Hospitals - Is It Time to Replace Your Strategic Plan?

Health care organizations put a lot of effort into preparing strategic plans, and then work even harder to implement them. An essential component of a thoughtful plan is a mechanism for monitoring its ongoing progress and relevance. When they are conceived, strategic plans are based on a large body of assumptions about an organization’s available resources and external environment several years in the future. When the resources and environment change, responsive management makes adjustments to the plans.

All the best-managed hospitals in the US have in place strategic plans whose assumptions have been utterly disrupted by events of the last year or so.

RESOURCES

The capital available to hospitals for strategic investment has decreased markedly. Because of tighter credit standards, access to both debt and equity capital is reduced. Hospitals have seen declines in their investment income and a sharp drop in individual charitable contributions. States have cut back on the provider reimbursements from their Medicaid budgets. Slowing demand from financially-stressed patients has led to further revenue stagnation.

ENVIRONMENT

For several years, there has been accelerating interest from unaffiliated physicians and physician groups in closer relationships with hospitals, including purchase of their practices and employment by the hospitals. In an April 2009 American Hospital Association survey, 71% of hospitals reported physicians seeking employment with them and 37% were approached by physicians wishing to sell their practices.

There currently is a greater likelihood of radical health care system reform than at any time in the last 40 years. Yet, the direction of that reform remains highly unpredictable. The present emphasis in reform proposals is on changing the structures and methods for provider reimbursement. One popular idea is the bundling of payments to all providers treating a patient during an episode of illness, a method that rewards greater coordination of care delivery among those providers. If payment bundling catches on, it will start with CMS (Medicare and Medicaid) and spread inevitably to private payers.

Portents of Bundling Payments to Providers

President Obama said in his talk to the American Medical Association on June 15, 2009 that, “We need to bundle payments so you aren’t paid for every single treatment you offer a patient with a chronic condition like diabetes, but instead are paid for how you treat the overall disease. We need to create incentives for physicians to team up …”

The Senate Finance Committee has suggested bundling of hospital and post-acute care payments, but there are indications that the physicians who perform procedures and treat chronic conditions may also be drawn into the payment bundle.

In its annual report to Congress in June 2009, the Medicare Payment Advisory Commission spoke in very positive terms about “accountable care organizations” which it defines as entities comprising “primary care physicians, specialists, and at least one hospital. In other words, a modest form of integrated delivery system.

Further in June 2009, at its Annual National Institute in Seattle, the Healthcare Financial Management Association stated that “All signs point to changes in payment streams that will provide the incentives for hospitals and other providers to collaborate to reduce costs and improve quality.” It urged its member hospitals to form integrative arrangements with their physicians.

During the same month, the head of the Medical Group Management Association told the BNET website that, “The handwriting is on the wall. The push is going to be towards more integration of physicians, hospitals, home health, and other services.”

Also in June 2009, a coalition of CEOs of major health care organizations (including Group Health Cooperative, Merck & Co. Blue Shield of California), entitled Health CEOs for Health Reform, called for the replacement of Medicare’s fee-for-service reimbursement with bundled payments tied to clinical outcomes, breadth of services, and risk sharing.

IMMEDIATE EFFECTS

Hospitals have responded to these changes in several ways. As a survival instinct, many have gone into a crisis-based management mode, concentrating on preserving cash on hand and maintaining positive cash flow. They also have taken steps to manage more tightly their spending on capital projects.

• Capital decisions are made at higher levels of management. For instance, approval of a $10,000 capital purchase that previously could be given by a middle manager now must have the consent of a vice president.
• New capital initiatives and spending are frozen. For the time being, there are no new capital projects.
• There are detailed reassessments of capital projects and other strategies already approved and in progress.
• Capital expenditures are shifted to later in the project schedule.
• If they are not canceled outright, less essential capital purchases are postponed for months or years.
• Rather than replacing existing facilities, they are renovated or retrofitted.
• Organizations are searching for unused capacity within their present structures and facilities.
• All service lines, all facilities, all activities are reexamined for their strategic viability.
• The organization's entire capital planning process is reviewed to see how accurately it assesses capital availability and strategic growth prospects.
  

At the same time, hospitals are remaining alert for unusual opportunities that may emerge during a time of economic pessimism. If the hospital is fortunate enough to have access to investable capital, it may be able to take advantage of unique strategic prospects. An ideal example would be hospital service lines that are doing well but still have room for growth through means that do not require large capital expenditures – such as hiring new physicians who can attract additional patients in related specialties.

CONCLUSIONS

Several strategic conclusions can be drawn from these developments. Savvy hospital executives are pausing the intensity of their strategic plans, looking for less capital intensive ways of carrying out the same initiatives and pursuing the same goals. The challenge is in deciding which strategic initiatives to cancel, which to cut back, and which to continue at full funding.

Those same executives must also decide how they will divide their limited time and attention between current financial pressures and longer term opportunities. They cannot completely ignore the organization’s strategic interests. While ensuring the organization’s continuing financial health, corporate leaders must be positioning the hospital for growth once the economy begins to revive.

If the direction of reform initiatives described earlier holds true, hospitals are well advised to begin aggressively exploring alignment and integration opportunities with physicians. In doing so, they must be careful to avoid the mistakes made during the wave of physician practice acquisitions in the 1990s. Hospitals then found that their competence in managing hospital operations did not necessarily translate into effective management of physician practices. Furthermore, the productivity of employed physicians working on straight salary declined noticeably. This time around, hospitals must study and understand the key success factors in running a physician practice, and must institute productivity measures and incentives.

There are numerous proposals being made for reform of the health care system, and each of them contains multiple changes in the way that health care would be delivered and financed in the US. Forward-looking hospital strategists would like to anticipate the changes most likely to be implemented in order to be able to take greatest advantage of them. This is one of the keys to success in strategic planning and management.

INSTRUCTORS

1. These strategic challenges currently facing hospitals raise the sorts of issues addressed primarily by Chapter 10, Monitoring, Fine-Tuning, and Changing the Strategy. They drive home the point that strategic plans are not written in stone, to be implemented unvaryingly to their completion. Strategy decisions are based on estimations of future events, and no one can fully predict the future. Therefore, adopted strategies must be infinitely malleable. Organizations must be willing to expand, shrink, cancel, restructure, refocus, or postpone their strategies.

2. An interesting continuing exercise in this area is to ask each student to assume that she is a strategy leader for a particular type of health care organization (e.g., small/medium/large, single/multiple specialty physician group practice, teaching/community hospital, managed care organization, large pharmaceutical company, small biotech venture), to begin to follow the details of the reform proposals as they emerge, to speculate on their implications (in terms of threats and opportunities) for the organization, and to suggest strategic adaptations that the organization might make. This requires the student to become intimately familiar with the changes likely to be occurring in the health care system, and to develop the practical ability and mental flexibility to modify strategic plans on which much effort has been spent.

3. With regard to the possibility of bundled payments, two student assignments are possible. One is to describe the terms and conditions of a new relationship between a hospital and its physicians that would enable them to take maximum advantage of such a reimbursement scheme. Under what circumstances would it make sense for the hospital to acquire the physicians’ practices? Whether the practices are acquired or not, how should the hospital supervise the physicians’ work to enhance their integration with hospital operations, their role in the continuum of care, the quality of care they deliver, their utilization of resources, and the satisfaction of the patients they see? It might be appropriate to discuss briefly the mistakes that hospitals made in the 1990s when they attempted to join with physicians to gain greater bargaining power with health plans.

