The Fall of the House of AHERF: The Allegheny System Debacle

Lawton R. Burns, John Cacciamani, James Clement, and Welman Aquino


Health Affairs. 2000;19(1) 

In This Article



  1. AHERF and its affiliates filed under Chapter 11 of the federal bankruptcy code. The affiliates included eight Philadelphia hospitals, organized into two divisions (Allegheny University Hospitals -Centennial, Allegheny University Hospitals -East); its physician practice network known as Allegheny University Medical Practices (AUMP); and its Allegheny University of the Health Sciences (AUHS), which included the combined Medical College of Pennsylvania/Hahnemann Medical School.

  2. The bankruptcy trustee has reestimated the debt to be $1.5 billion. Creditors have challenged the amounts AHERF has listed as owing them.

  3. According to the American Bankruptcy Institute, the 1992 filing by Charter Medical was the largest bankruptcy in health care.

  4. The research on which this paper is based draws on interviews with AHERF executives and physicians in Pittsburgh and Philadelphia. Information also was gleaned from interviews with Moody's Investors Service; Municipal Bond Investors Assurance Corporation (MBIA); Duff and Phelps Credit; Pennsylvania Attorney General D. Michael Fisher; and local health care consultants. Virtually all of those interviewed wished to remain anonymous. The research also draws heavily on published stories on AHERF taken from the Pittsburgh Post-Gazette and the Philadelphia Inquirer. Writers at the Pittsburgh Post-Gazette include (in alphabetical order) Len Boselovic, Katy Buchanan, Joyce Gannon, Pamela Gaynor, Joann Loviglio, Steve Massey, Jim McKay, Michael Newman, Frank Reeves, Peter Shelly, Christopher Snowbeck, Byron Spice, and Lynda Guydon Taylor. Writers at the Philadelphia Inquirer include Andrea Gerlin, Josh Goldstein, Donna Shaw, Karl Stark, and Marian Uhlman. Each newspaper also released an excellent overall summary of the AHERF bankruptcy. We also relied on other published reports on AHERF in trade magazines and the Philadelphia Business Journal and on speeches by AHERF officials, as cited below.

  5. AGH had roughly 180 residents in twelve residencies. In 1986 the University of Pittsburgh operated Western Psychiatric Institute and Clinic, Clinical Eye and Ear Hospital, and the outpatient Faulk Clinic. It was affiliated with Presbyterian University Hospital (568 beds), which it subsequently controlled and then complemented with Montefiore Hospital (408 beds). The result was a large medical enterprise with four hospitals, a medical school, a cancer center, and an outpatient facility.

  6. John Westerman, brought in as CEO in 1982 from the University of Minnesota Hospitals, pursued a slow pace of change that failed to elevate AGH's stature and led to his termination prior to 1986.

  7. S. Abdelhak, "Allegheny Health, Education, and Research Foundation: Successful Integration Strategies for Anticipating the Managed Care 'Wave' Before It Hits the Beach" (Speech delivered to the Symposium on Governing Integrated Healthcare Systems, Naples, Florida, 12 January 1998).

  8. 1998 bankruptcy court documents reveal that actual losses in FY 1998 in the eastern operations and the AHERF parent totaled $385 million, or more than $1 million a day.

  9. Hospitals have failed to garner more than 10 percent of revenues from capitated contracts and have lost money on the contracts they have won. Much of this problem stems from a lack of managed care infrastructure. L. R. Burns and D. P. Thorpe, "Physician-Hospital Organizations: Strategy, Structure, and Conduct," in Integrating the Practice of Medicine, ed. R. Conners (Chicago: American Hospital Publishing, 1997), 351 -371.

  10. M.L. Sirower, The Synergy Trap (New York: Free Press, 1997). An examination of 300 hospital mergers and affiliations found that most have failed for a wide variety of reasons. G. Colon, A. Gupta, and P. Mango, "M&A Malpractice," McKinsey Quarterly (February 1999): 62 -77. Academic research suggests that hospital mergers typically do not result in economies of scale or lower prices, except for small hospitals and competitive markets, respectively. See E. B. Keeler, G. Melnick, and J. Zwanziger, "The Changing Effects of Competition on Non-Profit and For-Profit Hospital Pricing Behavior," Journal of Health Economics 18, no. 1 (1999): 69 -86; and R. A. Connor et al., "Which Types of Hospital Mergers Save Consumers Money? "Health Affairs (Nov/Dec1997): 62 -74.

