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Control Without Ownership: Governance of Nonprofit Hospitals

May 03, 2023

At the Gupta Governance Institute 16th Annual Corporate Governance Conference held on April 14 2023, Katharina Lewellen, Professor of Finance at Dartmouth University, showed that nonprofit hospitals lack features that are traditionally associated with good governance, such as nimble boards, an active market for corporate control, and the alignment between the incentives of managers and the goals of the organization.

Key Insights

  • Nonprofit organizations are prevalent in the healthcare sector. Nonprofit boards are weaker than their for-profit counterparts: monitoring of management is more effective when boards are agile, independent, and incentivized to exert effort on behalf of the principals they represent. However, nonprofit boards of hospitals are unusually large, include directors with conflict of interests, and their directors typically hold no financial stake in the organization.
  • The market for corporate control can discipline incumbent managers. However, the nonprofit market for corporate control, while active, is limited. Both nonprofit and for-profit CEOs and directors face major career setbacks after a change of control, but the frequency of mergers, acquisitions, closures, and private equity deals is significantly lower for non-profits. Furthermore, acquisitions in nonprofits are unresponsive to non-financial measures of performance such as service quality or provision of charity care, which are goals of nonprofit organizations.
  • Compared to for-profits, nonprofits’ objectives are less well defined and more difficult to quantify. This makes it harder for boards to tie CEO pay and turnover to organizational goals. In fact, CEO remuneration and turnover respond to hospital profits, but not to non-financial performance indicators, such as patient satisfaction, mortality, or readmission rates.

Summary of Complete Findings

This study offers a comprehensive analysis of the governance structures of nonprofit firms, focusing on the hospital sector. Nonprofit and for-profit organizations differ in fundamental ways: nonprofits have no shareholders, and their profits (if any) are retained rather than paid out to capital providers. Nonprofit objectives are often stated in terms of serving a broader community, which can include customers and society at large. However, nonprofits and for-profits share a key similarity: in both cases, decision rights reside with professional managers who retain control over capital allocation. Consequently, both types of firms must rely on governance systems to ensure that managers allocate funds consistently with their firms’ objectives.

Nonprofits are prevalent in the healthcare sector, which comprises a large fraction of U.S. employment and GDP. Critics have argued that nonprofit boards are poorly equipped to be effective monitors, due to the boards’ self-perpetuating nature, the lack of financial incentives, and no external scrutiny by shareholders. Many nonprofit board members may also lack the necessary business knowledge, particularly if they gain the board seat based on their financial contributions. Nonetheless, nonprofits are also governed by boards of directors with fiduciary duties analogous to those in for-profits, and external oversight comes from the state attorneys general and the IRS. Furthermore, while there is no market for corporate control in the traditional sense, nonprofits can become takeover targets, and takeovers can hurt the career of nonprofit CEOs.

Using a sample of over 3,000 hospitals between 2000 and 2018, the researchers explore three fundamental areas of governance in nonprofits: (1) the structure and composition of boards; (2) change-of-control events, such as system acquisitions and mergers; and (3) the CEO incentive contracts and turnover.

The first striking observation is that nonprofit boards are unusually large. An average nonprofit hospital has 14.6 directors, and an average nonprofit system has 17.6 directors. This compares to 9.0 directors for a – typically much larger – for-profit system. Boards of nonprofit systems of comparable size have, on average, 20.7 directors. While larger boards can bring more diversity and expertise, they are also more prone to free riding and coordination problems.

The researchers provide two ways to interpret these differences. One is that the larger boards in nonprofits are necessary to fulfill their more complex responsibilities (due to, for example, less quantifiable objectives, heterogeneous stakeholders, or fundraising goals). The implication is that nonprofit boards ‘give up’ the agility associated with a smaller size to accommodate their additional challenges. Another interpretation is that nonprofit boards are sub-optimally large because they lack external oversight by shareholders who would otherwise constrain their size. A direct consequence of either interpretation is that a nonprofit board’s ability to perform its functions of monitoring and advising is diminished.

The second key feature of boards is their independence. While the IRS imposes no restrictions on the independence of nonprofit boards, it requires nonprofits to disclose the numbers of independent directors. The IRS considers a director to be independent if they are not compensated as an employee of the organization (or related organizations) and has no other conflicts of interest, for example, via business transactions or family relationships.

