The nation's economic and financial market woes have depleted healthcare endowments and raised questions about how best to manage portfolio risk.
Despite the market rebound, memories of 2008's dismal returns have healthcare execs taking a hard look at portfolios
Equities markets have rebounded since lows that followed the sharp declines in the final months of 2008 and earlier this year, but gains have not erased concerns raised by recent volatility about how well investment strategies protect assets and liquidity, say hospital and health system investment insiders.
An annual survey by the Commonfund, a not-for-profit money manager and investment advisory firm based in Wilton, Conn., found last year's dismal returns all but wiped out gains during the four preceding years.
On average, returns plunged by slightly more than 21.2% for the year that ended Dec. 31, 2008, among the 143 hospitals and health systems surveyed. Of those, 71% said returns included endowment or foundation funds, though figures were not reported separately, and roughly half said portfolios included funded depreciation reserves (52%) and working capital (51%).
Cambridge Associates, Boston, in a survey of roughly 60 healthcare endowments, found a median decrease of 26.8% in 2008 and 4% in the first three months of 2009 before rising 11.8% between April and June.
William Jarvis, managing director of Commonfund Institute, says his organization's survey results reflect the unsparing volatility in markets last year, which left investors without performing assets to offset losses among those hit by the downturn. “All the diversification strategies failed,” he says.
Despite the high percentage of assets in traditionally liquid and safe investments, hospital and health system portfolios only marginally outperformed foundations or charities, Jarvis says. Fixed-income and cash constitute nearly half of hospital and health system investments, 39% and 7%, respectively, the Commonfund survey found. Respondents reported an average return for fixed-income of a negative 0.8%, while cash and short-term securities earned a negative 1.1%.
Meanwhile, a Commonfund survey of 300 private and community foundations for the year ended Dec. 31, 2008, found fixed-income and cash made up 16% and 6%, respectively, of portfolios. Nonetheless, foundations' average returns were minimally worse than those in healthcare: negative 26% vs. the negative 21.2%. And in an identical survey of 107 operating charities, portfolios comprising 32% fixed-income investments and 4% cash/short-term securities yielded an average negative 25.8% return.
Some not-for-profit investment committees entered 2008 with a poor grasp of investment portfolio risk and the organization's risk tolerance, Jarvis says. Risk exposure turned out to be greater than expected as the year unfolded; risk tolerance proved to be the opposite.
“In the light of the experience of the last year, when many traditional portfolio construction techniques failed to provide the diversification that was expected, many nonprofits are re-examining their approach to portfolio construction and are seeking truer measures of diversification” than the traditional broad asset classes, Jarvis says.
Jarvis adds that developing models of asset risk look beyond traditionally defined categories to performance of key measures under various market conditions—good and bad.
Not everyone found their investment strategy shaken by last year's upheaval. The Mayo Clinic's endowment, which fell 18% in 2008 has rebounded by 8.9% through September, says Harry Hoffman, chief investment officer and treasurer for the Rochester, Minn.-based system, which owns 20 hospitals and manages another two in five states. “We seem to have come back from the abyss,” Hoffman says, though he says that he remains cautious.
Mayo adjusted its portfolio “modestly” to preserve the system's liquidity. Its $1.4 billion endowment as of June 30 included 31% public equities; 18% bonds; 24% in hedge funds; and 27% in private investments such as real estate, natural resources and private equity.
Hoffman says the system sought to preserve access to its cash by slowing the pace of investment in less-liquid private funds and redeeming some hedge funds and equity investments in fall 2008. Mayo returned cash to equities earlier this year “as it became clear that the world wasn't going to end,” but has retreated some as markets have rapidly surged upward, a sign of volatility, he says.
Mayo has not changed its overall strategy for a highly diversified portfolio. He says the system continues to see hedge funds and private investments as strong vehicles where investors have an opportunity to exploit inefficiency for higher returns and a more diversified portfolio. Mayo works with 125 fund managers to oversee its investments.
The system's endowment, which totaled $1.6 billion as of the end of 2007, should rebound fully to that peak within six months to one year should donations and positive returns continue, he says. As of Sept. 30, the endowment totaled $1.5 billion, he says.
Donors continue to give to the health system, which has not trimmed its fundraising budget or staff of 215, says James Lyddy, chairman of Mayo's development department. Mayo Clinic reached its $1.25 billion fundraising goal six months ahead of its five-year schedule, though some larger benefactors have extended payment schedules. To date, the effort has helped fund 51 new faculty positions.
