Healthcare systems are facing changing circumstances as they plot their future investment strategy. A number of trends over the past 10 years have converged, including:
- Faster growth in investment assets as compared to total debt
- Increased availability of external liquidity sources
- Disruption and uncertainty caused by the COVID-19 pandemic
- The ever-present threat of changing market conditions
These trends have created not only an opportunity, but a need for healthcare systems to re-evaluate their investment strategy in order to better position themselves for the future.
With improved liquidity comes newfound flexibility
Perhaps the biggest shift over the past 10 years is the growth in investment assets and associated liquidity. Following a period of strong returns, A-rated healthcare systems have generally experienced a faster increase in balance-sheet investment assets versus operating costs, giving rise to an increase in days cash on hand. This improvement happened despite somewhat unfavorable trends in operating margins:
While inexpensive debt has assisted in the expansion of system balance sheets, that increase has been considerably slower than the rise in investment assets.
Several factors have supported the faster growth in investment assets as compared to total debt:
- A decade of strong investment returns, with a traditional 60% equities, 40% investment grade fixed income returning approximately 7.5%
- Manageable CapEx, with investment in facilities consistently of 110%-120% of depreciation, below the pre-financial crisis levels of 150%-160% of depreciation
- Access to capital at unprecedented rates and tenor, borrowing at 3.5%-3.75% for 30-year funds, with an increasing percentage of fixed rate facilities
External liquidity has led to asset growth
Perhaps most critically, healthcare systems have avoided tapping their investment portfolios, even in periods of capital needs or operating stress, such as the COVID-19 pandemic. Over the past 10 years, healthcare systems have utilized external liquidity sources, including drawing on existing lines of credit, new debt facilities, or advance payments from Medicare, to mitigate demands on their balance sheets. This financial flexibility is especially critical in poor market scenarios. The biggest risk factor for any investor is not the volatility or drawdown of the portfolio itself, but capital demands made on that portfolio during those periods of market stress. Those forced capital draws in periods when the investment portfolio is experiencing poor performance will be the most damaging factor in determining long-run investment values. Limiting demands on hospital investment portfolios in those stress periods through access to external liquidity and strong treasury functions has not only supported portfolio growth, but carries implications for healthcare investment strategies going forward.
The experience of hospital systems in 2020 was particularly instructive. Markets fell precipitously in April 2020, with the Dow declining 37% of its value from February 12 to March 23. Restricted economic activity in response to COVID-19 forced hospitals to stop all but the most critical healthcare procedures. This dramatically impacted patient volumes and associated revenues, while expenses remained close to pre-pandemic levels. This resulted in an unprecedented decline in prospective operating margins, cash flows and potential need for financial support. However, rather than access investment portfolios to support declining cash flows, hospitals utilized new or existing lines of credit, as well as advanced Medicare payments. In perhaps the most critical period of need, hospitals avoided monetizing losses in their investment funds, allowing those funds to not only recover fully but experience the strong market performance of 2020.
On the horizon: Uncertainty for healthcare operating environment and investment markets
In addition to the changes in the operating environment over the past 10 years and the strong growth in liquidity, other factors necessitate a reevaluation of investment strategy going forward. Market conditions, always uncertain, are currently particularly so because of:
- Reflationary market conditions marked by rapid GDP expansion following the aggressive COVID-19-related economic shutdowns.
- Relatively high valuations across risky assets and very low bond yields: After years of strong equity returns, U.S. equities appear expensive, well above historic medians. Ten-year treasuries are yielding close to their all-time lows. Credit spreads for investment grade debt and high yield are very tight, limiting portfolio expectations.
- The first threat of inflation in a generation caused by the massive fiscal and monetary response to the COVID-19 crisis and the current strong economic rebound following many years of low and deflationary conditions despite aggressive central bank efforts.
- Large expansion of fiscal deficits and the Fed balance sheet, potentially distorting the price of government securities, while creating considerable debate regarding the amount of fiscal headroom available.
- Shrinking labor forces, with many countries facing declining and rapidly aging populations, potentially shifting consumption preferences and savings patterns.
- A new age of digital commerce and web connectivity increasingly rewarding scale and concentrating value in the largest global competitors.
These factors, following an unusually strong investment decade for both public equities and bonds, suggest reduced expected investment returns over the next decade, particularly for traditional public equity and fixed income asset classes. It is fair to say this environment is one no investor has ever faced, and should be approached with a fresh perspective. Healthcare systems, operating on fairly thin margins, face their own set of ongoing operating challenges. These challenges include:
- Rising Medicare and Medicaid payments as a percent of total revenues
- Increasing competition from non-hospital-based healthcare, including surgical and primary care facilities
- Shifting revenue formulas based on quality of outcomes rather than fee for service
- Flat to decreasing operating margins
- Accelerating technology demands with more rapid obsolescence driving spending
These factors may place future demands on investment assets that differ significantly from the growth and encouraging factors of the past 10 years. Potential demands may shift from uncertain, improbable, but potentially large unanticipated draws, to lower, predictable, but more consistent outflows. Examining the investment strategy now in light of these factors can better position healthcare systems for the future.
