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The Greater Fool

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.

Paul Levy is the former President and CEO of Beth Israel Deconess Medical Center in Boston. For the past five years, he blogged about his experiences in an online journal, Running a Hospital. He now writes as an advocate for patient-centered care, eliminating preventable harm, transparency of clinical outcomes, and front-line driven process improvement at Not Running a Hospital.

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10 replies »

  1. First, I agree that there are not many obvious economies of scale that accrue to large hospital systems. The largest cost, by far, to run a hospital is staff salaries and benefits. Second, I also agree that most hospital consolidation so far has been largely motivated by the higher insurance reimbursements that flow from increased local or regional market power.
    That said, there are a number of important trends that could mitigate future cost growth that are starting to take hold. The first, as Maggie Mahar mentioned, is consolidation among insurers. This will be helped along by PPACA as technology and scale become more important in the insurance sector. Within Massachusetts, the #2 and #3 insurers, Harvard-Pilgrim and Tufts, are talking about merging which would enable both to better compete with BCBS of MA. Second, employers are finally showing more interest in both narrow network products and tiered networks. Third, new approaches like BCBS of MA’s Alternative Quality Contract will be interesting to watch. Under this approach, provider groups who control costs within an agreed upon budget can share in the savings assuming they also meet their quality goals. This gives them an incentive to ensure that their patients get care from the most cost-effective specialists and hospitals.
    As for the most sophisticated procedures that community hospitals generally can’t handle, I wonder if Paul or anyone else has any data as to the percentage of teaching hospital revenue that these procedures account for. Even in the case of hard organ transplants, if the price disparity among hospitals that perform these is wide enough, medical tourism within the U.S. might be a viable option creating national competition for the big name medical centers.
    I also think for profit hospital groups would be quicker to close or at least downsize antiquated, underperforming hospitals or facilities with persistently low occupancy rates that are unlikely to turn profitable anytime soon. While unpleasant, especially for workers who would lose their jobs, rationalization of capacity in the market would come sooner rather than later with likely positive effects on systemwide healthcare costs.

  2. “And I suspect that they will be standing up to large
    hospitals–refusing to overpay”
    Recently here UNC hosptial and Aetna could not agree on contract so UNC just decided to not accept Aetna insurance. Anyone using Aetna at UNC will have to pay out-of-network. Of course BCBS commands most of the premiums so I don’t know how much patient volume leverage Aetna held – I guess not much.

  3. Paul—
    This is an excellent post–thank you.
    I agree, we’re looking at another bubble.
    And Bill is right — M&A’s in the hospital industry don’t seem to lower costs, though they do create pricing power.
    But under reform, private insurers also will be consolidating. We’ll wind up with fewer,large insurers.
    And I suspect that they will be standing up to large
    hospitals–refusing to overpay– because under the ACA, they’ll have a harder time passing excess charges on in the form of higher premiums.
    Insurers are likely to follow Medicare’s lead–and Medicare will be focusing on paying for quality, not volume. That means rewards for providers who manage to keep patients out of hospitals.
    We won’t need more beds (in most parts of the country) and we don’t need to replace aging hospitals with new inpatient facilities. Sub-par institutions should be closed down. In many areas, they will be replaced with the new and expanded community clinics that the ACA is funding. The goal of these clinics: to manages chronic diseases so that patients don’t land in the hospital.

  4. Bubbles (market hype and/or just plain fraud) are sustained when the players think there is an unlimited number of new investors with unlimited cash and no end to increasing price tolerance. Health care is a little different as it’s more need than want, but how long can the system just keep eating itself with annual 6%-10% compounded price increases. The new “solutions” don’t address prices or costs they just want to repackage the insurance and offload the risk to patients. A recent capital bond prospectus from my wife’s hospital contained no assurances of projected income as to how the investors were to be repaid. It was like Enron’s “trust me” sales pitch. The hospital of course took on no risk and shouldered no responsibility as the success of the bond repayment.

  5. shouldn’t we be looking to replace capacity at poor performing old facilites 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.

  6. 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.

  7. 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?

  8. 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.

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