Improving market conditions aid CFOs

Since the recession began, credit rating agencies have generally held a negative outlook on not-for-profit healthcare providers in the U.S. The Affordable Care Act has not helped. The squeeze on hospital and health system margins shows no sign of letting up.

In this difficult environment, many providers are looking to investment portfolios for some relief. The goal of bolstering revenue with higher investment income makes sense given a bullish stock market and low interest rates.

“With pressure on margins, we just don’t have the cash flow we had in the past,” said Charles Santangelo, CFO at not-for-profit Susquehanna Health, a four-hospital integrated health system based in Williamsport, Pa. “We’re not alone in this. Many organizations I talk to all comment on the operating margin pressures.”

A case in point is Essentia Health, in Duluth, Minn. “We just don’t know how much the Affordable Care Act will affect our revenue streams down the road, although there is cause for alarm,” said Tom Crook, vice president of treasury services, at the integrated health system serving patients in Minnesota, North Dakota, Wisconsin and Idaho. “The legislation is similar to disruptive technology, compelling us to change in diverse ways.”

The squeeze is on

The Affordable Care Act has altered the traditional income paradigm for healthcare providers from a model where the institutions were paid for services to now where they are rewarded for the value of these services – the patient outcomes. With all payers injecting quality scores into their payment formulas, the revenue predictability that hospitals once enjoyed has been replaced by income uncertainty and worse – lower revenues overall.

This is the conclusion of Standard & Poor’s. The ratings agency posted a negative outlook in December for the not-for-profit healthcare sector, attributing it to a multitude of factors, including top line revenue constraints leading to operating margin and coverage compression, the impact of healthcare reform readiness activities, soft demand for the financially important inpatient business and emerging changes in the payment environment to value-based payments from fee-for-service payments.

“While we believe that many hospitals and health systems will manage this period of change and reform effectively, it is our opinion that even the strongest hospitals and health systems are, at best, only likely to hold existing margin and reserve levels while weaker providers will likely see ongoing operating margin and cash flow erosion and, eventually, balance sheet weakness, leading to rating deterioration beginning in 2014,” S&P stated.

The rating agency summed up its analysis with a comment that the sector is at a “tipping point,” explaining that the industry’s accelerating cash flow and operating margin compression are fostering incremental balance sheet deterioration.

The cash flow disruption caused by the healthcare reform is causing these and other providers to comb their investment portfolios for greater income opportunities. “The more investment returns we can generate, the better we will be able to deal with the revenue pressures,” said Crook.

“We are certainly relying on our investments to supplement our capital needs,” Santangelo said, “relying more on investment income to help fund whatever changes we need to make as a result of the act, in addition to just being more competitive.”

Diversification Strategies

That said, neither Susquehanna Health nor Essentia Health has extensively altered their investment philosophies specifically because of the ACA. Both continue to pursue what they consider to be a balanced approach to investment opportunities and risks.

The core approach of finance administrators at Essentia Health is to use a combination of Harry Markowitz’s modern portfolio theory (developed in the 1950s) and frontier calculations. Crook said they also apply a Monte Carlo analysis to test standard deviation and produce hundreds of possible outcomes. (“It helps us examine truly worst case scenarios,” he said.) Finance administrators wrap up the investment examination process by determining how much cash the company needs on hand to efficiently run operations, which is then compared to the other analyses. “This may all sound like rocket science, but it really isn’t,” Crook said.

Other healthcare providers retain an equally careful, if not conservative approach to their portfolio investments. Despite bullish stock market conditions, the investment policy at Schneck Medical Center dictates that it never invest more than 60 percent of available reserves in equities. “It’s for the sake of safety and security,” explained Warren Forgey, executive vice president and chief administrative and operations officer at the one-hospital healthcare provider in Seymour, Ind. “And we typically stay well below that (threshold).”

Schneck relies on two external investment advisers to manage portions of its portfolio and make investment decisions for us, Forgey said. “They know that we need to be free from significant risk and default.”

Consequently, the advisors steer away from riskier investment options. “Our focus is hitting singles and doubles; we’re not looking to hit home runs,” he said. “We just want a good batting average.”

Susquehanna Health also retains the services of institutional portfolio consultants to advise the board of directors on investment decisions. “Like other providers, we have a written set of investment policies and guidelines addressing asset allocation and other portfolio requirements,” he said. “With that in hand, the consultants advise the board, which makes the decisions.”

The low interest rate environment and the seemingly bullish stock market conditions have conspired to slightly alter Susquehanna Health’s asset allocation.  Approximately 55 percent of the portfolio is now allocated toward equities, with a threshold limit of 65 percent. Roughly 35 percent is invested in fixed assets and the remainder is a variety of other investments like real estate, which accounts for about 5 percent of the total allocation. While not particularly aggressive, the ranges and limits are higher than they were in past.

The higher limit for equities promoted the hiring of additional investment managers. The company now has seven equity managers, each focused on a particular segment like international value, large cap value or small cap companies, and two fixed income managers, said Santangelo.

Overall, the tweaks have helped produce a banner year, investment-wise, for Susquehanna Health’s $180 million portfolio. “Our year end was June 30^th and it was a good one, in terms of investment income,” said Santangelo. “It put a solid $25 million on the bottom line.”

That is the kind of success that many CFOs would welcome in the face of revenue pressures down the line.