Corporate Structure And Capital Strategy At Catholic HealthcareWest

This paper analyzes the evolution of capital investment strategy at Catholic Healthcare West (CHW) between 1996 and 2005, as the forty-hospital system reversed its financial losses and diversified into ambulatory services and high-growth markets. The system developed a formal process for allocating capital among profitable facilities and those providing charitable services in communities with high social needs. Capital priorities shifted from weak facilities in low-growth markets (from 35 percent to 27 percent of total investment) to strong facilities in high-growth markets (from 32 percent to 45 percent). Mission-related investments were made to sustain, but not expand, the system’s presence in low-income communities. [Health Affairs 25, no. 1 (2006): 134–147] P ol i cy attent ion to the consol idat ion of the hospital industry has focused on mergers among adjacent facilities, balancing the hope for economies of scale with the fear of stronger pricing power. The striking feature of the contemporary hospital landscape, however, is chain organizations, both nonprofit and for-profit, that extend across multiple cities and, in many instances, across states or regions. The hospital chain should be interpreted as an internal market for capital—the deployment of financial surpluses generated from established facilities to the penetration of new markets and services. Local operating efficiency and pricing power are important for generating the surplus, but a central role of the parent organization lies in evaluating the portfolio of markets in terms of where to increase and where to decrease investments, where to buy and where to sell. Corporate strategy in the chain is inherently about entry and exit, the transfer of capital from markets where expansion opportunities are limited to those where demographics and economics offer the potential for profitable growth. This paper analyzes the market strategy and role of capital finance at Catholic Healthcare West (CHW) to illuminate the strengths and challenges of chain organization in the hospital sector. CHW is representative of U.S. large nonprofit hospital systems, with forty acute care facilities and numerous ambulatory, physician, and ancillary services spread across California, Arizona, and Nevada. During the heyday of managed care in the 1990s, it embarked on a strategy of vertical and horizontal integration and suffered severe losses from conglomerate overexpansion. CHW subsequently returned to black ink by centralizing governance and imposing performance benchmarks, developing turnaround strategies for underperforming facilities, and divesting unprofitable hospitals in economically unattractive markets. It is now expanding in high-growth cities such as Las Vegas and Phoenix, defending its strongholds in central California, and limiting its losses in economically unfavorable markets such as Los Angeles. CHW offers a good context for studying chain organization because it is not a monopoly in any market and faces competent competitors even in communities where it is strongest. CHW’s recent history sheds additional light on the dynamics of chain structure due to its nonprofit heritage, built through the amalgamation of facilities from seven Catholic orders and now spread over dozens of forC o r p o r a t e S t r u c t u r e H E A L T H A F F A I R S ~ V o l u m e 2 5 , N u m b e r 1 1 3 5 at UNIV OF CALIFORNIA on August 29, 2012 Health Affairs by content.healthaffairs.org Downloaded from merly Lutheran, Methodist, nondenominational, and governmental institutions. The organization must continually balance the chain strategy of entering profitable markets and exiting unprofitable ones with the religious mission of focusing on communities with large clinical and financial needs. This imperative pushes CHW beyond the “no margin, no mission” reality facing every nonprofit organization to a continual examination of where it is making money and where it is losing it, and then of ensuring that the losses in the unfavorable markets are targeted, predictable, and sustainable. The Strategy Of Integrated Delivery CHW was formed in 1986 as an affiliation of facilities that perceived the increasingly competitive environment as demanding more than a charitable mission and a cost-plus revenue strategy. Because hospitals often have fiercely independent community boards and medical staffs, hospital aggregation rarely generates economies of scale even in the most favorable market environments. CHW experienced the extra challenge of having its most prominent facilities concentrated in Sacramento and San Francisco, where Kaiser Permanente and capitation payment drove prices and utilization to national lows. CHW embarked on a strategy of organizational integration, acquiring and investing in multiple medical groups and independent practice associations (IPAs). The pursuit of physician affiliations, capitation contracts, scale economies, and bargaining power culminated in the decision to expand its statewide and multistate presence, acquiring facilities in Phoenix, Las Vegas, and various southern California communities. The growth frenzy peaked in 1998 with the acquisition of eight non-Catholic facilities in Los Angeles, the most competitive U.S. health care market. Underpinning CHW’s efforts at vertical integration with physicians and horizontal integration with hospitals was the belief that the fundamental unit of service would change from the hospital admission to a continuum of inpatient, outpatient, primary, specialty, and ancillary services for a defined population of patients. This view underlay the system’s physician practice acquisitions, designed to feed referrals into the hospitals and to piece together the new, larger health care product. It