Private Equity and Non-Profit Hospitals: Strange Bedfellows or Saving Grace?
Consolidation activity in the healthcare industry has been accelerating for several years, driven by changes in reimbursement, spikes in the rate of the uninsured and major shifts on the horizon in light of government health reforms. That's led systems small and large to buddy up in partnerships ranging from simple clinical affiliations to corporate mergers and sales. But, one type of transaction may be picking up in popularity: non-profit hospitals and health systems partnering with private equity firms.
That's been evidenced by three recent high-profile examples. In 2010, Boston-based Caritas Christi Health System was acquired by Steward Health System, an entity created by private equity group Cerberus Capital Management. In the same year, Nashville, Tenn.-based Vanguard Health Systems, owned by private equity firm Blackstone Group, bought out the ailing Detroit Medical Center. And Catholic health giant Ascension Health, based in St. Louis, formed a funding joint venture in 2011 with Oak Hill Capital Partners, also a private equity investor.
The appeal of private equity"The major non -profit systems around the country are talking strategically. They want to get bigger," often through partnering with others, says Adam Buchanan, vice president of municipal credit at Ziegler, a specialty healthcare investment bank. "I think the private equity side of it is a little more unique."
Sometimes the smaller systems seek the big private equity-backed partners in order to stay relevant, as in the case of DMC, or in order to compete in a saturated market like Caritas in Boston, Mr. Buchanan says. But, the larger multistate system's use of private equity partnerships is for strategic purposes. "The Ascension Health System and Oakhill Private Equity Fund joint venture provides Ascension access to capital to acquire mission-driven smaller facilities and systems," he says.
That model is one that's becoming a favorite of non-profit buyers, says Jonathan Spees, a senior vice president with healthcare management consulting company The Camden Group and the founder and owner of two private equity-backed hospital companies. The for-profit entity buys up hospitals for the non-profit partner in the joint venture. "Instead of using their own capital, [the non-profit] gets to acquire ownership and at least some measure of control [over the acquired hospitals]," he explains. The private equity body is the taxpaying entity and pays a share of dividends or proceeds, but is not subject to the same non-profit regulations. Communities, if they can be assuaged that charity care and services won't suffer, may support these agreements for the increased tax base a for-profit can bring.
"Private equity's biggest draw for non-profit hospitals is the access to capital made available in such partnerships," says Patrick Pilch, managing director at BDO Consulting. "Specifically, many hospitals are using private equity capital to secure the appropriate IT platforms, which provide connectivity that is essential under health reform. In addition to enabling significant investments in infrastructure and other capital investments, private equity capital can be particularly attractive because it may assume a system's liabilities as well as assets."
What's in it for private equity?The latest deals are still new, and there's not enough historical data of private equity firms throwing their hats into the non-profit hospital ring to know what a typical return on investment would be, but in other industries returns yield 10 to 20 percent annually to private equity investors, Mr. Spees says. That's a much higher operating margin than many small non-profit hospitals clear. "Changes in reimbursement methodologies does make it riskier than in the past, in my opinion," he says, but "since they're definitely contributing capital to this industry, they've concluded that it's not too risky."
Although it would seem non-profits with charitable missions or uncompensated care requirements would be unattractive investment picks, Mr. Pilch says "Private equity doesn't necessarily balk at these opportunities because some people will only go to a non-profit, religious, academic or charitable system."
The turnaround time for these deals ranges from three to 10 years, with the average falling somewhere between five and seven years, he says. That short turnaround time and high margin means private equity enters agreements with a detailed exit strategy, building the features future buyers will want and pruning what they don't. That way, when the purchased hospital or system is sold, the short-term private equity partnership can be replaced with a long-term and sustainable one.
For that reason, Mr. Spees says, non-profits may consider private equity to help dress them for a future partnership deal. "Every non-profit who's considering entering into this path establishes the guiding principles that they'll use to guide a pending transaction, review the proposals they'll receive, and the transaction is outlined in their guiding principles."
The case against private equityBut private equity deals are not simply a windfall for failing or cash-strapped hospitals. David Kirshner, director and senior CFO consultant at Warbird Consulting, said he's skeptical private equity will become a big and growing trend for non-profit health systems.
"Eighty percent of hospitals are tax exempt, and the primary reason they stay that way is because they're able to acquire capital at low-cost rates [through debt markets] and pay no property or sales taxes," he says. "The lion's share of reasoning is that there's a huge advantage to staying non-profit…Private equity is going to be much more expensive."
Selling a hospital's controlling interest to a private equity firm that aims to earn a tidy profit in a short time horizon may compromise a hospital with a faith-based or charitable mission, Mr. Kirshner says. "Generally speaking, for the trustees, there's a lot of soul-searching that is done, one reason why it hasn't been done much yet."
However, Mr. Pilch of BDO maintains private equity ownership can allow for non-profit hospitals and health systems to revert to non-profit status and such an agreement to do so can be made prior to the deal's closing to maintain the hospital's mission or even grant original operators is temporary and hospitals may be sold again to non-profit operators. Furthermore, agreements can be made before the deal's closing to maintain the hospital's mission or even grant original operators commanding governance on some issues.
While non-profit health systems currently have access to cost-effective capital through the issuance of municipal bonds, Mr. Buchanan notes Moody's Investors Service downgraded $20 billion of debt in this sector last year. Lower credit ratings make it more difficult and expensive to issue tax-exempt bonds, and capital needs are great. Considering more than 60 percent of the downgrades occurred at hospitals with less than $500 million in top line revenue, and that Moody's has maintained a negative credit outlook for non-profit hospitals since 2008, Mr. Buchanan says private equity is likely to remain a consideration for non-profits looking at partnership possibilities.
"CEOs, CFOs and boards should look at all partners and available sources of capital, assess them and make sure that any arrangements make sense for their hospital, their system and their communities," Mr. Pilch says. "One size does not fit all. The decision needs to incorporate and address such questions as, 'What is our strategy, what is our mission and what are we going to be?'
"I do believe private equity-backed firms can offer a viable model for non-profits to consider. They can be a win-win opportunity where the non-profit legacy continues to be involved post-transaction," Mr. Pilch adds. "In many cases, the discipline operationally and capital-wise that's brought by a private equity firm can be a major factor in keeping the system healthy and sustainable."
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