Integrating investment decisions with business objectives

There is little debate that the current environment is challenging healthcare finance executives to keep their organizations financially viable. While all three major credit rating agencies did not agree on the outlook for 2011, they agreed that there are significant concerns for future years.

 

S&P and Fitch have stable outlooks for 2011, yet both left open the possibility for a downgrade should financial conditions worsen. Moody’s issued a negative outlook for 2011, in part because they feel that many of the future concerns have already started to materialize.

 

The expectation is that most healthcare organizations face significant challenges in generating revenues, controlling expenses and managing the overall balance sheet. Revenues are expected to decrease from all major payers including Medicare, Medicaid, commercial insurers and overall donations. The reasons for the expected decrease range across state and federal reductions in reimbursements, membership losses on the commercial side and the expiration of stimulus spending.

 

Additionally, many healthcare organizations are finding it difficult to reduce expenses after two straight years of doing so. Further reductions will also be difficult in light of the cost of implementing healthcare reform. These additional costs come at a time when one could argue that the need for capital access has never been greater.

 

The sector has large expenditures on the horizon given IT requirements related to healthcare reform and deferred capital spending over the last two years. Other strains on the balance sheet include under-funded pensions and negative swap valuations forcing collateral posting. Healthcare finance executives, boards and investment committees are being forced to deal with all of these complicated issues on a nearly daily basis.

 

How can integrating investment management help?

In response to these challenges, new, innovative strategies need to be developed, and healthcare organizations have never been more dependent on external expertise from their various partners. From an investment management standpoint, historically most healthcare organizations had primary objectives focused on total portfolio return, but many are now taking a more organizational risk-focused approach.

One example on how this approach can help would be a creditor insisting on a dollar-for-dollar match of all variable-rate exposure, essentially requiring the organization’s unrestricted invested assets be pledged to the creditor. The decision to enter such a covenant must consider the “domino impact” on all of the organization’s financial objectives.

 

For example, what if in attempting to accommodate the creditor’s request, the organization also has a financial goal of staying within predetermined performance bands around “days cash on hand” and “cash to debt ratio?” The organization would need to create a cash reserve large enough to pledge to the creditor while also generating enough investment returns to stay within the targeted credit metrics.

If returns were below expectations, additional pressure would be put on operations to support balance sheet growth.

 

The asset allocation needed to support these goals would be conflicting, with one allocation being detrimental to the other goal. One solution might be to separate the unrestricted investments into two pools where one would be the cash reserves equal to the amount of newly issued letters of credit and the other pool would be to implement a return enhancement strategy.

 

The first pool could have an allocation of cash and shorter-duration fixed income to help negate principal risk associated with market volatility and interest rates movements. The second pool could have a return-focused allocation featuring domestic and international equities, real estate and alternative investments.

A focus on organizational risk in portfolio decisions can also have a positive impact on an organization whose primary objective is to maintain and improve its existing “Debt to Capitalization” ratio. This objective would create a need to control volatility, match or exceed the organization’s interest expenses on its debt, and generate sufficient returns to buffer the amount necessary from operations to rebuild the balance sheet.

 

Understanding these objectives when making portfolio decisions could lead to the decision to reduce equity exposure while increasing the allocation to fixed income, with an emphasis on specific durations designed to minimize interest-rate risk. These changes would be designed to decrease the portfolio’s standard deviation while still maintaining acceptable levels of return.

 

These are very specific examples, but demonstrate that considering the invested assets and their allocations is a critical part in overall financial concerns. Gone are the days when investment committees designed return-focused asset allocations in a vacuum separate from other business discussions.