Lisa Goldstein

The AHERF bankruptcy highlighted the importance of strong leadership and governance oversight of management in healthcare organizations.

At a Glance
Important lessons from AHERF's downfall:

  • Strong governance and oversight of management are needed to ensure accountability.
  • Disciplined growth strategies need to be supported by rigorous financial planning and feasibility analysis.
  • Physician integration is critical to grow market share, but needs to be methodical and measured.
  • Robust information systems are necessary to manage costs, maximize revenue, and provide differentiation in quality and clinical outcomes.
  • Disclosure of the financial performance of all of a health system's operations creates greater transparency and builds credibility.

July 21, 2008, marks the 10th anniversary of the bankruptcy filing and payment default of Allegheny Health and Education Research Foundation (AHERF). With $2 billion in revenue and $555 million of outstanding debt, AHERF remains the largest not-for-profit health system to file for bankruptcy. AHERF's downfall resulted from both external, industrywide forces and the organization's own management and governance failures. As they did then, hospitals today face a growing number of industrywide pressures, which-while different from those faced in 1998-make it increasingly difficult to maintain financial health and bond ratings. The ability to absorb these external challenges today will depend on effective management and leadership.

Moody's believes there are important lessons learned from AHERF's downfall that are applicable to today's analytical efforts to determine which health systems will be able to navigate future challenges. These lessons are as follows:

  • Strong governance and oversight of management are needed to ensure accountability.
  • Disciplined growth strategies need to be supported by rigorous financial planning and feasibility analysis.
  • Physician integration is critical to grow market share but needs to be methodical and measured.
  • Robust information systems are necessary to manage costs, maximize revenue, and provide differentiation in quality and clinical outcomes.
  • Disclosure of the financial performance of all of a health system's operations and obligations (including nonobligated entities) creates greater transparency and builds credibility

 

Industry Dynamics Continue to Challenge Hospitals a Decade Later

In 1998, the healthcare industry faced a number of challenges, some of which affected hospitals nationally and others that were more specific to certain regions. Nationally, these challenges included:

  • Cuts in Medicare reimbursement under the Balanced Budget Act of 1997
  • The presumption that capitation would be the predominant method of reimbursement, causing hospitals to enter into large capitated contracts without adequate information systems to control and monitor utilization
  • The growth of managed care, which placed pressure on commercial rates to hospitals
  • The frenzied acquisition of physician practices and high costs to purchase and subsidize practices
  • The shared philosophy that "bigger is better," which resulted in aggressive and sometimes failed hospital mergers and acquisitions
  • The explosive acquisition appetites of the for-profit hospital companies

Additionally, in the Philadelphia and Pittsburgh regions where AHERF operated, hospitals faced:

  • Highly competitive and overbedded markets with the presence of several reputable academic medical centers
  •     The domination of the health insurance market by one or two large commercial payers, which leveraged their position and reduced rates to hospitals

These last two issues in particular were key drivers in AHERF's aggressive growth strategies. Today, in 2008, new challenges are present, including:

  • A weaker national economy and several especially weak state economies causing increased charity care and bad debt expense, softer volumes, and more difficulty negotiating with commercial insurers
  • A looming workforce shortage, particularly in the area of physician specialists and subspecialists
  • More aggressive balance sheet strategies, which can present both upside potential and material downside risk
  •     Operating risks associated with the opening of major construction projects for many hospitals and health systems
  • Intensified need for sophisticated governance to respond to rising government scrutiny and oversee management's more complex financial strategies

Because not-for-profit hospitals in the United States receive on average half of their revenues from just two government programs-Medicare and Medicaid-federal and state funding and regulatory decisions have a disproportionate impact on the hospitals' financial positions. As in 1998, Medicare, especially, remains a key concern today given its huge claim in federal government revenues and forecasted deficit in 2019. Many market participants predict another large reduction in hospital rates similar to the reduction seen in 1998. Also, even more than a decade ago, not-for-profit hospitals remain under high scrutiny to justify their tax-exempt status.

