When Northwestern Memorial Hospital began planning a decade ago for a new core facility, it decided to build a world-class structure that would keep patients and research dollars in the Chicago area and present strong competition to local rivals.
Executives also decided they wanted to construct the 492-bed, 2 million-square-foot hospital without sacrificing any of Northwestern's operating income.
More than half -- $305 million -- of the $580 million financing for the project comes from returns from investing nonoperating income in the stock and bond markets and a four-year cost-cutting project. The rest of the financing comes from $225 million in loans, $50 million in fund raising and $65 million from Northwestern's affiliated medical faculty foundation.
Northwestern's strategy is an example of how savvy hospitals are using wisely invested nonoperating dollars to finance construction projects and service expansion.
The available evidence indicates hospitals have plenty of financial ammunition for expansion, if not the will to use it. In 1996 the Investment Management Institute, a New York-based provider of financial and investment management, projected that the nation's largest 1,300 hospitals had a total of about $400 billion in assets available for investment. According to Ed Winslow, director of IMI's client relations, hospitals probably have more than that actually available.
"Hospitals are very conservative," Winslow says. "It's very hard to know without being on the inside how much any given hospital has."
Protecting operations. While other hospitals might not make as huge a commitment as Northwestern has, they are looking to strategically grow their businesses. And while acquiring another hospital or system is one way to grow, many hospitals are looking at expanding services instead.
The big obstacle facing many not-for-profits is how to make improvements without eating into operating income. Several hospitals have stopped watching the markets and have started actively investing nonoperating assets in order to make great returns and reinvest that money in themselves, as Northwestern has done.
"In the past, investment management was something looked at periodically," says Jim Morrissey, vice president of the healthcare group at Miller Anderson & Sherrerd and Morgan Stanley Asset Management, West Conshohocken, Pa. "But income from investments represents a greater portion of net income, so many hospitals have received the wake-up call and have taken a more strategic look at nonoperating assets."
The new Northwestern facility, expected to open in the spring of 1999, will replace three clinically obsolete pavilions with two new ones. The project will consolidate outpatient facilities now scattered in 22 sites over a six-block area. The new facility will be able to handle more contemporary care than its predecessors, which were built in the late 1920s and 1930s. It will house 600 physicians, and the two pavilions will be connected by eight floors of diagnostic and therapeutic services and public space.
Gene Principi, senior vice president for finance and treasurer, says the nonoperating assets were conservatively invested in fixed-income instruments when an investment program got under way in 1989. But Northwestern has been progressively more aggressive in moving into domestic and international equities. Its fund also has an allocation to alternative investments. Net investment returns on the fund, after management fee payments, for the past three years alone have been impressive: up 26.5% in 1995, 16.1% in 1996 and 19.9% in 1997.
"This helped us get our cash reserves much sooner than anticipated," Principi says.
Northwestern officials declined to disclose the size of the hospital's nonoperating assets.
Missing out. Hewitt Associates consultant Tim Solberg says many hospitals finally are realizing they have missed out on incredible returns and are continuing a recent trend to increase the equity exposure of nonoperating assets. Solberg, who plans to put out a study this spring on not-for-profit hospital and multihospital system investment practices, expects to see equity allocations in funded depreciation accounts from 28% to 30% for 1997. The last time the study was conducted in 1995, equity allocation in multihospital funded depreciation accounts -- the nonoperating asset account usually used to fund capital improvements -- was 21%.
"There has certainly been an acceleration and a definite movement in taking a risk-appropriate asset allocation stance," Solberg says. He adds that many hospitals also are taking aggressive positions in their nonoperating accounts as protection against possible takeovers or the Medicare spending changes passed by Congress last year. By having this pool of assets, hospitals might be able to buy competitors, acquire a physician group or in another way increase market share and become more profitable, Solberg says.
Gainesville, Fla.-based Shands HealthCare revamped its funded depreciation account in 1994 in part to help prepare for new projects. Four years ago, the account shifted from being 100% invested in cash equivalents, to 50% fixed income, 30% large cap domestic equities, 15% cash and 5% international equi-ties. Since the shift in asset allocation, Shands' funded depreciation account has done quite well. In 1996 it was worth $73.9 million, and in 1997 its value increased 16% to $85.6 million.
"I think (strategically investing nonoperating assets) is absolutely essential," says Shands Chief Executive Officer J. Richard Gaintner, M.D. "Without a funded depreciation account, you can't replenish your plant source of capital."
This year Shands plans to use a portion of its funded depreciation account to help pay for a new diagnostic center. The new center, which will be co-funded by Shands and affiliated medical faculty, will consolidate several diabetes-related programs under one 10,000-square-foot space. After the facility becomes operational this fall, Shands expects to treat 7,000 patients per year. While the center more than likely will break even for its first few years, Shands estimates net income of $50,000 on net revenues of $925,000 by year four, says Laura Latham, director of corporate development.