As healthcare and other not-for-profit endowments struggled with steep losses, lawmakers in more than a dozen states moved to offer relief. Forty-three states as of August had adopted legislation that allows managers to spend from endowments that have seen funds drop below the value of initial donor gifts, says Peter Erichsen, a not-for-profit governance and compliance lawyer who is a partner with Ropes & Gray in Boston. That's compared with 28 states as of late March.
Prior rules, introduced in 1972 and modeled on what is known as the Uniform Management of Institutional Funds Act, allowed endowment managers for the first time to spend income gains to portfolios other than dividends or interest, unless donors specified otherwise. The rules did not explicitly prohibit spending from endowments with value below that of initial donations—a position described as “underwater”—but were widely interpreted to do so, Erichsen says.
Endowment managers in states with the expanded laws must spend prudently, a standard that will evolve through trial and oversight by state attorneys general, he says. However spending decisions must consider factors that include: fund preservation and duration; fund and institution purpose; general economic conditions; inflation or deflation; expected fund return and investment appreciation; the institution's other resources and investment policy.
Linda Matza—who oversees institutional sales for Ziegler Capital Management, a money manager that often works with health system endowments with less than $100 million in assets—says healthcare investors haunted by unpleasant surprises during the recent market turmoil are now more aggressively vetting their investment options to prevent negative returns and preserve liquidity. “Transparency is very important,” Matza says.
As falling returns wiped out assets, portfolio assets began to deviate from policies that dictate how money should be divided among investment classes. Some investors that sought to bring portfolios back in line with policies by divesting some assets to invest elsewhere, known as rebalancing, discovered that some assets believed to be liquid were not, Matza says.
Prior to the credit crisis, endowments increasingly invested in alternatives—a category that includes venture capital, real estate, private equity and hedge funds—and during the credit crisis, certain alternatives, such as hedge funds, could not be readily turned into cash, she says.
Health systems and hospitals surveyed by Commonfund reported 13% of 2006 portfolios in alternatives compared with 17% and 18% of 2007 and 2008 portfolios, respectively. Alternatives returns dropped 19% for the year ended Dec. 31, 2008, the survey found, with the sharpest declines among energy and natural gas, a decline of 21.9%, and hedge funds or other marketable strategies, which dropped 19.3%. Private equity, venture capital, real estate and distressed debt saw negative returns of 5.6%, 6.5%, 10.9% and 4.5%, respectively.
Now, some health systems are hedging against risk by investing as much as allowed under endowment investment policies in fixed-income assets or buying guarantees that lock in the price at which equities can be sold, taking out insurance against a sharp drop in value, she says. If an investment plunges below the locked-in price, Matza says, such a deal pays off; otherwise, investors may pay for protection they never use.
Matza says she believes health system endowments should brace in coming years for lower returns as a result of an economy unlikely to rebound quickly and more conservative portfolios seeking to avoid volatility after the decade's second recession. Two painful downturns so close together “really made people think,” she says.
Endowments aren't the only investments under scrutiny by healthcare executives shaken by recent volatility in the markets.
At Virginia Hospital Center, Arlington, the governing board has launched a review of investment policies and a recommendation is expected by year-end, says Robin Norman, the 349-bed hospital's senior vice president and chief financial officer. She says the hospital has undertaken similar reviews during the past 15 years and did so because volatility prompted the investment committee to pause and look again.
Since January, its reserves have climbed 27% to $334 million. In 2008, assets dropped 34% to $271 million. That's compared with historical annual returns closer to between 6% and 8%.
Norman says the portfolio asset allocation calls for 50% to 70% equities, 10% to 20% alternatives and 10% to 20% fixed-income and bonds. As equity markets declined, Virginia Hospital Center's equity assets dropped to the low end of the policy's range. Meanwhile, fixed-income and alternative investments as a percentage of the overall portfolio increased to the top of their ranges, she says.
Virginia Hospital Center does not rely on its reserves to offset operating losses or fund capital needs other than major construction, she says. But the hospital expects to refinance debt in 2011, and the recent upheaval exposed the risks of its existing investment strategy.
Norman says that a more liquid and less volatile portfolio would be more attractive to potential lenders and credit analysts when the hospital seeks to restructure outstanding debt first issued during the more robust market of 2005 that is scheduled to convert to auction-rate bonds in 2011.
The auction-rate market collapsed in February 2008 after exposure to subprime mortgages brought down bond insurers that backed bonds in the $330 billion municipal market. One alternative market for the debt requires borrowers to guarantee sufficient cash to pay back investors on short notice, either with liquidity from borrowers' balance sheets or banks.
Now the hospital's balance sheet and investment policies must adjust to markets altered by the credit crisis, she says. “It all made sense in 2005.”
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