Monday, April 29, 2013

An investment banker asks a question

This is a true story.  An investment banker friend, very astute as to the issues surrounding private equity investments but not so familiar with health care, was confused.  He laid out the scenario as he saw it and then asked me the final question.

He said: You run a private equity firm and you are awash in cash, looking to create a portfolio of interesting investments that will satisfy your funders.  You see that the US government has passed the health reform act, assuring insurance coverage to a large percentage of the population.  You wonder if you can apply private equity principles to this sector.  What are those principles?  Get into a situation in which there are not likely to be a lot of bidders; satisfy political entities and other constituencies who might be concerned about the viability of the acquired firm and therefore view you as the "white knight;" put in place a hard-driving CEO; leverage your equity component with a healthy dose of debt; focus on extracting as much cash as possible from the business; take actions to grow the top line of the firm, as well as EBIDTA, so that you will be able to present a colorable story to future investors as to the company's growth potential; and then flip the business in an IPO or to another private equity firm after a few years.

Coincidentally, you learn that a faith-based hospital chain is having financial troubles.  Among other things, the institution faces a hangover of employee pension obligations and has been forced to underfund renewal and replacement and other capital improvements.  The religious organization that owns the system is unfamiliar with the operation of  health care facilities and views the system as a financial and operational drain not central to its mission.  For reasons of control, though, it created a governance structure that gives little authority to the hospital chain's board of trustees.  Further, its CEO is keen to arrange a sale of the hospital system to a private equity firm to show that he can create a vibrant business proposition.

So your private equity firm offers to buy the property, making promises to regulators and stakeholders in the community.  Few objections are raised and the deal is approved.  The private equity firm, new to health care, gives an unprecedented level of authority and autonomy to the CEO.  He rewards your confidence by executing the key elements of the business plan.  Assets are sold for short term gain, with little concern for the downstream costs: After all, the hospital properties will be flipped in a few years anyway.  The hospital system's laboratories are sold to a private laboratory service company, in return for a long-term contract to use that company.  Real estate is sold and leased back.  The system agrees to a front-end-loaded risk-based reimbursement contract with the largest private insurer, one that calls for substantial reductions from the trend of medical expenses in future years.  Physician practices in the community are purchased at above-market prices to create an increased flow of referral business to the hospitals.

The partners of your private equity firm have some concerns, but not enough to act.  The new corporate headquarters for the hospital system seems a bit large and luxurious.  Very high prices are paid to recruit tertiary care specialists into the hospital system.  For the high acuity services that this hospital system cannot deliver, patients are being sent to the highest cost hospital in the region instead of equally competent, but lower cost, alternatives. Also, experienced senior level executives that are recruited leave soon after arriving, either being fired or choosing to take lower paid jobs elsewhere. Insiders are promoted to replace them. 

But then the money falters.  Revenues take a tumble and days in accounts receivable grow during an extended transition to a new centralized billing system that was designed to take the place of the billing systems run by each hospital.  The risk contract with the insurer starts to limit annual price increases.  Medicare and Medicaid rates are constrained by the federal and state government.  Top line revenues fall, EBIDTA falls, cash flow falls.  Finally, the private equity partners are nervous.

They turn off the spigot and impose cash constraints on the system.  Normal maintenance of building systems is deferred.  Medical equipment expenses, too, are kept to a minimum.

The private equity firm searches for a new person who will be told to fix things, and quickly.  When he arrives, he will realize that the previous decisions that were made are now starting to burden the system with unavoidable operating costs and revenue constraints.  The only place to save money is on staffing.  He must make dramatic cuts in the upper management levels but will also be forced to make other cuts in the clinical support and lower administrative staff. Band-aid capital spending will be permitted when unsafe conditions exist, but the hospitals will start to fall behind on upgrades of important medical equipment and devices.  He will be in a race against the clock.  Can he hold it together long enough to permit the investors to get a return in the flip?  Finally, he will realize that closing one of the hospitals has to be part of the answer.  Investors will be relieved when he does so, but the community and governmental constituencies that supported the initial acquisition will get worried.

