The Not For-Profit / For-Profit Divide

Picture 3Many people involved in hospitals wonder how it can be financially prudent for investors to put their money into for-profit ventures that buy non-profit hospitals. (Examples here and here.) After all, the argument goes, the newly privatized entities will have to pay taxes, issue taxable rather than tax-exempt debt, lose the benefit of philanthropy, and otherwise be at a competitive disadvantage compared to their antecedents.

In answer, some might make the case that for-profit firms will run hospitals more efficiently. But this is an unproven and unreliable basis for such transactions. Even if there were some efficiency gains, they would be unlikely to offset the additional costs listed above.

No, the answer lies in the risk-reward expectations of equity investors and of purchasers of high-yield taxable debt.* Those expectations are quite different from purchasers of the municipal or other tax-exempt bonds that support the capital needs of non-profit hospitals. It is the difference between a forward-looking, optimistic view of the world and a backward-looking, cautious view of the world.

Let’s start with the tax-exempt debt market, one characterized by risk-averse investors focused on debt coverage ratios and other protections built into indenture agreements.

The rating agencies who serve these investors look at the past performance of the non-profit hospitals and ask, “What could go wrong in the future that might put debt service at risk?” There is a highly limited pool of people interested in such debt, and when ratings fall to near or below investor grade, the number of investors becomes smaller still.

Contrast this with people willing to risk their money in the for-profit world. They are sold on the potential for financial gain, not on the proposition of protecting principal. Those offering this paper present business plans and pro forma’s based on what might be. Sure, due diligence allows an assessment of the downside, but this pool of investors has hedged their bets by building a diversified portfolio.

How does an equity investor make money in this kind of transaction? Leverage is important. The capital structure of theses deals includes equity, but also a significant component of debt. If the hospital throws off enough cash to pay down the debt, the equity holders see a growing opportunity to earn a current cash return. And hospitals do throw off enough cash—even hospitals with low or zero margins.

Why? Because the income statement includes a substantial non-cash expense, depreciation. It is the earnings before depreciation that are most meaningful to these investors. As long as immediate capital needs do not exceed available cash, debt will be serviced and equity will likely be rewarded as well on a current basis.

The real payoff, though, occurs when the properties are flipped to another purchaser after a few years.** By then, debt levels have been reduced, and the proceeds from the asset sales enure mainly to the benefit of the shareholders.

We are currently in a phase of capital markets in the United States in which there is a virtually insatiable demand for equity investments of this sort, and also for high yield debt that supports each deal’s overall financial structure.

We are also in a period in which non-profit hospital boards and tax-exempt investors are worried about the future. In an odd divergence of perspectives, non-profits worry about decreased reimbursement levels resulting from the national health care reform law; they therefore fear that they will lack capital for renewal and replacement of physical facilities and clinical equipment. For-profit investors, in contrast, see the new law as enabling an increased number of insured citizens to show up as patients in their hospitals; they therefore look forward to growing cash flows to reward their risk-taking.

Mark Twain said, “It is difference of opinion that makes a horse race.” Here it is the verve and optimism of the equity markets compared to the caution and pessimism of the non-profit sector. Expect a huge influx of investment capital to change the face of the hospital world over the next two years.

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  1. It has hit the streets and now people are asking whats up with this International Boycott Of The Arabic Drug Empire ? Why so many supporters and no one is challenging this movement. We vote no to Prop: 19 and by the way we no vote to methylenedioxymethamphetamine, also known as Ecstasy a Healthcare Concept for our Vets…linked here,
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  2. I recently heard someone refer to Community Health Systems as the next Wal-Mart of healthcare. It certainly seems that might be a possibility. They are aggressively buying up mostly small hospitals that are struggling financially and then expecting the community to conform to their practices and protocols. I would like to hear from others about their experiences with CHS, both bad or good.

