The Importance of Effective OCIO Due Diligence for Healthcare Asset Owners

Introduction

As the world (hopefully) emerges from the pandemic, and as the economic, market, and geopolitical environments still present further challenges, there lies a great need and opportunity to review the oversight of the management of institutional asset pools. This is especially true in the healthcare industry, which has been impacted by recent experiences in uniquely meaningful ways.

The area of focus here is on the investment consultant role, or Outsourced Chief Investment Officer (OCIO), serving a healthcare institution. The strategic asset allocation analysis, manager implementation, and oversight are increasingly being outsourced to an OCIO, usually an asset manager, consulting firm, or bank.

The decision to hire an OCIO and the ongoing oversight of the firm are fiduciary roles for the asset owner. Beyond simple performance monitoring, effective due diligence is essential to good fiduciary governance. What follows is an exploration of some key considerations for executing these responsibilities.

The Importance of Effective Due Diligence

Being a healthcare CFO or financial management executive is a complex and multi-faceted role. A sizable portion of the balance sheet consists of investable asset pools. These assets may include defined benefit retirement assets, long-term reserves and operating pools, foundations, and self-insurance trusts.

There is a growing trend toward outsourcing the management of any or all of these assets to an OCIO. There is also a path to consolidate the oversight of the various asset pools with a single firm to achieve a holistic, integrated level of oversight.

Outsourcing shares, but does not eliminate, the fiduciary responsibility of the healthcare entity. As such, a CFO has important asset management oversight responsibilities and with these responsibilities comes the need to perform due diligence.

What does due diligence mean? Fiduciary governance requires active oversight of whomever is tasked with the management of the assets. This is especially true when making the initial decision to outsource. When outsourcing has already been implemented, an effective due diligence process requires an annual internal evaluation, regular independent benchmarking of services and fees, and, periodically, more in-depth and formal due diligence.

Current Challenges Facing Healthcare Asset Owners

The current environment facing institutional asset owners, particularly healthcare providers, presents many challenges. An effective OCIO can provide valuable assistance in addressing these.

COVID has uniquely and meaningfully impacted the healthcare industry. As the pandemic (hopefully) diminishes, there is an important need to revisit current and projected financial circumstances and assess whether investment objectives need to be updated to be better aligned with conditions.

One financial area that is always present is the need to manage fees. The fees of an OCIO and the underlying managers, including all performance-based fees, need to be carefully assessed. A regular oversight process of reviewing and benchmarking fees to the marketplace is an effective way to manage this.

As healthcare entities assess their financial conditions for the future, there is an acceleration of the trend toward mergers and consolidations. When this occurs, issues are presented about the combination of asset pools and who has the decision-making rights over them going forward. When multiple service providers overlap management and custody functions, plans for consolidation need to be formulated.

Further, as the economic, market, and geopolitical environments shift, this changes the expectations and implementation of investment strategies. For example, capital market assumptions have universally been reduced, especially in this higher inflationary and rising interest rate environment, which challenges the ability to meet the important financial needs of the assets.

Healthcare asset owners may diversify their investment solutions and seek other potential sources for returns, but in doing so, they may expose the assets to greater risks. The need for thorough risk management is critical to ensuring investment programs remain well-structured to meet the institution’s goals while being able to withstand difficult periods in a market cycle.

The Strategic Goals of Different Healthcare Asset Pools

A typical healthcare entity has multiple asset pools, which likely have quite different objectives:

Pension plans—progressing from improving funding -> de-risking/LDI -> potential termination or risk transfer.
Long-term reserves and operating pools—short-term liquidity and operational needs balanced with long-term growth.
Foundations—important to serving the community and satisfying donor objectives for the long-term, as well as capital campaigns.
Self-insurance trusts—short-term liquidity & operational needs balanced with long-term growth to protect the institution.

The targeted diversification of these asset pools can include multiple asset classes with varying levels of alternatives, as well as illiquid assets where appropriate. These introduce risk factors that should be carefully evaluated.

The OCIO can provide valuable assistance with the analysis and articulation of these differing objectives in one (or multiple) investment policy statement(s) or investment guideline(s). Institutional asset owners should keep in mind that they, at a minimum, retain shared responsibility for the strategic allocation even when utilizing an OCIO.

Of further note, more asset owners, especially not-for-profits and religious-affiliated entities, are expanding their interests in values-based investing. This includes making a positive impact on environmental, social, and governance (ESG) matters. Diversity, equity, and inclusion (DEI) has also expanded in importance, which can also include specific impact investing goals (e.g., green energy). These goals often relate to the mission of the institution on a broader level than their fiscal impacts.

These items also increase the need to carefully design, communicate, and implement these objectives with the OCIO across the different asset pools. Having a single OCIO provider across multiple pools can often enhance the integration.

