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."