Health Affairs, 25, no. 1 (2006): 134-147 doi: 10.1377/hlthaff.25.1.134 © 2006 by Project HOPE	New Online   Senate Health Reform Bill   Rewarding Providers   Public Option Policy Brief   Health Reform & Abortion   Delivery System Reform

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Consolidation

Corporate Structure And Capital Strategy At Catholic Healthcare West

PROLOGUE: The hospital competitive landscape has endured often convulsive transformation during the past decade. The industry has been buffeted by conflicting forces, hampering its health as a sector and influencing the strength of its competitive posture with respect to other components of the health care delivery system. Such factors have, at various times, included persistent overcapacity, misallocation of institutional assets and resources, low payment rates, aggressive competition from physician-owned entities and specialty hospitals, and the increasing burden of uncompensated care.

Under the conventional competitive wisdom that size begets strength, such market forces have sparked a trend toward rapid and aggressive hospital mergers and the ascendancy of hospital systems operating as integrated delivery systems. And, as we learned from Health Affairs’ 2003 thematic issue on hospitals, hospital consolidation, by way of hospital systems acquiring other hospitals, far outstripped the competitive transformation achieved through mergers.

This paper analyzes the market and capital investment strategy at Catholic Healthcare West (CHW) between 1996 and 2005 to illuminate the strengths and weaknesses of chain organization. Abandoning its erstwhile focus on integrated delivery and growth for growth’s sake in favor of selective divestments and investments, CHW achieved a remarkable turnaround in operating earnings and financial asset strength. As a nonprofit organization with religious sponsorship, however, CHW also developed a strategic approach to how to balance the financial investment and divestment priorities with those stemming from its charitable mission. The paper illustrates CHW’s strategy to distribute capital investments across the system’s forty hospitals in terms of each facility’s profitability, the economic prospects of the market in which it is located, the extent to which it provides charitable services, and the social and health needs of its community.

James Robinson (jamie{at}berkeley.edu) is the Kaiser Permanente Distinguished Professor of Health Economics at the University of California (UC), Berkeley, School of Public Health. Sandra Dratler (dratler{at}haas.berkeley.edu) is a lecturer at the UC Berkeley School of Public Health and Haas School of Business.

Abstract

 
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.

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.² 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 formerly 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

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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.³ 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, out-patient, 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 fee-for-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 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.

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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.⁴ 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.

The Strategy Of Selective Diversification

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The turnaround initiatives at CHW were mandated by its dire financial situation but also reflected a new interpretation of its markets and services, which was able to flower when the worst of the losses were contained. The new interpretation might be denoted the "strategy of selective diversification" and contrasted with the erstwhile strategy of integrated delivery.

The fundamental assumption of selective diversification is that some health care services are inherently profitable while others are inherently unprofitable, and that organizational success is determined by a judicious choice as to which to provide and which to avoid. Gone is the assumption that health care will be aggregated into bundles of physician, hospital, and ancillary services that are priced and purchased per member per month, and hence where the relation between marginal cost and marginal revenue for each individual service is unimportant. The ambitions of managed care are replaced by a more humble acknowledgment that no organization can do all things well and should not try. Firms should focus on services where the relation of price to cost is especially favorable, because of the clumsy reimbursement formulas used by public and private insurers, or where the organization enjoys some comparative advantage in cost or reputation. Hospitals compete with each other not for the entire clinical continuum but for each service separately, and hence the decision of which services to avoid is as important as the decision of which to provide.⁵

The principles of selective diversification carry over from choice of services to choice of geographic markets. Some communities are inherently advantageous, because of a growing, prosperous population and comparatively weak competitive environment, while others are plagued by small populations, low incomes, or aggressive competitors. As CHW reassessed the goal of integrated delivery, it recognized that Los Angeles, its biggest market, was also its least profitable, with millions of Medicaid beneficiaries and uninsured residents, a surplus of hospital bed capacity, and large physician organizations willing to move patient admissions to low-price facilities. The best potential markets were Las Vegas and Phoenix, with rapid growth, economic prosperity, and no capitation. The sunbelt cities already had attracted major investor-owned hospitals chains and, in Phoenix, had a large nonprofit hospital incumbent. But the rising tide of population, prosperity, and FFS payment was lifting all boats.

