While investments in healthcare innovation took a hit in the early months of the pandemic, an encouraging sign came in the third quarter of 2020 when private equity funds shifted from shoring up their existing portfolios to spending their pent-up reserves. The uptick in deal volume could likely persist in 2021, especially for companies in the high-performing life sciences, technology and healthcare industries that have maintained high valuations over the last year.

For hospitals and health systems looking to transform patient care through improved diagnostic tools, solve operational issues with data-integrated software systems, or address a host of other challenges, innovation centers have become an increasingly popular investment in recent years. However, just as no two health systems are identical, there’s no one-size-fits-all model for innovation centers. Deciding on the right investment structure is the critical first step for any organization, especially given the potential tax, financial, compliance and liability issues at stake.

This column will discuss what hospitals and health systems need to know about why and how to invest in innovation, including types of structures to use, potential benefits and risks, and considerations for aligning investment priorities to the health system’s mission.

Making Innovation a Strategic Priority

While innovation centers are a relatively new concept, hospitals and health systems have long sought to improve the delivery of care through homegrown medical products and initiatives. Innovation centers simply take a more active approach that may extend to third parties, such as by investing in startups developing surgical devices or in funds offering access to a broad portfolio of innovative companies.

Many hospitals and health systems find that creating an innovation center offers a strategic advantage to their organization. Centralizing investments in research and development can accelerate the introduction of cutting-edge medical products and services into the market, thereby directly improving the care a system is able to provide or solving a specific problem they are facing. The investment can also diversify a health system’s portfolio and help improve operating margins. Plus, visibly prioritizing innovation could enhance the organization’s reputation and help recruit top talent.

Deciding on a Structure

Innovation centers are often custom-built around the organization’s needs, with input from the hospital or health system’s clinicians, board, patients and community. They follow four typical structures:

• Direct investing
• Direct investing through a subsidiary
• Forming an investment fund
• Forming an investment fund in partnership with an outside fund sponsor

Determining which of these innovation models to pursue involves weighing the amount of financial risk the organization is willing to undertake, the complexity of the venture and the expertise available to guide the center’s development.

Direct Investing

Hospitals and health systems most often favor direct investment in innovative ventures to avoid the complexities of forming a separate investment entity. This is off-balance-sheet investing, perhaps in the form of purchasing an outside company’s stock or forming a joint venture structure.

Direct investing enables hospitals and health systems to clearly define roles and responsibilities and have authority over investment decisions and funds. This type of structure allows them to directly integrate investments with clinical care and research operations, so the health system’s strategic objectives—the clinical or operational need they’re looking to address—can drive the investment.

Although direct investing offers the simplest point of entry, potential complications loom. Organizations that adopt this structure may be less insulated from tax, financial, litigation and compliance risks because there is no firewall between the hospital and its investment.

The tax risks require particularly close attention. As one example, a tax-exempt health system investing in a for-profit biotech startup could be endangering its tax exemption if the investment generates significant income for the nonprofit. This is where it is important to assess the receiving entity’s corporate structure and the health system’s level of business collaboration as part of the investment. There can even be reputational risks to consider in cases where close collaboration could create conflicts of interest for insiders at the hospital or health system.

Direct Investing Through a Subsidiary

The second-most common investment structure is designed to mitigate tax and litigation risks. Direct investing through a subsidiary, typically wholly owned by the health system, more clearly establishes a firewall between the innovative investment and the system’s clinical and research operations. This helps to set clear lines of authority and accountability while also streamlining the decision-making process for the investment function.

A dedicated investment subsidiary carries the added benefit of attracting specialized expertise and co-investors, generating an entrepreneurial culture and promoting active involvement by internal inventors. However, this structure is time-intensive and labor-intensive to execute at the start, which can stymie its innovative output.

Forming a New Investment Fund

A hospital or health system looking to supercharge its investment may consider forming a fund. This structure, too, offers clear authority lines and streamlined decision-making for the anchor investor, but the addition of limited partners multiplies the available money to invest.

The involvement of other investors is also the downside of this structure. The investment will no longer focus solely on the hospital or health system’s strategic goals. There’s the potential for tension between delivering financial returns to partners and realizing strategic returns for the organization itself. It’s important to weigh the innovation center’s ultimate objective before forming a strategic investment fund.

The existence of limited partners in the fund also makes this structure the trickiest to navigate in terms of possible tax and reputational risks. Partners often tend to be people who have a relationship with the hospital or health system, such as a board member or a donor. Even the appearance of a conflict of interest for these insiders could draw scrutiny, so it’s key to implement an upfront process to thoroughly analyze potential conflicts, even if it delays the work of the innovation center.

Forming an Investment Fund with an Outside Fund Manager

Bringing in an outside sponsor to manage the investment initiative is another option when forming a fund. Because healthcare and life science are popular areas of specialization for venture capital and private equity, an experienced investor can add valuable expertise to a fund, although their previous experience may raise issues around compensation and conflicts.

As the anchor investor in the fund, hospitals and health centers have wide latitude to negotiate for a beneficial innovation structure. Items on which to consider negotiating include:

• Preferential or participatory fund economics: It may be possible to get reduced management fees and carried interest payable, or a portion of the fees and interest that limited partners pay to the sponsor.
• Preferential most favored nation rights: Systems may be able to negotiate rights that are equal to or better than the rights of other investors in the fund—or even exclusivity as the only hospital or health system investor.
• Management company equity: Getting a piece of the management company in perpetuity is a boon if the sponsor goes public one day or has success with other funds, but it does require the anchor investor to offer something very special in exchange.

Other negotiable opportunities for anchor investors include rights to preferential co-investments, service on the fund’s limited partner advisory committees and consent over fundamental transactions. Keep in mind that any preferential terms are heavily dependent on the size of the investment.

Preparing for What’s Next in Healthcare

Each of these investment structures comes with its own set of upsides and downsides, as well as opportunities for further customization. Deciding on the best fit starts with determining the organization’s goals. Size, appetite for risk and availability of clinical champions to collaborate with third-party medical product developers are just a few of the factors to consider, not to mention legal and regulatory concerns. As the use of technology and data continues to expand, a hospital or health system’s approach to innovation could determine how well poised they are to succeed in the evolving healthcare landscape.