Implications for investment strategy: Revising mental models
In light of these challenges, healthcare systems should evaluate their strategy in regards to both investing and borrowing. Some of the factors to evaluate include:
- Reconsidering the investment framework or “mental model” of hospital investment structure
- Supporting return requirements by adopting a more sophisticated approach to portfolio construction, evaluating equity and fixed income allocations, as well as adding and expanding alternative investments
- Potentially accelerating borrowing under favorable terms, where financial headroom exists, adding those funds to the balance sheet, while managing market exposure through modification of the investment portfolio
Revisiting the hospital investment framework
Historically, hospital investment pools have focused on providing growth over time, as well as liquidity in periods of potential crisis. This hybrid model implied a blend of two different strategies within a single portfolio. A portion of the portfolio was a “rainy day” fund, focused on safety and liquidity, with the balance being a growth fund with a greater equity allocation, a lower fixed income allocation and a higher expected return. Hospital portfolios in 2010 generally reflected this blended approach seen below.
The experience of the last decade has indicated, for highly rated hospitals with strong access to capital, that the rainy day allocation may not be necessary. The ability to source capital externally rather than access the portfolio itself, as well as declining bond yields, makes this allocation potentially unnecessary and a drag on long-term expected returns. Hospital portfolios increasingly reflect this reality, with the share of alternatives increasing from 8% to 15% over the last ten years and fixed income allocations declining to 30%. The investment model is gradually shifting from a blended rainy day and growth fund to one focused on growth and capital preservation.
A new investment model for the coming environment
Hospitals seeking to continue to grow their asset pools while protecting their strong gains over the last decade likely require a continued shift in strategy. The challenge is that playing defense in investing is significantly harder than playing offense. Constructing portfolios designed to support capital protection, with less reliance on treasuries in a low yield environment, requires more diversified portfolios and expanded asset classes. The portfolios of the next decade will likely be characterized by several factors:
- Increasing allocation to private investments, both equity and debt
- Increasing allocation to market neutral strategies, including hedge funds
- Reduced allocation to treasuries as portfolio ballast
- Opportunistic strategies designed to take advantage of short-term opportunities
Thinking through the leverage equation
A related issue is to what degree healthcare systems should apply financial leverage to support operational goals, as well as add capital to their investment portfolios. Hospitals have experienced a positive decade of utilizing leverage to capture additional investment returns – financing expansion with borrowing in effect adds capital to the investment portfolio that would otherwise have been monetized and applied to capital expenditures. The ability to borrow long term, at historically low costs, under favorable covenants, can clearly be additive to investment returns through time. A decade of borrowing at 3.5%-4.0%, while enjoying portfolio returns of 7.5% or more, has obviously been a positive contributor to asset values. However, this is not without risk, as leveraged investing adds to the risks associated with the investment portfolio. Leveraged portfolios carry a higher implicit beta, or market exposure, as the unlevered beta of the investment portfolio is increased to the degree it is using borrowed funds. Bond or bank borrowing effectively offsets investment portfolio bond allocations, assuming they have roughly similar coupons and terms. The investment portfolio of healthcare organizations is both long- and short-risk management fixed income assets, netting out the portfolio ballast of lower volatility fixed income within the portfolio and reducing the portfolio beta dampening benefit of investment grade fixed income allocations.
Lower borrowing costs are not solely an appropriate rationale for borrowing if the only intended use is investing those funds in the market. Assuming the risk premium associated with investment assets is constant through time, lower borrowing costs should be related to lower expected investment returns.
Expected return = risk-free rate + (beta x equity return premium)
July 7, 2011 8.2%= 3.17 + (1.0 x 5.5%*)
July 6, 2021 6.9%= 1.37 + (1.0 x 5.5%*)
However, the addition of borrowed funds could potentially add to investment returns through time. The impact on credit ratings is typically significantly less than the incremental expected return over the cost of borrowing (often 10-20 basis points between investment grade credit ratings). This spread could widen significantly in periods of stress, constraining the ability to borrow funds in adverse markets. The additional borrowed funds should be viewed as sufficient to meet a range of capital demands under adverse conditions.
Considering next steps
Over the past 10 years, healthcare systems have benefitted from favorable investment markets and more readily available sources of external liquidity. However, in order to maintain these benefits in the longer term, including the growth of investment assets, systems need to re-evaluate their current investment strategy to prepare for the inevitable shift in these recently favorable trends. This re-evaluation should include examining the existing healthcare investment mental model through a lens focused on growing assets through a more sophisticated portfolio construction process.
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1) American Hospital Association, “Hospitals and Health Systems Continue to Face Unprecedented Financial Challenges Due to COVID-19,” May 2020.
2) Kaufman Hall, “Effect of COVID-19 on Hospital Financial Health,” July 2020.
3) Variable-rate debt. An emergence from today’s lower-interest-rate environment to a higher one would almost certainly spark a renewed interest in variable-rate debt. Between 1998 and 2008, variable-rate debt represented, on average, about 20% to 30% of total debt, with the total reaching a high of over 60% in 2008. By comparison, variable-rate debt has constituted about 20% of the total since 2008. Part of the problem with our current data is capturing the information from the banks, which are major providers of variable-rate lending via direct purchases.
For much of the past 10 years, hospitals have enjoyed the luxury of low fixed and variable interest rates. Thanks to a Federal Reserve policy to keep short-term interest near zero, hospitals of all credit qualities have been able to finance and refinance at long-term rates in the 3% and 4% range and short-term rates in single digits. But hospitals should not assume that there is no possible end to these circumstances. They should be prepared for the pendulum to swing back in the direction of higher rates.
4) Duff and Phelps Equity Risk Premiums 2011, 2021
The material included herein is based on the views of SIMC. Statements that are not factual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and constitute only current opinions that are subject to change without notice. Nothing herein is intended to be a forecast of future events, or a guarantee of future results. This presentation should not be relied upon by the reader as research or investment advice (unless SIMC has otherwise separately entered into a written agreement for the provision of investment advice).
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