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.