The other approach is from the viewpoint of the physician practice. You might postulate a practice of three primary care physicians, aged 47, 52, and 59. All three wish to continue practicing medicine but are growing frustrated at their inability to manage the practice profitably. Their costs of operation rise steadily while the reimbursements they earn from health plans are stagnant. They seek alleviation of their practice administration burdens and some degree of income predictability and security. In their immediate area, there are two community hospitals and a teaching hospital. They have heard of physicians in other cities selling their practices to a hospital and then working as employees for them. They wonder if such an option makes sense for them, whether it would be available to them, how they should begin exploring it, and on what terms such an arrangement would be acceptable to them.

Hospital Strategy Adjustments in Economically Troubled Times

It used to be said that the health care industry was immune to the economic conditions that could boost or depress revenues in other industries. In either up or down times, people still get sick and will demand the services of health care providers. The current severe economic downturn is disproving those common beliefs and creating a “perfect storm” of dire financial conditions for many providers, particularly hospitals. This, in turn, poses major challenges for the strategic initiatives of these organizations.

NEGATIVE FORCES IMPACTING HOSPITALS

The forces having negative effects on hospital finances are coming from all directions.

Employers are suffering financially from the economic downturn. Their response takes several forms.

• Postponing pay increases that employees had been promised.
• Reducing wages or salaries paid to employees.
• Laying off employees.
• Declaring bankruptcy, leaving employees with no jobs and no health insurance.
• Cutting back on the benefits under their employee health insurance coverage.
• Shifting more of the cost of that coverage to employees through higher co-payments and deductibles.
• Cancelling all health insurance coverage for their employees.

Individual states are experiencing major budget shortfalls and are adjusting by cutting the funds allocated to their Medicaid programs. The range of services covered by Medicaid may be reduced or income eligibility standards may be raised. Current beneficiaries may lose their eligibility or be denied reimbursement for needed services.

There is concern that the health care reform initiatives enacted by the new administration will include cuts in Medicare reimbursements. The payer mix for hospitals is shifting away from the relatively lucrative commercial insurers and toward the more parsimonious Medicare, Medicaid, and out-of-pocket payers.

For all these reasons, patients find themselves with less overall income and less insurance coverage of health care expenses. Whatever income they are earning goes toward essentials like food, housing, and clothing, with little left over for health care. They react to these circumstances in several ways.

• They seek and obtain health care, but are unable to pay for it, leaving the hospital with uncollectible debts.
• They postpone seeking elective care, reducing the hospital’s revenues from such care.
• They postpone seeking necessary care, reducing the hospital’s revenues and allowing their medical condition to worsen, thereby increasing the cost when it finally is treated.
• Due to a lack of insurance or a worsened medical condition, they are more likely to seek care in the Emergency Department – care which is more expensive and more likely to be uncompensated.

Because of lower incomes/revenues and greater financial uncertainty, when patients and insurers are making payments to providers, they are doing it more slowly. This has the effect on hospitals (and physicians) of lengthening the age of accounts receivable and slowing cash flow. When they do not pay at all, uncollectible accounts become bad debt, which must be subsidized by funds from other sources.

At this moment when their revenues are under downward pressure, hospitals face demands to launch some major capital projects. They are being asked to deploy expensive EMR/EHR systems that will integrate with other providers in a nationwide network. Many hospitals built decades ago are solely in need of renovation and upgrade; some are already in the middle of capital renewal and expansion projects. Hospitals in California also must comply with a state mandate to upgrade their facilities to protect against earthquake threats by 2013.

Financially stressed physicians are also turning for assistance to the hospitals with which they are affiliated. The requested support takes these forms:

• Increased pay for on-call services at the hospital (83%)
• Direct employment by the hospital (69%)
• Hospital purchase of the physicians’ practices (31%)
• Partnership with the hospital in making equipment purchases (23%)

If there is a silver lining in this dark cloud, it is found in the promises of the newly elected president to allocate substantial new funds to general economic stimulus and specific health care initiatives. One proposal is to pump over $100 billion into the health care sector, with $80 billion of that going quickly to state Medicaid programs. The remaining $20 billion would serve as a down payment on the $50 billion total that eventually would be spent to create an integrated national EHR network and other system upgrades. Various additional reform measures may lead to increased demand for certain services, decreased demand for others, and pressures to keep the prices of all services down. As soon as the overall economy begins to revive, many of the financial stresses on employers, patients, and providers also will begin to ease.

DATA ON HOSPITAL PERFORMANCE

The effects on hospitals of these conditions is measurable.

The American Hospital Association (AHA) reported that a recent survey of 557 hospitals found that their average profit margins went from a positive 6.1% in the third quarter of 2007 to a negative 1.6% a year later. Their aggregate non-operating income fell from a plus $396 million to a minus $832 million during the same period. Thirty-eight percent of the hospitals experienced moderate declines in admissions and 31% saw similar drops in elective procedures, coupled with an 8% increase in uncompensated care.

Another survey of 54 hospital executives by CSC, a technology-oriented consulting firm, in late November 2008 produced these results.

• 55% were already experiencing cuts in Medicaid revenues
• 74% have begun carrying out some kind of response to the national economic crisis
• 60% were delaying or postponing capital construction projects
• 55% were delaying or postponing IT projects
• 15% have accelerated IT projects in the hope that they will help deal with the fiscal cris through more efficient management
• 75% intend to cut operating costs in some way
• 59% will tighten up revenue cycle management
• 43% plan to lay off staff
• 21% expect to cut services

Of all California hospitals, 73% have seen an increase in consumers having difficulty paying out-of-pocket health care expenses, 33% report increases in emergency room (ER) visits by uninsured patients, and 30% have encountered a decline in the volume of elective procedures. Thirty-eight percent of the hospitals say that they cannot meet the 2013 deadline for seismic upgrade of their facilities.

HOSPITAL RESPONSES TO POOR FINANCIAL PERFORMANCE

Hospitals have taken a variety of steps to deal with these financial stresses, including these:

• Cutting back and reducing non-clinical services
• Outsourcing services like housekeeping and security
• Reducing cardiology, obstetrics, and other clinical service lines that are money-losers or with high operating costs
• Closing subacute and psychiatric units
• Eliminating skilled nursing beds and ER beds
• Trimming workforces through layoffs, attrition, and hiring freezes
• Reducing staff pay

In a few situations, none of these measures were sufficient and the hospitals have closed.

These are some specific examples of how hospitals have responded to the current financial climate.

• In mid-December 2008, the Cleveland Clinic initiated a hiring and salary freeze among all of its 33,000 employees along with restrictions on travel and use of third party consultants and contractors.
• Three hospitals that are part of the Beaumont system in Detroit have cut salaries for managers and doctors by 4% to 10%, reduced overtime for some employees, and eliminated 500 jobs, all in an effort to take $60 million out of its cost structure.
• In New Jersey, five of the total of 79 acute care hospitals that were in operation in January 2008 have closed.
• Other hospital closures around the country include Physicians Medical Center Carraway (617 beds in Alabama), Century City Doctors Hospital (176 beds in Los Angeles), and Lincoln Park Hospital (420 beds in Chicago).
• The two-hospital Hawaii Medical Center has filed for bankruptcy, the Hawaii Health Systems network of a dozen public hospitals required a last minute advance of $13 million to avoid closure, and other hospitals in the state have laid off large numbers of employees.
• Additional hospitals that have filed for bankruptcy include Hospital Partners of America (four hospitals in Texas and California), Michael Reese Medical Center (156 beds in Chicago), Associated Healthcare Systems (four hospitals in Tennessee, Louisiana, and Georgia), and North Oakland Medical Centers (366 beds in Michigan).
• Among the many hospitals that are laying off employees, reducing the work hours of part-time employees, and cutting back on the use of temporary agency nurses are St. Vincent’s Health System (four hospitals in Alabama), Columbia St. Mary’s (four hospitals in Wisconsin), and Boston Medical Center (Boston).

