HEALTHCARE Allocating Capital: Making the Right Decisions in a Changing Environment By Jason H. Sussman and Jess Block
Decision Making Related to Capital Spending Must Be a Strategic Function Respect for the relationship between strategy, capital capacity, and risk has never been more important given current pressures on operating margins. Organizations must find an acceptable balance between the need for continuing strategic investment and their ability to generate capital capacity i.e., the capital required to fund strategic and routine capital needs. $X The Corridor of Control reflects the Over-Investment balancing point between two opposing goals: Strategy and Related Investment Corridor of Control Under-Investment 1. Compete effectively through aggressive investment of capital and operating dollars, BUT 2. Respect the fiduciary role of management and the board to maintain the long-term financial integrity of the organization as a community asset $0 Capital Capacity $X 2 Allocating Capital: Making the Right Decisions in a Changing Environment
An Evolved Decision-Making Process Is Required In the current dynamic environment, long-term success depends even more highly on today s capital investment decisions: Transition from fee for service to payment for value limits revenue upside as a source of immediate return on strategic capital investments Expanded consumerism has created increasingly diverse capital needs, some of which extend beyond the traditional capital spending areas Given these pressures and others, the ability of an organization s core business to support all of its strategic capital requirements is limited. This means that the capital process must now manage a range of decisions, many of which were outside the purview of capital decision making in the past. Allocating Capital: Making the Right Decisions in a Changing Environment 3
Thoughtful Process Design Must Address Certain Fundamentals Strategic investments outside of existing operating structures add increased risk, but are vital to protect and/or improve the organization s net revenue stream. For example, to participate in delivery networks that are forming regionally and nationwide, organizations are pursuing affiliations and partnerships that may require significant capital investment. The investment safety net is gone the impact of bad capital decisions has both immediate and long-term implications. Previous failures in strategic investment include current areas of focus: Physician integration strategies Health plan ownership Capitation contracting Rapid market consolidation also is limiting capital capacity. 4 Allocating Capital: Making the Right Decisions in a Changing Environment
Integrated Decision Making Includes Strategy, Financial and Capital Planning, and Budgeting In a rapidly evolving and dynamic industry, integrated decision making and management are more important than ever. Can the strategies be implemented within an acceptable credit context? Financial Planning Mission-Based Strategies Annual Budget Balance financial abilities to strategy over five years Build cash and debt capacity Maintain single credit profile Completely integrated with strategic plan, financial plan, and capital budget How much debt? Under what structure? At what cost? Under what terms? Capital Structure Feedback and Control Accountability, credibility, and results are key Capital Support strategic implementation within credit profile Optimize flexibility and cost How much can/should we be spending? Where are the capital dollars best deployed? Corporate-based approach Quantitative rigor, NPV Monitoring of results Allocating Capital: Making the Right Decisions in a Changing Environment 5
Five Considerations Are Key When Allocating Capital 1 Redefine capital and its role in the planning process 6 2 Establish objectives and principles to frame the process 3 Quantify available capital comprehensively Allocating Capital: Making the Right Decisions in a Changing Environment 4 Institute concept and pre-planning phases for multi-year, high-dollar projects 5 Require complete business planning analysis of high-dollar projects
1 Redefine capital and its role in the planning process Two Components of the Capital Process Must Fit into the Comprehensive Planning Cycle Capital allocation is the planning process for deploying scarce capital resources (cash and debt capacity) for investment in: Mission- and community-based imperatives Existing service line growth New businesses/ventures Routine infrastructure Information technology Strategic, operational, and functional repositioning for the new era The balance sheet (i.e., cash reserves) to fund a competitive liquidity and credit position Capital management is the ongoing monitoring and control function that keeps the allocation decision process honest and ensures appropriate application of allocated funds. Allocating Capital: Making the Right Decisions in a Changing Environment 7
1 Redefine capital and its role in the planning process On a Fiscal Year Basis, Planning and Management Should Be a Continuously Integrated Process A comprehensive, integrated INTEGRATED PLANNING calendar will improve decision making throughout the annual management cycle. CAPITAL MANAGEMENT Retrospective Review Capital Monitoring Capital Spending Strategy Formulation Long-Range Financial Planning Short-Term Profitability Targets OPERATING BUDGETING Operating Budget Development Review Approval to Spend CAPITAL ALLOCATION Capital Constraint/ Available Capital CAPITAL BUDGET Capital Budget Integration Finalization BOARD APPROVAL Capital Requests Review and Evaluation Coordinated Operating & Capital Budget Allocation and Recommendation 8 Allocating Capital: Making the Right Decisions in a Changing Environment