  11. There is evidence that vertical integration into primary care through PCP acquisitions leads to losses of $50, 000 -$100, 000 per physician per year. Coopers and Lybrand, Owning Physician Practices: Challenges and Critical Success Factors (Chicago: Coopers and Lybrand, 1997).

  12. Such hospitals have low returns to net operating revenues, which results in little working capital, low ability to upgrade the facility, and little ability to support other activities. T. R. Prince, Strategic Management for Health Care Entities (Chicago: American Hospital Publishing, 1998). According to Prince, investment-grade securities require a minimum return of 6 percent for several years. AHERF's hospital acquisitions in Philadelphia consistently fell below this.

  13. MCP and GHS approached AHERF. AHERF initially approached United and Hahnemann, but nothing was consummated. Both of these institutions later approached AHERF when their financial condition worsened.

  14. Financial data on AHERF's acquisitions come from two sources: Official Statements issued in conjunction with each of the system's bond issues, and the Merritt System, a credit analysis and database management system supporting comparative financial, operational, and bond-issue data on not-for-profit hospitals. The Merritt System is a national database containing data from more than 1, 700 hospitals and 160 health care systems. It is the product of Van Kampen American Capital Management, Inc. , and its affiliates, a division of Morgan Stanley located in Oakbrook Terrace, Illinois. Copyright 1990 by Van Kampen Merritt Investment Advisory Corp; all rights reserved.

  15. Information provided anonymously by Philadelphia market informants.

  16. M. Cohen, "Child of the Revolution," Philadelphia Magazine (February 1998): 78 -105.

  17. When Moody's declined to upgrade GHS's debt in 1996, AHERF executives admonished Moody's, which then downgraded the GHS debt later that year.

  18. The five obligated groups were DVOG, Centennial, AGH, Forbes and Allegheny Valley Hospitals, and Canonsburg Hospital. Moody's rating policies actually encouraged this use of obligated groups.

  19. Some Philadelphia observers surmise that Abdelhak was seeking to amass enough hospital capacity in the market to sell the Philadelphia operations to Columbia/HCA (which was still aggressively acquiring hospitals). Former AHERF executives in Pittsburgh state that there was no such strategy.

  20. The 1998 median level of maximum annual debt-service coverage dropped, reflecting a lower ability of hospital borrowers to apply their most recent historical net revenue available for the debt service to the largest future annual principal and interest payment. P. Federbusch et al. , Not-for-Profit Health Sector: 1999 Outlook and Medians (New York: Moody's, September 1999).

  21. HMO data on these markets were obtained from InterStudy, courtesy of Douglas Wholey at the University of Minnesota.

  22. Pennsylvania Economy League, Greater Philadelphia's Challenge: Capitalizing on Change in the Regional Health Care Economy, Report no. 683 (Philadelphia: Pennsylvania Economy League, Eastern Division, 1996).

  23. S. Abdelhak, "Our Organization's Commitment to Creating and Achieving Goals" (Presentation to the 1997 Duke Private-Sector Conference), in Beyond Managed Health Care: The Role of the Academic Health Center , ed. R. Snyderman and V. Saito (Durham, N. C. : Duke University Medical Center and Health System, 1997).

  24. Abdelhak, "Allegheny Health, Education, and Research Foundation."

  25. In its bankruptcy filing, AHERF listed its top three creditors as U. S. Healthcare ($19.8 million), HealthAmerica ($16 million), and Independence Blue Cross ($8.1 million). HealthAmerica disputed the amount.

  26. Abdelhak, "Allegheny Health, Education, and Research Foundation."

  27. R. E. Hurley et al. , "Adapting to Mandatory Medicaid Managed Care: A Painful and Unproven Pursuit of Value" (Report prepared for the Pew Charitable Trusts, January 1999).

  28. Ibid.

  29. S. Hensley, "System Slashes Jobs, Pay," Modern Healthcare (20 October 1997):2,8. The trifecta is a feat achieved in racetrack gambling when one picks the top three finishers (in order) in a given race.

  30. J. George, "Slicing Up Cardiac Surgery Market," Philadelphia Business Journal (27 February/5 March 1998): 3, 28.

  31. D.D. Pointer, "Value-Added Governance" (Presentation to Integrated Healthcare 2000 Annual Symposium on Governing Integrated Healthcare Systems, Aspen, Colorado, 30 August 1999).