An AHA survey of its member hospitals in November found the following steps being taken in an effort to survive the financial crisis.

Cutting administrative costs (59%)
Reducing staff (53%)
Reducing services (27%)
Divesting assets (12%)
Considering merger (8%)

CAPITAL MARKET REACTIONS TO POOR HOSPITAL PERFORMANCE

The forces affecting the demand for health care services and the resulting decline in hospital financial performance have not gone unnoticed by the capital markets. Overreaching in the mortgage securities markets has led to a severe tightening of debt available for all purposes – including loans and credit lines for hospitals, and the sale of hospital bonds. Credit rating firms have become more skeptical about the financial health of hospitals. In November 2008, Moody’s Investor’s Services changed its 12 to 18-month outlook for both non-profit and for-profit hospitals from “stable” to “negative”. All three of the primary credit rating firms (Moody’s, Standard & Poor’s, and Fitch Ratings) have selectively downgraded the bond ratings for many non-profit hospitals. As a result, Moody’s said, in the near future “the cost of borrowing will likely be higher … and may be nonexistent for lower-rated hospitals”. Debt is the primary source of capital for non-profit hospitals.

For-profit hospitals also borrow money, but have the option of selling shares of their stock to raise capital. The dramatic fall in stock market prices has largely closed off that avenue of financing. (The Dow Jones Industrial Average dropped over 30% from August to December 2008.) As just one example, for-profit Tenet Healthcare (56 hospitals in 12 states) failed to meet financial targets in 2008 (and may miss them again in 2009), resulting in a stock price decline from $6.55 in early September 2008 to $1.10 by Christmas 2008.

Non-profit hospitals also rely to a degree on charitable donations from individuals and from their investment of liquid cash in stock and real estate. Lower personal incomes means charitable donations are down; depressed stock and property prices, plus lowered returns on investments, have reduced hospitals’ liquidity.

In the November 2008 survey of hospitals by the AHA, a third were being charged higher interest rates on their variable rate bonds. At least 10% reported the following difficulties in meeting their credit needs:

• Increased collateral requirements
• Inability to issue bonds
• Difficulty refinancing auction rate debt
• Inability to rollover or renew credit

Hospitals are reconsidering or postponing capital expenditures for projects involving expanded capacity/renovations (56%), clinical technology or equipment (45%), and information technology (39%).

California hospitals were questioned on their access to capital. Almost 70% of them stated that the deterioration in the value of their investments has had a moderate or significant negative effect on their overall financial condition. Several expressed concerns about their ability to comply with the cash and liquidity terms of their bond covenants. The general unavailability of credit and their degraded financial condition has prevented 16% of the hospitals from finding new sources if debt that would allow them to avoid the auction rate securities market. Over 25% report an inability to access the financing they need for construction, renovations, equipment purchase, and working capital. As a result, 41% of the hospitals have postponed construction projects or equipment purchases.

STRATEGY ADJUSTMENT TO HOSPITAL FINANCIAL DISTRESS

Many of the changes introduced by hospitals in response to their financial difficulties are designed to produce reductions in operating costs as quickly as possible. Others have the effect of slowing or halting the flow of funds into projects of a more strategic nature. A few hospitals are actually accelerating spending on strategic EHR systems in the hope that it will make them more efficient. It is worth giving serious attention to how an organization continues to conduct its strategic management in the face of the kind of economic crisis that currently exists in the US and is likely to persist for a year or two more.

The first concern is the funds that have been dedicated to the implementation of specific strategic initiatives. The typical hospital has a portfolio of strategic projects in process at any particular time. All together, they represent a capital outflow that probably is not sustainable. Decisions have to be made about how to reduce these capital expenditures. Several factors must be taken into consideration.

What is the total amount that must be cut from the capital spending budget? Immediately and at various points in the future? Can a rule be defined for carrying out further budget cuts conditional upon key financial metrics, such as free cash flow, liquidity indicators, revenue and profit projections, industry growth projections, and national economic indicators?

How will the cuts be applied to the hospital’s various strategic projects? Will they all receive the same across-the-board reduction in capital funding (e.g., 10%)? Will one or a few projects bear the brunt of the cuts? If the cuts are to be applied selectively, what are the criteria for choosing the projects to be cut? If different amounts are to be cut from several projects, how are those amounts determined? May one or more projects even see their budgets increased?

A standard across-the-board reduction usually does not make sense. Some projects may be closer to completion. Certain projects may be more essential to the hospital’s strategic vision than others. It is a complex task to decide which strategy budgets to cut and by how much.

The adjustments to strategy budgets may take several forms. The budget may be reduced by a particular amount with the expectation that it still will be implemented more or less as planned. Or the budget cut may be accompanied by a scaling back in the scope and goals of the plan. The budget can be considered permanent or temporary, the reduced amount to be reinstated when financial circumstances allow it.

In some cases, it is possible to put a strategy on hold, to postpone its implementation until the hospital can afford it. The nature of some strategies will not allow this. Occasionally, it becomes necessary to cancel the strategy entirely.

A second concern in the current economic climate is the continuing appropriateness of the strategies in the process of being implemented. They presumably made sense when the hospital first committed to them. However, good strategic management includes ongoing monitoring of the strategies to make sure that they continue to fit with the hospital’s internal and external environment. The dramatic changes in the national economy, the health care industry, and fiscal condition of individual hospitals are just the kind that warrant a reexamination of existing strategies, not only for their financial viability but also for their substantive validity.

After careful analysis, it may appear that even a low-cost strategy no longer contributes to the hospital’s strategic aims and should be dropped or substantially modified. Most intriguingly, the changed environmental circumstances also may argue for the launch of new strategies designed to take advantage of them. For instance, competitors may be in such a weakened condition that they will be unable to respond to the hospital’s aggressive strategic initiatives. If the hospital can find the necessary funds, it may be able to invest in new features (e.g., a highly personalized, patient-friendly EHR system) that markedly distinguish its products or services from those of the competition, thereby biting off a big new share of the market. Some competitors may be in such dire financial straits that they can be acquired outright for an extremely low price.

INSTRUCTORS

The crisis-level financial conditions facing many hospitals offer an excellent opportunity to explore with the students the fiscal underpinnings of organizational strategies and the importance of continually watching and fine-tuning them. Here are some ways of approaching the issues.

1. Ask students to do some modest research to learn the types of strategic plans that hospitals might have in progress, plans that were probably initiated two or three years ago. Alternatively, using their knowledge of how hospitals operate and compete with each other, ask the students to speculate on some strategies that a good, competitive hospital would be pursuing. Compile a list of five or six of the most common strategies.

2. Review the data and reports on the effects of the economic downturn on the hospital industry, as described above and in numerous news media.