My colleague surmised that it would be around this time that regulators would begin to understand that the corporate guarantees that might stand behind the private equity firm's acquisition of the hospital system are a nullity.  The owners' resources are legally separated from those of the hospital system.  It would take years of litigation to pierce that corporate veil.  Thus, the commitments that have been made to the governmental and private constituents in the community are supported solely by the financial resources of the hospital system itself.  But that hospital system faces high debt service costs and obligations, other long-term cost commitments, and increasingly difficult revenue restrictions.

It would be around this time, he figured, that the capital markets would get wind of the fact that this hospital system cannot generate a risk-adjusted equity return that is commensurate with other industries.  An exit strategy that was predicted on a flip through an initial public offering or sale to another private equity firm would looking less and less viable

His question to me, "What would happen next?  Don't we need these hospitals to be in good condition to serve the public?"

My answer:  Assuming my friend's scenario is correct, pressure will build--from the employee unions, from the doctors, and from the legislators and municipal officials who were promised job preservation and growth in income taxes, sales taxes, and property taxes.  Behind the scenes, the dominant provider organization in the state--the only organization with sufficient cash flow to remediate the poor state of these decapitalized properties--would let the governor and others know that, because of its "concern for the public," it will "reluctantly" take over several of these distressed properties, but only "if it is asked."  The deal is struck, and the dominant provider finds itself owning facilities in several new regions in the state, broadening and enhancing its market power.

At that point, people throughout the region would sit and wonder, "Where did all the money go?"  Investors in the private equity fund would be less concerned:  They received their cash flow for several years.  Even though the exit strategy didn't work out as hoped, this hospital system investment is just a small component of a diversified portfolio managed by the private equity firm.

"Oh, " he said, shaking his head, "I was afraid of that."


Dwight L Davis said...

From Facebook:

Vulture capitalism at its finest.

Paul Griffiths said...

From Facebook:

You would be a three headed dog from New York who colored outside their lines?

Thomas Connors said...

From Facebook:

Very interesting, and accurate from a corporate investment and medical services view.

Susan Keirn said...

From Facebook:


Erin S., OHSU School of Medicine said...

From Facebook:

An absolute must-read.

Anonymous said...

Keeping in mind the state of BIDMC before you took over, your essay makes me wonder if this scenario has to do with private equity per se or just with mismanagement.

nonlocal MD

David Joyce MD said...

But at the end of the day, what was the ROI for that private equity firm. Easy to figure, just figure the NPV of all the cash flows including the sell off to the larger hospital group and compare it to the purchase price. My suspicion is that this was a loser for the equity firm. Investment Capital does better when it takes a bad firm and make it better, ask Buffett.

Anonymous said...

And why would we think that this scenario only applies to hospitals? Pulling out all the cash, and inserting CEOs only interested in their short-term gains, has been the the mode of operating for private equity for years.

Anonymous said...

The public (as well as the politicians) doesn't want to think about the fact that hospitals are big business, just like any other corporation. We labor under the delusion that because they can kill people, that morals will out when decisions are made. Not so.

Anonymous said...

If only this were fiction.....the business plan was to put lipstick on a pig and sell it to the next fool from the start. It was a transparent plan from day one which should have been evident to everyone. The politicos knew it was big business from the start and feasted with the CEO at a big fundraiser the day following the acquisition of the hospital system . Many executive pigs fed hungrily at the trough and proclaimed their cleverness while the pig which was intended for market grew long in the tooth and less than attractive. It was never about good health care-----it was always about money. Morals had no place at the table where decisions were made. Shame on them all.

Anonymous said...

I applaud the efforts and strategy of the organization. What this article fails to recognize is the fact that this company, which for some reason goes unsaid, is driving change in the healthcare industry. Heck, even if they can get these small physician practices to throw away their fax machines and learn how to do business in the 21st century, they have succeeded in my book. Non-profit healthcare systems have bankrupt millions of individuals right under our noses, yet we turn these noses upward when positive disruption enters the industry because of their profit status? Giving up on this strategy after two years is short sighted and borderline ignorant.

