Risk and reward

Hospitals and health systems may have recovered from the acute distress of the credit crisis, but investment and debt strategies that proved riskiest during the market tumult continue to cast a shadow over balance sheets.

Analysts who rate the credit of U.S. not-for-profit hospitals say they more routinely and closely consider those strategies—alternative investments that lock up cash for months or years; debt sold to short-term investors; and deals to hedge against fluctuating interest rates. Too much risk could prompt further scrutiny of operations or nudge credit ratings or outlooks lower for borrowers on the edge, analysts say.

“In cases where we've seen a pronounced disparity that sticks out like a sore thumb,” in risk from a borrower's investment and debt portfolio compared with other similar borrowers, analysts at Fitch Ratings now more thoroughly review borrowers' operating strength, says Fitch analyst Jeff Schaub. “It wouldn't change the rating in and of itself,” Schaub says. “But it could contribute to an overall negative rating profile that could result in a rating change.”

Eighteen months ago Fitch began to ask hospitals and health systems to disclose in greater detail investments that temporarily put cash out of reach, such as hedge funds, private equity or real estate, Schaub says. The ratings agency previously did so when borrowers' risk and cash reserves raised questions, but reporting is now more “standardized, rigorous and detailed,” he says.

Analysts have classified investments and request information on cash available from one to seven days; eight to 30 days; 31 days to 180 days and more than 180 days, he says.

Martin Arrick, managing director in corporate and government ratings at credit-rating agency Standard & Poor's, says questions analysts already asked intensified after unlikely risks became plausible during the credit crisis.

“It's not that we weren't cognizant” that alternative investments were less liquid or short-term bonds and swaps could abruptly drain cash off balance sheets, but suddenly such risks were “much more tangible,” he says.

Arrick says S&P also sees upcoming risk from short-term variable-rate bonds that require new commitments in the next two years from banks that guarantee borrowers' credit and access to cash. He notes borrowers have scaled back exposure from variable-rate bonds to less-risky fixed-rate debt. “Everybody is taking risk off the table, and there's more fixed-rate debt than there has been in the past,” he says. “I think people are moving more conservative all the way around.”

Moody's Investors Service in January introduced new liquidity measures for the 500 healthcare borrowers with roughly 2,000 hospitals that carry the agency's credit ratings. Moody's now requires from all borrowers information on eight investment types—or asset classes—including hedge funds; private equity and venture capital; and real estate—and whether investments can be cashed out within a month, a year or longer. Analysts use the breakout for four new measures of cash ready within a month or money available in a year to fund operations or meet obligations of debt that allows investors to swiftly exit and demand repayment (known as demand debt).

John Nelson, managing director of Moody's healthcare ratings team, says analysts previously calculated liquidity from financial statements, which do not break out investment restrictions on cash. Moody's previously sought additional detail on investment restrictions on a case-by-case basis, he says. Statements report unrestricted cash and investments together, even though it can take months or years to cash out alternatives versus a matter of days needed for fixed-income investments or equities.

“We could no longer rely on unrestricted cash and investments for a measure of liquidity,” Nelson says. “It was a measure of wealth, institutional wealth.”

Nelson attributes some of the liquidity risk during the credit crisis to hospitals' response after the last decade's first recession, which ended in November 2001 after eight months.

Healthcare investors emerged from the relatively mild 2001 recession to see portfolios depleted by equity volatility, Nelson says. As the economy recovered, fixed-income investments were less attractive and stock performance lagged behind hedge funds.

Hospitals began to consider hedge fund investment as a strategy to diversify risk and improve returns, he says. “I would say the logic is quite compelling if you did not value liquidity as a risk,” Nelson says. “That's where the fly in the ointment came to be.”

Alternative investments made up 18% of not-for-profit hospital and health system portfolios for the year ended in December 2008 compared with only 8% in 2003, according to the most recent yearly survey of portfolios by investment manager Commonfund, Wilton, Conn.

Many hospitals committed cash to alternative investments as they took on additional risk by borrowing in short-term markets debt that could be unloaded by investors for quick repayment, assuming bonds could be sold to new investors, Nelson says. Some used derivatives known as “swaps” as an interest-rate hedge for bonds in short-term markets.

But as the financial system faltered in 2008, healthcare borrowers' variable-rate bonds sold to short-term investors faced the risk that hospitals would be forced to hastily pay off those bonds should investors flee—a scenario considered unlikely before the crisis, but made real by bank distress and bondholder anxiety. The interest-rate hedges swung negative for healthcare borrowers, forcing many to post millions in collateral or pay fees to exit the deals. Negative swaps forced some major systems to make significant collateral postings. The Cleveland Clinic Health System was required to post $105 million in collateral while Catholic Health East, Newtown Square, Pa., posted $98 million.

Hospitals and systems have somewhat retreated from that risk, analysts say, and also have cut spending to boost cash reserves. Still, finance chiefs say alternatives—which also include commodities—continue to add much-needed diversity to portfolios.

Catholic Health Initiatives, Denver, temporarily withdrew about one-fifth of its hedge funds and poured the $115 million into short-term investments, says Linda MacDonald, vice president of treasury services at the system.

MacDonald, who oversees the 59-hospital system's $3.4 billion portfolio, says CHI “amassed liquidity” to guarantee the system had ready cash should jittery bondholders decide to flee during the worst of the credit crisis. The system returned the cash to hedge funds, she says, after market upheaval subsided and the system reduced its exposure to variable-rate demand bonds. She describes hedge funds as “not entirely liquid” but “not completely illiquid,” and the alternatives add portfolio diversity.