3. Discuss the connections between what is happening in the economy at large and the implications for those identified strategies. What is the immediate effect on the hospital’s financial resources available for funding the strategies, as well as its prospects for access to additional capital from debt and equity sources? Do economic trends, market trends, new health care reform proposals, and competitors’ new strategic initiatives alter the effectiveness and usefulness of any of the strategies? Exactly how is the relevance of each strategy changed? Has a strategy become so irrelevant that it should be aborted? Can it be salvaged through some amendments? Would it help to postpone its implementation until a more propitious time in the future? Does the discrediting of some existing strategies suggest possible new strategies that could replace them? I suggest going through the five or six strategies, one at a time, to highlight these effects and decide what changes, if any, a hospital should make to them.

4. An important feature of this discussion should be the highly dynamic nature of the environments in which hospitals (and other health care organizations) operate, requiring an equally dynamic approach to managing the strategies

5. The financial stress imposed on hospitals by current economic conditions also provides an opportunity to clarify in students’ minds the distinction between operational and strategic issues. Create a list of the ways that hospitals are responding to the stress. Many are mentioned above. Go through the list and identify which are operational in nature and which are more strategic.

Hospital Survival May Require Radical Strategic Restructuring/Reorientation

In the traditional model of hospital structure and operations, hospitals attempted to be all things to all people, to provide the full range of in-patient services that the population of its service area might require. As the movement to reduce costs pushed some of those services to ambulatory settings (e.g., day surgery), many hospitals also established their own out-patient facilities. Hospitals support this model with investments in the latest clinical technologies, recruitment of high reputation physicians, and boosting patient volumes to cover their high fixed costs of operation. They do this across the board, in all specialties within the hospital.

Challenges to the Traditional Model

However, forces are at work that will make this model obsolete. New more focused competitors are nibbling at the sustainability of that model. It began with ambulatory surgery centers set up by physicians as sources of additional revenues. This was followed by physician expansion into freestanding diagnostic imaging centers. The most dramatic step has been the establishment of specialty hospitals that concentrate in more lucrative specialties like orthopedic surgery. These new facilities succeed by taking away from local community hospitals the high-margin services that the hospitals rely on to subsidize low-margin services and specialties. Only the largest hospitals have the patient volume in all specialty areas needed to match the performance of organizations concentrating in one or two areas.

In addition, the swelling support for “consumer-driven health care” is empowering patients to select more carefully among available providers (hospitals and physicians) for the specific services they need. They are assisted in making their choices by a growing body of data and other information comparing the performance, price, and features of each provider’s services. Patients can now evaluate individual specialties and departments within hospitals, as well as the physicians who practice there, and choose the hospital that offers them the greatest value in the specialty that they require at the moment. A discriminating patient can elect to receive one specialty service from hospital A and another specialty service from hospital B.

Historically, hospitals have promoted themselves (if they did any promotion at all) as full-service in-patient service providers with an all-around good reputation. The implication was that the hospital offered quality and value in all departments and specialties. This was not just untrue; it was implausible. Some service areas were bound to be better than others. Now, there are data available to patients, employers, and payers that measure the overall quality, service, and prices of each area and, in some cases, of specific procedures performed within the areas.

Institutional payers (Medicare, Medicaid, private health plans) are wielding their market power to compel hospitals to improve their performance in all areas and to disclose data on how well they are doing. Through pay-for-performance programs and recognition of Centers of Excellence, the payers are wiling to reward high achievers.

A dramatic shift is occurring in the way that hospital services are purchased, and hospitals must adapt in order to survive.

Strategic Adaptations to the New Paradigm

To understand this new paradigm for managing strategy in hospitals, it helps to begin thinking in terms of “service lines” (e.g., obstetrics/gynecology, oncology, cardiology) and “treatment episodes” (e.g., childbirth, coronary artery bypass). The strategic focus of these institutions must shift from the entire institution (or several institutions, if it is a multi-location hospital chain) to these service lines and treatment episodes. This is where customers will be focusing and where the competition with other hospitals will be taking place. It is conceivable that top hospital executives will eventually view their institutions as portfolios of clinical service lines, to be manipulated like a multi-SBU corporation.

To appeal to those customers and respond to those competitors, hospitals are beginning to take some bold strategic actions.

1. The first step is selecting the service lines on which hospital management will focus its attention. These will be lines where the hospital is strong, could be strong, or needs to be strong. They will offer above average profit potential. The hospital will reallocate money and other resources according to these important choices. To prepare for making the choices, the hospital will:

• Assess where demand appears to be growing and shrinking among its service lines.
• Determine its market share for each service line in its primary service area.
• Evaluate its competitive position for each service line.
• Measure its revenues and profitability in each service line.

Without this information, a hospital does not have sufficient understanding of its cost structure and profitability by service line, payer, physician, or patient to be able to make thoughtful service line decisions.

2. The hospital then sets goals for growth and improvement in the selected service lines. These will encompass enhancements to operating activities, investments in new technologies, recruitment of new physicians and staff, and the launch of new marketing initiatives. In many ways, it will appear that the hospital is starting a new business venture. This impression is especially accurate if the hospital builds the service line into a true strategic business unit (SBU).

3. Varying degrees of authority and responsibility are delegated to the several service lines. The largest and most competitive clinical areas (e.g., cardiology, oncology, orthopedics, women’s health) are granted enough autonomy to be considered SBUs. For each unit, the hospital makes administrative (MBAs) and clinical (MDs) leaders accountable for growth of patient volumes, service levels, quality levels, patient satisfaction, and financial performance (revenues and profit). They are empowered to make capital investments, choose appropriate suppliers, and recruit new physicians and staff.

Even if not allowed complete managerial autonomy, the heads of other service lines are often given new responsibilities and authorities commensurate with their area’s role in the hospital’s restructured portfolio of service lines. Some clinical areas are simply unsuited to designation as SBUs; others are destined for de-emphasis within the hospital’s portfolio. A few may be closed down completely. In making these decisions, management will keep in mind the interdependencies among clinical areas.

4. The success or failure of a major restructuring and reorientation like this depends greatly on the competence of the managerial and clinical leaders of each SBU or service line, and their relationships with each other. The abilities that are adequate to “administer” a clinical area under close scrutiny from top hospital management may not be enough to “lead” a more self-reliant SBU. The units must be headed by people who can make important operational and strategic decisions as they take on increased responsibility. The goals and activities of the managers and the physicians must be in alignment.

Promoting Better Hospital-Physician Alignment

Many physicians have fallen into largely autonomous practice patterns that are aimed at optimizing patient care and physician rewards. Under a service line arrangement, physicians need to be reoriented toward quality of care based on collected data, service enhancements that foster patient satisfaction, and efficient practices that permit more competitive prices. Some vehicles for better aligning service line and physician goals are gain-sharing, direct employment, and strategic partnerships.

The strategies for building hospital-physician alignment must be better thought out than the attempts made in the 1990s. At that time, each hospital wanted to establish exclusive ties with its medical staff physicians so that they would send their patients only to that hospital. Hospitals purchased the physicians’ practices for dollar amounts exceeding their market value and placed the physicians on salary. Many created separate “physician-hospital organizations” (PHOs). It turned out, however, that managerial skills that worked well in running hospitals were less applicable to physician practices. In addition, the productivity of physicians on salary dropped dramatically. Most of the PHOs eventually were disbanded, with the physicians sometimes buying back their practices for a fraction of what they sold them for.