Paul Levy said...

I think you misread what I said. This is not an argument against for-profit companies, nor against disruption in the health care industry. Read it again and please explain to us which "efforts and strategy" of the organization you applaud.

Anonymous said...

Lets look at Partners Net Inpatient Service Revenue for 2011.

(Some hospitals specifically the Steward hospitals haven't submitted final 2012 data to the state government)

We will look at Eastern Mass from NH to the south coast, Excluding the UMass system which is really central, and Childrens Hospital which competes as a specialty hospital.

Partners revenues include those hospitals in the its system (MGH, B&W, NWH, Faulkner, North Shore, or clinically affiliated like Dana Farber and Mass Eye or in the process of being like south shore), and those whose doctors groups are dominated by Partners Community including Hallmark, Emerson, & Milford. Total Net inpatient service revenue for these hospitals 7 billion. Total for everyone else in Eastern Mass. 8.2 Billion as defined above for 2011. So partners controls 46% of Eastern Mass hospital revenues before they do anything else.

Lets assume regulators are aware of this? For real competition in Eastern Mass, Partners must be broken up. Some hospitals in the Partners network going with MGH and some with B&W and maybe some becoming affiliated with someone else?

If Partners is not going to dissolve or be broken up, adding hospitals to Partners Network only increases its monopoly power. Especially in light of the fact that the Steward Network is funneling many of its Patients to Partners with many of its new agreements including Emergency referrals, and referral agreements to B&W for the former Partners doctors groups that are now affiliated with Steward on the south shore.

I hope our regulators or Attorney General will not let Partners monopoly power grow further.

Anonymous said...

The real question is what happened to the federal anti-trust investigation of Partners. We need an update on this pronto; has it been somehow squelched?

Mark said...

Anonymous, but flavored like the system in question. All the back biting and whining about the monopoly and anti-trust issues related to Partners simply does not negate the fact that they hold sway because they offer what patients want. Paul's well made point regarding the "efforts and strategy" of the hospital system in question says volumes. The efforts and strategies relate to a hollow promise of good health care out in the community while patients vote with their feet. The best out come would be the demise of system #3 and the arrival of Partners or BID on the scene.

Anonymous said...

No, sorry Mark; I don't agree. No hospital system should have the amount of excess cash to throw around that Partners does, not to mention their driving up prices to astronomical levels. Don't get me wrong; they got it from playing the game by the rules very, very well - but accumulating cash is not supposed to be the endgame in nonprofit health care.

As far as offering what patients want, until there are statistics to prove their care is of 100% higher quality, safer and of more value than the poorer hospitals in Boston, showing they put all their money to good use, then no, that's not true either.

anon 0630

Anonymous said...


You seem to imply there is a healthcare market and we should let it function. But it is a flawed market. One in which most consumers of healthcare have little or no incentive to try to save money.

Let me make a care analogy. If of cars was subsidized when buying a car would anyone buy a Toyota or would everyone buy Mercedes, Lexus etc? There is no incentive to look for "good value", so everyone wants
"the biggest name".....even though a 70,000 car is no necessarily a 20,000 in getting from A to B.

Partners is not better, it has a "good reputation" and most people don't pay much out of pocket for the added cost of Partners care. Insurance is not a personal financial decision. If people had to pay out of pocket for their healthcare, they would examine their spending more closely.

As it is, Partners hospitals are no better in terms of quality of care, yet are paid much more.

You seem to imply there is a healthcare market and we should let it function. Your assumption is mistaken.

Anonymous said...

Certainly you are free to disagree, however, your comments are hardly supported by facts and seem based primarily on the kneejerk demonization of Partners. Partners is more highly reimbursed and has had more clout demanding these reimbursements because patients demand insurance which allows them treatment at what they perceive to be the "best hospitals." Indeed there is a healthcare market or the for profits would not have entered this market with the hope of making money for their shareholders. What is needed is increased transparency----there are few stats to show that the "poorer" hospitals deliver less costly care and even less showing excellence of outcome. The idea that patients should be forced into a cheaper, unproven system until this care is proven to be less costly and equal to Partners and BID is frightening.