The system also “took a holiday” from new private-equity investments, MacDonald says. Private-equity managers, who lock in cash commitments that can be drawn on demand, have not yet invested previously obligated funds, she says.

Nonetheless, CHI decided not to change the ratio of investments in equities, fixed-income instruments and alternatives (43%, 37% and 20%, respectively) after a recent review of its strategy. The system might even reconsider real estate this year in markets where values have dropped to make such an investment attractive, MacDonald adds.

The system modeled weak performance from its portfolio and found risk and returns acceptable, she says. “We're not an organization that took a great deal of risk,” she says, but notes since the credit crisis “we may be slightly more conservative.” MacDonald says the system has also sought to more thoroughly consider risks from global events such as Europe's debt crisis.

Dean Swindle, who joined CHI as chief financial officer in May from nine-hospital Novant Health, Winston-Salem, N.C., says it would be hard not to emerge slightly more cautious from recent events.

“It does make you a little more cautious, more pragmatic, more methodical to ensure that you do feel comfortable,” Swindle says.

Richard Rothberger

Michael Griffin, head of municipal credit research at Vanguard, an institutional investor in healthcare tax-exempt bonds, says healthcare borrowers have improved disclosure, but investors continue to push for more reporting on swap deals that siphoned cash for collateral or termination fees during the credit crisis.

Griffin says he does not expect overly sophisticated investment or debt strategies from hospitals but instead looks for strong operations. “We expect our hospital managers to be hospital experts and we don't want to find out that they have too complex a financial portfolio,” he says. “They're meant to be healthcare experts, not financial wizards,” Griffin says. “We're looking for hospitals that operate their business well.”

Trinity Health, a 30-hospital system based in Novi, Mich., began to voluntarily disclose how quickly the system can convert its investments to cash after it used its own balance sheet to guarantee debt for investors, says James Bosscher, Trinity's vice president of treasury.

The system has increased the percentage of its portfolio invested in alternatives to 19% from 15% this year to diversify its risk and hedge against inflation. But to curb volatility and preserve cash, the system has also reduced its exposure to equities to 29% and boosted fixed-income investments to 52% of its portfolio, he says. Bosscher says the system is seeking slightly lower risk and return in exchange for slightly improved liquidity.

The upheaval of 2008 also has been added to the yearly stress test that Trinity executives conduct to determine worst-case returns for its portfolio, he says.

Health systems have adjusted more than their portfolios; some have moved to change their management or oversight of investments.

For example, 75-hospital Ascension Health hired its first chief investment officer, David Erickson, nine months ago and shortly after hired Josh Kaplan as senior director of hedged strategies. Ascension, the nation's largest not-for-profit health system, declined an interview request.

The St. Louis-based system has not backed away from alternatives and recently told credit analysts at Moody's the system would scale back cash and fixed-income assets to increase its allocation to alternatives. The system's long-term investment pool totals $6.5 billion, according to financial statements.

Texas Health Resources, a 13-hospital system based in Arlington, has launched a search for its first senior vice president of treasury.

Executives created the job—which combines oversight of the system's investment portfolio, outstanding debt and insurance risk—after modifying a recommendation by its board and an outside consultant to hire a chief investment officer, says Ronald Long, the system's CFO. Long, also an executive vice president at Texas Health, says a plan to review investment oversight preceded the credit crisis. Market turmoil in late 2008 delayed the review, which was completed last year and included the recommendation to hire an investment chief.

But an investment chief, as recommended, would not be able to balance the combined risk to cash reserves from investments and debt that created such havoc during the credit crisis, Long says, so executives revised the proposal to give the incoming executive broader authority.

Texas Health holds no alternative investments and no swaps on its debt, two major sources of liquidity risk, but guarantees its own cash for short-term investors that have an option to quickly demand repayment on $115 million in bonds.

Long says the system maintains a conservative 50% allocation to highly liquid, low-risk fixed-income investments (with the rest in equities) because Texas Health relies on returns for more immediate needs, unlike long-term demands on pension portfolios that allow for greater risk and potentially higher returns.

At Scripps Health in San Diego, the governing board first responded to the 2008 investment plunge by holding more investment committee meetings, says Richard Rothberger, Scripps' executive vice president and CFO.

Rothberger says Scripps made only minor adjustments to its portfolio asset allocation but did move to further diversify its investments.

The four-hospital system held its alternative investments steady at 10% but diversified within the asset class, he says. Scripps did reduce exposure to equities by 5 percentage points to 50% with the rest in fixed-income, and diversified its bond managers, Rothberger says. The slight retreat from equities reduced volatility in Scripps' portfolio in recent weeks as Europe's debt woes have shaken markets, he notes.

Now Scripps may merge its board's investment committee—which operates in a “vacuum,” Rothberger says—into a subcommittee of its finance committee. Scripps, similar to other systems, looks outside its governing board to investment experts in the community to help oversee its portfolio, Rothberger says. These nonboard recruits bring needed expertise but lack board members' overall knowledge of Scripps.

If Scripps folds its investment oversight into a subcommittee of its board finance committee, members of both groups will benefit from a more complete picture of Scripps overall risks from assets and liabilities, he says. Rothberger says credit upheaval and market volatility have underscored the importance of diversified portfolios and strong operations.

“You clearly can't rely on investments,” he says.