What has changed in the last 15 years is that hospitals are less interested in brute force initiatives to increase patient flow, and are now willing to take a more nuanced approach that enhances the value of their service offerings in the belief that this will attract more patients. A “pull” rather than a “push” strategy. Value enhancements require incentives tied to metrics for quality, service, and cost, and they must be directed to all staff members, not just physicians.

For at least two decades, every type of organization that compensates or reimburses physicians has searched for a payment method that encourages desired practice behaviors without promoting undesirable conduct. It is argued that fee-for-service reimbursement gives physicians an incentive to deliver too much care while capitation reimbursement leads to under-treatment. A number of hospitals have found success with an arrangement that gives their employed physicians a below-average base salary coupled with substantial incentive payments tied to particular results like reduced costs, improved clinical outcomes, greater patient satisfaction, and increased revenues. If the incentive scheme is constructed properly, with input from the physicians, their performance and income are likely to improve and the their job contentment grow.

If the physicians prefer to remain autonomous of the hospital, care must be shown in constructing compensation plans to avoid legally prohibited self-referrals. One way around this is to form joint ventures in which all the physicians practicing in a particular specialty share an ownership interest with the hospital in that specialty or service line. Ultimately, this might involve spinning off the service line as an independent legal entity. A good candidate for this treatment would be an ambulatory surgery facility. Many specialties are not amenable to this approach.

5. After making the difficult decision about which service lines to emphasize, the hospital must deal with the reaction to the de-emphasis of other service lines. Physicians, regular patients, the local community, and even the media will express concern over the lower priority given to clinical areas they especially care about. It will be necessary to reassure physicians in those areas that they will not lose too many referrals, and patients that they will continue to receive good quality care.

Hypothetical Example of Service Line Emphasis

A hospital might take the following steps in giving emphasis to a particular service line.

· Choose a service line that faces only modest local competition (allowing the hospital to become a leader in that area) and returns a profit margin above the hospital’s average.

· To begin building up the service line, recruit a name physician to be its head, someone with an appreciation for delivering health care in a competitive environment.

· Appoint or hire if necessary an administrative leader of the service line who is experienced in managing with a high degree of independence.

· Make major investments in state-of-the-art clinical and information technology tailored to the service line’s requirements.

· If appropriate, seek and obtain disease-specific Joint Commission accreditation for the activities of the service line.

· Set a course to develop the service line as a Center of Excellence.

· Pursue other forms of independent recognition (NCQA, Leapfrog Group) as a superior provider of specialty care in its field.

· Begin aggressive marketing of the service line and its unique attributes to prospective referral sources in the local market and elsewhere.

A hospital that successfully implements a service line restructuring can expect to enjoy several benefits. As administrators and physicians pay more attention to the business-like running of their areas, they are in a better position to discover and share evidence-based best practices with their colleagues in other service lines or in the same service lines at other hospitals in a multi-hospital system. They will achieve higher patient throughput rates that can lead to volume economies and other scale benefits. It becomes possible to standardize processes and procedures. Both treatment rooms and patient-stay rooms are turned over more rapidly and efficiently. The hospital provides better care to its patients and more useful support to its physicians. As a result of wiser capital investment decisions and improved operational efficiency, there are gains in financial performance.

INSTRUCTORS

This topic provides an opportunity to introduce students to a seismic change that may be occurring in a major segment of the health care industry. These are some issues that might be raised with the students.

1. Explore in greater depth the competitive forces that may be compelling hospitals to change the way they view and manage their clinical areas. Research the different entities that are being created to draw off the more lucrative sources of a full-service hospital’s business. Within the immediate area of the school, are their examples of ambulatory surgery centers, freestanding diagnostic facilities, or specialty hospitals? Consider student interviews with the founders of those entities to learn their motives and their reactions to accusations that they are “skimming the cream” of local hospitals.

2. In addition to the service line or SBU strategy described here, what other steps could a hospital take to respond to these competitive attacks on its individual clinical areas? If such competitive threats exist in your area, try to interview strategic decision makers at the affected hospitals to learn their reactions and plans.

3. Is it really plausible for a hospital to manage itself like a “portfolio” of clinical areas, emphasizing some, deemphasizing others, perhaps discontinuing a few areas while creating entirely new ones? To what extent do successful hospital operations depend on the availability of a comprehensive set of clinical areas and the synergies among them? Imagine the kinds of clinical problems that might emerge in a hospital composed of only a subset of traditional specialty areas.

4. As a prospective consumer of hospital services, how would you perceive and value a hospital that did not offer a full range of specialty services? Would you be content with evaluating hospitals on a specialty-by-specialty basis?

Life Path of a Biotech Startup

Starting a new company to develop biotechnology products has never been more popular. A new generation of business school graduates with strong entrepreneurial instincts are drawn to the high-potential biotech industry. The large pharmaceutical companies are shifting their drug development models to greater reliance on narrow focus large molecule genomic-based drugs that are the primary emphasis of new ventures in biotech. The highly customized drugs developed by these firms will be a key element in the new brand of “personalized medicine” that will be offered under consumer-driven health care. Anticipating the revenue windfall from this new market segment, venture capitalists, large drug companies, and other new venture investors are supplying substantial amounts of capital to small biotech companies that show promise of creating marketable new drugs.

The biotechnology industry is unique among modern businesses, even others in the high-tech arena. Its drug products emerge after a long, high-risk, capital-intensive development process and must satisfy rigorous safety and efficacy standards before being approved by the Food and Drug Administration (FDA) for release to the market. Historically, drug development was the exclusive domain of large “legacy” pharmaceutical corporations like Pfizer, Merck, and Lilly. Recently, those companies have experienced increasing difficulty in their ability to innovate the “blockbuster” drugs that they depend upon. They have turned to outsourcing drug discovery and early-stage development to small, new biotech ventures.

The era of “biotechnology” companies may have begun on June 16, 1980 when the US Supreme Court ruled that a genetically-modified microorganism could be patented in the case of Diamond v. Chakrabarty. In the nearly three decades since then, the example of university-based scientists starting new ventures to commercialize interesting research ideas and earn millions of dollars has entered entrepreneurial lore.

The primary business of biotech companies is to translate an initial scientific idea into valuable intellectual property and monetize it through license or sale to another company. The research and development process conducted by biotech companies over a period of years steadily builds up the value potential of drug candidates through the proof of concept, clinical trials, and FDA approval to finally create a marketable product. In the early stages of the process, the apparent value is low, so it is hard to attract the interest of public equity investors. Funding sources prefer later-stage ventures with more clinically advanced drug candidates.

As the development process proceeds, the value of the drug candidate slowly increases, the financial risk of investing in the company slowly diminishes, investors become more willing to make the investments, the costs of continuing the development grow dramatically, and the size of the investments increase commensurately. The following is an example.

A biotech company that brings its drug to the Phase I clinical trial stage might be able to attract roughly $65 million in capital. When the drug reaches the Phase III stage, over $200 million in capital could be available. Of the Phase I money, perhaps $5 to $10 million would be in upfront cash and the remaining $45-50 million would be promised in highly uncertain success-based installments that might never materialize. The Phase III investment could be composed of $50 to $100 million in cash, followed by another $150 million as specific milestones are met, and capped by royalties on sales of the drug paid to the biotech company by the big pharmaceutical company that invested the capital and took a legal right to the drug.