  32. The Official Committee of Unsecured Creditors of AHERF v AHERF, U. S. Bankruptcy Court for the Western District of Pennsylvania, Case no. 98-25773 MBM through 98-25777 MBM inclusive, 17 November 1998.

  33. The Official Committee of Unsecured Creditors of AHERF v AHERF, AUHS, AUMP, Allegheny Hospitals -Centennial, and Allegheny University Hospitals -East, U. S. Bankruptcy Court for the Western District of Pennsylvania, Case no. 98-25773 MBM through 98-25777 MBM inclusive, Motion no. 99-2844, 22 June 1999.

  34. C. J. Loomis, "Lies, Damned Lies, and Managed Earnings," Fortune 140, no. 3 (1999): 74 -92.

  35. According to the Unsecured Creditors, the CEO and CFO redeployed the accounting entries to boost reported operating income and reduce reported operating costs, to yield one-time financial statement benefits of $100 million. The Official Committee of Unsecured Creditors of AHERF v AHERF, AUHS, AUMP, Allegheny Hospitals -Centennial, and Allegheny University Hospitals -East.

  36. R. Haugh, "The Ratings Slide: Are We Headed for a Capital Crisis? "Modern Healthcare (9 August 1999): 40 -43; and K. Pallarito," 1998 Bond Sales Shatter Record, "Modern Healthcare (18 January 1999): 37, 39.

  37. Prince, Strategic Management for Health Care Entities.

  38. The coding system for rating bonds differs between Moody's and S&P. Moreover, these rating systems change over time, making time comparison difficult. As a quick primer, we illustrate the Moody's system. The highest rating is triple-A, denoted Aaa, followed by Aa, A, Baa, Ba, B, Caa, Ca, C, and so forth. Within each of these grades, bonds can be further differentiated by a number, such as Aa1, Aa2, and Aa3. The lowest investment-grade rating is Baa. See Prince, Strategic Management, 512, Exhibit 22-1, for more details.

  39. We focus on Moody's rather than S&P in this section, because of their more frequent reports and indications of problems at AHERF and its affiliates.

  40. Moody's Investors Service, "Allegheny Health, Education, and Research Foundation: Fundamental Rating History" (New York: Moody's, 1999).

  41. Moody's internal rating of AHERF was "very, very low," and lower than the ratings maintained by other ratings agencies, according to Moody's officials. Yet Moody's policy did not allow it to go public with this "underlying rating."

  42. Cain Brothers, "The AHERF Bankruptcy and Its Aftermath: Implications for Managers and Trustees, Part I," Strategies in Capital Finance (Summer 1997): 1 -27.

  43. Moody's bond ratings for other AHERF hospitals remained high and unchanged over time. AGH had a high credit rating of Aa during 1986 -1988, reflecting its high margins. In 1989, however, its margins began to shrink (due to an "unusual event" resulting in a $6 million write-off in the annual report). The margins dropped further in 1990 to one-quarter of the average for 1986 -1988, while its net operating revenue had increased two-thirds. As the system expanded into Philadelphia, AGH's bonds retained their Aa rating until 1995, after which they were slightly downgraded (to A1, A2, and A3) until early 1998. Why did they retain high ratings? First, AGH avoided negative cash flow by using nonoperating revenues (for example, through its research institute). Second, AGH purchased debt insurance from MBIA for roughly one-third of the $60 million in bonds issued in 1991.

  44. T. Prince and R. Ramanan, "Bond Ratings, Debt Insurance, and Hospital Operating Performance," Health Care Management Review 19, no. 1 (1994): 64 -73.

  45. Prince, Strategic Management.

  46. K. Pallarito, "Paying for Innovation," Modern Healthcare (21 -28 December 1998): 2 -3, 12; and J. Asplund, "Uncertainties in Hospital Field Keep Pressure on Bonds," AHA News (25 January 1999): 7.

