Handle With Care

Katharina Lewellen and colleagues look at the investment patterns of nonprofit hospitals and find them remarkably similar to those of shareholder-owned corporations.

Just how efficient are the investment decisions of nonprofit hospitals? An optimistic view might be that a hospital's decisions are guided by the preferences of the community it serves. When the time comes to acquire a new MRI machine, for example, hospital administrators would weigh the costs and benefits of the purchase for the community and then choose the option with the highest net benefit.

Reality, unfortunately, tends to be less ideal. First, a hospital that attempts to do the right thing may be constrained from doing so by a lack of funds. This socalled "financing friction" could be especially significant for nonprofits that do not have access to equity markets and must rely instead on debt or donations to cover financing shortfalls. Second, a hospital's true objectives may be less noble than the decidedly optimistic view presented above. In lieu of shareholders, nonprofit insiders (or doctors, in the case of hospitals) can theoretically gain significant power over their firm's resources. In such cases, a hospital's investment decisions would reflect, at least to some extent, the preferences of their insiders rather than those of taxpayers or donors.

So just how important are these problems in practice and to what extent do they affect how hospitals invest? New research by three Tuck finance faculty members cleverly answers these questions through the following "experiment": Suppose a nonprofit hospital's endowment performs unexpectedly well in a given year. To what degree would its investment spending increase as a result of this cash flow shock? The question is clever because it turns out that in an ideal world—that is, one without financing frictions or governance issues— the level of investment should not change at all.

"This is because a hospital should invest only and always when it has good investment opportunities," says Tuck associate professor Katharina Lewellen. "The random performance of its financial assets should have no impact on these opportunities." In contrast, she explains, a financially constrained hospital will clearly increase spending when extra cash unexpectedly "falls from the sky." Insiders may also feel more comfortable buying new MRI machines when cash is available than when extra funds would have to be obtained from bankers or donors.

The researchers' empirical findings are striking and point to significant frictions. They found that an average hospital spends 10 cents of each dollar of unexpected financial income on additional investments. This amount increases to 30 cents when the investment period is extended to two years after the income shock. They also found that much of the extra spending goes toward major movable equipment such as MRI machines and CAT scans.

Lewellen and her colleagues' estimates are statistically significant and much larger than typical spending rules governing endowment distributions of nonprofits imply. Also, the sensitivities are greater for hospitals that appear to be financially constrained, whether they have more debt and/or smaller financial assets. Interestingly, however, the 10- to 30-cents-per-dollar estimate is not larger than estimates obtained for shareholder-owned corporations. For the researchers, this was surprising and revealed a more nuanced picture of how nonprofits operate.

"Though they clearly face governance and financing frictions," adds Lewellen, "nonprofit hospitals seem to be remarkably effective at dealing with them, or at least at limiting their impact on investment."