Clinical Trials in the Drug Development Process

A major component of the drug development process, the one that is most expensive and time-consuming, is the series of clinical trials leading (hopefully) to FDA approval. In order to conduct optimal strategic planning for a startup biotech venture, it is well to have a solid understanding of this trial sequence.

Clinical trials traditionally have been broken down into four phases that follow “pre-clinical studies”. Initiation of each phase depends on successful completion of the preceding phases.

Pre-clinical studies are composed of test tube/laboratory studies (in vitro) and trials on animal populations (in vivo). They are intended to gather preliminary information on the efficacy, toxicity, and pharmacokinetics of the drug that leads to a decision on proceeding to human-based clinical trials.

Phase 0 Trials. This new phase designation involves exploratory trials on a few humans (10-15) conducted under the terms of the FDA’s 2006 Guidance on Exploratory Investigational (IND) Studies. The trials administer sub-therapeutic doses (too low for any therapeutic effect) of the drug to determine whether its pharmacokinetics (how the body processes the drug) and pharmacodynamics (how the drug affects the body) are as suggested by the pre-clinical studies.

Phase I Trials. This is the first trial on a larger number of human subjects, typically 20-100 healthy (non-patient) volunteers. The subjects are studied in an inpatient clinic where they are observed full-time by clinical personnel. The trial is designed to evaluate the safety, tolerability, pharmacokinetics, and pharmacodynamics of the study drug. This trial also attempts to determine the drug dose necessary to produce the desired therapeutic effect.

Phase II Trials. Several hundred human subjects may be included in this round of trials with the purpose of continuing the safety assessments begun in Phase I and determining how well the drug works. This is the phase at which most drugs fail, if they are going to fail at all. The trials may reveal unacceptable toxic effects or poor efficacy. The phase is sometimes separated into IIA (dosing requirements) and IIB (efficacy) components.

Phase III Trials. In this phase, the drug developer conducts randomized controlled multi-center trials (the gold standard in clinical research) on groups of patients that may vary in number from several hundred to several thousand, depending on the condition or disease that is the target of the drug. The goal is to make a definitive evaluation of the drug’s effectiveness contrasted with the currently best available therapy for the condition or disease. These trials are the most expensive, challenging, and time-consuming to design and conduct. Possible additional purposes of these trials are to demonstrate the drug’s efficacy for conditions/diseases other than those originally targeted (“label expansion”), to gather more extensive safety data, or to back up specific marketing claims that the company wishes to make for the drug. Typically, two successful Phase III trial are completed before their results are gathered into a single volume of background material (i.e., trial methods and results, formulation details, manufacturing processes) for submission to the FDA. If the FDA approves the drug, the development company (or other entity that has licensed or purchased the rights to the drug) is free to begin the marketing and sales of the drug.

Phase IV Trials. These are referred to as Post Marketing Surveillance Trials. They are carried out after a drug has received FDA approval and is available in the marketplace. They focus on ongoing monitoring of the drug’s safety and provision of technical support that the drug may require. Such studies may be conducted at the FDA’s request or on the company’s initiative with the purpose of identifying new markets for the drug.

It is convenient and common to view the life cycle of a biotech company in terms of stages somewhat similar to the phases in the drug approval process.

Conception and Gestation

In the classic scenario, a new biotech company begins when an entrepreneurial scientist in academia or industry recognizes a scientific discovery that might have therapeutic implications, and decides to create a business to test out the idea. To have any commercial potential, the idea must be protectable by a patent or series of patents – leading to the intellectual property (IP) that is the fundamental asset of any biotech company.

The initial funding for this new venture can come from several possible sources – government and economic development grants, universities, the inventor himself, family, friends, and wealthy individuals (angel investors). The amount is usually modest, in the range of $1 to 5 million. The owners of the newly formed company are its founders – the scientific innovators and their co-investors.

The initial funding is rarely enough to do more than pay for studies of relevant basic science. Their purpose should be to strengthen the scientific hypotheses underlying the rationale for further development of the drug compounds. To move beyond this formative stage, the founders must develop a credible business plan and recruit a management team with industry experience and a successful track record.

Infancy

In this stage, the drug under study is moving toward human clinical trials. This step requires the filing of an Investigational New Drug (IND) application with the FDA. A prerequisite to the application are in vitro and in vivo preclinical tests that must satisfy strict and expensive regulatory requirements. These IND-precursor studies typically cost between $5 and $10 million.

If the initial angel investors are impressed enough with the company’s development progress up to this point and have sufficient additional investable capital, they can put more of their funds into the company and maintain their ownership shares. However, most are small-scale investors and lack the additional capital that the company needs. The company needs to find new sources of financing.

Venture capital (VC) funds usually enter the picture at this point, though there is a growing interest on the part of large pharmaceutical companies to invest in promising compounds here as well. The venture capitalists provide their funds to deserving companies according to a rather strict formula. The rule of thumb is a return of their investment within three to seven years at an average annual rate of 20%. Or, to put it more succinctly, they want to double their money within five years. Any companies that cannot fit within a VC firm’s time horizon, and meet financial benchmarks along the way, will not receive financing from them. Furthermore, even if a company is deemed an attractive investment candidate, additional compromises will have to be made.

The most obvious sacrifice is that the original owners will have to allow significant dilution of their equity interest in the business. Depending on the amount of VC capital brought in, the new investors may assume majority control. Even without ownership of 50% of the company stock, the VC investment terms may give them a controlling position on the board of directors. Through that board control, they will be able to exercise considerable influence over day-to-day operations and long-range strategy.

During this period in a new venture’s life, it will go through several rounds of additional financing until it is deemed ready for an initial public offering (IPO) of stock. At every additional infusion of capital, the founders’ ownership interest is diluted further, often falling to a few percentage points. Savvy VC investors recognize the potential effects of this dilution on the founders’ (often directly involved in conducting the research at the heart of the business) motivation and strive to hold their equity ownership interests at meaningful but not crushing levels. The investors may also implement equity compensation plans that provide additional incentives for the key founders to stay actively involved in company operations. The additional rounds of financing and the growing value of the firm must move in parallel – the investors of new capital (in a business that has not yet generated revenues) need to see increments in the value generated by their capital that exceed the amounts they have invested.

As the compounds under study make progress toward human clinical trials, opportunities may arise for the business to license the IP it has developed or to sell out entirely to a large drug company that will continue and complete the development process. There is always a trade-off between the point in biotech venture life cycle at which its IP is converted into money and the amount of money that will be received. The longer the company can sustain itself along the life cycle path, the greater the value of the IP that it is creating. Premature sale or licensure will yield a suboptimal payoff.

Adolescence

Another watershed in the biotech life cycle is the company’s application to the FDA for permission to begin clinical studies on human subjects, either relevant patients or volunteers. Getting to that point demonstrates a major increase in the therapeutic potential of the compound under study which, in turn, boosts the perceived value of the company to prospective investors. This is matched by a enormous jump in capital required, primarily to cover the cost of the human studies.

The larger amounts of capital called for now usually exceed the financial resources of the early-stage investors, including the VC firms. Yet other funding sources must be approached. These typically take the form of either larger established pharmaceutical corporations (sometimes called “legacy” drug companies) or a type of investment firm called a “crossover fund”. The legacy drug companies frequently establish special units of the organization dedicated to identifying and investing in promising new technologies that complement the companies’ own R&D efforts. A crossover fund is an innovative hybrid that invests in both publicly traded shares and equity of private companies that are not traded on open markets.

