In the late 1990s, Scripps Health in San Diego spent more than $1 million to design a state-of-the-art women's medical center on the campus of one of its five hospitals. But the pet project of the hospital's administrators and physicians was shelved after a new chief executive officer, Chris Van Gorder, arrived in May 2000.
The reason: It wasn't going to make money, Van Gorder says.
"It was a plan based on wishful thinking and hope versus strategic rigor," says Van Gorder, who started his tenure faced with a $25.9 million operating deficit that hammered the system's credit.
With the help of two consulting firms, Van Gorder and his management team spent two years crafting a 10-year capital and strategic plan, including several scenarios based on potential reimbursement and market changes. The plan dictates how the system, which owns a 350-member physician clinic, will spend an estimated $700 million in capital, or about $67 million annually, based on its projected ability to access capital from operations and borrowing.
Included is a strict new requirement: Capital investments must produce an overall return of 15%. That means projects that might be viewed as a community benefit, such as a clinic in an underserved neighborhood, must be balanced with highly profitable ones, such as a surgery center in a high-growth area.
Van Gorder says the high return is necessary to cover the system's higher costs and restore its balance sheet to a healthy level, ensuring the system's future viability. "What we're doing now is applying business theory that mission-oriented organizations in the past didn't have the expertise to do or didn't feel that they had to do," he says.
Scripps isn't alone. As the hospital industry undergoes its largest building boom since the 1950s while facing constraints on its borrowing capacity, more not-for-profit hospitals are adopting benchmarks for returns on their capital investments. Most target a 9% to 12% weighted cost of capital over the life of their capital investments, which includes interest payments, says Jason Sussman, a partner with healthcare consulting firm Kaufman Hall.
Required rates of return are part of a larger trend to control hospitals' capital allocation. Worried that hospitals won't be able to fund their strategic plans, the financial community has been pressing not-for-profits to integrate capital and strategic planning, extend their planning horizons and set measurable financial goals-strategies common in the corporate world.
Steven Berger, president of Healthcare Insights, which sells financial management software, estimates that from 40% to 50% of hospitals are doing financial planning in conjunction with their strategic plans, compared with just 20% five years ago.
Capital planning has come into vogue as lenders demand more security-including greater cash reserves and lower debt ceilings-to protect their bonds and loans in the wake of hospital industry implosions in the late 1990s that were exemplified by the $1.5 billion bankruptcy of the Allegheny Health, Education and Research Foundation, Pittsburgh. Now, hospitals must have more cash on hand to avoid default.
"The rating agencies and the bond insurers have raised the ante on not necessarily the interest cost but the overall cost of borrowing," Sussman says.
A small industry of consultants and software vendors has emerged to assist hospitals with capital planning. Mezzia, a software firm, has sold healthcare capital planning software to 150 hospitals since launching the product in 2001. Alternatively, hospitals are using manual systems based on Excel spreadsheets or other nonhealthcare-specific capital budgeting software, according to Mezzia.
At the Healthcare Financial Management Association's annual education summit this week in Nashville, the group plans to release a 27-page report titled Core Competencies in Capital Planning, designed to help chief financial officers work through the mechanics of strategic planning, balance sheet management and hiring advisers. The report is part of the HFMA's yearlong "Financing the Future" series.
Capital planning was broached by many of the 31 not-for-profit hospitals and health- care systems that gave presentations at a May conference for healthcare bond investors in New York.
"Most systems have put due diligence into providing a five-year capital spending plan. There's a focus and level of detail that goes into it now versus two or three years ago," says one of the presenters at the conference, Bill Shuttleworth, CFO of Catholic Healthcare Partners, Cincinnati. "It's something that always should have been there," he adds.
Shuttleworth says one motivation was the fall of the stock market, which some hospitals had previously relied upon to fund capital growth. "We realize now that investment income is a luxury. We used to live off of it," he says. "Now, we live off of operations."
No longer can hospitals draft strategic plans without considering their access to capital, according to Citigroup, one of the sponsors of the investor conference. The investment bank published a report in May with consulting firm Tiber Group and architectural firm NBBJ that calls on hospitals to extend their planning horizons to match the life of their capital purchases.
Too often hospital executives and boards are consumed by an annual budget-balancing exercise rather than focusing on long-term strategy, but that's starting to change, they say. "A three-year planning horizon is simply out of sync with a facility that is going to be there for 50 years," says David Burik, president of the Tiber Group. "We're trying to push them to seven or 10 years."
According to Tiber, strategic planning horizons for hospitals have shrunk to three years, shorter than other major industries.
HFMA President and CEO Richard Clarke says long-term planning was derailed after the Balanced Budget Act of 1997 caused operating margins to shrivel and forced executives to focus on short-term operational fixes, such as selling unprofitable businesses. At the same time, more bankers and business people with capital planning experience have joined hospital boards.
"Quite frankly, I think Sarbanes-Oxley (the 2002 corporate accountability legislation) was a very strong wake-up call to ensure that the right financial expertise is present on the boards of not-for-profit healthcare companies," Clarke says. Armed with specific financial goals, he says, "The organization is bettered positioned to make long-term decisions, rather than making them willy-nilly."