also supported what became an article of faith: that coordination would reduce overall costs even if the costs of some individual services increased. The emphasis on global revenues and aggregate costs diverted management’s attention from the incremental revenues and costs attributable to each site and service. The characteristic failing of fragmented clinical organization and feefor-service (FFS) payment had been inattention to synergies and systemwide performance. The failing of integrated delivery proved to be inattention to the individual performance of the system’s many components. CHW embedded the logic of integration into its market, brand, operational, and financial strategies. If covered lives rather than individual procedures were to be the economic unit, and if more covered lives brought lower costs and higher 1 3 6 J a n u a r y / F e b r u a r y 2 0 0 6 C o n s o l i d a t i o n at UNIV OF CALIFORNIA on August 29, 2012 Health Affairs by content.healthaffairs.org Downloaded from revenues, then expansion to the largest regional markets would ensure the success of the enterprise. Consistent with its efforts at integrated organization, CHW attempted to create a systemwide brand identity, blazoning the CHW logo on its hospitals and downplaying local brands. An increasing number of functions were centralized to the corporate level, including billing, purchasing, and information technology (IT). Financial performance was measured at the regional level, and operational shortfalls were covered by investment earnings, which impeded efforts to see where the firm was making money and where it was losing it. The strategy of integrated delivery is not necessarily flawed, but it requires mechanisms of governance that balance the authority of the system as a whole with the autonomy of its key service subunits. CHW suffered from an inappropriate structure of control, as management sought to make decisions and set direction at the corporate level while facility-specific local boards retained ultimate fiduciary authority. Local autonomy impeded the system from consolidating its financial assets and using the surpluses earned in its established markets as investment capital to deploy in communities with better growth opportunities. The strategy of integrated delivery, and the loss of focus it fostered, permitted CHW to remain a weak empire of strong principalities, a holding company whose distinct businesses hoarded any profit and clamored for subsidies to cover any loss. CHW’s life as a statewide integrated delivery system (IDS) was enthusiastic, traumatic, and short. Already in 1998, when the overexpanded system was acquiring hospitals in Los Angeles and deepening its dependence on overextended physician organizations, the financial alarms were beginning to sound. The Los Angeles facilities carried massive debt and helped swing CHW from a modestly positive operating gain of $26 million in 1996 to a loss of $353 million in 1999 and then to a further loss of $323 million in 2000 (Exhibit 1). Investment profits on its stock portfolio kept CHW afloat, but the bond markets scorned its once-stellar debt, with a costly series of bond downgrades from A+ to BBB. In June 2000, with falling liquidity ratios and the rating agencies threatening to downgrade its bonds to speculative (junk bond) status, CHW brought in a new chief executive officer and, with him, a new market, service, and financial strategy. Turmoil And Turnaround The organizational crisis that beset CHW in 2000 had the salutary effect of disposing the system’s stakeholders to grant the new executive team a relatively free hand in centralizing financial authority while delegating operational responsibility to the local facilities. To stanch the financial hemorrhaging, CHW began divesting physician practices and financially irremediable hospitals, outsourcing IT, C o r p o r a t e S t r u c t u r e H E A L T H A F F A I R S ~ V o l u m e 2 5 , N u m b e r 1 1 3 7 “Integrated delivery requires mechanisms that balance the authority of the system with the autonomy of key service subunits.” at UNIV OF CALIFORNIA on August 29, 2012 Health Affairs by content.healthaffairs.org Downloaded from and sharply restricting capital spending. These budgetary initiatives were predicated on a centralization of governance and consequent transformation of local hospital boards from quasi-independent fiefdoms to nonfiduciary advisory bodies. The corporate office stopped seeking a systemwide operational strategy and focused on developing performance benchmarks by which each local unit could be measured, compared with its peers, and held accountable for improvements. In its first turnaround year, CHW divested almost all of its physician practices plus several of its hospitals. It abandoned the once-heralded Shared Business Services and outsourced its major IT needs to Perot Systems. Contracts with insurers were renegotiated with an eye toward leveraging any untapped bargaining power in strong markets and toward allowing facilities in weak markets to benefit from better contract language and guarantees of contract enforcement. Capitation was renounced in favor of per diem contracts that included stop-loss thresholds, above which the hospitals were reimbursed a percentage of billed charges. The increase in revenues derived from higher prices and reversion to FFS was a major factor alongside improved productivity and cost reduction in the system’s subsequent improvement in earnings. Operating results improved dramatically, from losses of $134 million in 2001 to gains of $183 million in 2005. 1 3 8 J a n u a r y / F e b r u a r y 2 0 0 6 C o n s o l i d a t i o n EXHIBIT 1 Trends In Scale, Profitability, Asset Strength, And Other Characteristics At Catholic Healthcare West (CHW), Selected Years 1996–2005 Fiscal year ended June 3