1 Redefine capital and its role in the planning process The Definition of Capital Needs to Reflect the Breadth of Strategic Investments Capital should include all types of proposed project investments (i.e., uses of cash) that will be subject to the policies and structure of the capital allocation process. With the evolution and expansion of the strategic imperatives driving industry success, the definition of capital also must evolve to capture the organization s changing strategic direction. In today s environment, the definition of capital should be expanded to include: Facilities, equipment (including IT), and property New operating entities/programs Business acquisitions and partnerships Network development Managed care investments Program start-up subsidies/expansion Physician recruitment/arrangements System initiatives These capital investments must be covered by the process regardless of the accounting treatment or potential source of financing (including leases) anticipated to fund the proposed investment(s). Allocating Capital: Making the Right Decisions in a Changing Environment 9
1 Redefine capital and its role in the planning process Three Capital Allocation Pools Can Be Defined Healthcare organizations with successful, best-practice capital allocation and management processes define three pools an approach recommended for all organizations: 1. Threshold capital pool: A threshold capital request is any proposed capital expenditure above a dollar amount specified by the organization. This pool covers these expenditures, which require comprehensive business planning analysis and centralized review, as described later. 2. Non-threshold capital pool: This pool covers capital requests that are below the threshold dollar amount and can be handled in a decentralized fashion. Non-threshold capital pool Threshold capital pool 3. Contingency pool: This pool is intended to support/supplement funded or unforeseen threshold capital needs. Contingency pool 10 Allocating Capital: Making the Right Decisions in a Changing Environment
2 Establish objectives and principles to frame the process Clear Objectives Must Be Established to Frame the Process Objectives define the identified goals. They should be specific, measurable, and have a defined completion timeframe. Achieving these considerations should be kept in mind when setting processrelated objectives: Rational and consistent investment decisions Uniform criteria applied in a formal review process for evaluating all investment decisions Alignment of long-range strategic, financial, and related operating plans Application of a portfolio approach to assure that decisions add measurable financial and strategic value Integration of capital allocation decisions directly with the annual budget and multi-year financial plan Direct assessment of how decisions may affect capital capacity and credit rating Clear delineation of roles, responsibilities, and accountability Allocating Capital: Making the Right Decisions in a Changing Environment 11
2 Establish objectives and principles to frame the process Solid Principles Provide Decision-Making Focus Organizations should establish principles to guide their capital process. This ensures focus, consistency, and transparency, as well as the alignment of resulting decisions with the organization s strategic goals. Key considerations covered by process principles include: Definition of capital capacity and how it is generated Ownership and application of organizational capital capacity Portfolio-based evaluation of overall capital performance Incorporation of qualitative and quantitative data to reflect strategic goals Definition and segregation of capital project types based on their cost and relative impact Identification of centralized versus decentralized components of the decision process Requirements for quantitative financial analysis for threshold capital projects Comparative decision making through implementation of a singlebatch evaluation structure Separation of project investment and financing decisions Formal management of unspent dollars 12 Allocating Capital: Making the Right Decisions in a Changing Environment
3 Quantify available capital comprehensively Capital Availability Should Reflect Comprehensive Organizational Cash Flows A best-practice process clearly defines the organization s Capital Constraint the net capital available for spending during a designated time period. Based on the organization s multi-year financial plan, the Capital Constraint should account for all sources and uses of cash. Sources of Cash Uses of Cash Net income plus depreciation Principal payments New financing proceeds External transfers Existing bond-related construction funds Carry-forward capital Cash reserve spend-down Contingency set-asides Working capital release Balance sheet cash reserves Philanthropy (donor restricted) Working capital funding Allocating Capital: Making the Right Decisions in a Changing Environment 13
4 Institute concept and pre-planning phases for multi-year, high-dollar projects Large Projects May Require Multi-Phase Planning, Review, and Approval If planning for a large, multi-year project is elongated, it may be necessary to establish early stage way points for allocation decision making. Way points can be divided into the Concept Phase and the Pre- Planning Phase: These early stages typically require limited capital allocation, but should: Designate which project concepts should be pursued Establish specific funding priorities Creating a segregated contingency fund for these early efforts ensures necessary evaluation before major capital commitments are required. Concept Phase activities are internal with no material funding required Pre-Planning Phase involves defined funding through a Pre-Planning Contingency (part of the Capital Constraint) to pursue limited evaluative activities 14 Allocating Capital: Making the Right Decisions in a Changing Environment
4 Institute concept and pre-planning phases for multi-year, high-dollar projects Early Stage Evaluation Meets Strategy Development and Regulatory Needs Concept Phase Pre-Planning Phase Scope of Activity Broad definition of costs, strategic fit, and facility impacts Feasibility analysis to detail: Capital required Facilities impacts Requires a completed business plan Resources Internal resources only Outside architects Organization finance, planning, and facilities staff Approval Required to Enter Phase None Capital Management Council Sub-Committee Frequency of Approvals Not applicable Continuous on a monthly basis Funding Available None $XXX per project $XXX annually organization-wide Allocating Capital: Making the Right Decisions in a Changing Environment 15
