Financing The Future

Financing the Future | Capital Allocation

http://www.financingthefuture.org/2/capital_allocation_1003.htm

CAPITAL ALLOCATION Richard L. Clarke Rick Wolfert

three cases for financing the future Three CFOs share how they assess pressing capital needs in an era of tight resources. When it comes to capital, executives of hospitals and health systems are between a rock and a hard place — capital projects loom large, and capital resources are tight. There is no lack of worthy proposals for new facilities, increased services, and technology upgrades. But these come at a time when many hospitals are struggling to find the cash or credit to underwrite these projects. In the past year, the aggregate total hospital margin hit 4 percent, its lowest mark since 1993, according to a report by the American Hospital Association (AHA).a Operating margin was 2 percent, down from 4 percent in 1996. The AHA report notes that, at present, one third of all hospitals experience negative total margins. This funding shortage isn’t for lack of business. Inpatient admissions in community hospitals rose from about 31 million in 1996 to about 33 million in 2000, and outpatient visits grew from 441 million to 523 million during that same period, according to the AHA report. In areas of high population, midnight census of 100 percent and daily census of 120 percent are not uncommon.b Rather, increased staffing cost, increased malpractice/liability insurance expense, flat government payments, increased need for capital projects (some of which offer no quantifiable return on investment), increased need for information technology (IT), and the timing of equipment upgrades have all coalesced to stress hospital liquidity as never before. Capital budgets are under pressure to increase, without being able to project a proportionate increase in revenue. Hospitals Respond For many hospitals, current capital projects run the gamut from those that contribute to an organization’s growth and profitability, such as the addition of a new clinical service, to those the organization depends upon to remain viable, such as clinical IT and the replacement of aged or unserviceable facilities and equipment. Successful not-for-profit hospitals are able to vet capital projects so that organizational requirements for growth, stability, and community service are achieved. Specific processes vary by institution, but they have a common thread: the CFO is facilitator of a process that elicits opinions and expertise from all constituents — physicians, nurses, staff, and community members. An example is Advocate Health Care, Oak Brook, Ill., which serves Chicago and its suburbs. The health system’s list of current projects includes a new

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Financing the Future | Capital Allocation

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cardiovascular program at one of its hospitals. The program is expected to provide a needed service in the community, expand the hospital’s market share, and bring a financial return. Another project is a planned renovation and expansion of an ambulatory surgery center. The project will not create a significant return, but loss of the service would be financially harmful to the institution. One project with which the system struggled to come to terms was replacement of its phone system. Advocate has a patchwork of systems, with inconsistent reliability. The new system is a significant expenditure, says Lawrence J. Majka, Advocate’s executive vice president and CFO. There’s no quantifiable return, but also no choice — healthcare facilities need a working phone system. On the West Coast, California-based Santa Barbara Cottage Hospital is pursuing a daunting project at its flagship Santa Barbara facility—the $345 million rebuilding of its original building, built in the 1920s, long before the advent of the state’s strict seismic safety codes. Another wing, built in the 1970s, also must be replaced. Replacement of the building constitutes a huge investment for the 436-bed hospital, one of three in the Cottage Health System. The hospital realizes that the new construction won’t have a big payback, but it is a necessity for complying with state regulations and to make sure the hospital survives the next earthquake. “The payback will be in a generation,” says Joan Bricher, CFO of Cottage Health System. In Philadelphia, Northeastern Hospital has its own panel of projects under way, including an emergency department renovation and expansion that costs $2.5 million, and a new MRI that will run $2 million. These funds are hard to raise for the hospital, which has limited cash reserves and borrowing capacity. The hospital, part of four-hospital Temple University Health System, serves a primarily urban population, and Medicaid is the primary payer. The hospital has been profitable for seven years, but must continue to build its credit rating after nearly closing in 1994 (Northeastern joined Temple in 1995). Planned equipment upgrades and new technologies include a picture archive and communications system (PACS), new digital radiology equipment, and clinical order-entry systems. The hospital also must replace its elevators, sprinkler systems, and other infrastructure items. The hospital deferred these projects as long as it could, but simply could not put them off any longer. Decision-Making Process The complexity of hospitals as organizations coupled with the scarcity of funding make adherence to a disciplined, consistent capital allocation process critically important. The key to effective capital allocation for both profitable and profitless projects is a rational, clear, and open allocation and prioritization process. Advocate Health Care. In 2003, Advocate had $380 million worth of capital requests, which was about two to three times what was affordable for the system. How those requests were vetted, weighed, and selected serves as a case study in best practices of capital decision-making. With eight hospitals and 3,500 beds located around the Chicago area, Advocate sees more than 1.5 million patients a year. The system has total revenue of about $2.7 billion. All major capital decisions are made at a system level. CFO