Lessons Learned from AHERF Are Still Relevant Today

Although AHERF's challenges included the industrywide pressures discussed above, we believe its ultimate downfall was driven more by decisions of the organization itself-weak governance, poorly executed strategies, lack of refined leadership, and absence of methodical execution. Today, hospitals that have learned from AHERF's missteps are in a better position to weather the new challenges facing many hospitals nationally and preserve credit quality and bond ratings.

Strong governance and oversight of management are needed to ensure accountability. In our opinion, AHERF's board of trustees provided minimal guidance to a management team that dominated the system's decision making and was not held accountable for its actions. Controls on growth and capital investment were absent. Many systems that formed in the 1990s also underwent significant challenges stemming from the creation of "new" boards that were composed of "old" board members from their legacy organizations. Many of the boards still maintained an us-versus-them mentality whereby it was difficult to make decisions to benefit the new organization.

Governance is an important contributor to a bond rating and one of the five key factors in Moody's rating methodology. The credit impact of governance is often not observable in the short run, but frequently emerges during times of crisis-manifested through either strong leaders stepping in to address problems or a board's unwillingness or inability to handle serious problems. Ineffective governance that leads to unwise capital investments and unchecked capital spending-a key theme in AHERF's debacle-is often a contributing reason for financial troubles. Likewise, the unwillingness of the board to change ineffective or overly aggressive management is an indication of weak governance.

Today, as hospitals across the country seek to populate their boards with financial and industry experts, board members at the most successful organizations will use their expertise from their own professions to question management's strategies. These boards will educate themselves on the challenges in the industry and establish appropriate benchmarks to measure key financial and quality outcomes.

Disciplined growth strategies need to be supported by rigorous financial planning and feasibility analysis. AHERF pursued a very aggressive hospital acquisition and physician employment strategy to establish a statewide network in Pennsylvania and compete effectively with the other academic medical centers. Within a matter of a few years (see exhibit 1)

exhibit-1-The Failure of AHERF

AHERF grew from a single site facility, Allegheny General Hospital in Pittsburgh, to owning 14 hospitals in Pittsburgh, Philadelphia, and southern New Jersey. Furthermore, as AHERF added more hospitals through its fast-paced merger and acquisition strategy, it faced increasing difficulty in merging the hospitals due to different operating and medical staff cultures. As a result, the organization became overly complex and difficult to manage.

Today, the pace of hospital mergers and acquisitions has slowed, but we believe this pace could increase if the industry faces more pressures and struggling hospitals need partners. Additionally, hospitals today face similar challenges as they pursue growth strategies that involve construction of new hospitals or major expansions.

Moody's believes that disciplined growth strategies, including both horizontal strategies (adding more hospitals) and vertical strategies (adding other healthcare-related businesses such as physicians and insurance plans) can be successful over the long-term if supported by solid financial planning and realistic forecasts. The most successful organizations identify potential operating risks and challenges and articulate strategies to address various challenges. These healthcare systems are able to implement strategies on a timely basis, and adapt their plans if early indications suggest that goals may not be met. Additionally, these organizations do not overleverage their balance sheets and they phase in large projects, and the associated debt, to provide flexibility.

Physician integration is critical to grow market share but needs to be methodical and measured. AHERF went from owning no physician practices to employing more than 500 physicians in both markets in a matter of years, primarily through practice acquisition and paying high multiples for future earnings ("goodwill"). Losses quickly accumulated at the physician practices, which had no productivity measures in the contracts, creating greater pressure on the hospitals to subsidize physician losses. The accumulation of various physician practices failed to create a common culture; the strategy simply consolidated hundreds of physicians under one corporate structure with contracts that had little or no productivity incentives.

Today, many hospitals are pursuing a number of strategies to align with physicians and offering a "menu" of alternatives, including employment. Others are creating clinic models, which attempt to create one large multispecialty group that provides multidisciplinary services to patients. Regardless of the type of employment vehicle used, hospitals are being much more prudent and methodical in their selection of physicians. Hospitals are also developing effective productivity standards to ensure that financial performance is not unduly burdened with new costs compensating for physician losses.

