Testing the waters

Seeing a return to normalcy in the economy and markets, institutional healthcare investors are back in the game with some aggressively pursuing alternative investments.

Not-for-profit hospitals and health systems experienced the same scary plunge as other investors when credit markets seized and the recession worsened in late 2008 and early 2009, leading many to pull back from stocks and less-liquid investments known as alternatives to limit losses.

The decision to consider an increase in investments in stocks, hedge funds and other more risky investments is a sharp U-turn from recent times when volatile markets and a lack of liquidity led to a move into cash and fixed income. Not-for-profit healthcare investors' exposure to U.S. equities had fallen, fueled in part by the drop in prices, to 24% of their portfolios in fiscal 2008, down from 31% the previous fiscal year, according to Commonfund, which manages investments for not-for-profits.

The move out of cash and fixed income may be the right one, though a big rebound in equities has already occurred. The stock market, as measured by the Dow Jones industrial average, was up more than 60% as of last week from its 12-year low close of 6,547 on March 9, 2009.

Investment advisers caution that hospitals risked unnecessary losses by abandoning long-term investment policies unless changes to strategic plans or debt alter demands for cash. “Any time there's a significant downdraft, emotion takes over,” said William Courson, president of Lancaster Pollard's Investment Advisory Group. Those who abandon polices in fear miss gains as markets reverse course, he said. “It's unfortunate.”

Lisa Martin, a senior vice president with Moody's Investors Service, said larger health systems appear to be slowly looking at moving portfolios back into equities and alternatives from cash safe havens, but with more attention to the cash restrictions and limits of investment vehicles.

Among those potentially moving back into stocks and alternatives are Ascension Health and Advocate Health Care. St. Louis-based Ascension will cut back its cash and fixed-income assets, which grew under the Roman Catholic system's strategy to protect liquidity last year, in favor of alternative and equity investments, a recent Moody's report said.

At the end of December, Ascension held $5.6 billion in a long-term fund spread across various investments, the system's financial records show. (Ascension also has another $661 million in a short-term fund.)

Cash and fixed income equaled roughly 44% of the long-term fund, with alternatives and equities at 21% and 35%, respectively.

The system's investment policy calls for cash (and fixed income) and alternatives to each account for 30% of the fund with the rest in equities.

Move to alternatives

To reach its targets, Ascension will need to bolster its investments in hedge funds, private equity and other alternatives, a strategy the system launched during the boom years before the credit crisis. Ascension said in 2006 it would increase alternative assets to 30% of its portfolio from 3%.

In addition, the system, which operates more than 70 hospitals in 15 states and the District of Columbia, has recruited investment experts in recent months to help manage its considerable assets.

In February, Ascension hired Josh Kaplan, the chief investment officer of Drexel University, to become the system's senior director of hedged strategies. Last September, it recruited David Erickson from the University of Wisconsin, where he managed the foundation's $2.2 billion in assets, to become Ascension's first chief investment officer.

Ascension officials declined to comment, said system spokeswoman Trudy Hamilton.

In Oak Brook, Ill., Advocate Health Care has launched a review of how its investments are divided across assets. Executives last routinely reviewed the system's policy in 2008 and had considered boosting its exposure to alternatives and equities, said Dominic Nakis, senior vice president and finance chief for eight-hospital Advocate. But that was before the past 18 months.

Instead, Advocate began in the summer of 2008 to hold onto cash, he said. As equity values fell, and as Advocate poured operating income into cash and fixed income, the highly liquid assets grew as a share of its portfolio. Assets in cash and short-term money markets rose from 7.5% to roughly 18%, he said.

Since last July, inspired by improved credit and equity markets, Advocate has gradually poured more of its assets back into equities in an effort to reach long-standing targets: half cash and fixed income, 38% equities, and the rest alternatives. Cash and fixed income accounted for 64% of the portfolio last year but have since dipped to about 57%, he said. Nakis said he is not certain whether Advocate will change its policy once its review is complete this year.

Retreat too far from risk and investors lose out on returns, said Verne Sedlacek, president and CEO of Commonfund. He acknowledged that few calculated the risk of events that erupted in 2008 prior to the credit crisis, and investors should scrutinize policies for further risk. But he said policies should seek a balance between acceptable risk and returns.

Some see advantages in alternative assets despite analysts' heightened wariness of investments. “We've kept our policy intact,” said Dave Cytlak, chief financial officer for 181-bed Blanchard Valley Health System, in Findlay, Ohio, and continues to stick to its strategy, which puts 65% of its investments in equities and another 15% in hedge funds or real estate.

Cytlak said strong cash reserves allow the hospital to take risks with its $139 million portfolio that others may find uncomfortable.

Moody's noted the investment strategy warily, but said risks were offset by diverse investments and strong operating margins.

Cytlak described Blanchard's governing board as highly knowledgeable and comfortable with the two-campus hospital's long-term investment policy, which was tested against various scenarios by an adviser. And Blanchard finished a major renovation in 2007 and has no immediate plans for capital spending, he noted.

