Healthcare systems: Is your investment strategy aligned with the goals of the enterprise?
Executive summary:
- Amid higher interest rates and weakened operating conditions, we believe it’s vital for healthcare systems to ensure their investment strategies are aligned with the overall needs of the enterprise.
- When setting the investment strategy to align with enterprise needs, organizations should consider their risk tolerance and return objectives. Organizations with strong operations and financing conditions typically will be able to take on a higher level of risk. Conversely, those with stressed operational and financing conditions will usually have a lower tolerance for risk.
- Healthcare systems may want to consider splitting up their investment assets into two or three different pools with distinct purposes. Doing so can provide greater resilience to changes in operating conditions and financing capacity without requiring the committee to relitigate the strategic asset allocation.
Healthcare systems have had to navigate constantly evolving circumstances over the past few years. As rising interest rates have made the attractiveness of new debt financing less attractive for all systems, and many systems have had this compounded with weakened operating conditions, a focus has been put on the investment assets.1 This focus on investment assets is not surprising given the stability of the enterprise is often thought of as a balancing act—although with three rather than two sides. The three sides of this balancing triangle are the financing capacity, operating conditions and investment strategy of the enterprise. If one side of this triangle is undergoing stress, it is of greater importance for the other sides to provide strength and stability to the organization.
For enterprises that are currently experiencing stress in their operating conditions or financing capacity, ensuring alignment of the asset allocation and investment strategy based on overall enterprise needs and risk tolerance is of immediate importance. However, even for those enterprises that aren’t currently experiencing stress, ensuring alignment now can help position them to avoid future headaches.
Common drivers of risk tolerance
One of the first considerations in determining the ability to tolerate risk in the investment assets, is determining if there are any future liquidity needs. If the operating and financing conditions of the organization are strong, it is likely that there are no expected liquidity needs from the investment assets. However, the deterioration of operating or financing conditions over time could lead to the potential need for investment assets to fund operating shortfalls, capital projects or debt repayment. The possible need for liquidity from the investment assets will naturally reduce the tolerance for risk, as potential short-term losses would be crystallized.
Another key consideration in the ability to tolerate risk is the credit rating and potential debt covenants. The value of the investment assets is a component of key metrics used by rating agencies and commonly included in debt covenants such as days cash on hand (DCOH) and debt coverage ratios. Any investment loss would immediately lead to a deterioration of these metrics. Therefore, the ability to tolerate risk in the investment assets would be impacted by the extent to which an organization could tolerate a weakening in these metrics without breaching a debt covenant or falling to a level which could negatively impact the credit rating.
Common drivers of return objectives
Typically, we recommend that the return objective for the investment assets should be linked to the cost of debt, plus a cushion to provide for growth. Considering many enterprises could repurpose investment assets to pay down debt, or fund capital projects and avoid borrowing, there must be the implicit assumption that asset returns will be higher than the cost of borrowing.
For enterprises that cannot rely on positive cashflow from operations, but want to grow DCOH or debt coverage, that can also drive the return objective. In order to grow DCOH without positive cashflow from operations the return objective would naturally need to be higher than expense growth. This would likely require a significant premium above broad market inflation due to the extent that healthcare cost growth has outpaced the consumer price index (CPI).
Linking it all together
Given the ability of the financing and operating conditions to uniquely impact the above considerations for every organization, there is no one-size-fits-all answer.
For organizations with strong operating and financing conditions, there is often flexibility to take a high level of risk. These organizations typically have low expected liquidity needs and have DCOH and debt-coverage metrics solidly above peers and thresholds and could seek higher portfolio returns if desired.
Organizations with stressed operating and financing conditions may have the inability to tolerate erosion in DCOH and debt metrics, coupled with potential liquidity needs, creating a low tolerance for investment risk and losses. However, these same conditions could lead an organization to a desire to have investment gains grow DCOH to provide support while improvements in the operating plan are underway. These organizations are typically faced with the most difficult decisions.
Strategies for ensuring resilience through changing conditions
Once an enterprise understands what should be driving its investment strategy, it is still difficult to put in place an investment strategy that maintains alignment with enterprise needs if there are changes in the operating conditions and financing capacity of the enterprise through time. This has been of particular importance due to the ever-evolving circumstances many healthcare systems have experienced in the last few years. An organization that is currently having poor operating results, knows that a turn-around in their operating results is essential for long-term success—so the current conditions are not expected to last forever.
One strategy that we are seeing being increasingly embraced is the idea of segregating the investment assets into two or three asset pools with distinct purposes, often aligned with potential liquidity needs. In a simple example, a singular investment pool can be bifurcated into two investment pools. One investment pool that holds sufficient investment assets for any potential cashflow needs over the next 1-5 years. This short-term pool will have a conservative allocation, and along with ensuring stability for the assets that could be required for liquidity needs it will also naturally provide some stability to DCOH and debt coverage. The other investment pool will then be able to be allocated based on a true long-term investment horizon.
This structure can provide greater resilience to changes in operating conditions and financing capacity without requiring the committee to relitigate the strategic asset allocation. An improvement in operating conditions would likely result in positive cashflow that would be invested into the longer-term portfolio, as the needs for the short-term pool would be unchanged. This would lead to a natural increase in the risk level, and expected return, of the investment assets as a whole. On the other hand, projected weakness in operating conditions or a reduction in financing capacity would lead to an inclination to increase the value of assets in the short-term pool which would reduce the overall level of risk in the investment assets. This creates an overall investment strategy that is dynamic and responsive to the needs of the enterprise.
Historically many systems had a singular long-term pool with a moderate level of risk, and as liquidity needs and risk tolerance changed the committee would need to re-assess the asset allocation.
Concluding thoughts
There is no one-sized fits all answer given the unique needs of every healthcare system and hospital. However, the recommended approach of a holistic framework that includes the needs and concerns of the enterprise is an essential starting point for all organizations.
1 Although most hospitals and health systems have multiple asset pools, this blog focuses on the asset pools that contribute to key financial metrics for the organization and have an investment horizon of greater than one-year.