Wednesday, January 02, 2013

Beyond guns and gurneys

A friend sent a note a few days ago, citing an "an amazing op-ed on Newtown, Cerberus, and Steward" by a Boston Globe columnist.  The piece by Joan Venocchi was, indeed, hard-hitting about the fact that the private equity firm, Cerberus, owned both a major gun company and a hospital chain.

Any proceeds from the sale of Freedom Group now amounts to blood money. Why not invest it in a fund dedicated to the memories of those dead children and educators? Put it into schools or mental health programs. Pour it into something that nurtures and heals to atone for the fact that it flows from something that destroyed life, family and community.

She went further and called on the CEO of Steward Healthcare to take the lead on this proposal.

Well, yes, but the point that has been missed by the media relates to the ethical question of whether a private equity firm can properly represent the community's interest when it owns a chain of hospitals--irrespective of whether it also owns a gun company.

Over the course of several months, I set forth the business strategy of this and other private equity firms as they accumulate their portfolios of hospitals.*

There is nothing inherently wrong with for-profit ownership of health care facilities.  But if the purpose is to own the assets for a short period of time and flip them during an IPO or other financial maneuver, then questions of community purpose must arise.

Why is this an ethical question?  Private equity works by creating financial value for investors, with that value being extracted, first, during the pendency of the ownership.  How?  As I have summarized:

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.

The next phase of gaining value for the private equity investors occurs when the assets are sold to the next round of investors.  To make this work, that next round of investors has to be persuaded that their return on capital will be comparable to that received for investments of equivalent risk in the marketplace.

Given the financial realities facing hospitals in the future, sale of this kind of asset in the public marketplace has to rely on the "greater fool" theory.  As I have noted:

[E]ven if you believe that more people will have health insurance than in the past, this does not mean that the fees paid to hospitals will be fully compensatory. Unlike private equity firms, which can maintain cash flow to their investors by employing a high degree of leverage and not funding depreciation, a public company rises or falls based on the total margins produced by the hospitals. Those margins will be under substantial pressure for years to come, especially as hospitals face the need to fund deferred maintenance. Further, as for-profit entities, those hospitals will have to pay local property, sales, and income taxes. They also lose their ability to use the federal tax code to help generate substantial philanthropy and to garner lower interest rates on bond issues.

What happens then? A company whose value has been stripped away becomes a self-standing business unit owned in the public equity marketplace, facing the same kind of cost pressures and reimbursement constraints of all other hospitals.  I have yet to find a financial analyst who believes that the ongoing return on that investment will be sufficient to support the capital improvements needed for renewal and replacement of the essential clinical purchases required by the communities in which those hospitals are located.

This is what raises the ethical issue.  Who stands by to rescue decapitalizing for-profit hospitals in community settings, particularly if a number of those hospitals are safety-net facilities serving the indigent in cities scattered throughout a state?  There are only two answers: (1) Purchase of those hospitals by cash-strapped municipalities, perhaps with state assistance or (2) acquisition by those hospitals by the dominant non-profit hospital chain in the state--probably in response to panicked concern by mayors, legislators, and the governor--enhancing its monopoly position.  Neither result would be in the public interest.

* Here's a listing of those posts:

July 1, 2010:  Verve and optimism versus caution and pessimism
September 20, 2010: Seven is not a natural
September 26, 2010: Accelerated depreciation
October 5, 2010:  When exuberance fades
October 12, 2010:  A new wave in Massachusetts
February 5, 2011:  Is the "greater fool" theory alive in the hospital world?
February 13, 2011:  I was not skeptical enough
February 23, 2011:  Expand and acquire to prepare for the IPO
August 15, 2012:  Let's do the numbers

1 comment:

Anonymous said...

How timely; this just appeared in my mailbox today:

Of course, this article assumes that the for-profits intend to operate rather than flip the hospitals. However, one might cite HCA as an example; despite multiple 'flips' between public and private, they still operate hospitals. Sleazy? Perhaps. I can't help but wonder, but there are no studies showing their care is inferior.