  47. Federbusch et al. , Not-for-Profit Health Sector.

  48. Ibid.

  49. D. Aubin, "Municipal Bond Reinsurance Climbing Despite Rating Doubts," Dow Jones Newswires (9 April 1999).

  50. Prince, Strategic Management.

  51. C. Gasparino, "S&P's Caveat on Ratings: Don 't Blame Us," Wall Street Journal, 20 August 1999, C1, C10.

  52. Cain Brothers, "The AHERF Bankruptcy and Its Aftermath." This has become evident with other recent events. See Haugh, "The Ratings Slide." AHERF's largest competitor in Philadelphia, UPHS, likewise engaged in horizontal consolidation with area hospitals and vertical integration with PCPs, and full-risk contracting. In 1998 and 1999 UPHS incurred operating deficits of $90 million and $198 million, respectively, prompting a Moody's multinotch downgrade. Because the health system represented a large share of the University of Pennsylvania parent's revenue base and borrowed $123 million from the university in 1998, Moody's downgraded the latter's debt twice in 1999.

  53. Aubin, "Municipal Bond Reinsurance Climbing." MBIA reinsured 15 percent of its gross debt service as of 31 December 1998.

  54. Risky diversification threatens the bond insurer's Aaa rating with Moody's and may harm the insurer's business partners (the reinsurers), who often receive a fixed percentage of all the business underwritten.

  55. A June 1998 Moody's report, "The Changing Face of Healthcare May Impact Guarantors 'Exposure," documents an increase in insurers 'activity in "health care paper," which started becoming more risky in the early 1990s. Insurers ' retrenchment from this increasingly risky business (which only started after the AHERF bankruptcy) lagged behind the changing risk profile.

  56. MBIA has a third division, Insured Portfolio Management, which is "responsible for monitoring outstanding issues insured by MBIA Corp. This group's first function is to detect any deterioration in credit quality or changes in the economic or political environment which could interrupt the timely payment of debt service on an insured issue" (MBIA Form 10-K, Securities and Exchange Commission, 30 March 1999).

  57. "Moody's October 1999 Financial Guaranty Industry Outlook."

  58. In its SEC 10-K Form, MBIA states that as of 31 December 1998, $163 million had been set aside as a "loss reserve" for a health care facility in Pennsylvania (presumably AHERF). Between 1997 and 1998 MBIA's loss ratio (losses incurred divided by premiums earned) skyrocketed from 1.2 percent to 8 percent. MBIA had previously dealt with the firms reinsuring the $170 million, but the latter's involvement in this market was more cyclical. They were multiline reinsurers that become more active in the guaranty market when their traditional markets become softer.

  59. Between 1990 and 1996 the AG reviewed four mergers; in 1997 the AG reviewed twenty-one mergers. As the transactions became larger and more complex, the reviews became more time-intensive.

  60. The AG's office said it took AHERF's bankruptcy to convince legislators that AG review was not governmental interference or an "intellectual" exercise.

  61. The AG has challenged this point, which has not yet been absolutely determined in bankruptcy court.

  62. Cain Brothers, "The AHERF Bankruptcy and Its Aftermath."

  63. K. Pallarito, "Investors Aren 't Sold on Healthcare Bonds," Modern Healthcare (31 May 1999): 36 -37. Of course, the higher rates are now associated with the higher risks, reversing what some analysts refer to as the "artificial narrowing of spreads." Cain Brothers, "The AHERF Bankruptcy and Its Aftermath."

  64. K. Pallarito, "Bond Insurers Put the Squeeze on Strapped Hospitals," Modern Healthcare (15 March 1999): 48 -52. Bond insurers have always had these rights and remedies at their disposal. However, they are now exercising them, as the credits they insure have deteriorated. Insurers typically have quantifiable measures of deterioration ("trigger points") for when they can step in.

  65. A. D. Chandler Jr. , Scale and Scope: The Dynamics of Industrial Capitalism (Cambridge, Mass. : Belknap Press of Harvard University Press, 1990).

  66. Local systems that have recently contracted with large HMOs on more of a level playing field include Allina (Twin Cities), Sutter (Bay Area), and Columbia/HCA (Florida). Hospital systems now forming their own group-purchasing organizations include Continuum Health Partners (New York City) and Lee Memorial Health System/Sarasota Memorial Hospital (Florida).

  67. The authors thank Mark Pauly for his insights here.

  68. New sources of funds to help repay AHERF creditors include $25 million from the sale of AUH-West. Creditors are also suing to recover the $89 million in loans repaid to the bank consortium in spring 1998 and may recover monies from the directors and officers insurance policies. Tenet is collecting up to $65 million in accounts receivable, for which it receives a 10 percent fee. Cain Brothers estimates that creditors will get thirteen to fifteen cents on the dollar.


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