  3. If non-profit healthcare organizations were run as a for-profit organization, and for-profit organizations made the bottom line as patient outcomes, then value would be added to both sectors; with the dollar value added or lost becoming a secondary outcome.
    The current debate leaves the most important part of the equation out-The Patient and their needs!
    George Cheriyan
    American Mission Hospital, Bahrain

  4. I worked ever so briefly for Tenet Healthcare and what I witnessed was disgusting. This for profit entity was all about driving profits, setting unrealistic goals for departments and compromising patient care. The management team bullied department heads. The only reason quality was discussed in meetings was because Medicare would not pay for the hospital stay of a patient/beneficiary who received sub-par care. If I ever get sick, please take me to a not for profit.

  5. Beautifully explained. This divide holds very true for other industries as well.
    On a second note, any healthcare reform broadly covers two aspects – coverage expansion and effective systems and when it comes to applying, we see a more bias towards coverage expansion.
    What do the others say?

  6. In fact Nate, my claim is based on a medical doctor living in CA at that time and being daily involved in insurance working with and against them. I’d be careful of your disingenuous phrases.

  7. “California Blue Cross, was a non-profit organization that provided very adequate health care coverage. It was when they were taken over by Wellpoint, turned it into a for-profit and abruptly without explanation began denying coverages and treatments.”
    You base this on what Greg? Having lived in CA at that time and being daily involved in insurance working with and against them your claim is absolutly false and lacking any basis of truth.

  8. I have been so out of touch with this world and the issues within, and because of this system failure of brought on by this 9/11 , War and the Scams that brought the American People to their knees. I am a little bit angry, because some one said to me why, why Mr. Massingale do you persist? Because I choose to. I do not belong in this world of a Matrix, that most hold in the hearts as if it is all that.
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    The most hospitalizations were caused by painkillers, with visits more than doubling, and tranquilizers, with an 89 percent increase. King Pharmaceuticals Inc., in Bristol Tennessee, and Purdue Pharma LP, in Stamford, Connecticut, won approval in the last year for drugs to prevent misuse. A half-dozen drugmakers are developing pain pills that resist abuse methods such as crushing, dissolving in alcohol, and taking more than needed.
    “Additional measures are needed urgently,” researchers wrote in the CDC’s Morbidity & Mortality Weekly Report. “Recent public health and law enforcement measures intended to prevent nonmedical use of such drugs have not prevented rate increases.”
    The biggest increase in emergency visits was from adults in their 20s, according to the study. The researchers analyzed reports from 220 emergency departments across the U.S. to estimate the nation’s tally.
    –Editors: Bruce Rule, Jeffrey Tannenbaum
    To contact the reporter on this story: Tom Randall in New York at trandall6@bloomberg.net.
    To contact the editor responsible for this story: Reg Gale at rgale5@bloomberg.net.
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  9. California Blue Cross, was a non-profit organization that provided very adequate health care coverage. It was when they were taken over by Wellpoint, turned it into a for-profit and abruptly without explanation began denying coverages and treatments. They now had to show some kind of profit for their shareholders by denying some coverages and treatments.
    The desire for profit margins translates into less healthcare for patients in hospitals and other medical institutions. They must choose between increasing the profit margins of their individual facilities or supplying more support staff for the care of patients.
    Hell, the Pennsylvania Patient Safety Authority contracts with for-profit entities to collect, analyze and evaluate data regarding reports of serious events and incidents, transmit to the Authority recommendations for changes in health care practices and procedures and advise reporting medical facilities of immediate changes that could be instituted to reduce serious events and incidents.
    This sounds very much like privately-financed (i.e. big pharma) clinical trials. There is a tendency for major drug manufacturers to hide data about the safety and efficacy of its drugs, and produce data of scant clinical value. As a result, conflicts of interest have thoroughly corrupted American medical research. There are dangerous potential for conflicts of interest when pharmaceutical and other for-profit businesses control the dissemination of findings generated by medical research.
    Yea! I really support for-profit incentives when it comes to healthcare, like I need a hole in my head.

  10. hopefully there is a lot of for profit investors out there waiting, in the next 5 years there are going to be a number of public hospitals put up for sale. State and local government in good times could fund the inefficency of public hospitals, with the current debt crisis it can’t continue. UMC in Vegas would be the perfect start. After a decade plus of mismanagment, including a corrupt administrator from chicago, who would have ever expected that, the county just can’t afford it. It will either close or sell. Better to sell it and pay for charity care then continue to lose 30 million plus per year.