Anonymous said...

If you look at the reports produced by the Attorney General and the subsequent hearings which ended last year......there is tons of evidence that Partners quality is "average" as compared with other academic medical centers....

attorney general showed....that higher prices from Partners (and some other Berkshire, Cape Cod, Sturdy etc) are due to two things only:

1) Reputation (which was not supported by factually better quality as shown Ad Nauseam in the presentations and reports)

2) Geographic isolation in the case of hospitals like Cape Cod, Berkshire etc.

Other explanations proposed by partners for why they are paid more was "FACTUALLY" shown to be correct.

Look here for the attorney generals report:

there were also a whole series of hearings that provided lots of evidence from information required to be provided by Massachusetts hospitals....

It has been moved around ...but the successor agency for this data is here....explore to your hearts content....if you look for healthcare cost hearings and data.

Lisa said...

When choosing a healthcare facility, I am more likely to go where my colleagues go. I have never thought to consult the Attorney General or to peruse government reports to decide on a physician or hospital to use.

Paul Levy said...

Ah, but Lisa, your colleagues (and you) actually have no idea about the relative quality of the institutions in and around Boston. Indeed, even the referring physicians like your primary care doctor have no idea. Why? Comparative real-time data are not published. Referrals are based on doctors' habits, friendships, and which network they are part of.

The AG's reports have been correct in showing that the differential in rates paid to different hospitals is not based on the quality of care provided. But, as one commenter said, there is a public perception of a quality difference.

That's just life in the big time. Partners has executed a brilliant business and political strategy over the years. It is not demonizing them to say that. It's just the way it is.

Anonymous said...

We have gotten off-topic from for-profit health care, which is clearly another whole ball of worms, but Paul's point is the entire point of this sidebar - that Partners has done nothing to justify its disproportionate payments for care, other than play the political game to obtain them. A system which encourages this is not right, and it will change, despite all the lobbying dollars to maintain status quo. It must change - we can no longer afford Partners and its ilk given the lack of quality difference.

nonlocal MD

Anonymous said...

For profit healthcare can work to lower cost and improve quality, if there is a "real market" for healthcare, which as is discussed above doesn't exist.

I think there are efforts both in Massachusetts and by the Obama Admin to create this.

Pioneer ACO's, limited and tiered networks etc are all efforts to move medicine from a "pay per procedure" to a pay to "take care of a population"....the latter focused on "value".....which is high quality and low cost.

As Paul has said in this column many times "bundled payments" hasn't lowered cost costs yet (and its implementation in Mass but Blue Cross has had the opposite effect), but in theory it could if real price competition was injected into health care.

There are non-profits and for profits who are banking on a "high value strategy". In the Boston area Tufts Medical Center is famous for this and its potential for profit partner (small P) Vanguard Health Systems is another. Tufts Medical and Vanguard's focus is high value - low cost and high quality.

They have succeeded in producing High Value. But most healthcare consumers don't know this due to lack of dissemination of real time quality information (as is mentioned by Paul above) and do not have a strong enough financial incentive to move to High Value care.

In massachusetts health insurers have been limited by law to not make discounts for limited and tiered networks "too large"....initially I think 10 to 15% and then 20% to 25% in a few cases because they are concerned about disruption in the market for high cost providers if a tipping point is reached. Public officials didn't want large layoffs at one of the few sectors growing coming out of a deep

but those same officials forget that while high cost providers like Partners will be adversely affected other HIGH VALUE providers will be growing and Hiring. Lower overall healthcare cost will also help other sectors of the economy to grow or grow faster.

the time is now for allowing real price competition in healthcare. Mass insurance regulators need to allow larger discounts for tiered and limited networks.

McMike said...

