The Case for Keeping Dry Powder

The operating environment for healthcare systems continues to be difficult. Hospitals have been hurt by margin pressures, and unlike in 2020, there has been little government support to help alleviate significant operating losses. There are signs of stabilization as providers have made good progress in reducing reliance upon higher cost temporary contract labor, and the rate of inflation on wages, equipment, supplies, and services has decelerated. However, it is premature to say healthcare systems are out of the woods from cost pressures, and ultimate recovery toward normalized operating margins may take several years.

Strategically, capital spending needs continue to be high. Healthcare systems are executing cost management plans, streamlining day-to-day expenses, and increasing operating efficiency to help deploy cash toward multiyear investments in technology and new facilities. But cost rationalization can only go so far, and in many cases capital plans require the net use of cash. As the industry grows more competitive, those that fail to deliver become vulnerable to financial pressures, adverse patient market share trends, and credit rating downgrades. With these crosscurrents of capital demand and the ability to raise new debt compromised by higher market yields, investment liquidity is at a premium.

Impacts of the Rising Rate Environment

The Federal Reserve’s most aggressive tightening cycle in decades has resulted in a dramatic change in the interest rate environment. Rates spiked significantly, and the yield curve has changed from upward sloping to inverted, as central bank policy rates have driven short yields upward. Notably, the real (inflation-adjusted) interest rate on two-year yields has increased to positive levels of more than 2%, after many years of negative real rates in the past decade. Bottom line, yields have gotten interesting in both a nominal and real context (Figure 1).

This journey in interest rates had dramatically different impacts on each tier of capital on the balance sheet for healthcare systems. The shortest tiers held in cash and money markets for working capital purposes were stable, although such cash holdings lost value in real terms, given high inflation. Intermediate tiers—reserves for capital spending and other near-term purposes—suffered moderate losses given the fact that even low-duration pools were exposed to the abrupt spike in rates. And finally, longer-term tiers—invested in a mix of growth-oriented investments and core fixed income—incurred significant losses, given higher interest rate sensitivity and poor equity performance in response to the uncertainty created by extreme monetary tightening. Going forward, the sizing of these pools is an important discussion point. But as healthcare systems debate how to deploy excess funds between intermediate- and longer-term pools (with the trade-off of added volatility and lessened liquidity), we note that the pendulum has swung in favor of short duration by virtue of the extreme increases in interest rates.

Opportunity Cost or Gain?

For the first time in years, healthcare systems can earn decent returns on their dry powder. Previously, the decision to park funds in intermediate pools came at a cost, with low yields failing to meaningfully outperform inflation. Now, inverted yield curves provide the highest yields on the shorter end of the curve. Higher short-term interest rates directly benefit investment assets in the intermediate tier. Investment mandates for these intermediate pools are typically benchmarked to high-quality indexes with short duration (one to three years). Benefiting from higher Treasury yields and slightly wider credit spreads, the yield on the Bloomberg US Corporate 1-3 Year Index has surged to more than 5% (Figure 2).

Over long periods, there has been an opportunity cost when keeping excess funds invested conservatively in short-duration bonds, as long-term investment pools typically outperform due to their equity orientation. While equities have pulled back significantly (MSCI ACWI fell 18.4% in 2022), equity valuations are still at levels above historical averages and the earnings outlook is underwhelming. With short-duration yields meaningfully higher and future equity returns highly uncertain, it is important to reassess the current opportunity cost of holding dry powder rather than deploying into long-term tiers.

To assess the relative value of short-duration bonds and equities, it is useful to monitor the earnings yield of equities—reversing the calculation of a price-earnings ratio and taking earnings over price. By putting equities and short-duration bonds on the same wavelength of yield, it is interesting to note compression between the two. As it currently stands, there is little trade-off between the inherent yield of equities and bonds (Figure 3).

Healthcare systems are in a uniquely favorable position to keep dry powder for capital purposes parked in short-duration bonds with far less opportunity cost. As excess assets become available, it may make sense (dependent on the institution’s specific circumstances) to deploy funds into short-duration fixed income for an interim period. The healthcare system gets the dual benefit of capital flexibility, given extremely high liquidity, while getting compensated with solid returns in the process.

Caveats of Favoring Short-Duration Bonds

The ability to earn yield with low-rate sensitivity is certainly welcome, but the decision to take advantage of this opportunity should be viewed as specific to the current environment. Longer term, as the level and shape of yield curves normalize, it is likely that longer-term pools will outperform short-duration pools. We note several key considerations as healthcare system executives determine the best course of action.

1. Rates may fall significantly. Rates can move quickly, as can the shape of the yield curve. The opportunity to earn solid mid-single digit returns on the front end may prove ephemeral, as yields could decline as rapidly as they increased. In such a scenario, short-duration pools would benefit from higher bond prices, but the subsequent lower yield may be insufficient for future budgeting purposes and necessitate a reevaluation of pool sizing.
2. Bond yield is different from equity yield. The yields inherent in fixed income and equities do differ in character, as equity returns benefit both from current earnings streams and the potential for future growth. As a result, equities are likely to outperform short-duration fixed income over longer periods of time, given the ability to grow cash flow streams.
3. Equities could rally significantly. If global central banks win their battle against inflation and engineer a “soft landing” with sustainable growth, equities will likely benefit from normalized policy rates with associated lower yields (lower discount rates and costs of funding) and an appetite for “risk-on” assets, at a rate that could exceed the annualized yield of short-duration bonds.
4. Rates may rise significantly. It is possible interest rates may climb higher, presumably due to another upswing in inflation that causes central banks to raise policy rates beyond expectations. In this scenario, short-duration bonds may incur losses, but at much milder levels than losses inflicted upon longer-duration bonds and equities.

