Sunday, February 13, 2011

I was not skeptical enough

A recent webinar held by Day Pitney LLP made me wonder if my previous post may have understated the skepticism that should be applied to private equity purchases of hospitals.

The session was held on February 9 and was entitled, "Recapitalizing Not-for-Profit Hospitals with For-Profit Equity Capital." It had excellent and lucid presentations by Sandford Steever, Editor of The Health Care M&A Monthly; Wayne Ziemann, Managing Director of Alvarez and Marsal Healthcare Practice Group; and Lori Braender and Bruce Boisture of Day Pitney. The slides are here.

The theme of the day was that health care reform activities over the coming years will require massive capital investments to comply with the new federal law and associated regulations and to create accountable care organizations. This is a problem for not-for-profits, which are are often locked out of capital markets or have difficult access to such markets. In contrast, for-profits have an easier time raising capital.

One panelist then reported, though, that for-profits and not-for-profits have generally earned virtually identical after-tax profit margins. He also noted that equity holders demand a high return, in the range of 25 to 30 percent.

These remarks led to a series of questions from the audience: If for-profits are identical to not-for-profits with regard to after-tax profit margins, how can those puny margins be sufficient to justify investment by equity markets? Or putting it another way, if equity holders are demanding a 25-30% return, how do they earn that return if after-tax margins are the same as not-for-profits. Does this depend on flipping the properties in an IPO or to another private equity firm?

The initial reply was startling, "It is an apparent contradiction occurring in the market today."

Expanding on that, it was noted that private equity entry in this field is different from the for-profit hospital companies that have purchased properties in the past. "Private equity firms envision exiting, and not in the far future. Betting that there will be a buyer at some time in the future is the exit strategy. It is quite a gamble. They are banking a lot of health care reform and consolidation in the industry. Beyond that there is not much that is well defined."

Beyond that, there was a suggestion that the play in the marketplace right now is a "bet on a business plan" -- hoping that access to strategic capital will give these companies a competitive edge in the marketplace and grow market share. It is a bet on a transformation in the health care industry -- different payment models, being a low-cost, efficient provider, and wringing out inefficiency and overtreatment. "It is a heck of a bet to make," noted one panelist.

We were reminded that for-profit investors believe that community-based governing bodies lead to poor business decisions by not-for-profits. (This thought parallels the "stale bologna sandwiches" comment noted in my earlier post.) This belief, though, is interesting in light of a comment by one panelist who noted that not-for-profits have done better than for-profits with regard to building integrated networks of care and coordination of electronic health records.

Finally, though, there were two sobering comments from the panelists. The one: "It is kind of like the gold rush in years past."

The other was worse: "A third possibility beyond an IPO or sale to another investor is that the firm will simply shut down."

It was on this point that I concluded last week: Investors may come and go, but the community depends on its local hospital to provide high quality service. It is the residents of the community who are left holding the bag if the hospital corporation reaches the conclusion that ownership is not financially viable.


Barry Carol said...

If a non-profit hospital considers selling itself to a private equity firm because it needs capital to modernize and/or pay for expensive HIT upgrades, what’s the alternative if it can’t access capital itself and it’s not forthcoming from state, county or city subsidies? Under those circumstances, it is likely to continue to lose ground competitively and ultimately need to close or at least significantly downsize. If a private equity firm buys it, invests capital to upgrade the facilities, strengthen the pension fund, etc. but ultimately can’t make the investment pay off, it may have to close the hospital. If it can make it work by, for example, building an efficient, high quality ACO that can provide care at lower cost than its competitors, the local healthcare system is well served, it would seem. The bottom line is that if the non-profit can’t make it on its own because it can’t access capital, selling out to a private equity firm or a for profit hospital system doesn’t seem like such a bad alternative. One underlying assumption I make is that no local financially strong non-profit hospital system would want to buy its weaker competitor if it is likely to close sooner rather than later if left on its own.

Paul Levy said...


Do you see any difference between private equity with a short-term view and plan to flip a property, and another type of private investment entity with a long-term view?

BTW, it is also not clear that the "massive capital investments" discussed by the panelists are indeed "massive." Strategic alliances among a number of non-profits to create ACOs are quite possible. Each brings something to the party.

Finally, it is not clear that all non-profits' difficulty in raising capital stem from their being non-profits. Such problems can arise from the particular management team in place. A diligent Board can recognize that and make changes that result in a much healthier organization.

Anonymous said...

Quite frankly, I agree with Paul's last paragraph, and the hospital system I worked for was a poster child (commenting on which is the primary reason I have always commented anonymously).Despite being in a sophisticated metropolitan area with potential access to good Board talent and good competitive attributes such as location; over time it made a series of dumb decisions, sprinkled in with one unscrupulous CEO/CFO combo who manipulated the board into a huge(8 mil) golden parachute, which came close to sinking a longstanding and respected community hospital system. To this day the financial consequences are hampering it despite better management.
At such times, selling to PE seems like an obvious lifeline. There are for-profit health care companies in it for the long run (HCA for example) which, despite growing pains of their own, are successful. I believe Paul's post is about those recent-entry short term players looking for a quick profit on distressed hospitals by flipping - a clear and present danger in the current environment as exemplified by this webinar.

nonlocal MD

Barry Carol said...

Paul –

Actually, I’m not a big fan of private equity, especially when the approach is to improve profits by stripping assets, lots of layoffs and sharply increasing debt. If a struggling hospital can improve its market and cost position with new management, forming an ACO through strategic alliances with other hospitals or modernizing at low cost, if I were in their shoes, I would opt for one of those approaches too. All I’m saying is that if the alternative to private equity capital is closing altogether, it’s probably the best option available.

Anonymous said...

Paul, I once had the CEO in a non-profit health care organization lambast me and my colleagues for "not making money" like those guys in for-profit health care do. He asked: why can they do it. This was just prior to the Columbia HCA and Tenet revelations, followed by some nasty stuff in pharma and medical device firms. My response: It's easy when you cheat.

Greg said...

There are lots of angles to this question. First, profit margins at for-profit and non-profit hospitals may be similar across the board (is this in the slides?), but that may not be true for hospitals while they're held by private equity owners. PE firms are pretty good at cutting costs, and sometimes even growing revenue, so they may be able to raise margins which then are or maybe aren't sustained by later owners.

Second, PE owners have ways of goosing their returns apart from after-tax margins. If they get a sale for a higher multiple, that can create a great return without improving margins. PE firms are also notorious for giving themselves huge cash dividends paid for by debt while owning a company. Rather than a recapitalization, it's more like a de-capitalization.

In the end, it's a very mixed bag. PE owners can turn around struggling hospitals, but they can just as easily incur a huge debt load that weighs down the hospital. Often at the same time. At the same time, non-profit boards can also be good or bad.