Just one more anecdote in the epic tale of the Looting of America.

Could have been about a fabrication plant in Ohio, a garment factory in NC, a regional retail bank, a name brand power tool manufacturer, or a venerable snack cake company ...

We allowed, no.. encouraged a small cabal of investors to take advantage of tax breaks, regulatory forebearance, and government subsidies to systematically strip America of its productive assets and economic infrastructure, and convert that intangible and tangible system of accumulated wealth into liquidated bounty for a small circle of looters.

Like coating yourself in peanut butter and allowing a dog to gnaw on your limbs. In the end, you are reduced to a stump unable to care for yourself, and all that is left is a little fat dog with bad breath.

Anonymous said...

Partners is a very successful hospital system because it functions. It essentially runs as a for profit corporation dressed up as not for profit system. Steward, on the other hand, has incorporated every dysfunction we expect to find in the non profit world. It is failing because it is a for profit system that runs like a not for profit.

Anonymous said...

Paul - Cerberus is all about cash flow back to New York.... you seriously think a group that owns a large gun manufacturer is interested in the health of people? What happend to the $100 million cash from the sale of their medical office buildings or the cash from the lab sale to Quest? They are going to strip this thing dry of every dollar they can sneak back to New York and then try and sell it or, as you write, just walk away from the mess that is left. They gambled big on being a Pioneer ACO but that whole program is a mess as well. Empty hospitals with new ERs to make it look like a state of the art facility. This is not going to end well for the stakeholders in Massachusetts.

Anonymous said...

The reason why Partners and other high cost healthcare systems continue to gain market share and relatively low cost networks like Steward are empty is insurance pricing. As someone said earlier, low cost providers can not benefit, or do not benefit enough, because there are limits on discounts insurance companies can provide in the market.

Health "consumers" who might go to steward (and other low cost providers) for a 35% discount won't do so for a 10% discount. (Though if they knew Partners quality was no better than a group like steward , this according to studies done by Massachusetts health officials they might).)

Partners great reputation, means people will pay a premium for them. But at some point, the premium is too much. For instance, according to studies by attorney general, MGH and B&W were being paid 40% more than Tufts Medical by Blue Cross for work of similar quality and complexity.

Consumers might choose to go to Tufts Medical, to save some of that 40%, but with discounts limited by regulators mostly to 10 to 15%.....we cant test this hypothesis.

That is why low cost hospitals stand empty.

Mass regulators are protecting the MGH/B&W/Partners bohemoth.

Let all of the low cost hospitals form a network and price the insurance at a low enough level to attract patients.

Anonymous said...

Malarkey to the last post! Steward does not lack patients because the reimbursements are low or Steward hospitals cannot offer deep discounts. Who knows what the real pricing is----certainly not the poor patients. Nor do patients believe that there is any reliable proof that care in the community or a Steward hospital is of equal quality of that in the Boston teaching hospitals----AND not just Partners. Low cost hospitals here are standing empty because the patients are avoiding them, ambulances pass by and consumers follow the line of hospital administrators, nurses, pts and physicians into Boston where "world class healthcare" is more that just hype in an advert. "You can fool some of the people some of the time, but you cannot fool all of the people all of the time," I wouldn't climb on that "imagined" ladder and have no interest receiving care in an imagined healthcare system.

Paul Levy said...

I'm not sure how this thread evolved in this direction. For the most part, Seward is not currently a competitor with Partners. Indeed, it uses MGH for its tertiary referrals. It competes against other non-Partners hospitals in its geographic areas.

Anonymous said...

