Private Equity Interest In Nonprofit Hospitals Growing

Private equity firms are demonstrating a growing interest in the healthcare sector, and, with shrinking margins and growing capital expenses, many nonprofit healthcare organizations would welcome the attention. However, caution is merited before considering this approach.

"We're seeing lots of acquisitions of physician groups and more consolidation," says Brian Miller, president and founder of the nonprofit Healthcare Private Equity Association and managing partner in the Chicago-based private equity firm Linden Capital Partners. "As the healthcare landscape shifts … if a hospital can't afford an acquisition today they may look to partner with a private equity firm."

Growth tops the long-term strategic goals of many nonprofit healthcare organizations, and mergers and acquisitions and bricks-and-mortar expansions are two paths to achieve that end. The 2011 HealthLeaders Media Industry Survey showed nearly 46% of finance leaders anticipated either acquiring an organization or being acquired by another. Also, 26% of leaders plan their capital budgets for a new wing or building, according to the HealthLeaders Media Intelligence Report, 2011 Capital Spend: EMR Dominates Budget. The same survey showed that 42% of healthcare leaders anticipate increasing their capital expenditures budgets.

Mergers and acquisitions as well as expansion require large sums of capital, something that is—without the help of an outside funding resource—in short supply for many nonprofit healthcare organizations; indeed, 38% of finance leaders at nonprofits reported margins of less than 1.5%, according to the 2011 HealthLeaders Media Industry Survey. Reduced levels of revenue through Medicaid, Medicare, and reduced financing through the bond market have challenged nonprofit hospitals that have deteriorating operating margins and degraded credit ratings due to so-so balance sheets.

Stirring private equity interest

Though some nonprofit hospitals and health systems continue to turn to debt leveraging as a means to pursue growth opportunities, others are turning to and being welcomed by private equity firms. A Pepperdine University survey of private equity executives at the end of 2010 found that 11% planned to invest in healthcare, more than double what it had been just six months prior, 4.8%.

Healthcare is underrepresented in the public asset classes, according to data provided by HCPEA. It represents just 12% of Standard & Poor's 500, but is 17% of the gross domestic product. Moreover, Miller explains that the total healthcare equity market cap is $1.3 trillion; however, only a sliver of that is represented by for-profit hospitals and health systems (note that nonprofit hospitals cannot be traded): • 70% pharma/biotech • 16% medtech • 8% managed care • 6% other (including hospitals, nursing, doctors, distribution, services, supplies, life science, etc.)

"Healthcare is so fragmented that the vast majority of healthcare companies are too small to be publicly traded. The only way to access this investment class is through investment in private companies via private equity funds," Miller says.

What makes these opportunities so appealing to private equity firms now has much to do with the Patient Protection and Affordable Care Act. Fitch Ratings recently reported that although nonprofit hospitals still face financial challenges, they will benefit from increases in patient volume and "dramatic reductions" in uncompensated care, and be helped by provisions in the legislation that will promote "efficiency and effectiveness in the delivery of care" via pilot programs and payment incentives. Nonprofit hospitals or systems that traditionally served a large proportion of the poor and uninsured are expected to benefit from the legislation, which will extend insurance to 32 million previously uninsured.

There have been numerous well-publicized agreements between private equity firms, such as the Blackstone Group, which acquired the majority share of the 16-hospital, Tennessee-based for-profit Vanguard Healthcare system. Another well-publicized deal was the buyout of Massachusetts-based Caritas Christi Health Care, which was a nonprofit, by Cerberus Capital Management. The 2010 sale not only gave Caritas a cash infusion, but altered its tax status to for-profit. These acquisitions moved to center stage the use of private equity capital as a strategic opportunity for healthcare leaders.

For instance, this past February, the nation's largest Catholic health system, Ascension Health, partnered with the Stamford, CT–based private equity firm Oak Hill Capital Partners, embarking on a joint venture to buy Catholic hospitals.

