Financing a Digital Transformation
Adapting to health care’s emerging digital future is essential to healthcare organizations’ long-term survival, and for most organizations, the key concern at this stage is identifying the best sources of capital to fund their digital strategy.
Many healthcare organizations are investing in new approaches to healthcare delivery to meet the digital demands of mobile device-enabled consumers and other stakeholders. Data analytics, software systems, virtual technology such as telehealth, and enterprise network-connectivity platforms typically are early initiatives.
Each organization will have a unique approach to its digital technology strategy, based on its goals and where it sits on the spectrum of desired digital transformation. That spectrum ranges from traditional players that regard technology solely as an IT cost center, to experimenters that use technology with selected business functions to improve operational efficiency, and to innovators that leverage technology constantly to drive revenue and cost optimization. a However, organizations that invest solely in traditional IT to support healthcare delivery with a purely bricks-and-mortar focus can expect their competitive position to slowly erode over time, so remaining a traditional player clearly is not an option for long-term sustainability.
Digital transformation for the experimenter and innovator categories of players may encompass everything from advanced electronic health record (EHR) infrastructure and cybersecurity to software tools for consumer engagement and enhanced access to clinical decision support, care coordination, and population health systems. See related sidebar, which identifies key investment areas for a digital future: Investment Areas for a Digital Future.
The prioritization, sequencing, and monitoring of initiatives require close attention, but underlying these activities is a fundamental question: Where will we raise the required capital? Although investment in digital transformation may be well underway in some organizations, the methods to finance such initiatives in the industry are evolving and expanding, and senior leadership teams should consider applying one or more of these innovative methods.
The funding source for any chosen digital initiative an organization intends to pursue should reflect the organization’s business assets and its underlying risk profile and risk tolerance. Because digital initiatives typically are not fixed assets with long expected lives and steady projected cash flows that can be leveraged, the traditional options (debt, cash, or leasing) will need to be expanded to include more creative partnership financing activities. This is particularly true for not-for-profit organizations that are unable to raise external equity in the public markets.
To identify the most appropriate financing source to meet capital structure goals, leadership teams of for-profit and not-for-profit healthcare organizations require a strategic framework for decision making, as described below.
Balancing Capital Risk and Return
The fundamental goal of an organization’s overall capital structure is to fund business growth in a way that produces the desired risk-adjusted return, given the organization’s capital flexibility needs and risk tolerance. Capital structures—the combinations of debt and equity that fund organizations’ overall strategic plans—vary widely by industry and business profile.
A close look at a specific measure of overall leverage, such as debt to total assets (i.e., the proportion of the assets that are financed by debt), can indicate a lot about the business an entity is in—for example, whether the sector is light or heavy in fixed assets and how much uncertainty exists in projected cash flows—and its capital flexibility needs and risk tolerance.
Companies that are light on fixed assets or that are accustomed to making high-risk investments as part of their core business—software and energy companies, for instance—tend to have a lower median ratio of debt to total assets (24 to 26 percent), indicating they tend to use a high proportion of equity to fund their technology development or drilling explorations.
Organizations that are heavy on fixed assets and that have more predictable cash flow streams, such as real estate and telecommunications companies, tend to have a higher median proportion of debt to total assets (46 percent), because they expect their buildings and other infrastructure will produce a steady capital return over a long period.
The leverage ratio spread is even broader in the healthcare industry. For example, about 25 percent of healthcare organizations situated at the lower end of the leverage spectrum are large for-profit health insurance companies whose business involves limited fixed assets, but whose assumption (and tolerance) of risk is high by virtue of their core business. At the higher end of the leverage spectrum, 65 to 90 percent are more hospital-centric, for-profit companies that predominantly invest capital in long-dated, depreciating assets (e.g., inpatient facilities and related real estate investments).
Due to their lack of access to external equity markets, among other reasons, the balance sheets of large not-for-profit healthcare organizations have sizeable “internal equity” in the form of cash and investments. The three largest not-for-profit health systems in the United States hold $8 billion to $15 billion in cash and investments, yielding 185 to 260 days cash on hand. By comparison, the largest for-profit healthcare companies hold less than $1 billion in cash and investments, yielding only eight to 15 days cash on hand. Adjusting for the large cash balances on not-for-profit balance sheets, not-for-profits still have lower leverage than for-profit providers—with debt to “adjusted” total assets in the range of 36 to 41 percent.
Looking into the future, as health care moves further into value-based payment, hospital revenue is expected to flatten or decline. A high ratio of debt to assets adds the risk of overleverage to the organizational profile. For access to additional capital, not-for-profits will need to look externally for private-equity or joint-venture partners. Organizations with scale in terms of the number of managed lives will make attractive partners.
