A difficult operating environment for healthcare systems and the challenge of meeting return targets is changing the way these institutions approach asset allocation and portfolio structuring, according to the latest Cerulli Edge—U.S. Institutional Edition.

The prevalence of low long-term interest rates, combined with high equity valuations, suggests that equity returns going forward will be significantly lower than historical averages. However, yield targets for many health and hospital investment portfolios have not been lowered accordingly, prompting many investment offices to gradually turn toward higher-yielding private equity investments to meet return targets. According to senior analyst Daniel Uquillas, “Forty percent of health and hospital systems surveyed by Cerulli intend to increase their allocations to private equity within their long-term investment pools.”

Increases in private equity allocations occur slowly, as institutions build positions gradually to achieve vintage year diversification by spreading out capital commitments across several years. Similarly, drawing down private equity positions takes a long time as lockup provisions prohibit withdrawals for the fund’s duration, which is approximately 10 years in most cases.

While there are many ways to invest in private equity, Cerulli’s 2019 survey reveals that the majority (71%) of healthcare systems invest directly via funds with the help of investment consultants. The second-most popular method (29%) to get private equity exposure is through funds of funds. Methods used less frequently include co-investments and investing directly via funds without a consultant’s advice. “The relatively small number of systems that invest directly in funds without external consultant advice underscores how difficult and time-consuming it is to source, select, and monitor private equity investments. These tasks are particularly important in private equity because the dispersion between the best- and worst-performing funds is much higher than in other asset classes,” says Uquillas.

Health and hospital systems are also investing in private equity for reasons that are not strictly investment-related, such as supporting innovation in health technology and care delivery solutions. For example, a venture capital firm may facilitate collaboration between its portfolio companies (e.g., a telehealth solutions provider) and its limited partners (e.g., a major hospital system) where appropriate.

Lofty yield targets are also causing shifts in other parts of hospital systems’ investment portfolios. Inconsistent relative returns from active public equity strategies are leading some health systems to rethink portfolio construction. In interviews with Cerulli, several have expressed interest in the increased use of concentrated higher-tracking-error strategies combined with passive allocations in more efficient segments. Cerulli expects the coronavirus crisis to provoke another bout of increased scrutiny for active public equity strategies that have underperformed their benchmarks during the preceding bull market and continue to underperform in the current bear market.