Sunday, September 26, 2010

Accelerated Depreciation

The acquisition of the Caritas Christi hospital system by the Cerberus private equity company continues to generate press here in Boston, and well it should given the size and importance of the transaction. Indeed the Boston Globe has a special section on this, which is updated as it publishes stories and editorials.

As I have noted before, the purchase has a lot to recommend it (including stability of pension funds, investment in under-capitalized hospitals, and tax revenues to municipalities and the state), but it also raises challenging public policy issues that the Attorney General, DPH, and the Court have to address. I have been trying here to outline some of those based on what I have learned about this issue.

Many of my colleagues in the non-profit hospital world have expressed confusion about how such a transaction is possible in a world of decreasing reimbursements, where even non-profits have trouble achieving a positive bottom line. I provided a general perspective here, and in a post below, I talk about how the use of a non-cash expense, depreciation, can provide a financial return to investors.

After I wrote that post, a colleague in the finance world wrote to say that there is another aspect of depreciation that I had neglected to mention that produces additional cash flow to the private equity firm. This is a financial tool that provides no benefit to tax-exempt hospitals, and so I again present it for the benefit of my non-profit colleagues and other interested readers. (Not being an accountant, I cannot claim expertise on all these matters: I trust CPAs reading this will correct any errors I make.)

Under the US tax code, firms can use accelerated depreciation for tax purposes. What does this mean and why is it helpful? Why does it give the private equity firm an additional incentive to dispose of property more quickly?

Let's say that you have acquired $10,000 dollars of furniture, which you plan to depreciate over its useful life. If that useful life is 10 years, you would take an accounting expense for 1/10 of the furniture's cost each year, or $1,000. (This assumes no salvage value at the end of the useful life.)

Under accelerated depreciation, for tax purposes, you get to write off more of the asset's value in the early years. In year one, for example, you could claim an expense of $1429.

Now, you obviously can't do this on your taxes for the entire useful life, as you would end up expensing more than the value of the asset. Indeed, in the later years, the tax depreciation expense has to slow down (see chart).


So what does this mean? This goes back to the request of some competing hospitals to the AG that would require Cerberus to hold on to the Caritas Christi assets for seven years, as opposed to the three years to which Cerberus has committed. If the firm has to hold on to its assets for a longer period, it starts to lose the advantages of accelerated depreciation. It is to its financial advantage to dispose of assets more quickly. That seems to be a simple (and perfectly legal) result of the US tax system.

By the way, the next firm to purchase the assets gets to do the same, all over again -- using the new purchase price as the basis for the original cost of the assets.

On that point, maybe someone out there can advise on one last item: What cost basis can Cerberus use for the assets it seeks to depreciate? I do not believe that the firm is actually making a cash payment to someone to acquire the hospitals. After all, the Archdiocese is not an "owner" in the financial sense, like a shareholder would be, since this is a non-profit corporation. It cannot receive funds from a purchase that could then be used for other functions of the Church. As best I understand, Cerberus is making cash commitments -- e.g., for pensions and capital investment -- to the hospital system in return for ownership, but I think that is different from making an asset purchase.

So once Cerberus owns the Caritas hospitals and their associated medical equipment, computer systems, furniture and other capital assets, are the assets valued at their original cost, or can the private equity firm re-value them at replacement cost? Clearly, that will make a difference in the potential to generate cash flow through depreciation. If you know the answer, please provide a comment.

4 comments:

Anonymous said...

Even though I stick by my statement to Keith last week that the era of the independent community hospital is dead, this stuff is very discouraging to read. Is health care going to be the next bubble for private equity and other Wall St. investors, with the employees and patients at the mercy of financiers churning them from one owner to the next? What does it mean when the CEO's compensation incentives are tied to acquisition of more hospitals, instead of concentrating on improving systems of care and reducing patient harm as at BIDMC?

As I mentioned before, we the people need to be very, very careful what we wish for.

nonlocal MD

Anonymous said...

Paul,

The fixed assets to be held and used are to be valued at "fair value" on the acquisition date.

Paul Levy said...

Thanks. I find that here: http://en.wikipedia.org/wiki/Fair_value

Anonymous said...

I've been following with interest your posts on the Cerberus-Caritas deal. I'm doing an internship at Carney Hospital right now where of course the merger is #1 on everyone's mind. A rumor (that turned out to be unfounded) was going around last Friday that the deal had fallen through, and many employees were visibly upset.

Like you, I'm intrigued by exactly where Cerberus thinks they are going to make their profit, and accelerated depreciation was something I hadn't heard of until I read your post. Very interesting.