A modest proposal

I’m going to offer an idea that is so outrageous it might actually have merit.  This concerns the Boston area health care market, but my readers from other regions might also find it of interest.

There are two health care entities in Massachusetts that face uncertain futures.  One is Tufts Medical Center, a relatively small but highly respected academic medical center with a notable history, going all the way back to its antecedent’s founding by Paul Revere and other patriots. The other is Steward Health Care, a chain of hospitals purchased from the Boston Archdiocese several years ago by a private equity company, which converted it into a for-profit organization.

Not withstanding superb executive and board leadership over the past dozen years and a dedicated medical staff, Tufts remains trapped by the lack of an extensive referral network of doctors and community hospitals.  It suffers, too, from some bad luck going back to leadership decisions made several decades ago.  For example, although located in Boston’s Chinatown neighborhood, the community health center serving that densely populated neighborhood decided to affiliate itself with another academic medical center several miles away.  When people in Boston say, as they sometimes do, that there are too many academic medical centers in town, Tufts is the one that is most often suggested for elimination.  Such facile comments are, of course, unfair, in that the quality of clinical care, teaching, and research at Tufts is excellent: Were this institution to close, the community and the world would suffer a true loss.

Nonetheless, in the changing world of healthcare, a lonely academic medical center surrounded by other such centers with large (and growing networks) is at a disadvantage.  Tuft’s inability to keep and create significant strategic alliances with physician groups and community hospitals is a major vulnerability going forward.

Steward Health Care presents a totally different performance problem.  Owned by a private equity firm, the hospital system’s leadership has done what private equity managers do.  Assets have been stripped away to create cash flow for the owner. Actions have been taken to increase the top line performance of the company: Acquire, at high price, physician practices to increase referrals; sign front-ended loaded global payment contracts with the largest insurance company; sell (and lease back) real estate; sell clinical laboratories (and enter into a long-term vendor relationship with the purchasing firm); and minimize capital investment in the system, to produce earnings before depreciation that look robust.

But even those steps cannot hide the fact that actually running a hospital system in the Massachusetts market is not a highly profitable enterprise.  Payment increases from private insurers, Medicare, and Medicaid seldom rise at rates greater than overall inflation. Meanwhile, service worker unions expect wage and salary increases to exceed that rate of inflation. Renewal and replacement of capital facilities and medical equipment by far exceeds the original cost of such investments. A for-profit firm faces the additional challenges of relying on taxable debt rather than tax-exempt debt; having to pay sales tax, local property taxes, and the like; and being unlikely to attract philanthropy to support its programs.

The private equity business model calls for a sale (or flip) of purchased companies within a short time frame. Indeed, the investors in private equity funds are promised such terms.  In general, two types of sales are envisioned: An initial public offering, in which the company’s shares are offered to the general marketplace; or a secondary sale to another firm in the private equity market. In either event, the selling entity needs to create a colorable story that the enterprise has a high chance of financial success, meeting the hurdle rate of the new investors.

From reports I see in the media, it is unclear to me that Steward has much to offer to new investors.  As mentioned, its financial strategy seems to have been tied to stripping cash out, leaving questionable value for the next investor. Profitability seems difficult to achieve. Indeed, we can imagine the current firm seeking concessions from its labor unions and perhaps even asking for property tax relief from municipalities if its earnings deteriorate significantly. Such actions would be a precursor to a loss of political support.

There is talk of selling Steward to one of the large American private hospital companies.  But what can Steward’s owners truly expect such a company to offer in the way of a purchase price, when the likelihood of the system meeting a private market’s hurdle rate is so small? If I were the current owner, I would be searching for a way to get out—to take solace in the cash I have been able to extract, and to avoid the possible future costs of running the system.  Indeed, I might even be willing to give away the investment to cut future losses and report a reasonably successful investment result to my private equity fund participants.

It is that thought that swiftly leads me to today’s modest proposal. I suggest that Tufts and Steward would both be better off if they reach an agreement under which Steward sells itself to Tufts for $1and in which the hospitals in the Steward network are re-established as non-profit institutions within a greatly expanded Tufts network of physician groups and community hospitals.  Overnight, Tufts would become the second or third largest health care network in the state, with outposts throughout the Boston metropolitan area.  It would thereby enhance its ability to negotiate with the private insurance companies.  Steward’s tertiary referrals, which today go to the high-priced Partners Healthcare System, would instead be treated at Tufts’ main campus in Boston, offering lower priced care of equal quality. As non-profits, the community hospitals could again return to their tax-exempt status, saving millions in costs over the coming years and benefitting from the generosity of local donors. And, by the way, the two hospital systems are already part of the Tufts Medical School training program, so there are benefits of better coordination for graduate and undergraduate medical education.

How crazy is this? If you think through the alternatives for the two parties, the approach I outline doesn’t look so bad—and could look quite good.  The public policy ramifications are also positive: Beyond solving the sentimental problem of keeping Paul Revere’s legacy alive, the proposal offers the potential for the entry of a third vibrant competitor in a health care marketplace that is looking more and more like a duopoly.  Contestability in this sector requires at least three competitors.  This proposal could help make that scenario more likely.