This stage of venture financing is often described as a “Series D” or “Series E” round that provides “mezzanine capital”. The investors behind it have time horizons that range from a few months to a couple years. The money is targeted toward the development of clinical data that persuasively demonstrate the therapeutic value of the drug. This step in the biotech venture life cycle is referred to as the “proof of concept”, the clinical theory or model that will be the foundation of the planned drug. The strength of the data developed in this stage is a critical indicator to investors of the return that they can expect to earn on their investments.

The amounts of additional capital required at this point in the company’s life cycle range from roughly $10 to $30 million, depending on the condition or disease targeted by the drug under study. In some cases, the clinical trials necessary are larger and more expensive, and more of them are needed to prove the concept.

Because of the larger sums of capital called for and the looming risk of complete failure in the development process, willing investors are harder to find. The company’s founders and owners may also be reluctant to surrender even more of their control of the business. As a result, some biotech companies try to negotiate with prospective investors to craft innovative financing packages. For instance, entities like contract research organizations (CROs) may offer modest amounts of financing supplemented by non-monetary investments like facilities, equipment, and development expertise. In place of equity, some investors may be willing to accept a legal right to future royalties the company earns on the drug it is developing. Occasionally, a financing arrangement may allow the company to draw down additional capital – and give up commensurate equity – at times and in amounts that suit its needs, rather than in a single large investment.

Company Maturity and Investor Exit

As the drug development process progresses toward the point at which it appears that a marketable product will result, the company founders begin thinking about how to translate their imagination, hard work, and risk-taking into dollars. Simultaneously, the investors who supported the founders along the development path are planning their exit from the business, with the intention of earning the substantial return that was the reason for their original investments. This is the first time in the company life cycle that anybody receives more than a basic salary.

The form and timing of this exit strategy is a subject of careful calculation. There are two fundamental options – sell all or most of the existing equity to new investors, usually through an initial public offering (IPO), or sell the entire business to another larger entity through a merger or acquisition. The market for biotech IPOs has slowed greatly since its peak four years ago. Fortunately, the slack has been picked up by large pharmaceutical companies that are struggling to fill their drug pipelines as their established blockbuster products are coming off patent and facing the threat of competition from generics. Since 2005, over $60 billion has been invested in biotech company acquisitions by the pharmaceutical industry. This trend rose to new heights in the summer of 2008 when Roche offered to purchase for $44 billion the remaining 44% of the shares of Genentech it did not already own, and Bristol-Myers Squibb bid $4.5 billion in cash for the 83% of ImClone that it does not now own. In 2007, eight of the 17 new chemical entities approved by the FDA had been licensed or acquired from biotech ventures by large traditional pharmaceutical companies earlier in their development.

INSTRUCTORS

Many students in health care and business programs develop a strong interest in new ventures and startups. Biotechnology is one of the hottest fields for expressing such an entrepreneurial spirit. This blog entry, including the sidebar on the FDA clinical trial sequence, provides a good, succinct introduction to the stages in building a successful biotech company from scratch. It is best read in connection with Chapter 12, Strategy in Other Types of Organizations.

1. When a biotech company is launched by a research scientist, who leads it competently for a year or so, at what point is the general running of the business, particularly its strategic direction, handed over to professional, experienced managers? It can be difficult and emotional for a founder to yield control over his dream venture even though he may technically retain a majority ownership interest. How can this transition best be handled? What can the new managers do if the founder will not really let go?

2. As the biotech business progresses through the development process, the successive clinical trials and stages of financing, toward FDA approval of a marketable drug product, there is constant tension between the desire of the founders and early investors to retain some degree of control over the business and the need to give up control in return for capital financing necessary to continue the process. In what ways can a balance be found between these two interests? What options are available to a founder who wants to maintain a controlling interest for as long as possible?

3. The early life of a biotech company is marked by several points at which critical strategic decisions must be made. At what point to bring in an experienced management team and how much authority to give them? Whenever additional capital is required, what sources to approach, how much financing to seek, how much equity to trade for the capital, and what other constraints to accept from the investors? How far along in the development process should the founders cash in the intellectual property they have accumulated, through license or outright sale of the drug compound, or sale of the entire business? This early in a company’s life, it is a fragile entity without the resources to absorb major strategic errors.

4. Ask the students to trace through internet research the early history of a biotech company. To the extent possible, ask them to identify the specific phases in the development process, the financing stages, and the final outcome of the entrepreneurial endeavor. Does the company still exist? Was it able to carry out an initial public offering and go on to become a much larger, more diversified biotechnology business? Or did it disappear when it was acquired by a large pharmaceutical company?

Lessons in Strategic Management from the AHERF Bankruptcy

In July 1998, the Allegheny Health and Education Research Foundation (AHERF) filed for bankruptcy with $2 billion in annual revenues and $555 million in outstanding debt. To this day, it is the largest not-for-profit health care system ever to go bankrupt. There are some excellent lessons in managerial competence and incompetence to be learned from failures like this, just as there are from successes.

The lessons in this case are very well captured and summarized in the report “The 10th Anniversary of the AHERF Bankruptcy: What Have We Learned?” issued in July 2008 by Moody’s Investors Service, the credit rating firm. Moody’s and the other two leading credit rating firms, Standard & Poors and Fitch Ratings, are excellent sources of recommendations for “best practices” in strategic management that will optimize an organization’s creditworthiness.

Most private business corporations are very interested in the credit ratings they receive from firms like Moody’s and what it takes to earn higher ratings. The firms willingly reveal the criteria that guide their decisions. Many of these guidelines are available on the websites of the three firms and in articles based on the reports they publish. Sometimes derivative articles are the best starting points because the reports themselves are often proprietary and expensive. (The Moody’s AHERF report is available for $550). Savvy firms are well-advised to pay close attention to the criteria set forth and follow them as fully possible. These are the recommendations that appear in the AHERF report.

1. Maintain accountability over management decisions through strong governance and oversight.
2. Carry out only those growth strategies that are well-disciplined and backed by rigorous financial planning and feasibility studies.
3. Strategies that embody integration with physician practices are essential to grow market share but must be methodical and thoughtful.
4. The organization must deploy a robust information system that permits it to manage costs, maximize revenues, and differentiate itself on the basis of quality and clinical outcomes.
5. Through consolidated financial statements, disclose the financial performance of all the organization’s divisions and strategic units, both those with and without outstanding public debt.

They stem directly from the variety of disastrous actions at the governance and managerial levels that led to AHERF’s downfall, including weak oversight, poorly executed strategies, unsophisticated leadership, and sloppy implementation.

INSTRUCTORS

Founded as it is in the fiscal shortcomings of AHERF organization, this story and its lessons can be discussed under Chapter 11 on Strategic Financial. It also can be considered in the classes on Chapter 7, Formulating Corporate-Level Strategy.

1. The AHERF case is a classic example of human failure in strategic planning and management, at the level of the board of directors and the top executives. It is worthwhile, and rather entertaining, for the students to learn the lurid details of what went wrong. One way of doing this is to present them with the Moody’s recommendations as described above and ask them to search on the web for more details of what happened with AHERF and, specifically, the mistakes and misdeeds that led to each of the recommendations. They are available in numerous news accounts on the web. Alternatively, the instructor can gather the background facts beforehand, lay them out in class, ask the students to explain what was wrong with them and suggest how they could have been avoided, and then tell them about Moody’s recommendations. See if the students can anticipate and match those recommendations.