The study finds that nonprofit hospitals have higher numbers of both independent and non-independent directors compared to for-profits. Taking hospital systems as an example, the number of non-independent directors in for-profits is 1.8 (out of a total of 9.1) compared to 4.0 (out of the total of 17.6) in nonprofits. The higher numbers of independent directors in nonprofits are to be expected as this group likely includes donors. Nonprofits are also more likely to include a non-executive employee (0.98 employed directors for nonprofits and 0.00 in for-profits) and non-employee directors with conflicts of interest (1.11 directors for nonprofits and 0.48 for for-profits). Most significantly, nonprofit directors are less likely to receive retainers, and the amounts are much lower when they do. Therefore, nonprofit directors have weaker financial incentives to exert effort on behalf of their principals (patients, donors, and taxpayers) compared to for-profit directors. Overall, nonprofit boards score relatively poorly on attributes that are traditionally considered desirable to enable effective monitoring of firm performance.

The market for corporate control disciplines incumbent managers and, thus, serves as a governance tool. Managers of target organizations lose their jobs after takeovers, and their careers suffer as a result. Because nonprofits have no shareholders, they are not subject to the market for corporate control in the traditional sense. However, nonprofit hospitals are often acquired by other hospitals or hospital systems. While these transactions do not transfer ownership from one set of shareholders to another, they do pass on management decisions from the target to the acquirer board. When a takeover takes place, the turnover of both the nonprofit CEO and the board increase sharply in the acquisition year and remain elevated for the subsequent two years. Low profits are associated with higher turnover frequencies for both the CEO and the board. These results suggest that changes in control for nonprofits can, in principle, play a disciplining role.

The study, therefore, examines acquisitions, mergers, closures and private equity deals as four key types of events in the market for corporate control. It finds that nonprofit hospitals are significantly less likely to experience each of the four types of control events. Moreover, the likelihood of each event is substantially less sensitive to the financial performance of nonprofits. For instance, the probability of a system acquisition in a given year is 2.1 percentage points lower for nonprofits, compared to the baseline likelihood for for-profits of 4.8%. Similarly, hospital closures are substantially more likely for for-profits, particularly after poor financial performance. On average, 1% of for-profit hospitals close each year, and this frequency is 0.7 percentage points lower for nonprofits. Control events for nonprofit hospitals and hospital systems tend to be triggered by declines in profits but drops in charity or service quality have no effect for nonprofit targets.

One reason for the lower takeover frequencies may be that, in the absence of shareholders, nonprofit insiders are better able to resist acquisitions to protect their careers. In addition, a transfer of control over a nonprofit may be more difficult to accomplish, particularly when it results in a change in the target’s mission or organizational form. Overall, the threat to incumbent managers will be less severe in nonprofit organizations compared to for-profit organizations.

Compensation contracts should incentivize and attract CEOs. CEO compensation in well-governed hospitals should be tied to both financial and non-financial measures of performance to reflect the hospitals’ goals. However, the researchers find that while CEO pay in nonprofit hospitals responds significantly to profit margins, its link to non-financial metrics (such as mortality, re-admissions, and patient satisfaction) is either weaker or close to zero. The sole exception is the rate of Medicaid admissions, which does affect CEO compensation.

For-profit CEOs have stronger overall pay-for-performance incentives than nonprofit CEOs. The difference is mainly driven by the fact that for-profit CEOs usually hold equity in their firms, so their wealth responds automatically to changes in firm value. In hospital systems, for-profit CEOs’ annual pay is, on average, 98% higher than nonprofit CEOs ($7.1 vs. $3.7 million). This implies that the sensitivity of pay to firm performance is likely to be greater for for-profit CEOs.

Similarly to CEO compensation, there is no significant relation between turnover and non-financial performance metrics. However, in contrast to CEO compensation, CEO turnover responds significantly to a measure of customer satisfaction: a one-standard-deviation decline in the fraction of patients dissatisfied with the hospital is associated with a 2.1 percentage point decline in the likelihood of CEO turnover.

The findings that nonprofits dismiss CEOs only in response to poor financial performance and patient dissatisfaction are not necessarily sub-optimal. The hospital’s performance with respect to its non-financial objectives is harder to measure. This makes it difficult to use it in employment contracts. Because of this friction, the alignment of CEOs’ decisions with the interests of their principals is harder for nonprofits to achieve. As a result, nonprofit boards need to rely more on direct monitoring to discipline the CEOs. This, in turn, is challenging given nonprofit boards’ larger size and, arguably, weaker and conflicting incentives.

In conclusion, this study provides an extremely thorough analysis of governance in a critical sector of the U.S. economy and reveals how nonprofit hospitals suffer from significant weaknesses in their monitoring and incentive structures.

“Control Without Ownership: Governance of Nonprofit Hospitals” by Katharina Lewellen (Dartmouth University), Gordon Phillips (Dartmouth University), Giorgo Sertsios (University of Wisconsin Milwaukee).

View the working paper

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