If we were to think that only the Boston hospitals are in competition with each other and that the biggest battle is to somehow dethrone Partners so that reimbursements were more equitable among the teaching hospitals I would better understand your point. However, Steward and many other community hospital see "their patients" from their geographic areas going to Boston for care. Stats as high as 70% have been touted leaving the local community. Not long ago the Globe reported that Steward was trying to stem the "leakage" of patient dollars into Boston and patients as well as healthcare providers were told that they could not be referred out of network. Now when patients insisted, that was found not to be the case. To think that Steward who calls itself the third largest hospital system is not interested in grabbing some of the pie headed to Boston makes no sense. They have emptied the coffers, driven away good healthcare providers and replaced them with retreads, closed units and laid off staff from the start----all in contradiction to their promises to the AG. Indeed, their hospitals are doing poorly-----the word is out and patients are following the providers to where good care is perceived to still be had----in Boston. Now, following workers to a good café served me well when travelling and going where health care professionals have determined care is good does as well. The number crunchers and those pushing quality control under a veil of fog seem only to obfuscate the truth. When people are able to see believable numbers regarding good care at good cost, perhaps they will be able to make decisions. I hope when the local hospitals finally collapse, that the AG will have a plan to help the folks in the communities who were promised that their hospitals would be there for them. The hope the "a greater fool" would come in and buy them and they could declare a win dims......Someone need to call "BS" on this whole deal!

Anonymous said...

Stewards community hospitals provide good value, as do many of their competitors. As an example see the web site below.

Cleverly and Associates rates all hospitals on quality and cost. The have a list which includes the top 20% rated in categories Teaching (large, medium & small), Community (large & small)

Many Steward hospitals are on the list as are many of their competitors.

Do a search for "community value five star" and look at the list for massachusetts.

Steward hospitals include: Carney, Good Samaritan, holy family, morton, quincy, and St Ann's.

So are many of their competitors including: Milton, Lawrence General, Lowell General, Southcoast, Brockton, Jordan, Anna Jacques, Winchester, Hallmark, etc.

There are many good quality, low cost hospitals in massachusetts. In fact there are 27 Mass hospitals on this list out of 67 total Mass acute care hospitals or 40%. As I said earlier, the list is for the top 20% nationally. These hospitals are sitting empty because of the reputation of the Boston teaching hospitals.

Massachusetts health consumers believe that they must go to MGH for every belly ache, uncomplicated birth, etc even though it costs more than 50% more to do so when compared to high quality community hospitals.

If insurers would let health consumers feel the full difference in price rather than charging $500 per month for a bundle of services for which MGH/B&W charges 600, community hospitals charge 300 and other teaching hospitals charge 450, for similar outcomes. [Remember the Partners hospitals inpatient revenue is almost 50% of Eastern Mass, as someone said earlier.]

Mass Health Insurance regulators have to stop being dominated by the largest firms in their industries. Everyone knows this happens in private industry, that is why we decry lobbyists. But it also happens for huge non-profits.

Allow health consumers to benefit from the low costs of community hospitals and the cheapest teaching hospitals. It will bring health inflation under control, reduce increasing share of local, state and federal budgets by health costs.

Getting health costs under control is a panacea for our economy.

It must be done.

Anonymous said...

To add a few more facts.

As of Q3 2012 all stewards hospitals has a little over 2 million in total surplus for its 10 hospitals. Most of that surplus is from St Anns and an elimination of the loss at St Elizabeths.

Holy Family plus 0.6
St Anns plus 20.2
St Elizabeths plus 4.6

The loss makers

Carney minus 7.2
Norwood minus 4.0
Morton minus 2.2
Good Samaritan minus 2.2
Merrimac Minus 4.4
Nashoba minus 1.3
Quincy minus 1.3

and a question for Paul.

Paul if MGH is really the tertiary hospital for Steward (as you stated above) then what does it matter if Partners buys the weaker hospitals in Steward, other than to make Partners dominance clearer?

Paul Levy said...

It would give them primary and secondary care service organizations in parts of the state in which they currently do not offer much of those services.

Anonymous said...

Hi Paul,

Guess what I am wondering is whether the true issue is Partners buying a few small weak hospitals in new regions or should we really be concerned about them being the Tertiary systems for Steward....which means they already effectively have approximately 55% market share in Eastern Mass if Stewards market share is added to the 46% controlled already by Partners? [if UMass (central) and Childrens (specialty) are excluded].