2. The problems at AHERF illustrate one model of strategic management, a truly dysfunctional one in which untutored, unsupervised executives made unsupported, poorly conceived strategic decisions that were ineptly implemented and inadequately monitored. Use this case to discuss the appropriate role of the governing board (of directors or trustees) in the strategic management process. Just how involved should they be in setting overall strategic objectives, signing off a individual strategic plans, and overseeing the progress and success of those plans? What problems can arise when a board intervenes too much (“micromanages”) in strategic decision making? What metrics might a board use to evaluate the strategic competence of the organization’s executives?

Backward Vertical Integration in the Pharmaceutical Industry: Strategic Value of Controlling Interest Versus Total Ownership

On July 21, 2008, the Swiss pharmaceutical company Roche Holding announced its intention to purchase the stock of the US biotech firm Genentech that it does not already own. Roche currently owns 56% of Genentech, which has a market value of about $100 billion. Roche is offering $44 billion for the remaining 44%. (Wall Street Journal, 7.21.08.) If the transaction is approved, it would end the independent existence of what is considered to have been the first biotechnology company that has since grown to become the most successful. Amgen has higher annual sales, but Genentech’s market capitalization is higher.

The CEO of Roche, Severin Schwan (who assumed his position in March 2008) explained the reason for the proposed acquisition this way, “We will be better able to share technologies and expertise in pharmaceuticals and diagnostics across the group and broaden the mutual access to the external innovation networks of both companies. The transaction will also unlock synergies by leveraging the scale of the combined operations in the US and improving operational efficiency.”

A more specific reason may be that Roche currently has an agreement with Genentech that allows Roche to sell Genentech products in markets outside the US, but inside the US. That agreement expires in 2015. Without complete control of Genentech, it would have to renegotiate that agreement.

Regarding the proposed acquisition, the chairman of Roche, Franz Humer, said that it would “secure the access to Genentech’s products beyond 2015”, though he cautioned that it was not the primary reason for purchase. He added that the merger could save the combined companies over $800 million a year, while permitting them to more freely exchange ideas and research tools. (New York Times, 7.22.08.)

Roche bought its present controlling interest in Genentech in 1990 for $2.1 billion. It was a pioneer in the move by large pharmaceutical companies to form strategic partnerships with smaller biotech companies or acquire them outright. The purpose was to gain access to their drugs under development, in the wake of the declining productivity of the drug firms own labs. The biotech sector has been seen as more successful in bringing innovative new drugs to market.

At the time of the initial acquisition, Roche recognized that Genentech’s independence and unique culture were key to its research productivity, and it made every effort to allow Genentech to operate as a fully autonomous entity. Even so, many Genentech scientists and managers left to form their own biotech companies. Genentech survived their exodus and has prospered. Cancer drugs emerging from Genentech labs accounted for nearly a third of Roche’s total sales in 2007 (particularly the cancer medicines Avastin, Rituxan, and Herceptin). Over the last 15 years, Roche has followed a strategy of buying controlling stakes, rather than full ownership, in companies that research and develop drugs. What it did is now considered a model for a relationship between a large pharmaceutical corporation and a smaller biotech company.

There is concern that, if this transaction goes through, it will compromise the intellectual freedom that has driven Genentech’s research creativity and productivity. The managing director of an investment bank (Seaview Securities) specializing in life sciences commented, “I think that they are trading short-term benefits for long-term problems. The goose that’s been laying the golden egg so reliably. I think they risk killing it.”

Roche has responded to these concerns by committing to allowing Genentech research to continue to function independently. It also promises to offer incentives and pay packages designed to keep Genentech’s management and scientists from leaving.

Even though Roche has a controlling ownership interest, there is an agreement in place between it and Genentech that requires approval for a transaction of this sort from both the Genentech board of directors and the non-Roche shareholders of the business. If the latter do not give their approval, two investment banks could then be asked to independently set a value for the remainder of Genentech. Roche would have the option of buying the remaining shares at the average of the two values.

INSTRUCTORS

This proposed move by Roche is an example of backward integration in its industry value chain and is best discussed under Chapter 7, Formulating Corporate-Level Strategy.

1. A good first step is to work with the students to draw a diagram of the value chain for the pharmaceutical industry, locating biotech businesses like Genentech prior in the chain to the large drug companies like Roche. The biotech firms create initial value by developing a new drug to which their pharmaceutical company partners add further value by manufacturing, marketing, and distributing it.

2. It is worth exploring the terms of Roche’s initial acquisition of a majority interest in Genentech that left it with a commitment to seek further approval to purchase additional shares and a right to sell Genentech products only under limited circumstances (outside the US and until 2015). Why did Roche agree to these terms in 1990? What other options did it have then?

3. Discuss how the several reasons given by Roche officials to justify total ownership would work. Exactly what benefits will they bring to Roche, and to Genentech? Are they worth the monetary price that Roche will have to pay?

4. If Genentech’s present research autonomy is as critical to its success as claimed, how will it be affected by this merger? Exactly what negative effects might result and are they commensurate with the above benefits expected from the merger? In addition to the protective steps that Roche has said it will take, what else can be done to maintain Genentech’s value as a steady source of innovative new drugs?

Real-World Benefits of a Diversified Portfolio Strategy

A recent report in the Wall Street Journal (7.16.08.) illustrated rather well the bottom-line advantages of a diversified portfolio strategy. In the second quarter of 2008, Johnson & Johnson’s (J&J) profits from all operations worldwide increased 8% over the same quarter of 2007. This health care products and services company is organized into three divisions that encompass over 250 separate companies operating in 57 countries throughout the world. The divisions are Consumer Health Care, Medical Devices and Diagnostics, and Pharmaceuticals.

Although J&J is often discussed as a member of the “pharmaceutical industry”, many of the competitors there are pure-play drug makers. All their revenues come from pharmaceutical products while J&J gets only about two-fifths of its sales from drug products. The other three-fifths come from the consumer products and medical devices that are a reflection of its diversified portfolio management strategy.

The effects of that diversification strategy show up in this way. Sales of the Consumer Health Care division grew 13% and sales from Medical Devices and Diagnostics products increased 12%. On the other hand, global sales for the Pharmaceuticals division climbed 3%. If the benefits of the weak US dollar are taken into account, those drug sales actually fell just over 1%.

A diversification strategy works by spreading a corporation’s risk of success or failure across strategic business units (SBUs) competing in different industries or markets that are growing (or shrinking) at different rates. In J&J’s case, the significant gains in its consumer products and medical devices operations more than offset the disappointing performance of its pharmaceuticals division.

INSTRUCTORS

This topic is best discussed in connection with Chapter 7 – Formulating Corporate-Level Strategy.

1. Ask students to visit the J&J website (www.jnj.com). It is an attractive, well-organized, and informative window into the corporation’s operations. Ask them to look at how the company describes its organizational structure and management philosophy. Try to summarize the corporation’s long-range strategies, as revealed by the website.

2. The J&J portfolio management strategy is an example of “growth by related diversification”. What are the features of the three divisions that make them related to each other? Explore the degrees to which SBUs may be related. It is a continuum. What benefits does J&J gain from the relatedness among its SBUs? What SBUs might J&J develop or acquire that would be unrelated to its present portfolio of businesses? And what would be the disadvantages of doing so?