Leo P. Brideau, FACHE, president and CEO of the St. Louis–based Ascension Health Care Network, says the joint venture allows the organization to provide an alternative funding source for the acquisition of Catholic healthcare entities. He notes that through this partnership, Ascension will be able to offer financial, clinical, and operational resources to the entities it acquires. The system currently operates 68 acute care hospitals in 20 states and the District of Columbia, and Oak Hill Capital Partners has over $8.2 billion in total capital, a portion of which the organization can draw upon.

Brideau explained that Ascension Health Care recognized that to stay competitive and provide quality care, it needed to transform its system from acute care to a population health management approach; that required capital Ascension didn't have.

"Hospitals needed to invest in their technology and their facility to stay current, and the traditional approaches to doing this just didn't suffice—they have to be more creative," he says. "Before partnering with Oak Capital, our capital was spoken for by the needs of our hospitals. So, bringing in another hospital—especially one that might have significant capital needs—just wasn't feasible."

Brideau says seeing other Catholic hospitals financially flounder—only to be sold to non-Catholic entities—aligns with the organization's mission to grow its network of Catholic hospitals. The vision to strengthen Catholic healthcare was another driver for Ascension's partnership with Oak Hill Capital. Once the management team opted to go the private equity route, selecting a partner was a lengthy process. Finding firms with funds wasn't the issue, Brideau says; what made the process challenging was ensuring the right cultural fit. One of the deciding factors was Oak Hill Capital's agreement that Ascension Health would remain the sole authority over its Catholic healthcare identity, and that extends to any acquisitions.

Defining goals through due diligence

The core goal of a nonprofit hospital or health system is to provide patients with high-quality, cost-effective care, while earning a healthy margin; private equity firms have a different end goal. The general aim of a private equity firm is to achieve a large return on investment in the form of capital gains. How the private equity firm achieves those ends is where hospitals need to do their homework, Miller says. "Each equity firm has its own mission and values, and there are as many types of equity firms as there are hospitals," Miller says. "It's up to the hospital to do the due diligence and reference checks and to look at deals that these firms have done successfully and the ones that have gone south."

Though each agreement is different, in many instances the pathway to financial success is through an exit by the private equity firm, which may be through the sale of the equity stake rather than through a dividend income. In the case of Ascension Health Care, Brideau says there is no set exit date on Oak Hill's investment. Another key to its selection of this private equity firm, Brideau says, was the firm's approach to getting its return on investment.

"Many firms pay themselves a finder's fee so they can give it to the investors. Then they either charge a management fee or pay dividends to themselves as they go along. Oak Hill Capital doesn't take its profit until they exit. As the operator of a company, when you think about it, that's a terrific benefit because then their incentive is to make you as strong as possible for when they sell … and they aren't going to keep you capital-poor [in the process]."

Another exit strategy may also be through an initial public offering or a straight sale. This past spring, Vanguard Health Systems, which since 2004 has been majority-owned by private equity firm Blackstone Group, filed with the U.S. Securities and Exchange Commission to raise $600 million via an IPO.

The filing came not long after for-profit health system HCA raised $3.8 billion through the largest private equity-backed U.S. IPO on record. Due to the status of the pending IPO with the SEC, representatives from Vanguard Health Systems were not able to offer comment.

Regardless of how and when the profit is parceled out, once a private equity firm has made the investment, its primary objective is to generate a rate of return for its investors. To ensure some control, many private equity agreements require a majority stake in the partnership. In doing so, they may supplant or supplement the healthcare organization's management team or change the governance structure.

"We do an assessment of the quality of management team," says Brideau of how Oak Hill partners and Ascension approach managing the organizations they acquire. "If our assessment is that there is strong management but they are not succeeding because they are capital starved or because of some historic decision that put them in the hole, then those things are fixable—then you're crazy to want to turn over the leadership. High-quality leadership is scarce in healthcare."