely on the long-term pool as a crutch to fund cash shortfalls or support the credit rating in case additional debt is undertaken.
In a typical market environment, we don't usually see healthcare systems' cash needs and revenue generation as correlated to market returns. However, this wasn't the case during the COVID-related market sell-off in the first quarter of 2020, when markets fell as healthcare systems were experiencing revenue declines. Fortunately for health systems, markets rebounded from their lows prior to the end of the fiscal year, removing the possibility of reporting large losses on the income statement and preventing the need for cash—thanks to a combination of government relief programs and other cash sources.
However, different healthcare systems could have other unique circumstances that create overlap between enterprise financial strength and investments within the long-term pool. The long-term pool should be structured in a way that takes into account when its strength and liquidity will likely benefit the enterprise most.
One common example is that many hospitals and health systems maintain a significant exposure to private real estate on their balance sheets, in the form of buildings they own and operate. These enterprises may want to consider the potential impact of private real estate exposure on their balance sheets and long-term pool, in the event that real estate markets fall and fiduciaries need to avoid losses on multiple balance sheet items. In many cases, it still makes sense for hospitals with direct real estate holdings to include an allocation to private real estate in the long-term pool. This is because of the diversified and differentiated exposures within a private real estate fund relative to the hospital's direct real estate holdings.
Other examples that we have addressed with clients through time include the issuance of floating rate debt or large underfunded defined benefit pension liabilities. Those can impact the enterprise's exposures to changes in interest rates in ways that could impact cash flow needs and / or the balance sheet. It can also be important to integrate a credit rating agency's views on the system including less liquid investments in the long-term pool.
Overall, it is important for fiduciaries to consider when cash flow needs and / or the balance sheet will most likely be stressed to help validate that the long-term pool is appropriately allocated for the enterprise's needs.
2. Optimizing implementation vehicles in the portfolio to suit the enterprise's income-generation goals
As discussed previously, for enterprises that report both realized and unrealized gains and losses on the income statement, the impact of these can only be managed through asset allocation decisions. However, for enterprises that only report realized gains and losses, there are a few more options. The annual impact on the income statement can be managed through implementation and rebalancing decisions.
Enterprises that only report realized gains and losses should set guidelines in advance regarding the extent to which controlling gains and losses may supersede the need to rebalance portfolio allocations to strategic weights. These enterprises will also need to decide if the income objective is to avoid realized losses or pursue consistent income. Fiduciaries can utilize different investment approaches to balance these needs, depending on the goal. In both cases, we are assuming the use of commingled funds, as the commingled fund structure gives investors the greatest control as to when gains are realized, rather than separate accounts which will trigger gains and losses whenever the portfolio manager trades underlying securities.
Avoiding realized losses
Health systems looking to avoid realized losses from the long-term pool should seek as broad of an investment vehicle as possible, in terms of the variety of asset classes included. This would help enable the portfolio to react dynamically to changes in the market environment within the single commingled fund vehicle. That way, the enterprise wouldn't have to worry that selling investments at a loss would trigger recognition of an accounting loss. This should also lead to the accumulation of long-term gains that the enterprise could opportunistically realize when needed.
If the long-term pool has short-term liquidity requirements, sufficient assets should be held in lower-risk investments to help ensure that cash can be provided by these vehicles without the organization sustaining realized losses. However, because you can accumulate long-term gains within the multi-asset investment vehicle over time, it is also less likely that even after a market downturn, losses would be realized in the sale of growth assets.
Pursuing consistent income
On the other hand, health systems looking to derive consistent income from their investments have an incentive to implement their portfolios differently from those focused on avoiding realized losses. Income-paying vehicles are probably the only way to produce income when all segments are experiencing losses. However, constant recognition of dividends and coupons as income makes it less likely that gains will accrue to be realized at a later time. This makes income-paying vehicles less useful for enterprises that are hoping to accumulate realized gains from investments. An organization could aim to accumulate gains either to offset expected declines in margins, or to be available in case there are unforeseen losses in other parts of the enterprise.
Another strategy for pursuing consistent income is using different investment vehicles for individual asset-class segments, rather than a single, broad multi-asset investment vehicle. The wider the array of investment vehicles, the more likely it is that there will be an accumulated gain in at least one vehicle that can be realized when income is needed. In other words, the old adage don't put all your eggs in one basket rings true here. We strongly believe in diversification, as it helps reduce drawdown risk, but in this case, having a diversified allocation to distinct funds also provides income-generation benefits.
In sum, there are several strategies that hospitals and health systems can implement to keep the long-term pool in step with the overall enterprise:
- Address common market exposures across the portfolio and enterprise
- Optimize implementation vehicles to meet income needs
An organization’s financial goals and circumstances can have a significant impact on its investment pools, so it is vital that fiduciaries weave these elements together seamlessly. We believe these strategies will serve fiduciaries well as they manage their investment portfolios to support their organization's needs.