Saturday, February 05, 2011

Is the "greater fool" theory alive in the hospital world?

In the last four decades, we have witnessed a series of investment "bubbles" that have all collapsed. It seems that there is no end to the number of people with cash who will be intoxicated by a good story line, even when there is little substance to back it up. All of these stories depend on the capital markets to bolster the price of investments, counting on the "greater fool" theory: There is always someone who will take on a bad investment at just the wrong time, providing a good return to those who are lucky enough to escape before the crash.

In the early 1990s, ENRON was entering the market with a new electricity trading division. A business partner of mine was asked by one of the largest government pension funds to evaluate a proposal to invest $250 million in the start-up. He came to me a few weeks later, saying that he was having trouble evaluating the deal. They could not give a substantive answer to the basic questions: How will each transaction make money? What will be your competitive advantage in this business? What do you expect your market share to be? When he would ask the ENRON guys for a business plan, their answer was, "We did it in natural gas. We can do it in electricity. Trust us."

My friend advised the pension fund not to invest. It did so anyway, apparently because of personal relationships between the fund managers and people at ENRON. As we now know, the fiction behind ENRON's financial plan eventually led to its collapse.

A bit later, Bernie Ebbers was building a telecommunications company called WorldCom. His approach was to play on the stock market's desire for growth by acquiring other long distance phone companies. As the market capitalization of the company grew, its stock price rose -- notwithstanding a surplus in long distance capacity in the country and declining profit margins. The thing that finally stopped Ebbers was that the government would not let him continue to acquire companies (for antitrust reasons). Then, finally, he had to run the business as a business and make a profit, and he could not. Collapse followed.

More recently, we have all witnessed the subprime debacle, the sale of unsecured insurance products, and the like. As above, these were examples of money chasing money, of stated valuations with no inherent relationship to the actual value of the business enterprise.

What is the next bubble? Might it be private investment in hospitals and hospital systems?

I have discussed above the rationale for and some of the financial techniques involved in private equity acquisitions of hospitals. These acquisitions also tend to have great political support: A financially troubled hospital system will have a more secure pension plan, pay taxes to municipalities and the state, and the like. The private equity firm rescuing the system is seen as a "white knight" and makes commitments that sound very persuasive.

As time goes along, some of those early statements are quietly modified. This Boston Globe article, for example, reports that one private equity firm "also committed to pumping another $400 million in capital improvements into the system over the next four years, although [its CEO] acknowledges that those funds may come from hospital revenues in coming years, rather than from [the private equity firm] itself."

We also learn that strong commitments to local involvement can diminish. At a recent conference, one private equity official derisively talked about the inadequacies of local lay leaders eating their "stale bologna sandwiches" at Board of Trustees meetings, to draw a contrast with the unsentimental businesslike behavior of a board chosen by his firm.

Those seeking to regulate the behavior and financial decisions of for-profit hospitals will find that their post hoc authority will likely be insufficient to protect the public interest from a depletion of plant and equipment and from a plan that is mainly meant to burnish the pre-tax and pre-depreciation short-term earnings of the firm so that it is ready for the initial public offering or resale to another private equity firm.

Who gets hurt if these deals go bust when the next generation of owners takes over and discovers that creating the margin to generate the expected return is very hard in the hospital world? Well, that very last set of investors, the "greater fools." But, as we have seen in the examples above, the hurt goes much further. Hospitals, though, are in a special category. 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.

Perhaps I am being too pessimistic, but this feels very much like those conversations I had in the 1990s. Let's hope that I am wrong. So in the meantime, enjoy the Super Bowl and root for the good guys to win.


sjdmd said...

At a recent conference a JP Morgan Non-Profit Bond guy noted that 35-45% of his bond deals for non-profit hospitals in 2010 were to finance EHR installations. Seems like a set-up for a new junk bond situation ('sub-prime mortgages' for EHRs?) as I don't imagine that the software will be in use at the end of the 10-15 year bond term. Do you?

Anonymous said...

The snide comments by this CEO notwithstanding, your post has implications far beyond Boston. Early signs of a future bubble in health care are already appearing, with the trough-feeding going on around the HITECH (health IT) initiative, and increasing interest in health care by private equity firms concomitant with the new federal expenditures. Cerberus' investment is just an early symptom of this chronically relapsing disease. Previous bubbles just took people's jobs, homes, and retirement plans; now Wall St. will be going after their very lives.

Approaching the SEIU prospectively was another cynical move; the WSJ link below illustrates how such apparent legal blackmail is succeeding for the union:

Not that not for profit hospital systems don't have their own issues, as your blog has eloquently illustrated in the past; but the lack of transparency and profit imperative here add a new layer of dangerous conflict of interest.

nonlocal MD

e-Patient Dave said...


I wish, wish, wish more people would step waaay back from their complex, abstract analyses of healthcare, instead taking a ground-level look at healthcare delivery and ask "In this moment, this action, what value is being created or delivered?"

Industries only evolve when the value is delivered more effectively - at lower cost, more reliably, better quality, etc.

Conversely, prices can be driven up (without evolution) by cornering a market, and of course investors are often drawn to anything that seems to have paid off for others. I know people who got rich in the dot-com '90s (while I was saying "Are you kidding?? What's actually happening?") There's something to be said for riding an illusion, as long as you can get out in time.

But it seems to me private equity is a different game with different stakes than healthcare. Dot-com and subprime merchants sold to consumers and promised investors a return that eventually popped when they ran out of greater fools; the pop hurt the greatest fools and the consumers caught in the middle, who were left with essentially a carcass.