Getting to the Right Answer

Capital allocation decisions are seldom binary, and healthcare systems are best served by studying multiple iterations of investment outcomes. High yields on short duration provide good support on return expectations, but pool sizing and portfolio construction should be informed by the strategic role in portfolio first, and by the opportunity set second. If an enterprise review validates the ability to align investments with an extended long-term time horizon, those assets ultimately should make their way into long-term investment pools, even if done gradually in implementation. High income potential on low-risk short-duration bonds provides healthcare executives with a degree of freedom in keeping capital flexible during this period of uncertainty for the sector.

The post Inverted World: The Attractiveness of Short-Term Tiers for Healthcare Systems appeared first on Cambridge Associates.

These complex dynamics affect liquidity needs, investment pool sizing, and portfolio strategy for healthcare providers. To implement a successful long-term investment program, a hospital system must first be clear about liquidity needs and risk tolerance. In this environment, the investment playbook may call for building a solid defense—which means right-sizing near-term and long-term assets and securing sufficient liquidity—before playing offense in the implementation of a long-term investment strategy.

Financial Pressures

Many healthcare enterprises are expecting compressed operating and cash flow margins throughout 2022, as expense growth outruns uneven revenues. According to a recent Moody’s outlook, operating cash flow could decline between 2% and 9%, primarily driven by expense growth. The most significant disruption on the expense side is staffing shortages—especially among nurses and other skilled workers. This dynamic will drive up wages and labor costs, which represented more than half of health systems’ total expenses in 2020. The staffing cost outlook is difficult, as it will require significant effort and compensation to adequately retain physicians, nurses, and staff who suffer from burnout. Supply chain disruptions, inflation, increasing drug costs, and investments in cybersecurity will only exacerbate expense escalation that will place downward pressure on margins.

Capital expenditures are also expected to increase in 2022, as many hospitals deferred projects and decreased routine maintenance to preserve liquidity in 2020 and 2021. Capital needs are shifting dramatically as healthcare delivery shifts away from traditional in-patient treatment at hospitals toward clinics, local venues, and home settings. Exponential growth is still occurring in telehealth and digital strategies. While this transition is exciting, it requires agility as higher, more complex capital spending will be calibrated on a shorter capital cycle than what healthcare systems have traditionally encountered.

On the revenue side, shifts in patient volumes and reimbursement rates may suppress revenue growth in 2022. Patient volumes have recovered to varying extents but are still subdued compared to pre-pandemic levels. More profitable elective procedures are at risk of being cancelled or postponed as the labor shortage persists. If additional COVID-19 variants arise, they could further disrupt elective surgeries and will inhibit revenue growth more. Reimbursements from insurers are likely to increase modestly and may be insufficient to keep pace with inflation and staff costs, as commercial payers are exerting more leverage in negotiating lower prices for patient care. Relatedly, Medicare and Medicaid provide lower reimbursements than commercial insurance, and revenue from these programs is steadily increasing as a share of reimbursement and as a percentage of total gross revenue.

Healthcare system balance sheets were substantially strengthened by federal and state stimulus efforts in 2020, such as the CARES Act funds. Liquidity metrics were bolstered during 2021, but additional funds are unlikely, and some of this liquidity benefit will reverse as Medicare advances are repaid between April and September. Additionally, 50% of any deferred payroll taxes from March to December 2020 are due to be repaid by the end of 2022. Taken together, these repayments will decrease days cash on hand by a projected 30–40 days in aggregate. Balance sheets will also lose the highly favorable tailwind of low-interest debt issuance as higher rates are a reality across the yield curve. While spreads are still at favorable levels, healthcare systems can expect significantly higher average coupons on issuance.

In short, many healthcare systems came through the combined operating and investment market shock of the pandemic in good financial shape, thanks in part to increasing financial strength leading up to the pandemic, strong support from the government during it, and the relative brevity of the market correction. But we don’t know exactly what the next crisis will look like. Uncertainties around operating pressures, a more prolonged market correction, and rising interest rates could challenge the financial model and access to capital markets. Given this backdrop, many healthcare systems may need to rely more strongly on reserves and investment assets to support operations and capital initiatives.

The Investment Playbook: Ensure Sufficient Defense Before Deploying Offense

If combined with a negative investment market environment, the confluence of revenue and cost pressures, capital initiatives, and balance sheet complexities could create a perfect storm of financial stress for a healthcare system. Given this risk, we recommend ensuring there is sufficient defense to weather a difficult period before playing offense with truly long-term investment assets.