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Financing the Future | Capital Allocation

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Majka chairs a capital committee that meets at least quarterly. Members of the committee include the chief medical officer and several chief executives from the operating units, along with the chief strategy officer and other members. The committee screens all capital requests, prioritizes them, and then makes recommendations to senior management and the board of directors. The process of receiving and sorting the requests begins in the summer. Advocate uses a template for capital requests, which are sorted into seven “capital buckets.” Two of the buckets are for clinical technology requests, and the others are for requests relating to facilities infrastructure, IT, market growth, net cost-reducing investments, and major replacement construction projects. Sorting the projects by bucket allows similar projects to be compared. Each bucket is assigned to a “champion,” someone who is familiar with that type of project. The champions develop scoring criteria unique to each bucket, which are approved by the capital committee and used to rank the projects in the buckets. The rankings are presented during a three-day meeting of the capital committee in the fall, along with presentations by all of the operating units. Reflecting on the previous year’s presentations, Advocate CFO Majka says, “We didn’t find a single project that lacked merit — there weren’t any to automatically eliminate from the list.” Under those circumstances, the committee then has to rank the requests within each bucket. The committee uses four ranking levels. Level 1 is “must do,” no matter what the impact on the financial situation. Level 2 is “critical,” the next level of urgency as long as the project can be funded. Level 3 is “important” and is assigned to justifiable projects that reflect the system’s legitimate business concerns but that probably can’t be funded. Level 4 is “other,” for which the committee defers judgment to a later time. Cottage Health System. At the smaller Cottage Health System, capital planning is just as important, though the approach is different. Each of the three hospitals develops its own capital plan, rather than having the whole process centralized. The objective is the same: look for the right balance between keeping the facility state of the art and using available resources wisely. “We don’t have a recipe for our capital expenditures, but we do carefully plan each year,” says CFO Bricher. In past years, Cottage performed regular capital year spending at the rate of its depreciation. Within that parameter, Cottage more or less can budget $14 million, which is the amount of its depreciation. The basic breakdown was that 55 percent of the budgeted amount was applied to medical or other strategic programs, such as acquisition of an MRI. IT was allocated 30 percent of spending. Administration — office staff, furniture, office computers — was allocated 15 percent. “Our philosophy is to put our resources at the bedside,” says Bricher. Each year, Cottage convenes a special panel of physicians from each department to help sort and prioritize the expensive items. In this way, those disciplines within the hospital that excel at justifying their requests are balanced with other specialties. Northeastern Hospital. Northeastern is a hospital in transition. Once on the brink of closure, the hospital was able to achieve a turnaround with the assistance of Temple University Health System. Temple reduced the hospital’s cost structure,

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Financing the Future | Capital Allocation

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tightened the revenue cycle, negotiated fairer third-party contracts, improved patient care, and built volume. Temple also has eliminated duplicative services between four acute care hospitals that were located within five miles of each other. Today, the hospital has $12 million in the bank. And $7 million has been allocated for potential new projects. These include a new emergency department, which not only generates most of the hospital’s admissions but also is the largest single source of referrals for Temple University Hospital, the system’s tertiary care hospital just 2.5 miles away. In recent years, Northeastern has adhered to the discipline of basing capital allocation on cash flow from operations. Projects were prioritized based on factors such as revenue potential, medical staff needs, infrastructure compliance, safety, and quality. This year, CFO Lefton suspects, the process may not allow enough capital for future growth and positioning. “We’re near capacity in terms of space. With the recent closure of a Tenet hospital three miles away, it is likely we may need to add beds, requiring a major building project in the near future. Currently, our ability to take on debt is limited, which is why, at a health system level, we are looking at forming one large obligated group,” he says. “In a volatile market, you don’t want to borrow your future and live beyond your means. But at one point you have to borrow more than you conventionally would to move to the next level.” Profitless Projects For the not-for-profit hospital, the ability to identify and analyze potentially profitless projects is central to achieving a balance of mission and financial viability. CFOs at the most successful institutions have developed ways to categorize and prioritize capital projects. For Advocate’s Larry Majka, a profitless project might end up in the bucket called “major replacement construction project.” This type of project is a core service (hospital or medical group) whose loss would hurt financially, but whose replacement would not provide a quantifiable incremental return. For Advocate, projects that fall into this category include replacement of an ICU (price, $15 to $25 million) and replacement of an emergency department. Cottage’s Bricher says that her institution distinguishes between capital expenditures that by their nature have a payback in two to five years and those that do not increase revenue or even may operate at a loss. As the major community hospital in its region, Cottage is obligated to invest in services that are necessary to provide a standard of care for the community. One example is obstetrics, an area that does not make money and where revenues do not cover its costs. By prioritizing with physicians, the hospital is able to identify departments and projects, like obstetrics, that are too crucial to the mission of the hospital to set aside. “Our physicians are not prioritizing based solely on what’s going to make more money,” Bricher says. Ray Lefton, the CFO at Northeastern, also places projects in different categories. Things like the elevators and oil tank must be replaced to keep the institution functioning, even though they offer no return. Other decisions must be made based on quality of care or patient safety. Sometimes a department that does not provide a good return, such as emergency or obstetrics, nevertheless has financial importance because it is the patient’s gateway into the hospital’s more profitable services. “If one in seven emergency cases is admitted, we can pay our bills,” says Lefton.