Hospitals that approach physician alignment strategies more methodically and have the resources necessary to invest in these strategies will minimize the impact to their credit position. However, hospitals, like AHERF, that are unable or unwilling to control the cost of physician investment may more likely see a negative impact to their credit position or bond rating.

Robust information systems are necessary to manage costs, maximize revenue, and provide differentiation in quality and clinical outcomes. The lack of a larger number of payers in the Pittsburgh and Philadelphia markets left many hospitals, including AHERF's hospitals, with less control over payer strategies. In Philadelphia, 80 percent of the nongovernmental lives were enrolled in one of two plans, leaving the hospitals with little leverage when negotiating contracts.Given its large hospital and physician network, AHERF attempted to increase its leverage through a large exclusive capitated contract with HealthAmerica in Pittsburgh and Aetna/U.S. Healthcare in Philadelphia. However, AHERF did not have adequate infrastructure and technology to identify and manage the risk associated with capitation. AHERF's inability to manage this large contract was a contributing factor to its poor financial performance.

Today, information systems are even more critical to position a health system to manage costs, maximize revenue, and differentiate itself along clinical quality. Some hospitals have made progress in improving their information systems to better manage their costs and provide more efficient patient care while others are lagging behind. While we no longer see many exclusive contracts in most urban or suburban markets and very little capitation, payers have been consolidating, leaving hospitals more vulnerable to rate changes dictated by the payers. Having the right data allows a hospital to negotiate better contracts with payers and differentiate themselves on quality and outcomes.

Disclosure of the financial performance of all of a health system's operations and obligations (including nonobligated entities) creates greater transparency and builds credibility. The complexity of AHERF's organizational structure (see exhibit 2) 

exhibit-2-The Failure of AHERF

and lack of adequate disclosure resulted in difficulties in easily assessing overall financial risks and the interrelationship between various subsidiaries. Management did not prepare consolidated financial statements until 1998 and instead published separate audits on its various divisions that had public debt outstanding, despite the close relationship and frequent financial transfers between subsidiaries. Financial information on nonobligated members-such as the physician division, which required large subsidies from the hospitals-was not disclosed. Likewise, significant off-balance sheet structures were used to fund capital, namely in the form of operating leases, given the already leveraged position of the system with public debt.

Today, health systems are often even more complex, with various business lines and subsidiaries, some of which are legally obligated on their bonds and others that are not. Additionally, capital strategies are also often more complex today as health systems commonly use various financing vehicles to fund capital needs, some of which are off-balance sheet and pose "hidden" risks to the health system.

When analyzing large health systems, Moody's places great importance on systemwide operations, including the financial impact of nonobligated entities on the obligated group that issued the debt. Nonobligated group members often require, to the detriment of the obligated group members, large cash transfers for start-up costs or to supplement ongoing operations. Because many systems now operate as integrated organizations, we believe that analyzing consolidated financial information provides the best picture of overall financial health. Successful healthcare systems not only hold individual businesses accountable for operating performance but also take a system approach to managing and identifying both direct and indirect risks.

Navigating the Challenges Ahead

The failings of AHERF are numerous. This article touches on five of the most important lessons learned from the bankruptcy. Strong leadership and governance oversight of management are common themes that touch each of these lessons, and their importance cannot be overstated. As in 1998, strong leadership is needed today to help navigate the current and future challenges of the industry.

Lisa Goldstein is a member of HFMA's Board of Directors, senior vice president/team leader, Moody's Investors Service Public Finance Group/Health Care Team, New York, N.Y., and a member of HFMA's Metropolitan New York Chapter


The Moody's Report

This article is based on the report The 10th Anniversary of the AHERF Bankruptcy: What Have We Learned?, which was released by Moody's in July.

Publication Date: Friday, August 01, 2008

Login Required

If you are an existing member, please log in below. Username and password are required.

Username:

Password:

Forgot User Name?
Forgot Password?

If you are not an HFMA member and would like to access portions of our content for 30 days, please fill out the following.

First Name:

Last Name:

Email:

   Become an HFMA member instead