Monday, September 20, 2010

Seven is not a natural

With regard to the Cerberus private equity firm's acquisition of the Caritas Christi hospital system, I have been thinking about the request of a number of hospitals to the Attorney General that Cerberus should "commit to not selling Caritas for seven years instead of three"(see below.)

I came across a recent private placement memorandum (company not disclosed.) Here is what it says about this topic. I am not sure if this is the philosophy that guides the Caritas acquisition, but it is illustrative of the way in which private equity firms view the world:

The decision to exit an investment is based on a variety of factors, including the company's progress in achieving its potential, the General partner's view of an industry's competitive dynamics, the appearance of a willing buyer and the general state of the capital markets. The General Partner seeks to exit from a portfolio investment when it believes that the portfolio company has maximized or achieved a satisfactory level of operational improvement. Operational improvements may increase cash flow and allow the Partnership to realize a profit regardless of market conditions.

I read this as saying that imposing a seven-year requirement on sale of the hospital system or parts of it is likely to be a non-starter. Investors in a private equity firm expect that it will have flexibility to sell assets when it wants. While Cerberus has said it would not sell the Caritas assets for at least three years, that would be a minimum period needed to achieve operational improvements. Once you get past that length of time, you are more likely to have a going concern and you need to focus on the right moment to flip the investment to recover your capital and your profit.

I believe the concern expressed by the other hospitals is based on a fear that, if the retention time is short, the private equity group will under-invest in the Caritas hospitals and take the cash flow that emanates from the business to purchase physician practices and otherwise use the money to build market share. That larger market share would enhance the value of the overall business when the time comes to sell it to another buyer or to carry out an IPO.

I am not privy to financial projections or could say that this is the plan for Cerberus, but how could someone do it? It all rides on the existence of a major non-cash expense -- depreciation. If you take a hospital like BIDMC, with revenues of a billion dollars or so, a satisfactory operating margin might be $40 million, or about 4%. But our deprecation expense is, say, $65 million, so earnings before depreciation would be $105 million, or close to 11%.

If you chose not to use that depreciation for the usual purpose of renewal and replacement of capital plant and equipment, then it would be available for other purposes, like those that worry the competing hospitals. You would only do that if you did not plan to hold on to the assets for a long time. If you were planning to be a long-term operator, you would try to invest an amount at least equal to depreciation because you would have a concern for the long-term viability of your hospital.

So, I think these other hospitals are proposing a longer retention provision for the Caritas assets as a way of indirectly dealing with this possibility.

Since a requirement for a longer asset retention period is unlikely, another way of dealing with this concern is to get an enforceable commitment from the buyer that it would invest an amount at least equal to depreciation for the length of the retention period. In that way, it would not be as possible to "milk" the asset base for competitive purposes.

If Cerberus already intends to invest in the hospitals in this manner, such a provision should provide little or no impediment to the deal going through. If the company does not commit, then the regulators need to do a full analysis to see if there is cause for concern about renewal and replacement of capital facilities and equipment in these hospitals, especially if the plan is to use depreciation proceeds for acquisition of market share.


Anonymous said...

You have hit upon the 64K question, and that is, what is Cerberus' intent? Is it planning to be a longterm operator of for profit hospitals like HCA, or is it in this for the short term profit?

Since it is to Massachusetts residents' best benefit for the former agenda to be encouraged, I believe the AG should take a very long look at what requirements will be needed to encourage such an attitude. Maybe 5 years plus some provision as you have suggested. A signal needs to be sent that 3 years is suspiciously short.

e-Patient Dave said...

I hear you on this, Paul. I'm not in the investment banking game, but it seems apparent that everyone (including Cerberus) acknowledges it's not good to "flip" a hospital investment the way some people used to flip houses (buy and then quickly resell), because as you've pointed out, a whole lot of citizens' lives would be impacted by any manipulation, as has happened so many times in other industries. (I think the depreciation issue you cite is one example.)

I imagine Cerberus's "no sooner than three years" acknowledges this concern, and I imagine the requested 7 extends it.

p.s. I don't get "not a natural" - some play on words? I don't get out much...

Paul Levy said...

Sorry, Dave, I was just having some fun. Picking a headline is the best part of writing a blog.

It is from the game of craps. Seven is a "natural." You win if it is a natural (7, 11) and lose if it is craps (2, 3, 12).

Mark Montgomery said...


I was involved with venture capital and private equity for many years, first as a consultant, then VC. I became highly critical of the PE industry when so many institutional dollars chased the sector-- particularly pension funds attempting to make up for underfunded liabilities, that it fueled bubbles, incompetency, and systemic malfeasance.

What little I know about Cerberus is that you could do worse from a community stand point, but there are a couple of take aways I would offer.

Despite many claims, and reported losses, healthcare has it much much better than most industries in the U.S. by a large margin--for staff, and in particularly affiliated specialists, that is. I have been close to several with family dollars in gifting-- the combination of revenue models has been very good and exploited with great skill, often at the expense of everyone else in the community.

I am absolutely certain that the HC industry has been so far removed from economic reality that it has no collective understanding of the affect on the U.S. economy, with rare individual exceptions.

I suspect Cerberus views the opportunity for changes in modeling, and very likely lower payments to staff and contractors-- but they have missed big before on modeling, so I suspect the risk is great, and hubris alive and well.

Frankly, I see more opportunity to improve healthcare from modeling in lower cost clinics, increased home healthcare and self-care-- whether for profit or non-profit missions. For emergency I personally much prefer other models like in France, which has reduced emergency care (unlike your state model apparently).

The model in the U.S. is clearly broken, not just in hospitals, but throughout healthcare, which is a disservice to those who engage not for the unsustainable levels of compensation, but for making a difference in people's lives.

I for one do not believe that the type of tax entity has anything to do with performance, or salaries, or profit actually-- I've audited and reviewed far too many. I personally know many more non-profit execs in healthcare and education and government, making excessive salaries over say a half million per year-- guaranteed, than in the for profit sector.

Transparency can be a valuable tool, particularly when data is made available for people to make their own judgment.

Chris LeBeau said...

Having seen for profit hospital corporations strip facilities of value or simply invest in high margin services I feel that a contractual stipulation mandating upkeep would be helpful. Such a stipulation will reaffirm Cerberus's good intentions. As the recession lingers many independent hospitals have been seeking a buyer and this could be a good precedent in the future to ensure that for profit entities do not simply purchase undervalued or distressed assets intending to flip them shortly after while doing little to improve the facility.

Cerberus may be an honorable company but in the world of making a dollar, we cannot be sure that all corporations out there will uphold the same moral standards.

Cetus said...

I very much like Mark Montgomery's comment above. PE firms tend to be black boxes; we see their public faces and not much else...

Nobody's going to formally commit to hold onto a hospital asset for seven years come hell or high water.

Watch for a capital expenditure depreciation acceleration incentive to pass congress as an economic stimulus. It's been done before to speed recovery and there's some buzz now.

Predatory flippers hit labor, hard. They provide cover for subsequent purchasers to come on the scene wearing white hats.