5 Require complete business planning analysis of high-dollar projects Complete Analysis of Threshold Capital Projects Will Result in Better Decisions All threshold capital should require comprehensive business planning analysis and centralized review. The dollar amount of the proposed investment, in effect, triggers the appropriate level of analysis and review. Consistent application of standard analytic procedures is key to successful capital evaluation and allocation. Tried and true corporate finance techniques continue to provide the best basis for comprehensive decisions: Net present value (NPV) and risk-adjusted NPV Internal rate of return Multi-year cash flow projections Analytic requirements should be universal and well understood throughout the organization. As the definition and uses of capital expand, applying analytic rigor to qualitative measures also will be increasingly important. 16 Allocating Capital: Making the Right Decisions in a Changing Environment
5 Require complete business planning analysis of high-dollar projects Structured Qualitative Analysis Complements Quantitative Analysis and Enables Complete Assessment of Capital Priorities With increasingly varied capital investment needs, non-financial criteria have become more important to the identification of an effective portfolio of investments. Supplementing standard quantitative analytics, all proposed projects should be evaluated based on weighted qualitative criteria to generate a qualitatively ranked capital portfolio. Sample criteria might include: Mission Safety/quality Growth Physician alignment % % % % Workforce development % Efficiency % Allocating Capital: Making the Right Decisions in a Changing Environment 17
5 Require complete business planning analysis of high-dollar projects A Portfolio Approach Provides a Comprehensive View of Capital Requirements A comprehensive portfolio approach to capital allocation: Enables qualitatively based decisions Quantifies the impact of those decisions Protects mission and community initiatives Ensures that the overall investment will generate long-term value Providing structure to the review and comparison process is vital, especially in times of uncertainty: Focuses on areas of inconsistency Quantifies the changes in portfolio value on a real-time basis Provides a means to address evolutionary and innovative needs 18 Allocating Capital: Making the Right Decisions in a Changing Environment
A Structured, Portfolio-Based Allocation Approach Is Industry Best Practice The end capital allocation discussion should focus on the trade-offs among mission, strategy, and financial return for the entire portfolio. This is best achieved if: All project proposals are evaluated on an apples-to-apples basis The ultimate portfolio of projects has a positive expected NPV The agreed-upon portfolio will create sufficient financial return to support the organization s mission and broad strategic needs Final decisions are transparent, enabling management to reinforce support for all aspects of organizational strategy as reflected in the selected portfolio of capital investments Allocating Capital: Making the Right Decisions in a Changing Environment 19
About the Authors Jason H. Sussman, a Managing Director of Kaufman Hall, directs the firm s Strategic Financial and Capital Planning practices. He also is Chief Executive Officer of Axiom EPM, LLC, a subsidiary of Kaufman Hall, and responsible for the oversight of the combined Kaufman Hall Software Division. In addition to his management responsibilities, Mr. Sussman provides financial and capital planning and financial advisory services for private, nonprofit, and public entities nationwide. His areas of expertise include strategic financial planning, capital allocation, mergers and acquisitions, financing transactions, and management software. Prior to joining Kaufman Hall, Mr. Sussman directed the Chicago Capital Finance Group of a national accounting firm s healthcare consulting practice. Mr. Sussman is the author of The Healthcare Executive s Guide to Allocating Capital. In addition, he has authored articles for various industry periodicals, and received the Helen Yerger/L. Vann Seawell Best Article Award from the Healthcare Financial Management Association for Ensuring Affordability of Your Hospital s Strategies, an article he co-authored in the May 2009 issue of hfm magazine. Mr. Sussman received an M.B.A. in Finance and Accounting from Northwestern University s J.L. Kellogg Graduate School of Management and a B.A. from the Johns Hopkins University. He holds a CPA certificate in Illinois. jsussman@kaufmanhall.com Jess Block is a Vice President in Kaufman Hall s Software practice. He is the Product Manager for Kaufman Hall s capital software solutions, leading the design and development teams and helping to guide the products future direction. Since joining the firm in 2008, Mr. Block has implemented, trained, and consulted with health systems nationwide in the use of the firm s software suite. Mr. Block brings more than 15 years of software design, financial modeling, and consulting experience to his current role. He started his Kaufman Hall career in the Financial Advisory and Financial Planning practices, where his responsibilities included financial modeling and analytics to support the financial and capital plans and capital allocation processes of organizations nationwide. Prior to joining Kaufman Hall, Mr. Block was a manager at Archstone Consulting, where his responsibilities included post-merger integration, financial process design, and project management. Prior to this, he was Vice President of Consulting at Strata Decision Technology. Mr. Block has a B.A. in Finance and Actuarial Science from the University of Illinois at Urbana-Champaign. jblock@kaufmanhall.com 5202 Old Orchard Road, Suite N700 / Skokie, Illinois 60077 / 847.441.8780 phone / 847.965.3511 fax / kaufmanhall.com