Wednesday, August 15, 2012

Let's do the numbers

Julie Creswell and Reed Abelson offer a story in the New York Times about the HCA for-profit hospital system, noting "A giant hospital chain is blazing a profit trail."  The HCA story and similar ones about other hospital chains financed by private equity force us to consider how a such firms can achieve a return on equity that satisfies investors.

The answer is that they cannot, if we think about running the business on a long-term basis.  What makes it work is extracting cash and the exit strategy, the heart and soul of private equity.

As Warren Buffett might say, let's keep this simple.  A for-profit hospital system has the following disadvantages vis-a-vis a non-profit hospital system:  (1) Its finances are a mixture of equity and taxable debt, both of which are more expensive than the nontaxable debt of a non-profit; (2) it pays taxes--federal and state income tax, property tax, and sales tax--on which the non-profit is exempt; and (3) it is an unattractive vehicle for charitable donations, compared to the tax-advantages offered donors of non-profits.

These are hefty financial advantages for non-profits, which nonetheless are fortunate if they are able to earn an operating margin of 3%.  Admittedly, that's 3% of revenues, not a 3% return on capital.

An equity investor in a for-profit doesn't care about margin, strictly speaking, but rather is focused on the rate of return of his or her investment.  But let's stick with the operating margin just for a moment, and let's just accept that a 3% margin would not generate the kind of equity return demanded by the market place:  You pick the hurdle rate:  15%, 20%, 25%, more?  It doesn't matter.  A three percent margin just doesn't get you there.

Given the extra costs inherent for a for-profit firm, how can it do better than the 3% margin of the non-profit hospital?  How can it offset the relative disadvantages by decreasing its costs or increasing its revenues sufficiently?  Creswell and Abelson suggest that part of the answer for HCA has been to "upcode" its patients, collecting more money for the same services.  They note that individual doctors receive great pressure to contribute to the hospital's income statement by offering unnecessary, high contribution services.  They also suggest that HCA intentionally sends away lower paying patients.  Finally, they hint that there might be some operating efficiencies employed by the for-profits that are not used by non-profits.

I do not judge those assertions (although I note that these are very thorough reporters), but I say to you that even this mix of actions would not produce such a substantially different margin as to satisfy private equity investors. Those investors are satisfied by two financial techniques employed by private equity firms in all kinds of industries.

First, use the cash flow of the firm to produce interim equity returns.  Focus on EBITDA (earnings before interest, taxes, and depreciation).  Employ a capital structure with a very high percentage of debt (i.e., leverage up).  Minimize capital investments by not fully funding depreciation.  Sell off unnecessary assets.  These include things like the pathology laboratory, where you discontinue running your own laboratory.  Call Quest and sell them the business, agreeing to pay them laboratory fees.  Also, monetize the real estate value of your buildings, perhaps with sale-lease backs or outright sales.  Meanwhile, purchase physician practices that will produce referral volumes, offering above-market prices.  Pay your debt service costs, but extract as much cash as possible.

Your goal is to show steady growth in EBITDA. Think about it this way:  The top line (revenue) is actually more important than your bottom line (net income after interest, taxes, and depreciation).  You will do anything to add revenue (even, in the case of Vanguard Health Systems, buying the distressed Detroit Medical Center).*

But wait, some of those tactics produce cash in the short run but add operating costs in the long run.  Some actually lose money.  What good is that?

The answer comes from the second financial technique:  Avoid the long run by flipping the business in an IPO (or to another private equity firm in a secondary buyout).  The capital markets are awash in cash right now, money seeking opportunities. There is always a greater fool. You pick your timing, and you go to market with a success story--a record of top line growth, of EBITDA returns in the teens, a prominent public presence.  Here's the secret part.  You don't actually need to generate that much cash in your IPO to produce a great return for the equity investors.  Remember, you have been extracting cash all along for them.  Plus, you are highly leveraged.  A small increment on the sale prices relative to your purchase price gives you a nice hit on the equity return.

How best to characterize this whole situation? Please review this thoughtful summary by private equity experts at Day Pitney: "It is kind of like the gold rush in years past."

* I am mainly talking about the US market here.  For-profit hospitals in non-US locations can do very well indeed on a bottom-line basis.  They play in countries with national health insurance.  People who can afford private insurance or who are provided it by their employers (or international visitors) go to them for unregulated private-pay service, especially in the high-end, high-compensation specialties.  Those specialties might have long waiting times at the nationalized hospitals, or they might not be offered at all, or they might be viewed as substandard.  Those hospitals, too, often have a dominant geographical advantage in that market segment.

Interestingly, though, the unregulated nature of such hospitals can mean that the actual quality of care is undocumented, as they can be exempt from governmental reporting requirements.  Thus, such hospitals can have an unjustified reputational advantage, offering the appearance of higher quality without ever proving it.  They could also engage with impunity in the kind of practice cited in another Abelson and Creswell New York Times article, Hospital Chain Inquiry Cited Unnecessary Cardiac Work.


e-Patient Dave said...

