Long-term investing and your bond rating: when you take a good look at your healthcare organization's financial condition, do you use a telescope or a microscope?

Healthcare Financial Management, Sept, 2005 by Dennis Doody

A microscope gives you a close up view--so close, in fact, that you risk missing the larger picture. A telescope, on the other hand, is for long range vision--setting direction, staying on course, and observing the larger world.

The point? Simply that hospitals focus on days cash on hand as the measure of their financial health is too one-dimensional. It's the microscope in our analogy. That's not to say that days cash on hand isn't important--it is. But right up there with it is your institution's investment portfolio. Of the two indicators of financial health, it's the one that's more forward--looking and more focused on the long term financial health of your organization. It's the telescope.

What About the Rating Agencies?

It's true that the rating agencies want to see a strong cash position. But some healthcare organizations have far more cash on hand than they will ever need. It may be beneficial to put at least some of that money to work for you in long term investments. Your approach to investments tells the rating agencies something about your organization, too.

Rating agencies focus on the fundamentals, including an institution's financial history, current and projected debt, balance sheet and operating margin, competitive position in its served market, leadership (management and board) quality, and the presence of a long-term investment strategy. They perform a comprehensive review because they need to accurately assess the ongoing viability of an organization and its ability to repay debt, especially 30-year bonds.

Short-term liquidity doesn't automatically extrapolate into long term financial soundness. Healthcare organizations need a growing perpetual pool of assets for many reasons, including the simple reality that they are going to be in the debt market perpetually. So instead of seeing a conflict between long-term investing and your bond rating, you should think of them as complementing each other.

Also, many healthcare organizations are behind the curve when it comes to growing their investment portfolio to meet those long term needs. In an investment environment that has changed dramatically, too many institutions are relying on plain vanilla 60-40 stock bond portfolios. Largecap equities and laddered treasuries are not producing the kind of returns that will meaningfully grow a portfolio, net of inflation and costs.

Diversify--and Diversify Again

Investment decision makers shouldn't throw caution to the wind; after all, the prudent fiduciary weighs risk along with the prospects for return. Fortunately, there's a way out of the risk-return conundrum. One of the tenets of modern portfolio theory holds that the relative riskiness of a security has to be viewed in the context of the entire portfolio. Securities that exhibit low correlations with each other can lower overall risk at the portfolio level, even though their return pat terns may vary widely on an individual basis. In a word, it comes down to diversification.

Yet on this front, many healthcare organizations haven't gone nearly far enough. A portfolio with allocations to large and small-cap domestic stocks--both growth and value--and a mix of treasuries and investment-grade credits together with a modest international exposure isn't really diversified. A more effectively diversified portfolio would add relatively uncorrelated asset classes, including marketable alternative strategies (hedge funds and absolute return funds), private capital (venture capital, private equity, and international private capital), equity real estate, natural resources (oil, natural gas, and timber), and commodities.

Time to Get Educated

Comparing the healthcare community with the world of education highlights differences in how assets can be allocated to construct a diversified portfolio. The Commonfund Institute conducts annual surveys of the investment management policies and practices of educational institutions, healthcare organizations, and foundations. The 2004 Commonfund Benchmarks Study of 204 healthcare organizations found the following average operating fund asset allocation:

* Fixed income, 39 percent

* Domestic equities, 37 percent

* International equities, 9 percent

* Alternative strategies, 8 percent

* Cash and other short-term investments, 4 percent

By contrast, the 2005 Commonfund Benchmarks Study of 707 educational endowments nationwide found the following average asset allocation:

* Alternative strategies, 34 percent

* Domestic equities, 31 percent

* International equities, 16 percent

* Fixed income, 15 percent

* Cash and other short-term investments, percent

Among the largest educational endowments those with $1 billion or more in assets--the allocation to alternative strategies was even higher, at 42 percent.

It is noteworthy that among respondents to the healthcare survey, the organizations with larger (>$1 billion) and more diversified investment portfolios reported average annual returns of 17.2 percent, compared with 12.1 percent for those with smaller ($50-$100 million) and less diversified portfolios. Size was not the differentiating factor. Instead, the data suggest that effective diversification allows a healthcare organization to pursue higher returns while keeping risk at acceptable levels.