Bear Market Results Highlight the Need for an Integrated Approach to Risk and Resource Allocation

Twenty months ago, Kaufman Hall published observations on the capital markets, mentioning that “after a long hibernation, animal spirits may be awakening.” Previous monetary policy had been aggressively accommodative, but plans were moving forward to unwind the Federal Reserve’s support.

That activity, which commenced in Spring 2017, coupled with substantial tailwinds from corporate tax reform and deregulation, seemed to indicate that market stakeholders would need to be looking at risk and return with increased vigor. Indeed, lacking the Fed’s continued market support, stakeholders started adjusting to the notion of once again being in the driver’s seat with the uninsulated experience of risk and return.

2018: A Year of Diminished Returns

Fast forward to late 2018. Animal spirits were fully roused; unfortunately, what the spirits awakened were those of a  bear, who swiped prices downward amid widespread pessimism and negative investor sentiment.

The NASDAQ Composite entered bear territory, defined as a drop of 20 percent from its previous high, on Dec. 21, 2018. The other two major stock market indices, the S&P 500 and Dow Jones Industrial Average, also squarely entered correction territory, down more than 15 percent from their all-time highs.

The bear was not only stirring, but enraged. By the end  of  2018,  no  major  market  was  spared  of  the  “rolling  bear market.” The Asset Class Quilt of Total Returns (Exhibit 1) illustrates that  every  major  asset  class  or  index  struggled  relative to historical performance standards. No classes or indices even surpassed the rate of inflation, which was
1.9 percent. Only cash and U.S. Treasuries showed gains, albeit low ones of 1.8 percent and 0.3 percent, respectively. Losses exceeded 10 percent for numerous asset classes and indices.

Pronounced volatility occurred marketwide as 2018 drew to a close. The VIX index, which measures the expectation for stock market volatility as implied by S&P 500 index options for the next 30 days, was up 102 percent for the year. VIX was by far the leading investment alternative for 2018. The next closest alternative was natural gas, which was up 23 percent for the year.

Certain fundamentals persist in the market, namely trade tensions with China, arguably a late-stage economic expansion, and a Fed that remains interested in shrinking its balance sheet and raising short-term rates. In view of these factors, volatility will likely persist, and global markets are likely to remain challenged until these factors subside.


The Damage that Can Be Done by Capital Markets Risk

Following severely lackluster investment performance in 2018, the question now is whether healthcare organizations remain properly positioned to fund near-term strategic initiatives, major capital planning cycles, and even routine capital spending plans on a projected basis. The combined risk factors of lower investment returns and net asset values coupled with lower interest rates may also now call for additional pension contributions.

Kaufman Hall conducted a study of net income available for debt service (NIADS) based on audited 2017 financial results.1 Given that NIADS is an important source of capital for many healthcare organizations,  the study investigated the extent of damage that can be done by capital market risks.

The study revealed that approximately 25 percent of NIADS in aggregate is derived from realized investment income. The proportion varies to some degree by rating category, but only to a limited degree. Based on 2018’s investment performance, many organizations are likely to have generated a NIADS that is much lower than needed to fund their projected capital needs.

Get Integrated to Get Smart

Many compartments of risk reside within a hospital operating company. Some are controllable; others are not. Some can be hedged; others need to be owned and managed. Organizations that have properly mapped risk exposures and allocated resources accordingly should still be well positioned to maintain their capital commitments.

Identifying the contributors to cash flow variability is the first step to a better planning approach. Once properly identified, it becomes possible to quantify various risk characteristics and how risks might manifest themselves.
Integrating strategic financial planning with balance sheet modeling (both assets and liabilities) best positions an organization to achieve its strategic and financial objectives while protecting itself against the cash-flow variability generated by different kinds of risk.

Exhibit 2 provides an example of a relatively simple sensitivity analysis. It shows the impact on days cash on hand and operating margin of lower-than-projected performance with various growth, payment, and other assumptions. Note the linear trend line for most scenarios relative to baseline projections (Scenario A), which indicated 290 days cash and a little more than -1.5 percent operating margin in 2023. But also note Scenario G, which shows the impact of a 1 percent lower investment income during the forecast period. This scenario is non-correlated with operating performance, but the outcome of Scenario G’s nearly 50-days cash drop is a stark departure from the baseline credit position (i.e., Scenario A).


This sort of top-down scenario analysis is helpful, but a more thorough approach is required. Time and again, an organization’s balance sheet and invested assets, in particular, are the hedge of last resort against risks that cannot otherwise be managed. With that in mind, what can an organization do to protect its ability to fund its strategic and operational commitments while also positioning its balance sheet to grow and generate investment income?

Enterprise  Resource Allocation

Use of an integrated approach to stewarding cash and invested assets can answer this question by looking across the organization for the broad role that cash and invested assets play in relation to operations, strategy, and liabilities.  Within core operations, a wide array of exposures exists, and mere top-down scenario analysis is insufficient. Interviews with key stakeholders throughout the organization, coupled with thoughtful analysis and quantification, are necessary to properly reflect the exposures common to hospital providers.

Simultaneously, this approach aims to facilitate balanced growth and income from invested assets while buffering assessed operational and balance sheet risks. Further, the approach is mindful of key duties of cash, involving the preservation of credit ratings and funding access, coverage of demand debt, and maintenance of liquidity covenants. Under this view, invested assets serve many roles and should continuously serve as the balancing agent for resources and risk across the enterprise, given their adjustment capabilities compared with other risk-bearing pursuits of the organization.

The interconnectivity of the three elements of an organization’s treasury function—debt and derivatives, treasury operations, and invested assets—is important to consider.  But even more critical to success is the integration of treasury within the broader organization’s strategic, financial, and capital planning process. Identifying and managing financial risks across the organization requires an integrated approach to resource and risk allocation.