The right level of defense will vary in different conditions, but taking these steps can help determine potential liquidity needs. Considerations include:

• The pace of flows from operations into the long-term investment portfolio (LTIP). With operational cost uncertainty and pandemic-to-endemic transition, what is the likelihood the pace will continue, slow, or even reverse?
• Potential capital demands on the system over the next several years (capital expenditures, possible acquisitions). Which of these which are unavoidable (or potentially unexpected)? If operating margins are compressed, or if debt funding becomes less attractive, how might the system meet those demands? Could any plans be delayed?
• In light of the above, the use of an “intermediate pool” representing potential near-term demands on the system. This can be invested in short-duration, high-quality fixed income capable of generating at least some return while the system navigates potentially choppy waters.

With an understanding of potential liquidity needs, the system can then test its assumptions with some high-level modeling to help to assess the financial impact of a combination of dynamic variables.

Putting the Playbook Into Action: A Case Study

In our case study, we use Cambridge Associates’ Portfolio Enterprise Risk (PER) model to inform a hypothetical hospital system’s decision about how much of its assets should be invested for the long term and how much should be kept in reserves. We often turn to the PER model—a projection model that incorporates operating, capital, and investment assumptions—to analyze the intersection of enterprise and investment strategy and to better understand the implications for asset sizing. In this scenario, the hospital system has $1.2 billion in assets and has determined that it may potentially need $200 million of those funds. The system is deciding whether to invest the $200 million in the LTIP to generate higher returns or to keep it in safer, short-duration investments as a cushion against an uncertain operating environment. It is helpful to analyze the decision in a shorter-term framework that matches the need for the liquidity, so we model a five-year period.

For this hypothetical hospital, operating surpluses have historically been invested in the LTIP, but the hospital’s compressed margins are now expected to break even for the next few years, limiting future contributions. Given more constrained cash flow and the potential for capital funding needs, acquisition opportunities, and possibly constrained access to debt markets, we assume that the $200 million will be needed during the five-year window of this analysis. We model withdrawals of $100 million each in years two and three, and we pair the liquidity needs with investment market stress.

In the case study, we use the PER model to compare a conservative allocation approach with an aggressive approach. The conservative approach plays defense by placing the $200 million in a short-term bond portfolio as an added cushion against an uncertain environment, while the aggressive approach plays offense by investing the $200 million in the LTIP in hopes of earning higher returns. We assumed the short-term bond portfolio is made up of laddered bond instruments that result in an annual return of 1.2%. Figure 1 shows the breakdown of the system’s aggregate asset allocation in each approach.

To simulate an investment stress scenario, we model three years of negative returns for both stocks and bonds using Cambridge Associates’ Inflationary Bust assumptions, followed by two years of our Return to Normal assumptions, which estimate positive, though somewhat muted performance. The result of this prolonged investment stress, even followed by two years of positive returns, is a meaningful decline in the LTIP over the five-year period. The system’s substantial declines in investable assets are exacerbated by the timing of the outflows during years of negative returns. In this investment stress scenario, the conservative portfolio’s $200 million in additional short-term reserves cushions the blow, declining 27.1%. The aggressive approach suffers a greater drop of 30.8%—a net difference of $43 million (Figure 2).

Perhaps a more direct way to look at the trade-off between the two approaches is to consider what happens to the assets in two different market environments. If the system experiences a benign market environment, in which the long-term portfolio generates positive returns (our Steady State scenario returns 6.3% annually for all five years), the aggressive approach that invests the $200 million in the LTIP generates $40 million more than keeping it in reserve. But, in this benign environment, either allocation provides ample resources for spending, with money left over to be directed however the system sees fit. The Steady State scenario assumes positive economic growth but reflects current (high) asset class valuations. The return assumptions resulted in an annualized return of 6.3% for the long-term pool over the five-year period.

However, the inflationary bust puts the risk tolerance to the test: in this environment, the conservative approach that places $200 million in the bond reserve gains in value, with money left over after spending. In contrast, the $200 million invested in the LTIP loses $30 million by the time the first withdrawal is made and even more before the second withdrawal comes out, forcing the system to dip into other funds invested in the LTIP to meet spending needs. Depending on your perspective, the $34 million gain from the more aggressive approach in a benign environment may not outweigh the pain of the $43 million loss in a more difficult one (Figure 3).

This analysis shows that the long-term investment strategy may not be the right fit for assets needed in the near term unless the hospital system can find other funds to replace the $200 million or defer spending. With that flexibility, the funds can be invested in the LTIP with a long-term time horizon and withstand short-term volatility and potential loss in value.

Every hospital system will have different sensitivities to various inputs. Developing a scenario analysis that reflects a system’s unique circumstances can help inform whether a system has the wherewithal to withstand a rocky environment in pursuit of higher return, or whether it is more prudent to shore up defenses to weather any potential storm.

Conclusion

With confidence in its defense, a hospital system can move to its long-term investment strategy to play offense. There are a few approaches that can build performance and protect needed liquidity:

• Be aware of where you’re playing offense and defense at the total enterprise level. If you have accounted for potential demands on the system outside the LTIP, it may not be necessary to increase liquidity or defensive assets within the LTIP.
• If not, consider taking a “barbell” approach to liquidity within the LTIP: maintain (or continue to build) exposure to private investments that will drive returns, but make sure your bonds are high quality, liquid, and of sufficient duration to provide a hedge against a prolonged equity downturn.
• Scrutinize “tweeners”—hedge funds or credit strategies with longer lockups—that may not offer the same bang for the liquidity buck.