Using a Framework to Inform Funding Decisions
Whether an organization is for-profit or not-for-profit, its capital spending for digital initiatives must be funded through appropriate capital sources or channels. Each financing channel can be evaluated across a range of criteria, including cost, how quickly the organization needs the capital, and the level of control required in the capital investment given its degree of strategic essentiality.
Control. Whether the organization should own, either outright or jointly, the financed initiative is the most important, high-level strategic issue. For each investment type in the previously mentioned sidebar, a decision-making framework such as that shown in the exhibit below can be used to determine whether the investment requires a low or high degree of organizational control in its development or management (Y axis), given the extent to which the investment is deemed essential for establishing and maintaining the organization’s strategic essentiality or differentiation (X axis).
Strategic Funding Framework
Consider the lower left quadrant of the framework, for example: If a low degree of organizational control is required for a technology’s customization that has low importance in differentiating the organization from competitors, such investment types will appear in this quadrant. Such a technology product is likely highly commoditized and can be purchased off the shelf in the marketplace. For example, software for revenue cycle management (RCM) is an investment type that is unlikely to differentiate the organization from competitors. Further, development of RCM software systems need not be controlled by the organization but can be purchased or contracted for from an RCM supplier as part of normal operating expenses.
By contrast, the lower right quadrant will be populated with technologies that are strategically differentiating in nature but for which the organization would not require sole control.For example, an organization’s leadership team may view telehealth as integral to the success of consumer access strategies. However, leaders likely will not feel the need to control 100 percent of that business and are more likely to regard a partnership with a telehealth company as a more appropriate option, where the partner has incentives for co-development through upside sharing. External equity, secured via joint ventures or venture capital, could be useful to get the best minds and money to the table.
Appearing in the top two quadrants are investments requiring a high degree of organizational control for customization of the technology, which may or may not be strategically differentiating.
A digital asset’s strategic importance would determine whether an organization would want to have a high degree of governance control over its development. An essential or differentiating investment would be placed in the upper right corner of the framework and would be a candidate for private equity/partnership financing or use of internal cash or retained earnings.
For example, as patient access centers evolve from a fee-for-service model to a value-based model, organizations can view them as critical digital assets that will contribute to strong financial and clinical outcomes by ensuring that the right mode of care is provided—whether from a physician, nurse, advanced practice provider, or telehealth provider, for example. b The organizations therefore would be likely to want to exert a high degree of control over these strategic assets.
Where organizations place digital initiatives in the framework will vary by organization and will drive many of the next-order funding decisions. Funding choices will be based on the organization’s current and desired future strategic-financial position, credit rating, and many other factors.
Cost and speed. Another factor for evaluation that warrants mention is cost and speed to market. The cost of various types of external capital can be compared with traditional financing channels, such as the public debt markets. Use of the organization’s own operating or excess cash to fund initiatives carries an implicit opportunity cost because capital used for one project is not available for another. Debt capital ultimately would be a less-expensive alternative than equity capital, which shares the upside capital appreciation with another entity.
There is an argument for speed given that numerous digital initiatives could offer “first mover” advantages—for example, by attracting customers to a certain specialty or procedure. If the organization needs capital quickly, using its own cash to fund an initiative will be the fastest way to procure the money. The more complex the financing mechanism, the longer the financing implementation time frame. Outside equity arrangements (i.e., venture capital) might take up to a year or longer to secure, but if the organization has the time and patience, such arrangements can be the most appropriate funding source. Capital partners that are willing to take on risk also will share rewards with the health system.
Types of financing strategies for the investment areas shown in the sidebar include both internal and external sources.Internal capital sources. These are sources controlled solely by the organization. Such “self-funding” of new or ongoing investment areas can be achieved through the following means:
- Use of current operating or excess cash
- Improvement of cash flow through efforts such as revenue enhancement and cost- transformation initiatives
- Reallocation of existing capital
- Monetization of non-core businesses or services
Many organizations are establishing internal venture capital funds to invest in start-up businesses or ideas generated by their own clinicians, researchers, or other employees. The investments may yield both monetary rewards as well as products, methodologies, or processes that translate to the bedside to improve quality and customer satisfaction. c
See related sidebar: Case Study: Dignity Health
External capital sources. Use of external capital sources involves seeking investment from an unrelated entity. Options include debt capital, equity capital structures, and philanthropic funds.Debt capital is obtained by borrowing funds through public or private financing vehicles, including:
- Long-term debt through tax-exempt debt markets, which typically can be used only to fund the acquisition or construction of tax-exempt-eligible, depreciable assets (such as hospitals and clinics)—a class to which digital initiatives usually do not belong
- Long-term debt through taxable debt markets, which can be used to fund a much wider range of investments (e.g., physician practices, specialty clinics, and other initiatives that might be critical to an organization’s integrated population health strategies) and which provides more flexibility in type of use than tax-exempt debt but often has a higher cost and less flexibility around repayment
- Lease arrangements of various terms that allow immediate access to equipment or space
As with all capital sources, use of debt capital should be evaluated in the context of the organization’s overall credit position and capital structure, and the terms, covenants, and repayment structure being offered.