Boosting cash

Blanchard did boost its allocation to cash by $35 million in early 2008, when the hospital was forced to bid on its own debt after the brewing credit crisis toppled an auction market for tax-exempt bonds, Cytlak said.

The hospital saw an opportunity and continued to use the cash to invest in auction bonds or other short-term, tax-exempt debt after refinancing its own debt, but the system will soon return the cash to long-term investments, Cytlak said.

Some hospitals were unable to adjust portfolios to meet investment targets as markets fell because losses would run afoul of lending agreements, said Nicholas Bauer, a senior consultant for not-for-profit hospitals and health systems at MBO Cleary Advisors. Agreements with banks and other lenders to hospitals and health systems stipulate a minimum cash reserve. Violating those agreements can raise fees or force hospitals to hire consultants, he noted.

Moody's announced this month it has begun using four new measures of how quickly investments can be liquidated to cash. Martin of Moody's said former measures of cash reflected an organization's overall wealth but not ready access to cash to meet short-term debt payments and fund operations. Some hospitals and health systems saw investments plunge as credit upheaval soured interest rate hedges known as “swaps” that drained more cash from balance sheets for collateral on the deals. “We learned you could be very wealthy, but not have liquidity,” she said.

The Mayo Clinic continues to aggressively invest in alternative and less-liquid assets, one factor that prompted credit agency Standard & Poor's to leave the health system's rating unchanged last week despite a rebound from the weak operations and $1.9 billion drop in liquidity in 2008 that prompted analysts to downgrade Mayo to AA-.

The New York ratings agency revised the 20-hospital system's outlook from stable to positive. Mayo posted its best operating margin in five years, 4.4%, in 2009.

Vulnerable to operating stress

Stephen Infranco, a Standard & Poor's analyst, said alternative investments account for half the Rochester, Minn.-based system's $2.5 billion long-term fund, which leaves its balance sheet more vulnerable to operating stress. Analysts have questioned whether Mayo's 2009 operating performance can last. The system kept expenses largely flat last year, thanks in part to a wage freeze among doctors and executives that was lifted this year.

Some systems are standing pat with their decision to pull back from equities. “We wanted to reduce the risk to be sure we didn't have another 2008 on our hands,” said Pamela Vukovich, the chief financial officer for Legacy Heath System, of the system's gradual move to invest more heavily in staid fixed-income assets and inflation-protected U.S. Treasury securities and pull back from volatile equity markets.

Portland, Ore.-based Legacy closed its books at the end of March 2009—within weeks of market lows—and posted a $110 million investment loss. “Obviously, 2008 scared a lot of people,” Vukovich said. At the same time, the five-hospital system had significant capital plans, she said.

By 2012, Legacy is scheduled to have completed its $242 million, nine-story pediatric tower at 412-bed Legacy Emanuel Medical Center in Portland and an $89 million electronic health-record installation.

The system's directors didn't want to risk distress should markets sour again with projects under way, Vukovich said.

The board set more conservative targets roughly one year ago, but directed Legacy executives to move only as markets improved to avoid selling equities for far less than the system paid for them.

The new policy will leave Legacy with one-fourth of its assets in equities from its prior target of 53%. Fixed income and inflation-protected Treasury securities make up 45% of the portfolio. Previously, fixed income accounted for 17% of the system's assets.

Vukovich said Legacy has started to sell some domestic equities and will continue to do so gradually. But Legacy has also tipped the balance away from equities by directing new investments into fixed income or Treasury securities. Even Legacy in Oregon has held onto its alternative investments. Real estate and hedge funds each account for 15% of assets under targets in Legacy's revised policy.

Officials for Fort HealthCare, Fort Atkinson, Wis., are among those who stepped away from equities and are comfortable with that decision. James Nelson, senior vice president of finance and strategic development at Fort HealthCare, said the organization converted its portfolio policy to roughly 33% equities and the rest fixed income in January. Its targets were previously divided evenly between equities and fixed income.

Nelson said the board made the shift after the disruption of 2008 and changing its investment adviser.

In 2007, the organization refinanced and took on additional debt to remodel operating rooms and a laboratory at its 72-bed Fort Memorial Hospital. The $26 million in debt was sold in a daily market to short-term investors who can abruptly demand repayment. Nelson said as credit markets seized, the threat such short-term bonds posed to balance sheets became apparent. “Boy, there really is risk in there,” he said.

But the risks of a move toward less-liquid investments depend on whether hospitals and health systems can find vehicles that deliver enough return or portfolio diversity to offset the higher fees, lost liquidity and, sometimes, limited value information, of alternative investments, said MBO Cleary Advisors' Bauer.

Nonetheless, the credit crisis highlighted the cost to balance sheets without enough cash to weather the risks from various debt or investment vehicles, said Bauer, who advises clients to consider debt, operations and capital needs when drafting an investment policy. “People turned a blind eye to risk as it relates to liquidity.”

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