There is no one-size-fits all solution when it comes to determining the sizing of assets and time horizon of investments, especially in the dynamic environment of investment markets and hospital enterprises. In this paper, we have provided examples of modeling that can help test assumptions and assess the risk and return implications of decisions in different environments. Ultimately, each hospital system needs to assess their specific conditions and tradeoffs to find the appropriate balance between defense and offense.

Billy Prout also contributed to this publication.

The post Healthcare System Investments: Play Defense Before Offense appeared first on Cambridge Associates.

Sami Inkinen, CEO and Co-Founder of Virta Health discusses how his company is treating and reversing diabetes through an app on your phone. We also speak with Jasmine Richards, Cambridge Associates’ Head of Diverse Manager Research; Tuoyo Louis, Co-Founder of Seae Ventures; and Rochelle Witharana, CFO of The California Wellness Foundation.

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During the past decade, nonprofit healthcare providers have undergone a wave of accelerating consolidation. The trend toward mergers and acquisitions (M&A) has been driven by growing capital intensity of the healthcare industry, significant benefits of scale negotiation with payers and vendors, operational synergies, and technological demands. We believe this trend will persist, as smaller systems are compelled to align or merge with larger systems, and larger systems contemplate “mega M&A transactions” to expand their geographic footprint by forming large systems with expansive regional or intra-state coverage. Fiduciaries of systems during an M&A transaction should take a refreshed analysis of how the long-term investment pool (LTIP) is structured post-consolidation based upon the known financials of the combined entity.

LTIPs exist in most healthcare systems, representing the aggregation of free cash flow generated by the system, as well as endowed assets, but are kept distinct from healthcare systems’ working capital. Many LTIPs have increased through effective growth in margins and compounding of returns. The LTIP represents critical capital that the healthcare system can tap in future years for operational needs, capital improvements, debt support, and other needs for the enterprise.

We highlighted the importance of developing thoughtful risk/return profiles for LTIPs in prior publications, depending on objectives, risk tolerance, financial strength, and other factors. But how should a profile change if an acquisition is underway? Because every transaction and system are unique, we offer key considerations that guide answers to that question. Integration risks that may arise when healthcare systems undertake M&A transactions must be evaluated carefully, not only operationally, but also in terms of the potential impact the transition may have on the structure of the LTIP and the role it plays in the combined entity. ¹ To help specify how an M&A transaction might impact the structure of LTIPs, we offer two hypothetical scenarios later in this paper.

System Finances and LTIP Implications of an M&A Transaction

Given the importance of debt for healthcare systems, how the rating agencies assess an M&A transaction is crucial. Questions around the transaction that may impact agencies’ analyses include:

• Is there a cash outflow or inflow to the LTIP from the acquisition?
• What is the track record of the management team in mergers?
• Are there sizable unfunded pension liabilities?
• Will the combined entity fully consolidate balance sheets and income statements or keep them separate; and will there be separate governing bodies?

In some instances, the target entity retains authority on how to invest its specific LTIP and manage its specific income statement. This is all dependent upon the terms of the transaction. Ratings agencies sometimes view consolidation of governance and assets as offering stronger decision making, efficiencies, and scale. However, each system has a different perspective on the best solution and timing around any consolidation.

Some mergers have caused the acquirer to issue taxable debt to enhance days cash on hand (DCOH) ² and other key metrics supporting debt ratings. At the same time, an acquisition may require the acquirer to expand working capital funds kept outside of the LTIP. There are many operational variables that dictate how successful an acquisition will be in fulfilling the expected financial strength of the new combined entity.

To distill the impact of a transaction on the combined LTIP, a thorough understanding of the acquired system is needed.

• What are the key financial metrics of the target entity and how large is the system relative to the acquirer? (i.e., margins, days cash, market share, debt and related covenants, and any contingent debt such as swaps)
• How do these financials compare to the acquirer?
• What are the long-term goals of the combined entity related to capital plans, future growth and/or acquisitions, borrowing needs, margin expectations?

Although the long-term prospects for the combined entity post-merger may be strong, it may be prudent to reduce risk in the acquirer’s LTIP if the financials of the target entity are weak. This would be most relevant in a merger of similarly sized entities. At the same time, if the financials of both systems are roughly the same, no change may be needed. If the financials of the target entity are stronger, greater risk could be taken in the LTIP to seek stronger returns. Therefore, differing sizes of the merging entities, as well as the financial strength of each entity impact the risk/return profile of the LTIP.

Re-evaluating the LTIP Post-Transaction

Once a holistic financial view of the integrated entity has been assessed, those overseeing the LTIP should estimate how quickly a net benefit will be expected from this combined entity if it is consolidating LTIPs. Projected net inflows/outflows into the LTIP post-merger, as well as broader enterprise considerations, will likely necessitate a re-evaluation of the LTIP’s investment strategy, including appropriateness of the strategic asset allocation and liquidity needs. Also, the portfolio should be evaluated to determine if return seeking/illiquid holdings should be added or if it’s more effective to de-risk and hold greater positions in fixed income or hedge funds to moderate return and volatility. In the current environment, return prospects are slim for LTIPs heavily weighted in defensive fixed income with moderate yields. We observe that the larger LTIPs (AUM more than $1 billion) during the past five years have added exposure to equities, both public and private, while reducing exposure to lower-returning fixed income and hedge funds. If systems can add illiquid holdings without impairing their debt ratings, they have often also expanded their targets in private investments across asset classes. We expect that trend will continue absent worsening financial situations.