The Benefits of Outsourcing

Outsourcing to a highly qualified OCIO brings numerous benefits, including:

Manager selection and oversight
Providing access to top-tier managers, which is especially important in alternative and private asset classes
Specialized asset management expertise in establishing the strategic asset allocation within various return and risk projections
Tactical asset allocation shifts
Timely and strategic rebalancing
Increased implementation of best ideas and market displacement opportunities
Thorough performance and attribution reporting
Extensive risk management
Administrative support, such as reporting, transactional, legal, and regulatory
Management of fees

A note on fees: The fees of an OCIO and the underlying managers, including all performance-based fees, need to be transparent and objectively overseen. An effective, ongoing due diligence process is likely to ensure that fees remain competitive with the marketplace.

At the end of the day, an exceptional OCIO also ties the design, management, and results of their efforts back to the important goals of the healthcare entity overall. These can include meeting short-term liquidity needs, providing long-term growth at appropriate risk levels, meeting debt covenants and restrictions, and having a positive impact on the community and benefactors of the institution. Investing is more than performance and risk management; in its best form, it must tie back to the mission and purposes of the investor.

Managing the Due Diligence Process Well

Recognizing the challenges facing the healthcare asset owner and the benefits of outsourcing in addressing them, an institution and its stewards need a conscientious oversight process to fulfill their fiduciary responsibilities. This process needs to occur regularly, such as the following minimal suggestion:

Annually—Conduct an internal relationship review comparing service and performance satisfaction to fees.
Every 3–5 years—Benchmark services, performance, and fees (either internally or assisted externally, depending on resources and experience).
Every 5–10 years—Conduct a formal independent due diligence and evaluation process. Periodically engage in an RFI or RFP to compare incumbent relationships and program characteristics to the competitive marketplace.

These timeframes should be accelerated when the existing relationship shows signs of dissatisfaction or of not meeting the institution’s goals. Further, meaningful turnover in the institution’s stewards (staff or committees) might warrant a more timely review to either reaffirm, update, or potentially replace elements of the previous regime’s investment program.

The services and fees attributed to an OCIO relationship need to be competitive with the marketplace. Ongoing due diligence can be a great way to check in periodically to ensure that the relationship remains aligned with the industry and is value-additive and cost-effective to the healthcare entity.

Whether moving from a traditional consulting relationship to outsourced discretion or contemplating changing a current OCIO provider, a more formal evaluation and/or search process is necessary. This typically involves a request for proposal (RFP), where information is gathered from several potential providers whose offerings are compared by asset owners in the selection of a new firm or a renewal (and frequent updating) of the incumbent relationship.

Best practices strongly suggest that the incumbent should be asked to respond to the RFP as well and be evaluated with similar diligence as potential candidates. The field of initial candidates often includes other important strategic relationships typical of healthcare entities (actuaries, banks, board-level and/or community relationships, etc.). However, to ensure that the most competitive OCIO providers are included, significant research should be undertaken or one should enlist the help of a search consultant with expertise, industry/firm knowledge, and objectivity.

Beyond the RFP itself, the process also usually includes reference checks and in-depth finalist meetings with a short list of the firms most closely matching the institution’s objectives. This is where the firms can get deeper into the details and provide illustrations of how they would serve their client.

The entire evaluation process involves considerable time, effort, and complexity. Further, many asset owners don’t have access to the tools and research required for effective evaluations, especially of candidate track records. As such, many choose to enlist external assistance to lead the process and do the heavy lifting needed to ensure the search is done well and leads to an optimal outcome.

Effective Decision Making

The due diligence process is further complicated by the multiple internal parties likely to be involved in the review and decision making. No person, including the senior financial management, is an island. Other constituents usually include:

Investment or finance committee
Executive management of the institution
Board of trustees
Medical staff
Donors for a not-for-profit healthcare system or its foundation
The community-at-large being served

The members of these groups are dedicated and focused on the success of the healthcare provider but bring meaningfully diverse levels of financial knowledge. They may also possess a lack of familiarity with OCIO providers and their services and fees. This increases the need for education, guidance, and leadership to establish and maintain good governance throughout the process.

These decision-makers and others providing input to the process are encouraged to maintain a strategic focus on the selection, retention, and ongoing monitoring of their OCIO. It is with this in mind that many asset owners choose to enlist external assistance to handle the details of the process, which enables the internal parties to focus on the best path to meet the institution’s needs.

Healthcare providers often operate with a consensus decision-making style, which increases the need for whoever is leading the process to identify and assess the organization’s various interests and effectively drive constituents toward the optimum outcome.

Action Steps

The decision to hire an OCIO and the ongoing evaluation of the firm are fiduciary roles. As described here, prudent fiduciary governance requires regular, active oversight. The following are suggested action steps toward meeting fiduciary responsibilities over an OCIO:

Engage in ongoing monitoring and relationship review, including service levels, investment results, and fees.
Set a schedule (or create a policy) for periodic formal reviews, including assessing the competitive market landscape for current levels of services and fees available.
Provide regular education and opportunities for engagement with the institution’s committee, management, board, and other interested parties.
Determine whether the OCIO relationship is meeting the strategic goals and purposes of the institution overall.

Effective due diligence is essential to good fiduciary governance, which enhances the ability of the healthcare organization to flourish and meet its critically vital role in its community.