Investment Decisions of Nonprofit Firms: Evidence from Hospitals

• Date: 01 August 2015
• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/jofi.12234

THE JOURNAL OF FINANCE •VOL. LXX, NO. 4 •AUGUST 2015

Investment Decisions of Nonprofit Firms:

Evidence from Hospitals

MANUEL ADELINO, KATHARINA LEWELLEN, and ANANT SUNDARAM∗

ABSTRACT

This paper examines investment choices of nonprofit hospitals. It tests how shocks

to cash flows caused by the performance of the hospitals’ financial assets affect hos-

pital expenditures. Capital expenditures increase, on average, by 10 to 28 cents for

every dollar received from financial assets. The sensitivity is similar to that found

earlier for shareholder-owned corporations. Executive compensation, other salaries,

and perks do not respond significantly to cash flow shocks. Hospitals with an apparent

tendency to overspend on medical procedures do not exhibit higher investment-cash

flow sensitivities. The sensitivities are higher for hospitals that appear financially

constrained.

MORE THAN 20% OF U.S. corporations are nonprofit entities, yet this organiza-

tional form has received almost no attention in corporate finance. Nonprofits

dominate the healthcare space, which constitutes more than 15% of the U.S.

economy (Philipson and Posner (2006)) and has been at the center of intense

political debate. Hospitals are part of this debate as they account for approxi-

mately 30% of all expenditures in healthcare.1However, understanding invest-

ment decisions of a nonprofit hospital is challenging because standard finance

theories and most empirical research deal primarily with shareholder-owned

corporations, and their insights are not necessarily applicable to nonprofits.

Nonprofits differ from for-profits in fundamental ways. While the objective

function of a for-profit (in the absence of frictions) is to maximize shareholder

value, nonprofits do not have shareholders, and their stated objectives in-

clude serving donors, community, or the society at large (Hansmann (1980),

∗Adelino is with Duke University’s Fuqua School of Business; Lewellen and Sundaram are

with Tuck School of Business at Dartmouth. We thank Chuck McLean and Arthur Schmidt of

GuideStar USA for their extensive help in providing the data. The paper greatly benefited from

conversations with Robin F. Kilfeather-Mackey, Gary Husband, and Peter Martin of Dartmouth-

Hitchcock, Dianne Ingalls and Scott Frew of Dartmouth College, Michael Pagliaro and Nikki

Kraus of Hirtle, Callaghan, & Co., Rick Steele of Longmeadow Capital, LLC., and Diane Daych

of Marwood Group. We also thank seminar participants at Dartmouth College, University of

Pittsburgh, and University of Washington, as well as Heitor Almeida, Andrew Bernard, Ken

French, Robert Hansen, Leonid Kogan, Joshua Schwartzstein, and Jonathan Skinner for their

helpful comments and suggestions.

1CMS National Health Expenditure Projections for 2009 (http://www.cms.gov/Research-

Statistics-Data-and-Systems/Statistics-Trends-and-Reports/NationalHealthExpendData/

downloads/proj2009.pdf).

DOI: 10.1111/jofi.12234

1583

1584 The Journal of Finance R

Sloan (2000)). As a result, nonprofits might evaluate and select investment

projects differently than for-profits do, even in the absence of agency problems

or other frictions. The potential for agency conflicts adds another dimension

that sets the two types of firms apart. Donors and taxpayers have at best

weak control over their firms’ internal decision-making, and the literature of-

ten assumes that nonprofits’ objectives are best approximated as maximizing

insiders’ rather than donors’ or taxpayers’ utility (Feldstein (1971), Pauly and

Redisch (1973), Glaeser (2003)). This suggests that nonprofit firms are not in

close proximity to for-profits on the governance spectrum, and that understand-

ing these firms is important not only because of their economic significance,

but also because they offer a setting in which the effects of weak governance

on firm behavior may be most apparent.2

This paper takes a step toward a better understanding of how nonprofit

hospitals invest. Our framework builds on a long tradition of finance research

on corporate investment. The central questions in this literature are whether

firms’ investment choices are efficient and to what extent they are distorted

by governance problems and financing constraints. The standard approach to

identifying the effects of governance or financing frictions on investment has

been to focus on the sensitivity of investment to cash flows. This framework

relies on a prediction from Q-theory that cash flow shocks that are unrelated to

a firm’s investment opportunities should have no impact on investment. Using

this insight, researchers have interpreted the observed investment-cash flow

sensitivity as evidence of free cash flow problems or financing constraints.