These concepts may seem highly theoretical. Therefore, we offer two hypothetical scenarios to show specificity around how this might work in the real world.

Hypothetical Scenario 1: Two Large Systems Merge Where One Is Stronger Than the Other

What would happen to the LTIP if a large system with moderate financials acquired an equally large, financially distressed system within its region? Although the transaction might provide benefits in terms of expanding regional market share and operating synergies (due to beneficial vendor/payor improved terms), the combined entity may have weaker combined financial metrics, at least in the initial years after the merger (Figure 1). In this case, the target entity likely has few assets accumulated in its LTIP, given it has operated with negative margins for years. The acquirer LTIP in this scenario may need strong liquidity ratios and moderate volatility to support debt. Therefore, lower allocations to private investments and hedge funds may be warranted. At the same time, the LTIP positioning may require a more modest risk/return profile to maintain DCOH. As a result, this transaction may require the acquirer’s LTIP to increase its fixed income position to moderate volatility. In this scenario, it is likely that few, if any, board members or managers of the acquired system will sit on the Board of the new combined entity.

FIGURE 1 TWO LARGE SYSTEMS MERGE; ONE IS STRONGER THAN THE OTHER

Hypothetical Scenario 2: Two Financially Strong Systems of Different Sizes Merge

Another scenario is the acquisition by a large system of a similar rated, yet smaller system within its region that has financial metrics similar to the acquirer. Because the target system has cash flows that have contributed to their own LTIP, the new combined entity emerges from the transaction financially healthy. It is usually beneficial to combine the LTIPs to reduce oversight costs on the combined, larger LTIP. Benefits from combining in LTIP include adding exposure to higher returning illiquid strategies and ensuring growth sizing is appropriate with corresponding volatility (Figure 2). The expectation is that growth in market share, as well as synergies and scale, will benefit the new combined entity. It will be reasonable in this scenario to expect some Board members to join the combined entity Board but with minority voting power. In this case, the LTIP may lean into risk with the expectation that financial metrics will improve. A larger portion of the portfolio may hold growth assets, both liquid and illiquid private partnerships. The expectation of additional debt will need to be considered, which might mitigate this higher growth positioning.

FIGURE 2 TWO FINANCIALLY STRONG SYSTEMS OF DIFFERENT SIZES MERGE

Source: Cambridge Associates LLC.

Conclusion

Every M&A transaction is unique, and every healthcare system has specific strengths and weaknesses financially. When systems combine, the new entity created will have new financial health metrics. A fresh review of how a transaction will impact the newly combined LTIP is crucial. Transactions are undertaken for thoughtful and additive financial reasons to the enterprise in the long term. It is important to re-underwrite how the LTIP is structured post-consolidation based upon the known financials of the combined entity. The portfolio is a strategic component in the process. The industry continues to evolve, and Cambridge Associates stands alongside our clients navigating this complex environment.

Bridget Sproles, Managing Director
Jeff Blazek, Head of Healthcare Practice
Hamilton Lee, Managing Director

Footnotes

1. Nonprofit healthcare providers may call a transaction a membership substitution, merger, or acquisition. For the purposes of this paper, we will simplistically call it a merger.
2. Days Cash on Hand (DCOH) is calculated by dividing unrestricted cash and investments by the system’s average daily cost of operations (excluding depreciation).

The post An Investment Perspective on Healthcare System Mergers appeared first on Cambridge Associates.

What Has Happened and Where We Are

The COVID-19 crisis impacted investment portfolios and the operations of healthcare systems dramatically, but thankfully both are recovering. After the most rapid bear market in history and a 34% drop in global equities in a little over a month, stocks have more than recovered their losses to record levels, according to the MSCI ACWI in USD terms. Healthcare systems will look back at their first quarter 2020 balance sheet values as an adverse and (hopefully) brief low water mark.

The recovery in operational trends has been more complex. The pandemic’s evolution may be better categorized as a shift from sudden shock to more pervasive uncertainty. Elective procedures have recovered to varying degrees, but some healthcare systems are still confronting lower and less optimal operational run rates that may not recover to pre-COVID-19 levels in the near term. Healthcare systems have already made difficult employment decisions, including compensation cuts, furloughs, and layoffs. As the crisis has settled into this next phase of less acute but still challenging financial conditions, healthcare systems are balancing future operating expenses and capital initiatives against a backdrop of economic uncertainty and the reality that COVID-19 may persist for some time, even as vaccines are deployed.

