Tuck professors Katharina Lewellen and Gordon Phillips show the many ways nonprofit hospital governance differs from that of for-profits.
The health care sector is one of the largest in the U.S. economy, accounting for more than 18 percent of GDP and employing upwards of 20 million people. With those numbers, health care is nearly two times bigger than the manufacturing sector.
And yet, as Tuck professor Katharina Lewellen argues, corporate finance researchers have studied manufacturing extensively for decades, while health care has received little attention. One reason for this discrepancy is that health care is full of nonprofit firms, such as hospitals, and business school professors have traditionally shied away from studying nonprofits. The result is a gaping hole in our knowledge of how much of the health care industry governs itself.
An expert on corporate finance, corporate governance, and capital structure, Professor of Finance Katharina Lewellen teaches Corporate Finance in the Tuck MBA program.
With a new working paper, written by Lewellen and her Tuck colleague Gordon Phillips, along with Giorgio Sertsios of the University of Wisconsin, that gap in the research is smaller. In “Control Without Ownership: Governance of Nonprofit Hospitals,” the authors analyze and describe the governance structures of nonprofit firms in the hospital sector and compare them to the governance structures used by for-profit firms. They find a wealth of differences between the two and some potentially significant implications.
Governance is the set of mechanisms by which firms and their executives are held accountable to their stated objectives. The paper studies three broad governance tools used by both for-profit and nonprofit firms: the board of directors, the market for corporate control (i.e., the threat of a corporate takeover), and incentive-based compensation and CEO turnover.
In general, scholars agree that the role of boards is to monitor and advise management, and that boards can differ in size and independence. Lewellen and her coauthors find that the average nonprofit board is unusually large, compared to for-profit boards. In hospital systems, for example, the average size of a nonprofit board is 20.1, while the average size of a for-profit board is 9.1. The nonprofit boards include more independent members but also more insiders or other directors with conflicts of interest, including non-executive employees. Moreover, nonprofit boards are self-perpetuating, and their members receive no (or little) financial rewards. The authors acknowledge that these features may be necessary given the nonprofits’ heterogeneous stakeholders and more complex objectives.
[M]onitoring is more effective when boards are agile, independent, and incentivized to exert effort on behalf of the principals, and based on our findings, nonprofit boards score relatively poorly on these dimensions.
—Katharina Lewellen and Gordon Phillips
However, even under this “efficient board” interpretation, the likely side-effect is that the nonprofit boards are less well-equipped to monitor their organizations compared to their for-profit counterparts. As the authors explain in the paper,
there is a broad consensus that monitoring is more effective when boards are agile, independent, and incentivized to exert effort on behalf of the principals, and based on our findings, nonprofit boards score relatively poorly on these dimensions.
The authors find a similar weakness for nonprofits in the market for corporate control. Corporate finance researchers have argued that the threat of a corporate takeover
can discipline incumbent managers because being acquired causes major career disruption, they write. This threat for nonprofits, while real, is much less powerful than it is for for-profit firms. The authors show that, compared to for-profits, nonprofit hospitals are half as likely to be acquired when their financial performance is poor, and that weak performance on non-financial metrics (such as patient satisfaction, quality of medical services, or charity provision) has no effect on the takeover rate. Based on these findings, the authors conclude that external governance via a takeover threat is an unlikely substitute for the arguably weaker monitoring by the boards.
The Laurence F. Whittemore Professor of Business Administration and Professor of Finance Gordon Phillips teaches the second-year Tuck MBA course Venture Capital and Private Equity. He is also faculty advisor for the Tuck Center for Private Equity and Venture Capital.
Finally, the authors studied the role of incentive compensation and CEO turnover. While these are important governance tools, the authors show that they are more limited in the nonprofit context. For example, while CEO pay and turnover in nonprofit hospitals respond to financial performance, they are unresponsive (or weakly responsive) to non-financial performance, such as charity provision or service quality. One challenge is that nonprofit objectives are less well-defined and more difficult to measure than those of for-profits. An example of this is in the main objective of for-profit firms: to return profits to shareholders. In this scheme, a CEO holds a large equity stake in their firm, so their personal wealth responds directly to changes in shareholder value. This more tenuous link between nonprofit CEO pay and firm objectives puts a greater onus on the board to actively monitor the CEO rather than rely on incentive mechanisms built into the compensation contracts.
If all of these comparatively weaker dimensions of nonprofit governance make nonprofits look bad, that is not the authors’ intention. There are good reasons for organizations to be set up as nonprofits, and that structure has indeed led to better outcomes for nonprofit hospitals in terms of higher quality and better customer satisfaction. However, nonprofits do pay a potentially significant price for their nonprofit status in the form of weak governance. This may be true also for other firms shifting focus towards multiple stakeholder groups and more complex objectives.
What emerges from our research, Lewellen says,
is a picture of nonprofit governance that is less efficient than it is in the for-profit firm.