Capital Investment Priorities: Financial Margin

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The capital challenge facing the hospital chain is that each additional institution is another mouth to feed, hungry for infrastructure upgrades, enterprisewide IT, advanced clinical equipment, and, for many of CHW’s aging facilities, a major renovation or complete replacement. Investment capacity consists of internally generated surpluses and externally available capital, whose price depends on the creditors’ perceptions of the system’s long-term revenue and growth prospects. After holding capital spending near $200 million annually during the worst years and at $300 million in 2004, CHW’s improving operating performance offered it a capital capacity averaging $600 million annually for the remainder of the decade. Capital spending as a percentage of system revenues rose from 3.9 percent in 2002 to 4.3 percent in 2003, 5.9 percent in 2004, and 7.7 percent in 2005, with a projected average of 9.5 percent through 2009. This increased capacity presumed improvement in operating margins to 2.7 percent, cash-flow margin (earnings before interest and depreciation) above 9.0 percent, days’ cash on hand above 130 days, and debt-to-capital ratio below 50 percent. These financial targets largely were attained by 2004, as indicated in Exhibit 1, but the system would need to retain a vigilant eye on its balance sheet as it expanded its capital investments during the remainder of the decade.

CHW imposed a disciplined review on capital requests emanating from individual hospitals, requiring that they be either mandated by regulation, imperative to remediate quality deficiencies, or able to achieve a financial return greater than the system’s cost of capital. Even this slimmed-down list exceeded the system’s capital capacity, leading to an estimated investment shortfall of $1.8 billion between 2005 and 2009. Without an effective priority-setting mechanism, the system faced the prospect of being forced to expend much of its available funds on mandated but nonremunerative retrofit projects.

The financial strategy of selective diversification, illustrated in Exhibit 2, prioritizes capital investment and divestment decisions according to the economic characteristics of individual hospitals and the markets where they are located. Facilities with poor economic performance and located in unattractive markets, which fall in the lower left quadrant of Exhibit 2, must improve operational performance or become candidates for divestment in order not to bleed capital from the system. Some facilities might be retained because of their social mission. Prior to any divestment decision, CHW embarks on a lengthy process involving stakeholders, weighing options and considering the implications for the availability of health care in the local community. Facilities with strong current performance but in markets with limited growth opportunities, which fall in the lower right quadrant, are to be treated as a source of operating earnings (free cash flow) rather than as a locus of new investment. Weakly performing hospitals in growing markets, featured in the upper left quadrant, should partner with complementary organizations, such as chains of ambulatory surgery centers (ASCs), to improve financial performance without demanding substantial capital investment. Strongly performing facilities in growth markets, featured in the upper right quadrant, offer the potential to sustain and expand the system’s long-term capital capacity and, as such, are to be the principal locus for new investment.

View larger version (31K): [in this window] [in a new window]   EXHIBIT 2 Capital Investment Strategies In CHW Hospitals According To Market Economic Attractiveness And Hospital Financial Performance

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CHW evaluated its social contributions in terms of both the charitable activities of its individual facilities and the economic and health-related needs of the communities in which those facilities were located. The contributions of each facility were quantified in terms of the percentage of operating expenditures devoted to charity care for indigent people, both absolutely and relative to the percentages reported by neighboring hospital systems, plus the absolute and relative percentages of spending devoted to care for Medicaid beneficiaries. The economic and health-related deficiencies of its markets were quantified in terms of a community need index (CNI), a weighted sum of indicators of poverty, cultural diversity, education, housing stock, and (lack of) health insurance coverage in the markets where its facilities were located.⁶ Distinguishing between the social contribution of the hospital and the social needs of the market is important because some facilities in needy communities offer little charity care, while some facilities in wealthy communities provide considerable charity services.

