Behind the Push to Invest in Hospitals

Many of my colleagues and I have been steeped lately in conversations with hospital leaders that generally focus on expectations of declining reimbursements, standardization, efficiency projects and the feeling of general malaise about the difficulty of running a hospital or health system profitably. Why then, are so many players pushing their cash into inpatient care through hospital and health system purchases?

Many forces are pushing hospitals to consolidate—and predictions overall are that healthcare will become more efficient and more patient-friendly because, if nothing else, their very survival depends on it.

We hear a lot of negativity from senior leaders at many hospitals and health systems who bemoan the cuts in staffing and even services that they feel might be necessary to compete in a reformed healthcare system, where spending is dictated more by value than volume.

But if malaise is in hospitals' future, you wouldn't know it from the interest emanating from the Wall Street crowd. Why, for instance, are so many private equity companies jumping into healthcare? They don't make huge investments like Cerberus Capital Management's purchase of Steward Healthcare (nee Caritas Christi) in the Northeast or Vanguard's acquisition of Detroit Medical Center to lose money, after all. (Though publicly traded, Vanguard is significantly owned by private equity stalwart, The Blackstone Group.)

This conflict between mood and money has interested me for some time. Finally, I have a bit of an explanation, though I'm not sure I completely buy it. According to IBISWorld, a business development market research company, several sectors within healthcare promise huge growth potential over the next five years. The catalyst? You guessed it: healthcare reform.

Specifically, IBISWorld points to the recent (September) start date for a rule that requires states to scrutinize health insurance rate increases of 10.0% or more for policies sold to individuals and small businesses as part of the regulations for state-level health insurance exchanges, mandated by the Patient Protection and Affordable Care Act. 

What their argument boils down to is this: Cross-subsidization will carry the weight. Yes, the ability of hospitals and health systems, among other medical sector groups, to leverage strong revenue gains depends on a method of gaining higher payments from private insurers to subsidize inadequate government payers. Many, many people have predicted the demise of cross-subsidization, targeting it as a big reason for decades of ridiculously large healthcare cost increases. Let that sink in for a moment.

Not to overstate things, but IBISWorld put some serious work, and their reputation, on the line with this prediction. These are the sectors it identifies and their potential revenue gains from private insurance over the next five years: 

"Several healthcare industries rely heavily on payments from private health insurance. Since much of the healthcare reform legislation is still being debated, the move to issue rules is at least one indication that these industries will ultimately gain from the legislation in regard to having a broader and more stable customer base.

Revenue is forecast to improve in these industries with the implementation of the exchanges. Moreover, operating profit margins are projected to rise since commercial insurance payments make up a larger source of operating profit than government programs, such as Medicare and Medicaid. During the five years to 2011, operators in the listed industries have grown increasingly reliant on payments from private insurance. Government program payments, particularly Medicare, either barely cover the cost of providing care or reimburse at rates lower than the cost of care. Consequently, companies have been charging commercial insurance companies increasingly higher rates in order to make up for the shortfall in Medicare payments."

Well, we all know that. The key question is, can it continue? IBISWorld's argument is that more of the patient base will be covered commercially under exchanges, and that hospitals and health systems will retain pricing power.

I'm not so sure it's that simple, but if it takes a 10% annual increase in rates to draw regulatory scrutiny, maybe they're right. 

Based on their scenario, and this is a big leap in guesswork by me, maybe the reason so many investors are interested in hospitals and health systems isn't that they think the hospital itself will be profitable long term, but that it provides a natural "holding company" model in which the owned physician practices, labs, EDs and other affiliated partners bring the profits. But hey, hospitals are in the list too, so maybe they're ultimately winners as well. 

All that said, I don't know if I buy their argument. Do you? I'd love to hear from you if you agree with their conclusions.

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