An Opportunity to Recalibrate

As we stated in the initial days of April 2020, during what turned out to be the apex of the investment market crisis, it was imperative for healthcare systems to ensure immediate cash flow needs could be addressed and that long-term investment strategy be preserved as much as possible. We advocated determining liquidity needs, using as many levers as possible to raise needed liquidity (including drawing credit lines) before penetrating long-term funds. Once that exercise was completed, we emphasized the importance of rebalancing all portfolios back to target by adding risk assets, sticking to one’s long-term strategy to be positioned for recovery. The subsequent investment recovery has been rapid, but those that were agile and stuck to strategy with diligent rebalancing have been rewarded.

With investment losses largely recovered and volatility subsided, we believe this is a good time to refresh enterprise and investment models and reassess whether current portfolio structures are appropriate relative to the current outlook. We know that most healthcare systems conduct the exercise of an enterprise and strategic asset allocation review once a year, but we would advocate for conducting this review as soon as possible, even if “off-cycle.”

Scoping Out the Operational Outlook

An important initial step in conducting a thorough investment recalibration is weaving the new realities of COVID-19 into updated operational budgets and long-range plans for the healthcare system as an enterprise. While not as acute as the operating disruption witnessed during the early days of COVID-19, healthcare systems should refresh enterprise assumptions for the next several years and take the following steps to ensure a smooth transition out of the crisis.

• Model Multiple Stress Scenarios. Uncertainty will continue to be high with COVID-19, suggesting that systems should not anchor on one scenario when updating budgets. Fortunately, there have been many months of post-COVID operational trends that can be used to inform financial models around expected revenues and margins in a set of COVID-19 scenarios (“base,” “negative,” “severe”).
• Prepare for Economic Impact on Operations. Prior recessionary market experiences (2001–03; 2008–10) can be relied upon to inform how revenue may be pressured in the event of a prolonged recession driven by high unemployment. Healthcare systems can model adverse revenue mix shift, reimbursement pressures, potential bad debts risk on receivables, and other headwinds that have been experienced in prior recessions.
• Assess the Impact of Compressed Operating Margins. Most healthcare systems are operating at compressed (if not negative) operating margins, even if operating cash flow margins are maintained at a solid level. While throttling back capital spending and other cuts may help offset the adversity of these trends, it is important to adjust cash flow projections.
• Adjust for Strategic Initiatives and Capex. Healthcare systems must determine how much longer capital spending can be curtailed, as long-term cuts in capital cannot be sustained forever.
• If in a Position of Strength, Play Offense on M&A. Several larger and structurally well-positioned systems are fortunate to have maintained financial strength in this difficult environment. Those institutions have and will likely continue to play offense by opportunistically acquiring weaker hospitals/networks. If such a bolt-on strategy is in play, the investment portfolio must allow for incremental liquidity to help support such transactions.
• Determine Debt Capacity. While it is tempting to tap debt markets at record low financing yields, healthcare systems should balance the benefit from any new debt with how it could impact the system’s credit profile.

Resetting Investment Expectations

The investment return outlook for diversified portfolios appears challenging. Equity assets have fully recovered and hit record highs on depressed earnings and cash flow levels, further stretching the rubber band of valuation. Equity returns may be muted absent a recovery and acceleration in corporate profits. Sovereign bond yields are extremely low, resulting in less protection against downside shocks to risk assets. Additionally, credit spreads are relatively tight and provide little enhanced return if investors elect to take credit risk. Both equities and bonds offer these prospects in an uncertain economic environment, with COVID-19 looming as an existential risk. Reaching for yield in short and intermediate healthcare accounts has far less income potential than in prior history, yet the specter of equity price declines and/or seizing up of market functioning and liquidity cannot be ignored—a market crisis on par with March 2020 could always be imminent.

We believe it is imperative to update investment assumptions reflective of these valuation realities. As Figure 1 demonstrates, downward pressure on return expectations is a reality that must be acknowledged. Whether it be a more liquid orientation as expressed by our smaller clients ($1 billion and below), or a more alternatives heavy allocation that is typical of our larger clients ($1 billion and larger), return degradation relative to prior expectations is a significant risk. The expected return of portfolios using our “steady state” returns, which use asset returns reflective of current low bond yields, are over 2% lower when compared to expected portfolio returns using our long-term equilibrium expectations.

FIGURE 1 DOWNWARD PRESSURE ON RETURN EXPECTATIONS IS A REALITY
As of November 30, 2020 • Percent (%)

An update of the enterprise and investment model, using techniques described, will unfortunately lead to a downward re-rating of expectations on how robust investment gains will be for healthcare systems. The re-rating is a difficult message to internalize during such difficult times for healthcare providers, but it must be understood as future budgets and plans are created. Given this reality, systems should conduct the following steps to facilitate the most useful communication with the system’s executive leadership and governance.

