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Private Equity Funds Are Changing the Face of U.S. Hospitals

Private equity funds roared into many hospital executives' consciousness last year with two huge purchases of non-profit hospitals, and they are continuing to make their presence felt.

The private equity fund Cerberus Capital Management bought Caritas Christi in Boston for $900 million and Vanguard Health Systems bought Detroit Medical Center for $1.5 billion, backed by two large funds, Blackstone Group and Morgan Stanley Capital Partners.

Then in March of this year, HCA's initial public offering, backed by KKR & Co., Bain Capital and Bank of America, became the biggest private equity-backed offering ever, raising about $3.79 billion.

Private equity funds appear to be in acquisition mode.. Seattle-based Pitchbook reported in its annual Private Equity Fund Breakdown that "One of the more notable trends that developed during the year was an increase in appetite for larger deals, which was driven by the increased availability of leverage."

These funds are developing a strong interest in the healthcare sector, including hospitals. A Pepperdine University poll at the end of last year found that 11 percent of private equity executives polled said they planned to invest in healthcare, up from 4.8 percent in summer 2010. "There will be aggregation of existing hospital companies, diversification into outpatient sectors and more jostling among companies to pick up larger positions in local markets," Scott Mackesy, a general partner with the private equity firm Welsh Carson Anderson & Stowe, told the Wall Street Journal last year.

Conditions are ripe
Private equity firms are jumping into the hospital arena because of a growing need for their money. Hospitals require funding to invest in IT and prepare for healthcare reform, but "Traditional financing is harder to get," says Trey Crabb, president of Health Strategy Partners in Nashville, Tenn. "Banks pulled back from loans in the credit crunch. Now, the most favorable terms are only available to the larger healthcare companies."

In addition, "Hospitals are not performing as well as they used to, so it is harder for them to get the loans they need from the traditional sources," says David O. Neighbours, a partner at Waud Capital Partners, a healthcare private equity firm in Chicago. "Hospitals that used to have 3 percent operating margins are now breaking even or losing money. When that happens, no one wants to lend you money."

Well-managed hospitals, on the other hand, see an opportunity to buy distressed hospitals, but they first need the funds to do so. "Without private equity, hospitals can't get enough money to go out and buy other hospitals," Mr. Neighbours says. "That's why Vanguard needs Blackstone's capital."

Hospitals that might once have resisted for-profit takeovers are now rushing into the for-profits' arms. In Dec. 2010, when Holy Cross Hospital in Chicago signed a definitive agreement to join Vanguard, Sister Immacula Wendt, representing the Roman Catholic order that owned Holy Cross, stated, "Vanguard’s stewardship will remove the financial clouds that have threatened the hospital’s future and our new partner will invest a significant amount in sorely needed infrastructure improvements."

What private equity firms provide
In return for pumping large sums of money into healthcare, private equity arrangements demand a higher rate of return than can be found in more traditional investments like the stock market. In addition to their fees, PE firms keep 20 percent of the proceeds. That means fund managers have to ensure significant profits. These can be found in struggling hospitals where there is a great opportunity to make money in a turnaround.   

Private equity investments are typically committed for a 10-year period, in which the firms have six years to use the committed funds, called a "use it or lose it" provision. Private equity investors are "a fairly patient lot," says Adley Bowden, managing editor of Pitchbook. "They go for the long haul."

They are patient but also daring. "They're not afraid of doing turnarounds and jumping into underserved areas," says Linda Klute, national healthcare practice leader at Tatum, an executive services firm in Atlanta. They even have the temerity to go after bankrupt hospitals. For example, IASIS Healthcare, backed by TPG Capital, JLL Partners and Trimaran Fund Management, recently agreed to buy a majority stake in St. Joseph Medical Center in Houston, as part of Chapter 7 bankruptcy of the hospital's majority owner.

"When the private equity funds take up a struggling hospital, their aim is to add value to it," Mr. Bowden says. "They are going to make a great deal of money with hospitals that do well." The key, of course, is to improve efficiency. "The firms go in there and improve revenue cycle, introduce process improvement, and launch a service line or product lines," says Joe Burkhart, managing director of private equity at Tatum, a locum tenons executive firm in Atlanta.

An excellent management team is critical to making this work. Private equity firms are able to recruit the very best management in the business because they pay top dollar. "Without a private equity fund, do you think a hospital in bankruptcy would be able to hire a high-caliber management team?" Mr. Neighbours says. "These firms are bringing in a whole different system of accountability."   

Partnering with non-profits
Private equity is not just available to for-profit companies, but can also be tapped into by large non-profit systems. In February, for example, Ascension Health formed a joint venture with Oak Hill Capital Partners with the expressed goal of buying Catholic hospitals so that they would not be sold to for-profit organizations.

Sensitive to non-profit hospitals' resistance to for-profit takeovers, some private equity companies are allowing hospitals to keep their management and governance in place. For example, LHP Hospital Group, backed by CCMP Capital Advisors and Canada Pension Plan Investment Board, recently entered into a joint venture with Saint Mary's Hospital in Waterbury, Conn., valued at $135 million. LHP is the majority owner but the governance structure will be equally shared and local control and hospital leadership of the hospital are protected.

Mr. Neighbours says in such an arrangement, the hospital's management team would have to be well regarded for the private equity firm to agree to keeping it on. He adds that hospitals in such deals may be doing relatively well but may need extra cash for projects like acquiring other facilities or putting in an electronic health record.

Turning into permanent companies
The effect of the current huge infusion of private equity funding will be to create new, mostly for-profit hospital systems. On a set date, private equity funds want their money back, requiring the hospital company to raise the funds needed to pay them. If they have been turned around, it will be easier to borrow the funds or raise money in the stock market. This switchover will eventually impact systems with large private equity backing like Vanguard or RegionalCare, a Brentwood, Tenn.-based system that was formed by a $300 million infusion from the private equity firm of Warburg Pincus in 2009.

Private equity has the opportunity to do a whole lot of good for U.S. hospitals, Mr. Neighbours says. The work that such funds put in is "not a quick flip," he says. "They will be improving the profitability of the hospital. They will make it better for patients, the doctors and the community. Without private equity, many of these hospitals would have had to close."

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