Aligning your long-term pool with enterprise objectives: Best practices for healthcare systems
Healthcare systems currently have a lot on their plate. Which is why setting the asset allocation for their long-term investment pool—based on a moderate risk balanced asset allocation and a nominal or inflation-plus return target—may seem like a simple path forward, and one less thing to think about. But this isn’t a step to take lightly. In order to reduce future headaches that may arise due to unintended risk within the long-term pool, we encourage healthcare systems to define their asset allocation and strategy based on overall enterprise needs and risk tolerance.
Defining the objective of the investment pool
Often the first conversation we have with new healthcare clients about their long-term pools is regarding the objective of the investment pool. Other non-pension asset pools may have nominal or inflation-plus return objectives, but for the long-term pool we recommend the consideration of a return objective based on the system’s cost of capital plus a premium.
When funding capital-intensive projects, healthcare systems often have two choices: fund it from the long-term pool or borrow. Given low interest rates, many choose to issue debt to fund capital projects. As long as the investment results for the long-term pool exceed the cost of borrowing, this is a good trade-off. Therefore, the investment objective of the long-term pool should be aligned with this goal. By explicitly setting the return objective as the cost of capital plus a premium, the system is setting a goal and can balance the expectations on the reward expected for maintaining additional debt and undertaking investment risk.
The higher the premium targeted above the cost of capital, the more the system can expect to generate additional assets and outpace the interest on its debt. However, more investment risk must be undertaken to achieve these beneficial long-term results. Specifically, we believe the analysis of the potential premium that should be targeted above the cost of capital should include an assessment of the risk level that would be associated with portfolios structured to achieve various return levels.
The importance of analyzing short-term loss potential
This is why we don’t view objective setting as an isolated conversation. It must be integrated with an analysis of the short-term investment losses that the system could tolerate. By analyzing the expected returns on the potential portfolios in stressed market environments, we would estimate the potential for short-term asset losses—and the impact of those losses on financial metrics that matter to the system. The constraints would vary by system, but all systems will have a point at which losses aren’t tolerable.
For a system with limited operating income that recognizes realized and unrealized losses on their income statement, the ability to undertake investment risk might be constrained by the potential dollar loss, as well as the tolerance for the impact that that would have on the income statement. Another system might be concerned about the potential dollar loss, as they expect to spend from the long-term pool in the coming years and may want to avoid spending from a depressed asset base.
For the typical system that isn’t looking to spend from its long-term pool, but instead might want to issue debt to fund upcoming projects, they could be more concerned about the impact of asset losses on Days Cash on Hand (DCOH) and the knock-on impact of a reduction in DCOH on their credit rating. The risk constraint for these systems would likely be driven by the potential DCOH reduction that could lead to a single-notch or double-notch downgrade, and this analysis would demonstrate which market environments might result in this for a given asset allocation.
DCOH could similarly matter to a system that doesn’t plan on issuing debt in the near future but has DCOH covenants in their existing debt. No matter the exact situation, most systems are exposed to the potential for asset losses at some point during a full market cycle, so it is important to understand how asset losses would reverberate throughout the enterprise. For the healthiest systems, a high level of risk may be tolerable, but for many there will be at least one pain point for which the system would be adversely impacted by losses in the range of expectations.
The bottom line
Compromises may need to be made, if on the onset the return objective is set at a level associated with risks that the system cannot bear. The described approach allows a healthcare system to ensure it has:
- A return objective aligned with its overall financial situation
- An asset allocation that supports the return objective
- Confidence that the asset allocation won’t introduce unacceptable risk to the enterprise
Ultimately, we believe this holistic approach will serve systems well in the long run as they position themselves to generate the required long-term returns to outperform their debt costs, but also protect themselves from damaging their financial health in an unbearable manner in periods of market stress.