• Assess Expected Nominal Returns. Extremely low bond yields mean that the primary lever to maintain nominal returns is to increase risk and equity orientation. But investors should be cautious about adding equity risk at the most expensive equity valuations in nearly two decades.
• Do Not Ignore Downside Risk. Lower-return expectations do not equate to lower risk; in some cases, asset classes have been cast as “return-free risk” given volatility can persist, yet terminal returns can be quite low. Using the updated operational scenarios from the enterprise review, many healthcare systems regrettably may have even less tolerance for downside risk than they did prior to COVID-19, as future operational cash flows have been impacted.
• Recalibrate the Investment Policy as Necessary. Uncertainty abounds about future outcomes of the economy and capital markets, but because there is higher clarity, this is a far better time to make shifts in investment strategy than in times of market duress.
• Keep an Eye on Covenants. Debt ratings have been resilient for most systems despite the operational and investment volatility resulting from COVID-19. Any meaningful shift in equity orientation or liquidity profile must maintain conformity with key financial metric thresholds to sustain debt ratings. Fortunately, the low cost of financing that most systems can use in raising new debt is a favorable development that helps offset some of the pain resulting from lowering expected returns on assets.
• Adjust the Healthcare Systems Budget for Investment Returns. After assumptions have been modified, models have been updated, and asset allocations have been reviewed, it is paramount to adjust expected return assumptions that impact other parts of the healthcare system budget. While many of these adjustments may result in lower expected income and gains from investments, it is better to set realistic expectations than to be disadvantaged by shortfall for the next several years.

It will be disappointing to many constituents within the healthcare system community to lower investment return expectations due to rich equity valuations and depressed bond yields. That said, this exercise is valuable in refining expectations and budgeting earnings that can be reasonably expected from a healthcare system’s investment assets. Furthermore, if lowered expectations result in a gap that is too large to bear, it may be worth considering making changes to the fundamental risk profile of the healthcare system—including potentially increasing portfolio equity orientation—to raise the range of expected outcomes. Healthcare systems will be most successful by balancing their operational acumen with strong execution on capital initiatives, tactical M&A, and optimized investment portfolios.

Jeff Blazek, CFA, Head of Healthcare Practice
Hamilton Lee, Managing Director
Bridget Sproles, Managing Director

Kristin Roesch and Clare Skillman also contributed to this publication.

Footnotes

1. Nonprofit healthcare providers may call a transaction a membership substitution, merger, or acquisition. For the purposes of this paper, we will simplistically call it a merger.
2. Days Cash on Hand (DCOH) is calculated by dividing unrestricted cash and investments by the system’s average daily cost of operations (excluding depreciation).

The post Healthcare Systems: Recalibrating for 2021 and Beyond appeared first on Cambridge Associates.

In this four part audio series, several of our investment practitioners share key insights on how they believe these changes will impact future investment strategies.

In this segment, Jeff speaks about the importance of liquidity for healthcare systems in the wake of the COVID-19 pandemic and how he guided clients during the market downturn in March and April. He goes on to discuss the present state of the industry and what he believes will be the long-term implications of the crisis.

Footnotes

1. Nonprofit healthcare providers may call a transaction a membership substitution, merger, or acquisition. For the purposes of this paper, we will simplistically call it a merger.
2. Days Cash on Hand (DCOH) is calculated by dividing unrestricted cash and investments by the system’s average daily cost of operations (excluding depreciation).

The post Reshaping Industry Audio Series: Hospital Liquidity appeared first on Cambridge Associates.

Sources of Liquidity

Of the responding hospitals, 88% already had a line of credit (LOC) in place going into 2020 and nearly half of them have drawn on those lines this year. Of the three hospitals that did not have a LOC in place, one does not intend to turn to a LOC or debt for liquidity; one has issued new debt; and one has established a LOC during 2020.

The LOC has been the most popular source of liquidity for the group. Most respondents (14) have increased their access to a LOC, and four more systems are considering increasing their LOC. Six hospital systems have already issued debt in 2020, and three more are considering issuing new debt. Only five respondents do not intend to increase their LOC or issue debt this year.

SOURCES OF LIQUIDITY
As of May 2020 • n=26

The Role of the Investment Portfolio

In 2020, we are seeing more hospital systems relying on the long-term investment portfolio as a source of liquidity. Ten respondents (38%) reported that they are spending from the portfolio this year, with seven of them reporting that the spending is in response to the COVID-19 crisis. Only three respondents had originally budgeted to spend from the portfolio.

Only one institution in our study reported that they have changed the target risk profile of the portfolio. Nearly 60% of the participants have rebalanced their policy since mid-February, indicating that the majority of hospitals are sticking to long-term policy targets despite the near-term enterprise disruptions.

Looking Ahead

Eighty-four percent of the hospitals surveyed are planning for a resumption of elective procedures within the next three months. The remainder expect to resume elective procedures in three to six months. This group includes hospitals in New York, Massachusetts, and Minnesota. The resumption of revenue-generating activities will be key to stabilizing hospital cash flows and balance sheets. ■

Tracy Abedon Filosa, Head of CA Institute
William Prout, Senior Investment Director, CA Institute 

Footnotes

1. Nonprofit healthcare providers may call a transaction a membership substitution, merger, or acquisition. For the purposes of this paper, we will simplistically call it a merger.
2. Days Cash on Hand (DCOH) is calculated by dividing unrestricted cash and investments by the system’s average daily cost of operations (excluding depreciation).

The post Hospitals Seek Liquidity to Get Through Crisis appeared first on Cambridge Associates.

Providers must take steps to respond to market uncertainty regarding their liquidity and capital in this environment. We provide a simple and easily customizable model to help you understand your healthcare system’s threshold as the financial position shifts from a manageable cash flow situation to a worsening one. Critical support for an investment pool during this extreme environment requires preparation, anticipation and intervention.

