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 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.

Paul Levy is the former President and CEO of Beth Israel Deconess Medical Center in Boston, where he blogged for several years 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. I see non-profit hospitals worse than profit. Non-profit hide the money that goes to administration with million dollar payouts in salary. I saw a local non-profit more corrupt than anything I saw while working for government and that is saying a lot.

  2. In the future there will probably be fewer commercial insurance companies and they will be under more pressure to decrease costs. This development will make it harder for the HCAs of the world to cost shift, and the pressure on physicians at such facilities to provide more care than necessary or supported by evidence based medicine guidelines will only increase. Paul’s three disadvantages of for profit hospitals make such investments risky long-term.

  3. For years, I read about KKR and the impact of private equity on organizations and the squeeze out for short term profits. It was only recently, however, that I had the pleasure of working in an organization that was bought out by a private equity firm. The 2 methods of generating returns was clearly evident – (1) a massive focus on top line growth/generating revenue, even at the sacrifice of longer term principles and the underlying guiding values of the company and (2) setting up the company for the greater fool that will come along and buy them out, thus generating the return that the firm and investors were seeking. I have watched nearly all of the prior leadership leave and a total overhaul in staffing and the day to day goals of the company.

    A terrific analysis, Paul, and a welcome step away from the incessant discussions on quality and outcome (which though important, don’t cover some of these critical issues). I also agree with the commenter who mentioned that discussing case mix almost detracts from the financial maneuvering where the attention should be focussed. The problem becomes that when you’re cherry picking the ‘best’ (most financially lucrative) patients, to manipulate your case mix, that is part of the financial maneuvering that should also get some public scrutiny (see the NYT article about hospitals having to continue to take care of lower economic means patients for care which will unreimbursed under the new rules).

  4. There are surprisingly few economies of scale in the capital intensive hospital business. Equipment and supplies account for only about 15%-20% of the cost base for most hospitals. Labor and benefits are the biggest cost component by far at around 60% of costs. Every hospital in a market or region needs to pay a roughly comparable market rate for pay and benefits to its employees it is not likely that any hospital has a cost advantage there. At the same time, as Paul noted, the for-profit hospitals incur higher costs for taxes and capital costs than non-profit hospitals.

    For private equity firms to make money with a highly leveraged capital structure, they need to grow revenues at a respectable rate and they need a comparatively rich case mix and payer mix. That means lots of lucrative surgical procedures and an above average percentage of commercially insured patients. At the same time, there is a long term secular decline in the number of inpatient bed days per thousand insured members as more procedures are done on an outpatient basis and / or inpatient procedures are done in less time and / or new drugs can manage the condition without hospitalization at all or at least shorten the stay from what it was in the past. In short, it’s not the part of the medical business I would want to be in if my primary interest were making money. Drugs and devices are much more promising from that standpoint.

  5. The NYT reporters, to a degree, along with many commenters on the stories, do HCA a favor by overreaching for a Bain/Romney connection that isn’t there, thus obscuring the more damning elements of the stories.

  6. Wow, a truly incisive analysis. Questions about patient mix are a sideline to the huge cash flow maneuvers described.

  7. In early 2011, I attended one of the “Road Show” luncheon meetings for analysts and portfolio managers prior to HCA’s IPO. During the Q&A period, I asked the management to speak to the difference between HCA’s average reimbursement rates per adjusted admission for commercially insured patients vs. Medicare patients. The response was that HCA was paid roughly 60% more for commercially insured patients even though the average acuity of the Medicare patients was higher.

    Not only is this a clear example of cost shifting but it also shows how a hospital system can earn well above average returns if it has a comparatively rich mix of commercially insured patients vs. Medicare, Medicaid and uninsured patients. As an aside, HCA’s stock price is still 12% below the IPO price so the public investors have not (yet) done very well here.

  8. All excellent points, but I need to note that nonprofit hospitals behave in similar ways that for profit hospitals behave. They are also bureaucratic and nonresponsive to patients concerns and don’t even get me started on charity and uninsured care. I’ve seen more nonprofits ruin patients credit ratings than the for profits.

    At least the for profit hospitals are honest in the way the acknowledge their fiduciary responsibility to maximize the firm’s value for their shareholders. That’s much clearer than “community benefits.”

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