What should the decision makers do with healthcare’s larger cash position to achieve multiple goals?
Not surprisingly, that question is on the mind of senior financial decision makers everywhere. In recent years, healthcare M&A has spiked, driven largely by the rollout of the ACA, as well as the need for healthcare organizations to achieve scale and efficiency to improve margins. One of the benefits this activity has is greater cash on hand for healthcare organizations. This, however, has led to the law of unintended consequences, which is now in full effect as operating cash becomes a larger part of balance sheet assets and applies pressure on healthcare CIOs to achieve returns.
To understand how healthcare organizations are handling this, NEPC has created a survey and universe of healthcare peers.
Rethink Risk
Historically, healthcare CIOs have favored a significant allocation to cash and fixed income in their strategies. When interest rates were higher, this strategy could be relied upon to generate a consistent return with relatively low risk to boot.
However, in today’s low interest rate climate, achieving those same returns with a primarily cash and fixed income allocation is much more difficult, if not impossible. For example, investing in a two-year Treasury today yields less than one percent. As such, there is a high opportunity cost in addition to the risk of negative returns should interest rates rise. The concentration in cash and fixed income was thought to be a fairly low-risk strategy. However, given the environment, it has given rise to a new risk that healthcare organizations need to address – shortfall risk, the risk of not earning sufficient return.
Trying to balance this risk, along with the traditional investment risks, many healthcare organizations are beginning to reassess the role of cash and fixed income in the portfolio. To this end, they are looking to explore upping their risk/return profile through increased use of equities, alternatives (like hedge funds, private equity, private debt), and overall illiquid allocations.
Rethink Your Peers
Simply moving out of fixed income, however, to higher return/risk assets needs to be considered in the context of the organization’s overall risk profile and tolerances. Additionally, any movement out on the risk spectrum needs to be carefully weighed with how it may impact the organization’s Days Cash on Hand (DCOH) and overall debt rating.
What’s apparent in this new environment is that healthcare organizations need to have a better sense of what their peers (those with similar financial metrics and ratings) are doing, at least in the macro sense. While peer investing philosophy should by no means dictate an investment program, it does act to inform an investor on the risks they are taking relative to similar organizations. In the public pension world this is incredibly common, but since large operating pools are relatively new to the healthcare space, the sector is still playing catch-up.
Earlier this year, NEPC received data from several Healthcare providers, allowing us to obtain a good sample set of how Operating Pools are being invested and to create a robust healthcare universe. Among the key findings:
• Hospitals with above 300 DCOH and a debt rating of A or better tended to have better returns. On a five-year basis1 that group tended to generate an annualized return of four-to-seven percent, while those below that target had lower returns
• Regardless of DCOH or credit rating, the vast majority of hospitals appear to have the same appetite for risk – 10% or higher. Only 18% of respondents were appreciably below the 10% level.
• We’re seeing investments in non-core versus core fixed income. While it still remains a large allocation for many hospitals (majority of respondents were between 10% -30% allocation), the adoption of non-core allocations, such as absolute return fixed income, and alternative credit strategies, appears to be significant (majority between 10%- 20% of allocation). We believe this is directly tied to the low-rate environment and it appears to have no correlation to DCOH.
• Alternatives seem to play a major role (majority between 20%-40%) and the allocation seems to be highly correlated to DCOH.
As these organizations continue to focus on more return-seeking strategies, we believe the need to understand what peers are doing, as well as any industry trends, will be critical. And given what these organizations are asked to do, we believe the time has come to rethink the way we invest for the betterment of the industry and its stakeholders. The main goal of the universe is to be another tool that will allow providers to be better positioned to achieve these goals.
Dave Moore is a partner and team leader of NEPC’s healthcare practice. He’s actively looking for more healthcare providers to take part in the investment consulting firm’s research. Please visit the site to learn more.
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1 as of 12.31.15