An upcoming Board agenda includes a discussion about pursuing a large capital investment (i.e., building new space, and/or expanding and renovating existing space) to improve existing services or create new opportunities for expanding into new service lines. How do you prepare to fulfill your critical role in oversight and governance on this issue?
There is a lot of business school literature and theory on how best to approach this decision, but this article is not about theory and instead focuses on how a board member can approach this decision practically and reasonably in fulfilling their fiduciary responsibility to the organization. Even among the experts, there is no “right” answer that applies to every situation so Boards must rely upon due diligence – asking the right questions–and their judgement in deciding how to plan and finance a capital investment.
Here are the most important three questions to ask about the potential capital project:
Is the project going to benefit the hospital and the community?
This initially seems like a very basic question but its purpose is to explore how the intended project is specifically expected to impact how the healthcare system can work better for everyone in a measurable way. This helps distinguish between “wants and needs” in investing capital resources to ensure that funding is being directed to areas where the organization has the ability to make the biggest impact on meeting the community’s healthcare needs and how the proposed project will specifically address those needs. For rural hospitals that have facilities designed around inpatient care, this is often creating space available for developing outpatient services and reducing the outmigration for services that can be safely provided locally. For larger, more suburban markets, this may be an expansion into more community sites of care to improve access for the service area population and increase market share or respond to competitive threats in the market.
Can we afford the project? Is financing available? What are the options?
Once the merits of the project are well understood and established, the Board can start to focus its attention on feasibility, including identifying the source of funding available to result in the lowest cost of capital for infrastructure improvements. For most rural hospitals and organizations located in communities of 50,000 people and fewer, this typically is USDA Community Facilities funding due to the low rates available under these programs due to the federal government’s credit backing. Larger organizations will likely excess capital through the tax-exempt bond market and aim to improve (lower) their cost of capital by seeking a credit rating from an independent rating agency that has evaluated the project and the organization’s finances overall. After exploring options, the administrative team should present the Board a Plan of Finance that encompasses all of the expected costs for the project (including construction, architectural and engineering services, financing fees, and other related costs) that constitute the “uses” for a project and then match up the resources needed for the project to the availability of the “sources” which includes the amount of money that we need to borrow as well as the equity contribution for the project from reserve accounts or operating cash.
How do we determine how much equity to put into a project?
Equity, or the money the organization contributes toward the project to reduce the debt amount, can come from multiple sources such as fundraising, depreciation reserve accounts or other pools of money set aside for long-term capital investments, and operating reserves. As referenced earlier, there is a lot of theory discussed in business schools to answer the question of how much equity is the “right” amount to contribute, but in reality, the answer comes down to establishing a consensus among the organization’s leadership (including board and administrative leaders).
From a practical perspective, the potential sources of equity listed above is the order in which organizations should contribute equity. First is fundraising, second is reserve accounts, and lastly is operating cash or short-term investment accounts. Fundraising to support a significant investment in the healthcare infrastructure is an opportunity to engage the community in support of the health and sustainability of its operations over the long term and to solicit fundraising specifically for the bricks and mortar investments to enable it.
Secondly, if the organization has set aside prior year resources into a Board-restricted account for capital investments, that is a great source of equity for the project; however, depending on the balances of those accounts, it may make sense to reserve (hold onto) some portion of those funds for the potential of future, unforeseen needs arising, such as an equipment problem.
The last source of equity in contributing operating cash reserves should be addressed carefully. Putting too much operating cash into a long-term capital project can potentially expose the organization to future operating risks and the need to use the cash on hand as a “rainy day” fund. The best way to address this is to identify a minimal amount of days cash on hand (i.e., how long the organization could cover its expenses without generating additional cash) for operating purposes going forward. If the actual operating account balances are significantly in excess of the minimum, then the difference may safely be invested into the long-term capital project. While each organization is different, the minimum days cash on hand would be at least 60 days or more. In the event of a financial crisis, a lower the days cash on hand results in less time leadership for leadership to implement corrective measures to generate positive cash flow.
The last factor to consider in identifying the most appropriate equity contribution is the costs of the debt itself; low interest rates, as we’ve seen for some time, generally means that organizations are more likely to hold onto their cash to be prepared for the unknown future and to increase their borrowing. This is especially true if the loan is a long term fixed rate that doesn’t expose the organization to future market fluctuations and the loan then becomes is a predictable expense that can be planned for going forward (or paid for by the return on the investment from the project itself because of the new services added, for example).
There are no shortages of challenges for Board members of healthcare organization; from the myriad acronyms to the deeply technical issues and considerations noted above. Yet, the benefits of well-planned long-term investments into the bricks and mortar and equipment can be so highly impactful to the organization, that it is one if the most important discussions that Boards can have–being curious and asking the right question is the best way for Boards to contribute to these ends for their community.