A new wave in Massachusetts

Several days ago, the Attorney General released her report on the issues surrounding the acquisition of the Caritas Christi hospital system by a private equity firm, Cerberus Capital Management. In a very thorough review, the AG found that the acquisition was in the public interest, providing that a certain number of conditions were applied to it and to the operation of the system in its new for-profit manifestation.

Several days later, the Boston Globe editorial page opined that the AG had imposed insufficient conditions on the transaction.

While the Globe editorial writers might be justified in some of their sentiments, they are incorrect in their overall conclusion. There are limits as to what the AG could have ordered in this case. As a matter of business and finance, she went as far as she could go, assuming that she wanted the transaction to proceed. And given the financial realities of the situation at Caritas Christi and the likely benefits of the acquisition, she had good reason to want the transaction to proceed.

Now, however, comes the fun part -- for those who define “fun” as watching a sector turned topsy-turvy. For that is what is likely to happen.

What has changed? Well, we now have a new entrant in the Massachusetts health care marketplace, one whose rules of engagement and incentives are quite different from the non-profits that have operated in the state for decades.

For one thing, Cerberus has cash to invest. The only other hospital system that has cash is Partners Healthcare System. But Partners is already under review from government antitrust officials. It is severely constrained with regard to acquisitions and other expansion of its hospital and physician network.

Partners, too, has to recognize a new reality with regard to future revenue streams. Its ability to use its market power to demand disproportionately higher reimbursement rates from the commercial insurers has been dramatically eroded by public reports, hearings, and legislation that have presented and will lead to greater disclosure and transparency of payment rates. While PHS can benefit for a couple more years from previously signed contracts, the likelihood of receiving equally generous ones in the future is diminished. The general trend in the state will be towards a greater equalization of payments. Meanwhile, too, payments from Medicare and Medicaid will no longer rise at historic rates. Also, NIH funding of research following the expiration of the federal stimulus program will level off. Thus, in planning for the future, PHS will have to harbor its resources more carefully.

For another thing, Cerberus is likely a short-term player in the market. It now has explicit recognition and approval from the AG of a business strategy that consists of flipping its Massachusetts investments in a few years. Whether through an IPO or sale to another private equity firm or leveraged buyout by its senior management group, the business model of private equity is to get in and get out quickly, providing a return to its investors within a time frame promised to them when they chose to invest.

So, Cerberus has an interest in burnishing the profile of its Massachusetts portfolio to get ready for that future set of transactions. How would you use your cash to do that?

The likely answer is to expand the reach of the system so that it can have a higher likelihood of a greater market share. While insurance payment rates may become more equalized over the coming years and no longer reward the previous form of market power, the new health care environment of Accountable Care Organizations and global payments will reward those systems who cover more patient lives. There are two ways to cover more lives: (1) have more primary care practices in your network and (2) have more community hospitals in your network.

The loci of such activities are likely to be those communities served by both a Caritas hospital and another hospital. Even before the Cerberus transaction achieved the latest level of state approval, both paths were being foreshadowed by Caritas management. Over the coming months, we can expect Cerberus to use its cash resources to purchase community-based primary care practices in the hope of shifting volume to the Caritas hospital in each community and away from the other one. There is no way the independent non-profit, often cash-strapped, hospital in town will be able to afford to offer its current physician groups the attractive purchase options Cerberus will be able to pay.

We can also expect Cerberus selectively to use its cash to acquire the other hospital in town. That, of course, will be easier if that hospital has suffered, or fears to suffer, losses from the exodus of key physician groups. Whether its goal is to reduce costs by consolidating services between the two hospitals or close down the other to enhance the Caritas facility, Cerberus will find itself with a larger portion of the community’s patient base.

Note that this strategy does not require major expansion of a Cerberus-owned tertiary base, which would be a very expensive proposition. Tertiary hospitals in the ACO world will lose their Ptolemaic hold on the health care system. They will provide service to ACOs and will have to compete for the privilege of doing so.

As long as Cerberus adopts this approach in a careful way that does not run afoul of anti-trust concerns or other legal prohibitions, its plan can be carried out in compliance with the Attorney General’s conditions and, indeed, in a manner consistent with sound business practice. What makes the situation so different from the prior environment is that no other player in the Massachusetts market has had the resources and incentives to adopt this business strategy.