Hospitals also are structuring their financial goals in different ways, according to the HFMA report, which was financed by GE Healthcare Financial Services and partly researched by PricewaterhouseCoopers.
For example, seven-hospital Iowa Health System in Des Moines has set an 8% return for low-risk projects, a 10% return for moderate-risk projects and a 10% return for high-risk projects such as high-tech equipment purchases. To access capital, each hospital also must show an operating profit, the report says. Operating margins are another measure. Advocate Health Care in Oak Brook, Ill., has set a target operating margin of 4% to 5%, versus margins of 1.8% to 2.6% since 2001, the report says.
Hitting the brakes
For some hospitals, limited debt capacity has meant scaling back or delaying projects, particularly those that aren't guaranteed moneymakers. For example, Scripps expects to take about a decade to expand all of its overburdened emergency rooms, an activity that will not generate a profit. The same requirement for profitability led Scripps to give its money-losing Otay Family Health Center, which serves mainly low-income patients, to the San Ysidro Health Center, a not-for-profit primary-care provider, last year.
"Charity care is part of our mission going forward, but it's got to be offset by projects that have a return," Van Gorder says. For example, he says Scripps committed up to $15 million to add a profitable diagnostic surgery and imaging facility in the growing Carmel Valley, about 20 miles north of downtown San Diego, he says, along with a medical office building there.
Scripps' board agonized over its recent decision to merge its money-losing Chula Vista, Calif., hospital near the Mexican border with Scripps Mercy Hospital in San Diego, a Catholic facility, says Janet Rodgers, chairman of the Scripps' strategic planning committee. The change should reduce administrative overhead and ensure the flow of Medicare disproportionate-share funds to both facilities, but physicians and administrators are concerned that the facilities will lose their individual cultures, she says.
But Rodgers, a retired nursing school dean from the University of San Diego, says having clear financial benchmarks communicated by management has helped Scripps' board make tough decisions and win acceptance from physicians, local hospital administrators and the community. The system has turned around its operations, posting an $18.4 million profit on nearly $1.3 billion of annual revenue in 2003, and is preparing to issue bonds for the first time in several years.
"We have a real sense of trying to have a sound financial organization, but our mission is so important to us," Rodgers says.
Indeed, many hospitals appear to be improving the returns on their capital investments. Median operating cash flow margins, which Sussman uses as a proxy for returns on investment, increased last year for most credit categories, according to Standard & Poor's. They ranged from a median of 8% for hospitals and systems with BBB ratings to more than 12% for those with higher ratings.
But while hospitals meet pent-up capital spending needs, a bumper crop of surgery centers, heart hospitals and medical office buildings in many markets has alarmed consumer groups. There's growing concern that hospitals are spending too much money on projects that are meant to generate profits, rather than serve public health needs.
"You can make a balanced decision in the context of your institution, but that doesn't mean it results in a balance for the community's health system, and that's the problem," says Susan Sherry, deputy director of Community Catalyst, a national consumer- health advocacy group.
Sherry says there needs to be a public policy framework to keep hospital capital spending in line with community needs. "There are elements of (certificate of need) that probably belong in the mix. There are elements of more global capital budgets that belong in the mix. Greater community involvement is probably part of it, too," Sherry says.
There's been a slowdown of the 1990s trend for states to dismantle CON laws. Maine will attempt to rein in hospital capital spending via its Dirigo Health insurance reform law passed last year, which provides for the state to set a "global budget" for hospital capital spending. "For too long we've left the community out of the equation because those (capital spending) decisions were being made in private boardrooms," says Joseph Ditre, executive director of the Consumers for Affordable Health Care Coalition, Augusta, Maine. Last week the group released a report calling for more stringent CON reviews. Among recent capital projects, he says, "You don't see a lot of expenditures for primary-care centers."
In Ohio, where all three hospital systems in the state capital of Columbus are building heart hospitals, one community healthcare advocate favors restoring a CON law that was phased out in the late 1990s and requiring hospitals to report their community benefits. The state also de-funded regional health-planning agencies that gathered data on community needs.
"Do we need three heart hospitals in Columbus? I don't know," says Cathy Levine, executive director of the Universal Health Care Action Network of Ohio. "If you had community benefits reporting and certificate of need, the public would have information on which to determine whether the hospitals are striking the correct balance between financial solvency and addressing community health needs."
Levine believes better community-needs data would enable local governments to forge partnerships with not-for-profit hospitals to bring facilities to underserved areas.
But hospitals say community needs won't be met if hospitals can't access capital to develop profitable business lines. Moreover, hospitals need to generate profits to invest in patient-safety issues and clinical improvements, they argue. While construction projects grab the most attention, the most frequently cited capital projects in a recent survey of CFOs were for technology purchases that could improve the quality and efficiency of care, including digital radiology systems, computerized physician order-entry systems and new information systems.
"The hospitals that are doing well financially are also hospitals that often are able to invest the most in their community missions," Sussman says. "The issue is creating a balance. If we have these projects that are charity care or community-based and they have no return or a negative return, how do we balance those with profitable projects? It basically puts a little bit higher emphasis on returns from those projects that can generate a return."
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