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Hospital Capital Formation, Harry Markowitz and Modern Portfolio Theory

Strategic Risk Considerations for Physician-Executives and Healthcare CXOs

[By Calvin W. Wiese; MBA, CPA, CMA]

To most all financial advisors, wealth managers and stock-brokers, the work of Harry Markowitz and Modern Portfolio Theory [MPT] is not usually discussed in terms of hospital capital formation. But, perhaps it should!

Capital Investments Create Risk

Capital investments create risk. Risk is the uncertainty of future events. When hospitals make capital investments, they commit to costs that affect future periods. Those costs are known and relatively fixed. What are unknown are the benefits to be realized by those capital investments.

Defining Risk

For capital investments, risk is the certainty of future costs coupled with the uncertainty of future benefits. In some cases, while the future benefits are uncertain, there is a high degree of certainty that the benefits will exceed the costs. In these cases, risk can be very low. Risk may be better defined as the degree to which the uncertainty of unknown benefits will exceed the known and committed costs.

Asset Burdens and Benefits

When capital assets are purchased, both the burdens and the benefits of ownership are transferred to the owner. The burdens are primarily the costs associated with acquisition and installation. The benefits are primarily the revenues generated by operating the capital assets. Risk of ownership is created to the degree that the benefits are uncertain.

Understanding Risk

Hospital managers need to be skilled at putting hospital assets at risk. Without clear knowledge and understanding of the benefits and the burdens, hospitals can quickly find themselves at unacceptably high levels of risk. Risk must be continually assessed and evaluated in order to successfully put hospital assets at risk. Hospitals require many varied capital investments; their capital investments represent a risk portfolio. An effective combination of risky assets can often create risk that is less than the sum of the risk of each asset.

Modern Portfolio Theory

Of course, financial managers have know this for years as a basic principle of Modern Portfolio Theory (MPT), first introduced by Harry Markowitz, PhD, with the paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller, PhD, and William Sharpe, PhD, for what has become a broad theory for securities asset selection; and hospital assets may be viewed as little different.

Prior to Markowitz’s work, investors focused on assessing the rewards and risks of individual securities in constructing a portfolio. Standard advice was to identify those that offered the best opportunities for gain with the least risk and then construct a portfolio from them. Following this advice, a hospital administrator might conclude that a positron emission tomography (PET) scanning machine offered good risk-reward characteristics, and pursue a strategy to compile a network of them in a given geographic area. Intuitively, this would be foolish. Markowitz formalized this intuition.

Detailing the mathematics of diversity, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios of securities, or capital assets that each individually has attractive risk-reward characteristics. In a nutshell, just as investors should select portfolios not individual securities, so hospital administrators should select a wide spectrum of radiology services, not merely machines.

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Assessment

Savvy hospital managers will mitigate ownership risk by constructing their portfolio of risky assets in a manner that lowers overall risk

Conclusion

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Capital Formation for Hospitals

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Understanding Strategic Expenditures

[By Calvin W. Wiese; MBA, CMA, CPA]


Some of the most important strategic decisions hospital executives make are related to capital expenditures. Almost every hospital has capital investment opportunities that are far in excess of their capital capacity. Capital investments are bets on the future. How these capital bets are placed has long-lasting implications. It is of utmost importance that hospitals bet right.

Strategic Importance of Capital Investing

Hospitals are capital intensive businesses. Hospital buildings are unique structures that require large amounts of capital to construct and maintain. Inside these buildings are pieces of expensive equipment that have fairly short lives. Technological innovations continually drive demand for new and more expensive equipment and facilities. The ability to continually generate capital is the lifeblood of hospitals. In order to compete and succeed, it’s imperative for hospitals to continually invest in large amounts of capital equipment and expensive facilities.

Profit Driven

Capital investment is fueled by profit. In order to continually make the necessary capital investments, hospitals must be profitable. Hospitals unable to generate sufficient profit will fail to make important capital investments, weakening their ability to compete and survive.