Jewish Hospital in Louisville, Ky., has taken a different tack for growth and financing. Jewish is continuing its strategy to become one of the nation's leading heart-surgery and organ-transplant centers in the nation. The hospital says it already ranks eighth in heart services and 25th for organ transplants. Focusing on these niches calls for a long-term operational and financial strategy, says Jewish's president, Henry Wagner.
"We are going to grow this business because it's the only way to hold and grow our market share," Wagner says. "We certainly don't want any competition."
As part of its expansion plan, Jewish hopes to be the first hospital to transplant a hand from a cadaver to a living person this year. While Wagner wouldn't say how much is invested annually to expand both programs, he did say the hospital's funded depreciation account is critical to its long-term growth strategy.
"Fifty percent of our bottom line comes from our nonoperating income. . . . We're in a position where we must invest that money so nonoperating income investments act as a safety net to help us hold and grow our bottom line," Wagner says. "It's critical to our operations. It's the only thing that's allowing our hospital to grow."
Jewish has a $150 million nonoperating asset account, of which 70% is invested in fixed income and 30% is in actively managed U.S. equities. While Wagner agrees the asset allocation is conservative, the hospital's strategy for growth is set to match the growth of the fund. Once the account surpasses $200 million, Wagner says he hopes his board will consider a more aggressive shift into equities.
Looking to expand. Dave Garets, research director at the Gartner Group IT Healthcare, Boston, says different types of new services are popping up nationwide. Garets, who plans to put out a study tracking new services sometime in May, says many hospitals are looking at instituting or expanding occupational health, home health, long-term-care, information technology and customer service initiatives.
John Kralovec, a principal at the William M. Mercer consulting firm in Philadelphia, says heart and oncology services had been very popular, but now many hospitals are looking at creating women's health services centers. The hook here is that patients get in early through obstetrics and maternity services and keep returning for other specialty needs. The question each hospital -- whether for-profit or not-for-profit -- should answer is, can the patient base support the new service?
While for-profit systems don't face the same investment issues as not-for-profits, they do need to invest strategically in new services to compete.
Santa Barbara, Calif.-based Tenet Healthcare Corp. will spend $8.7 million this year to overhaul one of its newest acquisitions: 286-bed Brookside Hospital in San Pablo, Calif., now renamed Doctors Medical Center, San Pablo. For fiscal 1997, Tenet spent $400 million on projects at 75 hospitals nationwide, says spokesman Lance Ignon. When Tenet bought the San Pablo hospital in January 1997, it was nearly bankrupt, San Pablo CEO Gary Sloan says.
While investing in a financially shaky and clinically outdated hospital might not seem to be an advancement for the nation's second-largest healthcare company, Sloan says the facility has linked to another Tenet hospital to create a mini-network. Doctors Medical Center, Pinole (Calif.), was a stand-alone facility about four miles away from San Pablo. The two facilities are about 27 miles north of Tenet hospitals in the San Francisco Bay Area.
"Without the two facilities to the north, we wouldn't have nearly as developed a network," Sloan says. "This creates a larger regional picture."
The San Pablo hospital -- a tertiary-care facility -- was in dire need of a face lift as well as a new operational plan. Between the two nearby hospitals, services needed to be consolidated. Today all inpatient surgery is done at San Pablo. The facility also includes a new cancer center and an updated obstetrics floor. Tenet plans to replace San Pablo's catheterization laboratory, intensive-care unit and radiology equipment next year.
Meanwhile, the 137-bed Pinole hospital retains its emergency room and remains the area's community hospital without tertiary-care abilities.
The strategy has paid off for Tenet. While the changes are too new to quantify the return on investment, Tenet has seen a 56% to 63% increase in patient volume since it took over the San Pablo facility. The Pinole facility has had an increase of between 19% and 29%, Sloan says. Subsequent annual increases won't be as dramatic, but Sloan estimates about a 4% annual rise.
Like Tenet, Brentwood, Tenn.-based Community Health Systems often purchases hospitals that are in financial trouble. CHS then goes in and invests sometimes millions of dollars in physical as well as operational improvements to gain majority market share. Recently CHS signed a definitive agreement to purchase 158-bed Eastern New Mexico Medical Center in Roswell from Chaves County. The state approved the deal last week, and CHS is expected to take control of the facility April 1. CHS committed $20 million over the next 10 years for capital improvements and new services at the hospital.
"It's not only the way we increase our volumes, but it retains more people in the community," says CHS chief executive Wayne Smith.
He added that in most of the communities it services, the company has a 45% to 60% market share. CHS usually does a demographics survey for each new service to determine whether there is enough volume to support the new service. Then it figures out the cost.
Everyone has to have a higher return on investment than the initial cost, otherwise the new service will end up losing money, Smith says. It's all right for the service to initially lose money, but by the second or third year, it should begin to recoup that loss, he says.
On the other hand, if losses from services start eating into operating income, "that's the beginning of the end," says Jewish's Wagner.