Thursday, July 01, 2010

Verve and optimism versus caution and pessimism

Many people involved in hospitals wonder how it can be financially prudent for investors to put their money into for-profit ventures that buy non-profit hospitals. (Examples here and here.) After all, the argument goes, the newly privatized entities will have to pay taxes, issue taxable rather than tax-exempt debt, lose the benefit of philanthropy, and otherwise be at a competitive disadvantage compared to their antecedents.

In answer, some might make the case that for-profit firms will run hospitals more efficiently. But this is an unproven and unreliable basis for such transactions. Even if there were some efficiency gains, they would be unlikely to offset the additional costs listed above.

No, the answer lies in the risk-reward expectations of equity investors and of purchasers of high-yield taxable debt.* Those expectations are quite different from purchasers of the municipal or other tax-exempt bonds that support the capital needs of non-profit hospitals. It is the difference between a forward-looking, optimistic view of the world and a backward-looking, cautious view of the world.

Let's start with the tax-exempt debt market, one characterized by risk-averse investors focused on debt coverage ratios and other protections built into indenture agreements. The rating agencies who serve these investors look at the past performance of the non-profit hospitals and ask, "What could go wrong in the future that might put debt service at risk?" There is a highly limited pool of people interested in such debt, and when ratings fall to near or below investor grade, the number of investors becomes smaller still.

Contrast this with people willing to risk their money in the for-profit world. They are sold on the potential for financial gain, not on the proposition of protecting principal. Those offering this paper present business plans and pro forma's based on what might be. Sure, due diligence allows an assessment of the downside, but this pool of investors has hedged their bets by building a diversified portfolio.

How does an equity investor make money in this kind of transaction? Leverage is important. The capital structure of theses deals includes equity, but also a significant component of debt. If the hospital throws off enough cash to pay down the debt, the equity holders see a growing opportunity to earn a current cash return. And hospitals do throw off enough cash -- even hospitals with low or zero margins.

Why? Because the income statement includes a substantial non-cash expense, depreciation. It is the earnings before depreciation that are most meaningful to these investors. As long as immediate capital needs do not exceed available cash, debt will be serviced and equity will likely be rewarded as well on a current basis.

The real payoff, though, occurs when the properties are flipped to another purchaser after a few years.** By then, debt levels have been reduced, and the proceeds from the asset sales enure mainly to the benefit of the shareholders.

We are currently in a phase of capital markets in the United States in which there is a virtually insatiable demand for equity investments of this sort, and also for high yield debt that supports each deal's overall financial structure.

We are also in a period in which non-profit hospital boards and tax-exempt investors are worried about the future. In an odd divergence of perspectives, non-profits worry about decreased reimbursement levels resulting from the national health care reform law; they therefore fear that they will lack capital for renewal and replacement of physical facilities and clinical equipment. For-profit investors, in contrast, see the new law as enabling an increased number of insured citizens to show up as patients in their hospitals; they therefore look forward to growing cash flows to reward their risk-taking.

Mark Twain said, "It is difference of opinion that makes a horse race." Here it is the verve and optimism of the equity markets compared to the caution and pessimism of the non-profit sector. Expect a huge influx of investment capital to change the face of the hospital world over the next two years.

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* High-yield bonds bear a greater resemblance to equity than they do to traditional tax-exempt debt.
** Or, when the private equity firm sells the venture to a broader group of investors with an initial public offering.

4 comments:

Cetus said...

Paul, interesting post. You are more optimistic about the overall economy than I am. Munis and other tax-exempt bonds have always been relatively illiquid. The problem now is sovereign debt, which is translating to state budget crises here in the US. Unemployment and declining real estate prices are contributing to state and municipal shortfalls -- and to hospitals dependent on state and federal funds. This, in turn, is causing bond downgrades, lots of talk about "austerity" and so on. Ultimately, we're still at risk for deflation and it's unclear whether the Fed has any tricks left up its sleeve. IMO we're still in deep doo-doo.

Also, not sure you can fairly characterize muni or tax-exempt bond holders as "backward-looking" people... it's simply a tax shelter a fair number of investors (many institutional) hold to maturity.

The rah-rah "Go capitalism!" pitch falls flat with me. No, what this really is all about is big capital looking for new resources to exploit (which in a way is exactly what you're saying), in this case traditionally non-profit healthcare institutions. The internal guiding principles determining structure and services will change from community needs to what the market will bear and where the margins are greatest. The temptations will be greater for "accounting irregularities" like we saw at HealthSouth. And watch out, unions.

If it happens -- and I don't doubt that it's coming -- it won't be a net positive in my opinion. But I guess I'm just a backward-looking pessimist who wants to preserve "community capital" rather than enjoy the cornucopian benefits of our glorious future charted by the unmatched verve and optimism of equity investors.

As we say here in Boston, Good luck with that.

Paul Levy said...

Dear Cetus,

This post is not about my investment choices or my view of these kinds of transactions. I am trying to explain how the participants in these funds view the world.

And by saying "backward-looking," I don't make a value judgment. I mean merely to explain part of the methodology used to evaluate the riskiness of tax-exempt debt.

Anonymous said...

As the repeated recycling of HCA from private to public and back again indicates, savvy investors have discovered there is $$ to be made in health care, whether one considers that "productive" or not.

But does this mean that for-profit hospitals will be the next financial bubble? That is a bothersome prospect, indeed.

nonlocal

Cetus said...

Paul, thanks for the clarification. The third paragraph threw me, especially the last sentence: "It is the difference between a forward-looking, optimistic view of the world and a backward-looking, cautious view of the world."

It colored my reading of your post because it suggested (to me anyway) a characterization of the type of investor involved. My point was that a balanced investment portfolio can certainly contain munis/tax-exempt bonds. IOW, some overall "bullish outlook" portfolios can and do include them.

Re-reading after your note, you're just trying to explain tolerance for risk to a broader audience, so apologies for misunderstanding you.

But I would still caution you that some readers might attach positive/negative connotations to the characterization of investor psychology and think that one or the other is more or less desirable.

Lastly, I would add that the point about cash flow and depreciation is a really nice one.