Exhibit 3 illustrates the mission-related capital investment options facing CHW. The horizontal axis measures the social contribution of each hospital while the vertical axis measures the social need of the market. Facilities in the lower left quadrant offer few charitable services and are located in prosperous communities and hence rank low in terms of CHW’s mission strategy. They are candidates for divestment unless they perform well financially, in which case they would be retained based on the system’s financial strategy. Facilities in the upper right quadrant offer considerable charitable services and are located in communities with sizable social and health-related needs and so are of highest priority for capital investment from a mission-related perspective. The system seeks to improve their operating performance by exploring alternative sources of revenues, particularly from governmental programs. Facilities in high-need communities that offer few charitable services, located in the upper left quadrant, should explore alternative ways of meeting social needs, especially through funding of nonacute and noninstitutional services. Facilities that offer substantial charitable services but are located in wealthy communities, in the lower right quadrant, should seek new revenue sources or be considered for divestment.

View larger version (19K): [in this window] [in a new window]   EXHIBIT 3 Capital Investment Strategies In CHW Hospitals According To Community Need And Hospital Charitable Contribution

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View larger version (28K): [in this window] [in a new window]   EXHIBIT 4 Capital Investment In CHW Hospitals According To Market Economic Attractiveness And Hospital Financial Performance

The allocation of capital investment among individual hospitals in terms of their priority with CHW’s social mission strategy is presented in Exhibit 5, which arrays each hospital according to its charitable contribution (including Medicaid volume) on the horizontal axis and the social and health needs of the community it serves on the vertical axis. The largest investments are scheduled for facilities that provide only modest charitable and Medicaid services, relative to the entire portfolio of CHW hospitals; this is consistent with the system’s emphasis on expanding its most profitable facilities. However, there are several major projects scheduled for hospitals that rank high in both dimensions of CHW’s social mission—renovating or replacing facilities that offer substantial charitable services in low-income communities (upper right quadrant).

View larger version (26K): [in this window] [in a new window]   EXHIBIT 5 Capital Investment In CHW Hospitals According To Community Need And Hospital Charitable Contribution

Top The Strategy Of Integrated... Turmoil And Turnaround The Strategy Of Selective... Capital Investment Priorities:... Capital Investment Priorities:... Implementing Capital Priorities Balancing Mission And Margin Concluding Comments NOTES

View larger version (30K): [in this window] [in a new window]   EXHIBIT 6 Capital Investment In CHW Hospitals According To Financial Performance/Market Attractiveness And Charitable Contribution/Community Need

Concluding Comments

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The excess capacity has gradually been sweated out of the U.S. hospital industry, as many facilities have reduced bed counts, some have closed altogether, and the population has grown. This has strengthened the bargaining positions and balance sheets of the remaining institutions. The economic revival of the sector remains uneven, however, with some markets hindered by weak population growth and some facilities finding themselves unfavorably placed even within a generally desirable environment.⁹ The chain structure is well adapted to this new industry reality, as hospitals come to interpret themselves as sources of capital and operational know-how that can be moved among clinical services and geographic markets depending on the relative advantages and disadvantages of each, rather than as being wedded to any particular service or market for historical reasons. The IDS has been replaced by the diversified organizational chain.¹⁰ The core competencies of the chain include the ability to evaluate existing and potential markets, to analyze the internal capabilities of the firm and understand where best these capabilities can be deployed, to accumulate the financial resources necessary to take advantage of new opportunities, and to maintain the self-discipline essential for decisions to exit underperforming markets and services.

The strategy of selective diversification is central to all conglomerates, but the nonprofit chain must also evaluate services and markets based on social needs as well as financial returns. Those services and markets where the nonprofit can make its most important social contribution often are those with the weakest economic position and from which an investor-owned firm would be quickest to depart. The analysis of each service and market and the matching of social needs with organizational capabilities are important in precisely these contexts, lest the organization’s limited resources be expended on activities that made sense only in the past. The quantification of needs and capabilities might serve the nonprofit organization well in an environment of public skepticism toward tax-exempt status. The "trust me" era of nonprofit accountability is being replaced by an attitude of "trust but verify," and a diversification strategy could help nonprofit systems document the practices that distinguish them from their for-profit competitors. A charitable mission inevitably is limited by a financial margin, and the social effectiveness of a nonprofit organization can be furthered by a strategic approach to how best to lose money as well as how best to earn it.