But scooping up something that affects a community's health and milking it, adding value in no identifiable way, seems risky. Has anyone extracted from them an explanation of real (not paper) value?

Said differently:

Can anyone other than a sucker think that what healthcare needs is a dose of what Wall Street did for us?

InformaticsMD said...

You left out another Bubble: health IT. Maggie Mahar says it well in her post (that comments on one of my HC Renewal posts) here:

Too Many Buyers, Too Many Sellers, Too Little Information

I am hardly an IT expert. But I have spent enough years observing markets—stock markets, real estate markets, and most recently, our health care market—to recognize a big, bright Bubble when I see one. Eager to take advantage of fat federal subsidies, too many buyers, with too little information, are scrambling to purchase health IT. And, as is always the case, too many sellers are all too eager to satisfy the buyer’s desire to part with his money.

-- SS

Paul Levy said...

From The Health Care Blog:

Rich: It won't be the first health care finance bubble. Back in the 90s the market fell for the same kind of argument from practice management companies. They were sure they could find enough unclaimed revenue from managing medical practices to benefit both the practices and the market. That industry no longer exists.

Roy Poses: See our take on this on the Health Care Renewal blog:

The current Steward Health Care CEO's history of focusing on the short-term, and his apparent reliance on a dubious "leakage reduction" strategy as business plan suggest we should be very skeptical about Steward's insistence it is in it for the long haul.

Barry Carol: I don’t know, Paul. Cerberus’ acquisition of Caritas Christi makes reasonable sense to me if they can execute the strategy described in the Boston Globe article you linked to.

There is no question that the hospital group needed access to capital, not just to bolster its pension plan, but to modernize as well. I suspect that the cost to build an equivalent number of community hospital beds today is far higher than what Cerberus is paying. If they can form an ACO that makes sense for both payers and patients, they may well be able to grow market share, especially if they can keep routine care away from the highly paid big name teaching hospitals and still score well on patient satisfaction. Caritas Christi also seems to have a dynamic and passionate leader.

If there is too much hospital capacity in the Boston market, some of it will have to close eventually. The long term winners will be those who can provide high quality care at low, or at least acceptable, cost. The big teaching hospitals will need to focus more and more on providing the most sophisticated care which only they can handle. The question is how many teaching hospital beds does the Boston market need and afford to pay for?

Paul Levy said...

From The Health Care Blog;

Bill: Good discussion about the relative merits of non-profit vs for-profit access to capital markets.

These days the evidence seems to suggest that the value of the non-profit tax benefits far outweighs modest differences in the after-tax cost of capital.

I have yet to see any convincing evidence that efficiencies and economies of scale are realized from hospital M&A combinations.

However, the key element which has driven previous hospital consolidations/M&A activity is pricing power. Larger entities have a well documented ability to negotiate higher reimbursement rates from private payers.

In a health care world where government reimbursements are on an unfavorable trend, this may be the strongest argument in favor of larger hospital systems.

Nate: shouldn't we be looking to replace capacity at poor performing old facilities with new modern capacity at nice new facilities? That was one of the problems with CON, it killed the market that would force bed owners to innovate and stay current. As long as we take steps to control the utilization we should allow as many beds as people can build and let the market sort it out.

Paul Levy said...

From Health Care Renewal:

Steve Lucas: The only thing I could ad to this piece is: Here we see a sales person allowed to take over the reigns of leadership.

Sales people have some common traits:

Ego, and the feeling of superiority.

The need to win at any cost and the willingness to say anything that is need to get what they want.

The desire to be the center of attention.

Ultimately sales are about belief in the person and sales people relish this role. Here we see this personality in the extreme. In the past a sales manager would control and mark a person like this as not managerial material.

Sadly, in much of American business this has become the norm. Past performance is swept aside in favor of someone with no track record who promises, that with their over the top plan, they can change the world. Reality is something that is to be bent to the needs of this person. Accounting tricks and staying one step ahead of the consequences of their actions keep these people employed.

As noted, it is those left at the end of the process who now have to clean up the mess, while the perpetrators of this fraud look for new jobs telling everyone who will listen: I made X million dollars at my last job and improved sales by Y amount.

Josh Kosman said...

I think Paul is right to be questioning the rationale behind leveraged buyouts of hospitals.

In my book The Buyout of America: How Private Equity is Destroying Jobs and Killing The American Economy, I investigate in Chapter 3: Doctoring Customer Service how private equity owned hospitals impact patient care. The Vanguard Chain gives bonuses to hospital CEOs mostly for hitting earnings projections and not patient care.

The results, as described in the book, include a huge spike in pneumonia rates at its unclean San Antonio hospitals.

Hal Andrews said...

As the executive responsible for buying two hospitals in MA and converting them to for-profit status, one of which was owned by CareGroup, I find this thread puzzling. Both facilities were poorly managed and had been neglected from a capital investment standpoint for years, if not decades. It is always amusing to me that the tax-exempt guys want to criticize the for-profit industry, but they are never around to help when a fellow tax-exempt hospital is on its death bed.

As for the analogy to PPMs, the difference is of course that the assets of the practice are intangible, while hospitals are full of tangible assets.

As for the undocumented claim that the for-profit guys only get paid on financial metrics, the reality is that for-profit management have substantial components of their (much-lower) compensation at risk for quality outcomes and patient satifaction than do their tax-exempt peers.

Paul Levy said...


You bought those with the intent of staying in the business and operating them. That is different from the model at play here.

Anonymous said...

Mr. Andrews;

Much lower compensation? I would be interested in documentation to back that up. I do not believe that is the case with Dr. De la Torre.

nonlocal MD