Systemic Stress

In parallel with the operational disruption, healthcare system investment assets have been hit hard by what has become the most rapid equity bear market in history. The plunge in equity prices has hammered long-term investment pools (LTIP) with high equity orientations. Compounding this pressure, healthcare systems have seen adverse investment returns in their short- and intermediate-term pools, as even high-quality fixed income markets have not escaped liquidity squeezes and price declines.

The most pressing issue is maintaining sufficient liquidity to sustain the healthcare system when the sector is under systemic financial and medical stress. This double whammy results from the healthcare system doing the right thing—focusing solely on providing the best care possible to those affected by COVID-19. Even with aid to come from the recent $2 trillion economic stimulus package, the cash outlays by healthcare systems in recent weeks are truly a black swan event: a low probability, unforeseen situation come true. Congress is expected to provide additional support to healthcare systems in the coming weeks, but as with any cash flow crises, timing is everything. The cash burn hurts.

Providing Critical Support

In this trying time, we offer the following enterprise and investment guidance as healthcare systems navigate the weeks and months ahead. Inevitably, these ongoing enterprise dynamics necessitate day-to-day check-ins with healthcare system leadership and require the finance office to provide daily cash on-hand information. Providing critical support requires an order of operations, starting with the most urgent actions to a stage where a health system can contemplate and plan for its future state:

1. Revisit cash flow needs. Utilizing the run rate of lessened (if not negative) operating cash flow in response to the pandemic, healthcare systems need to employ a conservative approach and extrapolate these operational losses into multi-month scenarios. Healthcare systems should stress test assumptions to the downside on lessened inflows from traditional sources (e.g., receivables collection extends, debt-issuance flexibility decreases, philanthropic gifts dry up in a recession). Some systems operating in geographies with more severe outbreaks may need to layer into these assumptions higher capex due to ramping up equipment and beds to handle surging COVID-19 cases.
2. Revisit cash flow sources. Healthcare systems should then map out the size and composition of all short and intermediate pools; focus on how much is immediately sellable and liquid (Treasury bills and short-duration Treasuries), and obtain pricing on short duration bonds and lines of credit, which will need longer lead time for sale (due to atypical liquidity markets and wide bid-asked spreads on many bonds). We recognize bond issuances may be more challenging in the months ahead as investors price in risks associated with COVID-19 and the healthcare sector.

Compare needs and sources, and develop a plan to raise liquidity for the near term. Healthcare systems should determine the order by which cash will be raised, and understand what impact, if any, net cash needs will have on longer term pools. A sensitivity analysis using a model as shown below can inform the enterprise’s ability to withstand further market drawdowns. By entering three inputs (unrestricted assets, one day’s cash needs, and minimum days cash on hand), the model suggests return scenarios in which the healthcare system violates days cash—a proxy we use to understand how much more risk a system can take, or if there is a need to de-risk. With the sensitivity analysis done, using conservative assumptions, institutions should work to determine how much liquidity may be required to carve out of the LTIP.

ONE DAY’S CASH ON HAND SCENARIOS 

1. Be willing to tap LTIPs now, and replenish later. Healthcare system leaders should remember that the LTIP, and a long-term, customized investment framework, were designed for today’s situation. As we mentioned in Mission Critical, these investment pools are constructed with the understanding that they are a two-way street. Healthcare systems have benefited for many years from healthy margins, philanthropy, proceeds from debt issuance, and other infusions. They are understandably are loathe to tap LTIPs, but these pools are designed to be tapped in times of stress precisely like the situation we face today. The enterprise should embrace using the pools to forestall future financial pressures, but such withdrawals from the pool should be carefully sized and implemented.
2. Once liquidity is addressed, develop a rebalancing plan. It is paramount to ensure all liquidity needs are addressed for the next number of months in the event more draconian cash flow scenarios materialize, given the high uncertainty of coronavirus. What remains in LTIPs should be rebalanced to maintain beta targets with equities, which are now more attractively valued than they have been in years. This will likely require selling bonds and hedge funds to purchase equities. The LTIP should have a very long time horizon, and rebalancing requires discipline in order to achieve long term gains.

Like the COVID-19 virus, much is uncertain about the near-term and longer-term impact of the virus on healthcare systems. While the medical staff tends to the sick, an action plan for reviving the enterprise is required: clear foresight around cash needs, cash sources, and other liquidity requirements; an understanding of the threshold at which a healthcare system puts itself in financial risk; and a willingness to be bold and tap the Long-Term Investment Pool to save a healthcare system from permanent financial impairment. These are the essential elements of an investment-oriented life support system for the enterprise.

Jeff Blazek, Head of Healthcare Practice
Hamilton Lee, Managing Director
Bridget Sproles, Managing Director

Footnotes

1. Nonprofit healthcare providers may call a transaction a membership substitution, merger, or acquisition. For the purposes of this paper, we will simplistically call it a merger.
2. Days Cash on Hand (DCOH) is calculated by dividing unrestricted cash and investments by the system’s average daily cost of operations (excluding depreciation).

The post Navigating Healthcare System Investments Through the Coronavirus Crisis appeared first on Cambridge Associates.