Our paper extends this literature in three ways. First, our analysis focuses

on the nonprofit healthcare sector, which, as we argue above, has been largely

neglected in corporate finance despite its economic importance. Second, we

use returns from endowments as a novel source of variation for identifying

the causal effect of cash flows on investment. This helps us to address one of

the key difficulties in this literature, namely, that of identifying shocks to cash

flows that are unrelated to investment opportunities (e.g., Blanchard, Lopez-

de-Silanes, and Shleifer (1994), Gilchrist and Himmelberg (1995), Kaplan and

Zingales (1997), Lamont (1997), Erickson and Whited (2000), Moyen (2004),

Rauh (2006), Bakke and Whited (2012)).3Third, we use unique data on hospi-

tal (over)spending on medical procedures to study the mechanisms that drive

investment-cash flow sensitivities in nonprofit firms, and possibly in corpora-

tions at large. The two most common explanations—financing constraints and

agency conflicts—are fundamentally different but are difficult to distinguish

empirically (Stein (2003)).4

2These arguments are discussed, for example, in Easley and O’Hara (1983), Fama and Jensen

(1985), Glaeser and Shleifer (2001), and Fisman and Hubbard (2005).

3The literature has also questioned some of the assumptions of the Q-theory, pointing out that

the presence of monopoly power or the absence of adjustment costs would affect its implications

for how investment should respond to cash flows (e.g., Gomes (2001), Alti (2003), Abel and Eberly

(2011)).

4Hadlock (1998) shows that the sensitivity of investment to total cash flows (i.e., accounting

profits plus depreciation) varies nonmonotonically with insider ownership, consistent with agency

Investment Decisions of Nonprofit Firms 1585

Hospitals offer an attractive setting to study the link between investment

and cash flows. One reason is that nonprofit hospitals are exposed to signifi-

cant exogenous and measurable cash flow shocks because, in contrast to most

corporations, these firms own large financial assets in the form of endowments.

Gains and losses from these financial assets make up a large fraction of hos-

pital profits and have the potential to affect capital and other expenditures.

Importantly, cross-sectional variation in returns on these assets is unlikely to

be correlated with hospitals’ investment opportunities or with any other aspect

of a hospital’s production function. This allows us to use returns on finan-

cial portfolios to measure the impact of cash flow shocks on various types of

expenditures.

Another advantage of this setting is that hospitals publish detailed informa-

tion on their capital investments and spending. In order to receive Medicare

funding, each hospital must provide detailed cost reports on different types of

capital spending, including expenditures on major hospital equipment (such as

CT scans, MRIs, and other major surgical and diagnostic equipment), buildings,

and minor equipment (such as surgical instruments). In addition, in annual

filings with the Internal Revenue Service (IRS), hospitals report other types of

expenditures, including executive salaries and travel and conference expenses.

We combine these different data sources to obtain a detailed picture of the

types of expenditures that respond to cash flow shocks.

Finally, spending by hospitals has been the subject of a large literature in

healthcare economics, and extensive research focuses specifically on identifying

and measuring “excessive spending.” The term captures the idea that some

hospitals spend more on medical treatment than is optimal from the viewpoint

of their residual claimants, and in particular the communities they serve (see

the review in Skinner (2012)). The insights from this research allow us to

explore the role of overspending as an explanation for investment-cash flow

sensitivity, which is an opportunity rarely available in other contexts. One

influential approach to identify overspending has been to measure hospital-

specific attitudes to treatment at the end of patients’ lives, including the use of

life-sustaining treatment, chemotherapy, or surgical interventions. Following

this approach, we explore how hospitals’ medical spending relates to their

investment patterns, and in particular how hospitals with different spending

philosophies invest in financially good and bad times.

We start our empirical analysis by establishing a baseline estimate of how

capital expenditures of nonprofit hospitals respond to cash flow shocks. We find

that hospitals invest, on average, 10 cents more in a given year for every addi-

tional dollar returned by investment securities in the previous year.This impact

explanations (see also Pawlina and Renneboog (2005) and Degryse and De Jong (2006)). Hoshi,

Kashyap, and Scharfstein (1991) show that Japanese firms with strong ties to banks exhibit lower

sensitivities, pointing to both agency conflicts and financing constraints. Lewellen and Lewellen

(2013) show that, after accounting for measurement error in Q, even firms that appear uncon-

strained exhibit positive investment-cash flow sensitivities, which also suggests the importance of

free cash flow problems.