The capital markets may have displayed an unusual degree of perspicacity last week in how they valued Vanguard Health's initial public offering. Vanguard owns and operates 26 hospitals in five states, among other businesses. The IPO yielded a stock price well below that anticipated. According to this story:
That $18-a-share offering price was lower than the $21 to $23 price range targeted by Vanguard, a drop that one analyst attributed to investors having a less optimistic view of publicly traded hospital chains vs. when the company disclosed its targeted price range earlier this month.
Back in February, I explained how private equity firms prepare their assets for the day of an IPO:
Part of the business strategy is to create an organization with a larger revenue stream for when it comes time for the initial public offering in a few years. This simply creates a greater sales multiple when the IPO occurs. As we have seen in other sectors in the economy, this phenomenon is remarkably independent of the actual sustainability of the business as an operating entity in the long run. Capital markets flock to size during an IPO.
This is the same strategy being employed by Vanguard Health Systems in buying the financially troubled Detroit Medical Center. Each deal is likely to be highly leveraged, and as long as the cash flow from Jackson/DMC is positive for a few years, the strategy has the potential to yield an excellent return to the investors in the private equity fund.
Might it be that the stock market has come to understand that, in health care, a large revenue base is not determinative of future levels of profitability? (Maybe investors listened to this webinar.) You just have to watch the debates in Washington, DC, to understand that Medicare rates are unlikely to rise at the overall rate of inflation, much less the rate of medical cost inflation. Likewise, if you consider the actions of state governments, you have to know that future Medicaid rates will not come closer to covering the cost of providing clinical care than they do today. Finally, there is substantial pressure on private insurers to hold rates down, too.
So, even if you believe that more people will have health insurance than in the past, this does not mean that the fees paid to hospitals will be fully compensatory. Unlike private equity firms, which can maintain cash flow to their investors by employing a high degree of leverage and not funding depreciation, a public company rises or falls based on the total margins produced by the hospitals. Those margins will be under substantial pressure for years to come, especially as hospitals face the need to fund deferred maintenance. Further, as for-profit entities, those hospitals will have to pay local property, sales, and income taxes. They also lose their ability to use the federal tax code to help generate substantial philanthropy and to garner lower interest rates on bond issues.
Can it be that the Vanguard IPO gives an early signal that the kind of investment "bubble" we have seen in other sectors is less likely in the health care sector? If so, that is probably to the good.