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Financing the Future | Capital Allocation

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Financing Options Organizations have a limited menu when it comes to identifying financing options. These options are operating income, investment income, philanthropy, and outside financing. The financing options are consistent from one hospital to another, but hospitals vary in how they make their decisions. At Advocate, capital capacity is sized by looking at the organization’s current cash position, with a projection to the end of the year as well as to the next year. Projecting these numbers involves making some assumptions on projected operating income, investment income, and philanthropy — what Majka calls “a three-legged stool.” The system regards days cash on hand as the constraining, critical ratio. The difference between days cash on hand and the projected cash balance is the capital capacity. Such projections are more difficult in recent years, because the investment income leg has been wobbly for the past three years. Consequently, Advocate is taking a closer look at its financing alternatives. An internal task force identified alternative financing scenarios such as additional borrowing, leasing, off-balance-sheet financing, and noncore asset sales. The result has been a comprehensive financing program that uses some of the financing alternatives identified by the task force. Advocate decided it would need to access the tax-exempt bond markets for about $115 million in 2003 for new projects. The system has projected cash spending on capital projects for 2003 at $225 million. During 2002, the system sold $60 million worth of physician office buildings, a nursing home, a hospital, and other properties. Advocate also worked out a $25 million master lease line arrangement with a major financial services company. Leases offer a way to reduce the risk of technological obsolescence without the constraint of a depreciation schedule. Majka says, “Advocate has also pursued better management of current assets and liabilities, with a corresponding decrease in accounts receivable, and the system is negotiating better payment terms with its vendors. The combination of those two has helped us and will continue to help us.” The next piece of Advocate’s plan is improvement of operating margin. Advocate’s operating margin has averaged between 1.8 and 2.6 percent since 2001. It has set a 4 to 5 percent margin as a long-term target for viability and adequate reinvestment in capital needs. Northeastern’s Lefton agrees that profitability is fundamental, especially for an institution like his that has limited access to capital markets. “Profitability is the single thing we can do to help ourselves,” he says. Cottage’s Bricher says that her system, in anticipation of its $345 million upgrade, has cut back its annual allocation for routine capital expenditures from $14 million to $10 million. Having a healthy balance sheet and a good track record makes Cottage extremely credit-worthy, which is important as the system moves ahead with a huge, profitless expenditure. In addition, the system has been supported for 25 years by the Santa Barbara Cottage Hospital Foundation. This philanthropic organization supports the mission of the hospital by underwriting the hospital’s charity care (including virtually all its Medicaid),

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Financing the Future | Capital Allocation

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meeting certain capital and operating needs, and paying for the medical education program. Forecast for the Future CFOs predict this capital crunch will worsen in the future. According to Bricher, “The capital crunch will definitely escalate in the next five years, especially in the state of California, where the seismic building requirements are estimated to cost $42 billion.” Bricher believes the increase in demand due to aging babyboomers will need to be assessed on an ongoing basis. “As this generation is aging, alternative and preventive treatments are also maturing, thus rearranging the economic burden on the healthcare system,” she says. “We will need to continuously study these market demands and evaluate how best to balance the economic needs.” With abundant capital needs, increasing demand, escalating costs, and tight margins, hospitals have a clear charge: create a systematic approach to capital planning that objectively assesses capital projects and intelligently pursues a range of financing options.

About the authors Richard L. Clarke, FHFMA, is president and CEO, Healthcare Financial Management Association, Westchester, Ill. Rick Wolfert is CEO and president, GE Healthcare Financial Services, Chicago. Questions or comments regarding this article may be sent to Richard L. Clarke at [email protected] or to Rick Wolfert at [email protected].

a. Hospital Statistics, Chicago: American Hospital Association, 2002. b. The Future of Not-for-Profit Healthcare Capital Financing, Healthcare Finance Forum, 2002.

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