Capital Finance

William F. Jarvis

In the post-reform era, robust endowments and strong development programs will become even more important for not-for-profit healthcare organizations.

Not-for-profit organizations could be said to be in the "deficit reduction business." The rationale for this view is that as soon as a not-for-profit opens its doors, it is faced with the task of finding the financial resources to defray current expenditures and provide for the future.

Not-for-profit hospitals and health systems rely primarily on earned revenue to fill this deficit. Payment from government and insurers forms the greater part of this amount, followed at a distance by other sources of direct income. To the extent that there is a surplus of revenue over costs, an organization can claim a positive operating margin. If the operating margin is negative, gifts and endowment income must make up the difference.

Over the past 20 years, Medicare spending has grown at an annual rate of 8 percent. The Affordable Care Act of 2010 aims to reduce that rate of growth to 6 percent per year, largely by reducing Medicare payment-a step that will have a profound effect on the revenue line, and the operating margins, of many hospitals.

Even now, operating margins are not static. Last year's Commonfund Benchmarks Study Healthcare Report-a nationwide survey of 85 not-for-profit healthcare organizations-showed an average operating margin of 4.2 percent among participants, a notable increase over the previous year's 2.9 percent. Significantly, participants with larger endowments reported higher operating margins. Average operating margins for organizations with endowments over $1 billion were 4.1 percent. Those with endowments between $500 million and $1 billion had average operating margins of 4.3 percent. Margins among those with smaller endowments were notably lower. Healthcare organizations with endowment assets under $250 million reported margins of just 2.3 percent.

This phenomenon is indicative of an increased dynamic of cost-cutting that is likely to continue across the industry over the next several years. Large hospitals and health systems have been able to increase their operating margins not because payment levels have increased, but because they have been able to reduce their operating expenses, increase operating efficiencies, and capture greater economies of scale. Anticipating decreased payment over the long term, large healthcare organizations are acting now to reduce their cost structure.

Smaller healthcare organizations appear not to have been able to restructure themselves to the same degree, and as a result, their operating margins are increasingly squeezed. The newly enacted healthcare legislation and other cost-control initiatives tend to favor large-scale health networks that have the ability to control costs over a greater number of patients and sites. Local and community hospitals, lacking that scale, may well find themselves forced to create their own networks, merge with a larger network-or risk going out of business.

Endowment Assets Taking Center Stage

If we are entering an environment in which the revenue side will be more constrained, it seems inescapable that a healthy endowment, aided by a robust development program, will be required to support reduced or negative operating margins and to enable a healthcare organization to make the capital investments and strategic expenditures necessary to remain abreast of advances in the industry.

Endowment assets thus become more important than ever for the long-term support of the not-for-profit healthcare sector. Here, the question is not merely the size of the endowment, but also the rate at which it can grow over the long term-a factor that is governed not only by asset allocation and investment practices, but also by the strength of the organization's development and fund-raising capabilities.

As is well known, healthcare organizations have larger allocations to asset classes and strategies that are less likely to generate growth in real terms. For example, compared with higher education endowments and most foundations, healthcare organizations have larger allocations to fixed income and short-term securities/cash. In this regard, the traditional requirement of rating agencies for hospitals to possess a certain amount of days' cash on hand has undoubtedly been counterproductive: It has led healthcare organizations to underperform compared with other types of not-for-profits over the years.

Recent signals that rating agencies may be prepared to be more flexible on asset allocation issues may foretell an acknowledgement on their part of the need to balance portfolio liquidity with the increased total return that comes from a greater equity bias in an organization's investment policy. Similarly, a portfolio structure that is more aligned with that pursued by other large not-for-profits, such as educational institutions, may be a harbinger not only of higher total return, but also of a more consistent development narrative within healthcare organizations as they approach donors and the public.

For smaller hospitals and health systems with few endowment assets, active development efforts to increase gifts and donations will be critical. These organizations will need to find ways to differentiate themselves so that donors will be attracted by their mission and value to the community. Ironically, in previous years, the Commonfund Benchmarks Study Healthcare Report has shown that the largest organizations are not as reliant on their endowments as are some of their smaller counterparts, thus sharpening these smaller organizations' urgency.

Building Endowment Assets

Larger hospitals and health systems have seen the future and are taking steps to reduce costs and tighten their organizational structure. With more substantial endowments to support operations, they have a significant resource to help them adapt to the more stringent demands of the new regulatory environment.

Smaller hospitals and health systems already are examining how to achieve greater efficiencies within their own organization and possibly merge operations to form more competitive entities. Along with these actions, they will need to focus on building endowment assets and making the case to donors via a strong development program. These are long-term tasks that will determine the competitiveness, and perhaps sustainability, of many smaller hospitals and health systems.


William F. Jarvis is managing director, the Commonfund Institute, Wilton, Conn. (wjarvis@cfund.org).



 

Publication Date: Monday, May 02, 2011

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