Editor's Notes

 
This research was supported by the Robert Wood Johnson Foundation, through its Changes in Health Care Financing and Organization (HCFO) initiative.

NOTES

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1. A.E. Cuellar and P.J. Gertler, "Trends in Hospital Consolidation: The Formation of Local Systems," Health Affairs 22, no. 6 (2003): 77–87[Abstract/Free Full Text]; G.J. Bazzoli, et al., "Two Decades of Organizational Change in Health Care: What Have We Learned?" Medical Care Research and Review 61, no. 3 (2004): 247–331[Abstract/Free Full Text]; D. Dranove and R. Lindrooth, "Hospital Consolidation and Costs: Another Look at the Evidence," Journal of Health Economics 22, no. 6 (2003): 983–997[CrossRef][Web of Science][Medline]; Y.K. Kim et al., "The Influence of Hospital Integration on Hospital Financial Performance," Journal of Health Care Finance 31, no. 1 (2004): 73–84[Medline]; C.S. Lesser and L.R. Brewster, "Hospital Mergers and Their Impact on Local Communities," in Understanding Health System Change: Local Markets, National Trends, ed. P.B. Ginsburg and C.S. Lesser (Chicago: Health Administration Press, 2001), 19–36; and G.J. Bazzoli, "The Corporatization of American Hospitals," Journal of Health Politics, Policy and Law 29, no. 4 (2004): 885–905.[CrossRef][Web of Science][Medline]
2. Information for this case study was obtained through interviews with senior and midlevel executives at CHW with responsibilities in finance, operations, and strategy; extensive internal documents on capital strategy and investments; revenues, expenditures, and other dimensions of performance on a market and facility-specific basis; publicly available CHW documents such as annual reports and presentations for external audiences; and bond rating reports specific to CHW, to the California market, and to the tax-exempt hospital sector as a whole.
3. L.R. Burns and M.V. Pauly, "Integrated Delivery Networks: A Detour on the Road to Integrated Health Care?" Health Affairs 21, no. 4 (2002): 128–143[Abstract/Free Full Text]; L. Friedman and J. Goes, "Why Integrated Health Networks Have Failed," Frontiers of Health Services Management 17, no. 4 (2001): 3–28[Medline]; and K. Carey, "Hospital Cost Efficiency and System Membership," Inquiry 40, no. 1 (2003): 25–38.[Web of Science][Medline]
4. CHW continues to contract on a capitated basis with health maintenance organization (HMO) products in Sacramento and selected other areas where it has strong links with physician organizations and where managed care competition is strong.
5. M.E. Porter and E.O. Teisberg, "Redefining Competition in Health Care," Harvard Business Review (June 2004): 65–76.
6. R. Roth, P. Presken, and G. Pickens, A Standardized National Community Needs Index for the Objective High-Level Assessment of Community Health Care (San Francisco: Catholic Healthcare West, 2004).
7. The capital investments presented in Exhibits 3 and 4 are projections in 2005 for the subsequent four-year period and are subject to revision over time.
8. Major projects, defined as costing in excess of $25 million, account for 58 percent of total capital expenditures for CHW. The remainder are facility renovations costing less than $25 million (22 percent of total), information technology (12 percent), physician alignment and outpatient expansion projects (4 percent), and miscellaneous (4 percent).
9. L. Zuckerman et al., "The California Health Care Market: Recent Strength Defies Expectations," Standard and Poors Ratings Direct (proprietary Web site); and J.E. Wells et al., "2005 Nonprofit Hospitals and Health Care Systems Forecast," FitchRatings (proprietary Web site).
10. J.C. Robinson, "Entrepreneurial Challenges to Integrated Health Care," in Policy Challenges in Modern Health Care, ed. D. Mechanic et al. (New Brunswick, N.J.: Rutgers University Press, 2005).

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