Equity capital structures involve co-ownership through growth partnerships and joint ventures with other healthcare organizations, technology firms, private-equity firms, or other entities. These arrangements typically are used to fund ideas, research, and other nondepreciable assets. The partners share investment requirements and upside opportunities, whether generated from care delivery, patents, or other sources.
See related sidebar: Extent of Corporate Venture Funds in Health Care
Philanthropic funds are a benefit many health systems enjoy as a result of their community, academic, or faith-based affiliation, and they require no repayment. If associated with a particular capital initiative, the funds may flow directly to the balance sheet rather than being recorded as an income item.
From Fixed to Digital Assets
With digital transformation, innovative, hitherto hospital-centric enterprises will be moving from fixed-asset businesses with substantial bricks and mortar that are financed largely through long-term debt to businesses that are more like technology companies with assets such as licenses and patents that are not easily leveraged through traditional debt financing.
The conventional capital sources for healthcare capital decision making—debt, cash, or leasing—will not be appropriate for many elements of the digital transformation. For example, it will not make sense (or even be possible) to borrow 30-year capital for investment in an analytics-driven population health management platform with indeterminate useful life and uncertain prospects for success.
Internal equity and cash reserves are a limited resource. Most healthcare organizations will find transforming a technology platform to be a capital-intensive undertaking. If an organization wants command and control of a highly strategic and differentiating digital offering (in the upper right quadrant of the previously discussed exhibit), access to outside equity markets likely would be required to grow and scale the initiative. Some innovator organizations can use cash and internal equity to build the capabilities without assistance, but they—like other organizations—can accelerate progress by partnering with another enterprise to do so through joint-equity, risk-sharing arrangements.
Even digital initiatives that do not appear to be scalable at this time (e.g., neural nets, artificial/augmented intelligence, blockchain) deserve consideration by leadership teams. Some forms of financing, as described earlier, may be available for such initiatives. The digital landscape is moving rapidly, and the picture five years from now likely will look considerably different.
Smaller organizations will require partnerships with larger providers and technology companies to be able to make digital progress. A portion of capital budgets will increasingly be allocated to pilot tests of emerging technology.In larger organizations that can fund significant digital transformation from internal capital and develop their own venture funds, prioritization will be the key leadership issue. Financing decisions likely will reflect response to the questions:
- What level of control will be required for this investment?
- How will the investment enhance the organization’s strategic essentiality in desired communities?
- How quickly can the organization access its internal capital and at what opportunity cost?
An Unprecedented Challenge and Opportunity
Transforming an organization in a completely new way requires an enormous amount of capital. In the words of Peter McCanna, president of Dallas-based Baylor Scott & White Health: “Two constant challenges present themselves: sticking with the effort by providing the adequate capital; and resisting the gravitational pull of staying in the past.” d
Creative partnerships can help leadership teams in all organizations expand financing sources to help ensure a successful digital future.
Matt Robbins, CFA, is senior vice president, Kaufman, Hall & Associates, LLC, Boston.
Munzoor Shaikh is director, Healthcare & Insurance, West Monroe Partners, Chicago.
Therese L. Wareham is managing director and a founding partner, Kaufman, Hall & Associates, LLC, Skokie, Ill.
a. For a discussion of these differences, see Fitz, T., and Shaikh, M., “4 Tactics of Effective Strategic Technology Planning for the Digital Future,” hfm, November 2018.
b. Shaikh, M., and Loebig, T., “The Journey to Value-Based Care: A New Value Chain for Patient Access Centers,” West Monroe Perspective, 2018.
c. Arrick, M., “Shifting Competition Leads U.S. Not-for-Profit Health Care Organizations to Accelerate New (and Old) Strategies,” S&P Global Ratings, May 14, 2018.
d. McCanna was speaking as a panelist in a session titled “Meeting Disruption Head On,” 2018 Kaufman Hall Healthcare Leadership Conference, Oct. 17, 2018.