I'm no expert at management in healthcare or education, but this post immediately brings to mind the recent Doonesbury series on for-profit "higher education." It starts here; click Next below each strip, through Aug 10th.

I wonder if it's a coincidence, btw, that the company in that Times article (HCA) is a classic case study of Bain Capital, founded by the guy who says he wants to repeal the Affordable Care Act. Dunno.

RI doc said...

On 4/9/12 I was the only one to testify against Steward buying Landmark Hospital in front of the Director of the Dept of Health and the RI AG

I hope you had a chance to read my OpEd piece in the Jan 5, 2012 Providence Journal, entitled “Steward’s Landmark Bid Bad for RI”. That piece outlined why I think Steward/Cerberus and for-profit hospitals are bad for Rhode Island. Obviously, I am even more strongly concerned about permitting Cerberus/Steward to acquire more than one Rhode Island hospital, possibly 4. I understand that just last week they acquired their 11th hospital in southeastern Massachusetts.

Building on my OpEd piece, I would like to point out that it is a fallacy that Steward/Cerberus Health Care Systems is going to be pouring money into Rhode Island hospitals. Cerberus is simply buying assets. While it is true that Steward is part of a $24 billion Manhattan private equity investment firm, the Steward system itself is a conglomeration of bankrupt Massachusetts hospitals. There’s no money there. Go ask. Just like a bunch of bad mortgages rolled into a single financial product doesn’t make the whole any better than the pieces, the same with this mix of hospitals.

Steward hospitals will be for-profit, and unlike non-profit hospitals, they will have to pay taxes and dividends to investors. So, if a Rhode Island hospital can barely survive as a non-profit, I don’t see how it will be able to provide services and employment opportunities when it becomes for-profit. The only solution is that Steward will sell off assets and downsize and reduce services and act against the public’s interest.

Make no mistake of Cerberus’ and Steward’s intentions. As my article mentions, they have already started selling off assets from their recently acquired Massachusetts hospitals. Just last week they completed the sale of $100 million of medical buildings from Steward in Massachusetts. Keep in mind that only after three years, when several contractual restrictions expire, will we see Cerberus’/Steward’s true intentions, as far a Massachusetts is concerned. In Rhode Island, Steward is asking for only a two-year period of good behavior.

By allowing Cerberus/Steward to acquire several Rhode Island hospitals and gain market share, even more harm will be done. It is very clear to me that the first thing Cerberus/Steward will do is to use its market share to force Blue Cross and United Health to pay their hospitals more, which will undoubtedly end up hurting primary care and the public.

Primary care has minimal market power since its physicians have no ability to collectively bargain. A great many of primary care doctors in Rhode Island practice in small groups of 1 and 2 and 3 doctors. The hospitals have market power, the insurance companies have market power, and the medical specialties have market power by the nature of their exclusivity and small sizes and close affiliations with the hospitals.

Up till now, Blue Cross has taken the long-term perspective and invested in electronic medical records for primary care and patient-centered medical homes and increased reimbursement for primary care in order to attract and protect and retain good primary care doctors in the state. All this is at risk if Cerberus/Steward is allowed to acquire market share in Rhode Island.

The hospitals not associated with Lifespan and Care New England probably are getting under-reimbursed because they lack market power and political power, and by ganging up by joining Cerberus/Steward they see an opportunity to fight for higher reimbursement. THIS IS CRAZY.

There needs to be a way more in the public’s interest of distributing hospital monies, not based on hospital monopoly power and politicking. The state and Dept of Health need discretion in setting hospital reimbursement. I understand the Dept of Health has none currently.

e-Patient Dave said...

Here's his op-ed:
Steward's Landmark Bid Bad Deal for R.I.

e-Patient Dave said...

N.B. the last line of Dr. Shulman's op-ed, about this private equity firm:

"Ironically, Feinberg named Cerberus Capital Management after a three-headed, dragon-tailed dog from ancient Greek mythology. Cerberus guarded the entrance to Hell. All were invited to enter, but none permitted to leave."

Who says that's ironic?

This reminds me of nothing as much as the tobacco industry's Project Kestrel, part of a campaign to attract children to smoking through sweetened flavors. Here's a journal article about the campaign.

From its summary:


"The documents provide evidence that the industry invested great time and resources in developing strategies to attract young people through Youth Smoking Prevention strategies (including education strategies) and marketing to youth. The results include information from published literature and direct excerpts from the tobacco industry documents.


"The tobacco industry documents confirm that the tobacco industry has promoted and supported strategies that are ineffective in reducing smoking by youth, and opposed strategies that have proven to be effective."


Here's the PDF of the scanned 1997 report about Kestrel, linked from that article.

Know what a kestrel is? It's a hawk that preys on small animals.

So when I read "Cerberus," I took it for granted that the whole idea was a blunt candid version of a proven profit model: the "captive market."

e-Patient Dave said...

Apologies, left out the URL to the journal article. It's here.