Capital Opportunity Selection

Hospital managers bear important responsibility in choosing which capital investments to make. There are always more capital opportunities than capital capacity. In many cases, capital opportunities not taken by hospitals create openings for others with capital capacity to fill the vacuum. By not taking such opportunities, hospitals are weakened, and their operating risk increases.

Stewardship

Stewardship is a term that aptly describes the responsibility borne by hospital managers in making capital investments. The New Testament parable of the talents describes this kind of stewardship. In this story, a merchant entrusted three managers with money to invest. One manager was given five units, another two, and a third one. At the end of the investment period, the two managers given five units and two units reported a 100% return. The manager given one unit reported zero return — he was fired and his unit was given to the first manager.

This is stewardship — and hospital managers are stewards of their organizations’ assets. Too often, not-for-profit hospital managers hold an erroneous view of the returns expected of them. Like the third manager in the parable, they think zero return on equity is acceptable. They understand capital investment funded by debt needs to cover the interest on the debt, but they view capital investments funded by equity as having no cost associated with the equity. From an accounting perspective, they are right. From a stewardship perspective they are dead wrong — just like the third manager in the parable.

Here’s why: as stewards, they are responsible for managing the entrusted assets. They can either put these assets at risk themselves, or they can put those assets in the market and let other managers put them at risk. If they choose to put them at risk themselves, and then they have the mandate of creating as much value from putting them at risk as they would realize if they put them in the market for other managers to put at risk. They have the duty to realize returns that are equivalent to the returns they could realize in the market; otherwise, they should just put them in the market. They can either invest in hospital assets or work the assets themselves, or they can invest in financial market assets so others can work the assets. When they choose to invest in hospital assets, the required return is not zero. That’s the return they get fired for. The required return is equivalent to market returns.

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Assessment

Thus, when evaluating performance of hospital management teams, the minimum acceptable performance level is return on equity that is equivalent to the return that could be realized by investing the hospital assets in the market. And when evaluating a capital investment opportunity, it is important to apply a capital charge equivalent to the hospital’s weighted cost of capital — a measure that imputes an appropriate cost to the equity portion of the capital along with the stated interest rate for the debt portion of the capital structure.

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Conclusion

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Hospital Financial Capital Capacity

An Economic Risk Measurement

By Calvin Weise; MBA, CPAho-journal5

Hospital capital capacity is all about risk.

A Risk Measurement

Since capital investments have risks associated with them, capital capacity is a measurement of how much risk a hospital can bear. Capital capacity is not simple to determine. Capital investments introduce varying levels of risk, depending on the relative uncertainty of the benefits to be derived.

For example, one million dollars invested in an MRI at a hospital that has a two-month backlog for scheduling MRIs has much lower risk than $1 million invested in a new service like a PET scanner.

Profit Margins

Profit margins affect capital capacity. Larger profit margins create larger capacity for uncertainty which implies more risk and that means more capital capacity. Higher liquidity means more capital capacity. Lower debt leverage means more capital capacity. Liquidity and leverage are balance sheet ratios. Both imply capacity to absorb uncertain outcomes; both affect capital capacity.

Capital Determinations

Determining capital capacity is more art than science because of the variability in risk presented by various capital investments and the subjectivity associated with trying to measure that uncertainty.

That having been said, it is important to build models that estimate capital capacity. Most capital capacity models ignore the variability in risk presented by capital investments. They are typically built from published rating agency financial ratio medians. These models are based on the view that financial ratios of similar rating categories represent equivalent risks.

Of course, this is a simplistic view as it suggests that credit analysts simply categorize risk on the basis of financial ratios. It is not the case as the recent financial meltdown has demonstrated. Even the major credit rating agencies have been implicated as suspect; of late

Assessment

Published medians are the result of credit analysis, not the basis for credit analysis. Importantly, what is not usually published is the range or distribution around these medians. Models that estimate risk need to differentiate among risks presented by capital investments. Capital investments with little risk should consume less capital capacity than capital investments with a lot of risk.

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Conclusion

And so, your thoughts and comments on this Medical Executive-Post are appreciated. How does your practice, medical clinic or hospital measure and report capital risk; does it?

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