When a tax-exempt hospital is sold, board members may wax eloquently about the synergies, the mission and the vision of the deal.
But how much the facility sells for is becoming the key issue in many communities where tax-exempt hospitals have been purchased by investor-owned companies.
Recent scrutiny by attorneys general in California and Massachusetts is raising questions about whether tax-exempt hospitals, which are defined as community assets, are trading at fair market value.
For example, when Good Samaritan Health System in San Jose, Calif., was soldto Columbia/HCA Healthcare Corp. for $185 million last month, Consumers Union, a consumer watchdog group, charged that the four-hospital system was being undersold by more than $100 million.
The California attorney general didn't agree, but the heated exchange opened up the issue of price, which often is veiled in secrecy when a tax-exempt hospital is sold.
Why are the selling prices of tax-exempt hospitals such big secrets? When buyer and seller enter negotiations, they sign confidentiality agreements that preclude them from disclosing the price, experts say.
After the sale is completed, the price is rarely revealed. There are exceptions, particularly with tax-supported public hospitals that must disclose sale terms. But many claim that tax-exempt institutions are community assets and trustees should be more forthcoming about their selling prices.
As more tax-exempt institutions are called on to reveal their sales prices, questions about how valuations are made will follow.
California case. A current example is unfolding in San Diego. Columbia and Sharp HealthCare have agreed to a joint venture in which Nashville, Tenn.-based Columbia will buy a 50%interest in four Sharp hospitals. Columbia is the nation's largest and most acquisitive healthcare company with 335 hospitals. Sharp is San Diego County's largest hospital system with seven hospitals. Terms haven't been disclosed, but sources say the deal is valued at more than $300 million.
Although unique in many ways, this deal is playing out like many recent hospital transactions. It's a real-life drama featuring the following protagonists: a tax-exempt hospital whose bottomline is degraded by managed-care contracts, an affluent for-profit chain anxious to buy into the San Diego market, and two hospital trustees who disagree with hospital managers about what the future holds.
On Nov. 30, 1995, Sharp's board assembled for a historic meeting. The tax-exempt hospital system that had brought open-heart surgery and outside nursery viewing windows to the San Diego area 35 years ago was going to bring in a for-profit partner.
Yet when some board members asked how much Columbia was going to pay for its 50% stake, they were answered with silence.
"They couldn't tell us what the price was," said Charles M. Ewell, a trustee of Sharp's flagship, 488-bed Sharp Memorial Hospital in San Diego. Sharp Memorial is one of the four hospitals that will be included in the partnership with Columbia. In addition to a system board, each hospital has its own board.
Ewell was so upset that he resigned from Sharp Memorial's board after the meeting, citing frustration with the way the deal was handled by Peter Ellsworth, Sharp's chief executive officer, and James Haugh, board chairman.
Ewell, president of the Governance Institute, is commonly regarded as the nation's leading authority on hospital trustees. The La Jolla, Calif.-based institute's mission is trustee education.
Yet, Ellsworth portrays Ewell as a disgruntled board member who was lax in attending meetings and, therefore, "doesn't know what he's talking about."
"There's nothing to hide here," said Marguerite Callaway, CEO of Sharp Consulting Institute, a for-profit Sharp subsidiary that advised the board. "Our commitment is to absolute full disclosure."
However, the price will not be revealed until negotiations are completed, she said.
Is the price right? The sale of a 50% stake in four Sharp hospitals illustrates how difficult it can be for trustees to determine whether they're getting the right price for their institutions. To start with, bidders offer different assets to the partnership.
In the Sharp deal, Columbia agreed to contribute 128-bed Mission Bay Memorial Hospital and North Coast Surgery Center, both in the San Diego area. Another bidder, Tenet Healthcare Corp., had offered to contribute 231-bed Alvarado Hospital Medical Center in San Diego to the deal. Santa Monica, Calif.-based Tenet is the nation's second-largest investor-owned chain with 75 hospitals.
Valuing those assets and what they bring to the partnership may be difficult, but what's even more challenging is forecasting the future value of those assets and Sharp's in a network.
At the Nov. 30 meeting, Ewell and the other Sharp trustees were given what Ewell described as a "disastrous scenario" of Sharp's future.
Indeed, Sharp's 1995 financials do look gloomy. The system posted a $15.1 million operating loss on revenues of $678 million in 1995, according to Moody's Investors Service, a New York-based credit-rating agency. That loss contrasts with three consecutive years that were profitable. Most recently, Sharp had net income of $8.7 million in 1994 on revenues of $704.1 million, Moody's said. Last month, Moody's confirmed Sharp's credit rating of A with a negative outlook because of the system's significant losses.
But was the system's financial health, and subsequent value, souring because of market conditions or because of leadership?
Ewell believes that improved internal management could reverse the hospital system's fortunes. "I told Pete (Ellsworth) that he should have resigned two or three years ago," Ewell said. He added that he also told Ellsworth a couple of years ago that if he started talking to a for-profit chain about a deal with Sharp, "it would be like a tar baby that he could not separate himself from."
Ewell believed the board was being pressured into a deal with Columbia. Describing Ellsworth as "kind of a control freak," Ewell argued that the board wasn't given enough information leading up to the Columbia deal.
In an interview with MODERN HEALTHCARE*, Ellsworth, clearly agitated by Ewell's comments, said it was a "travesty" to suggest that Sharp's board members didn't have enough information on which to base a decision.
However, Ewell's comments were echoed by James West, a Sharp system trustee for 15 years before he quit last August. West, a certified public accountant, also felt he wasn't being given enough information and quit when Sharp refused to pay for separate legal counsel for the trustees.
"I had advice from three lawyers who do a lot of work with big corporations, and they said the board should have individual counsel," West said.
Ellsworth countered: "I have over 100 board members. Two are unhappy, and I don't think that's a bad track record."
He also contended that Ewell's criticism of the decision to negotiate with Columbia belittled the time and effort of board members who served on a special committee to look at all the options. "There is not one single member of that special committee (who) started out in favor of for-profit companies," Ellsworth said. Yet, in the end, the committee unanimously approved signing the letter of intent with Columbia.
Callaway said the system's choices boiled down to three options: stay independent, partner with Columbia, or partner with Tenet.
Callaway bristled at any suggestion that Ellsworth and Haugh, a 39-year veteran of Sharp's board, concealed matters from trustees. She said board members went through an exhaustive process to research their options.
Beginning last August, the seven-member special committee met weekly to consider the system's options. Committee members talked to numerous suitors besides Columbia. They included InteCare, an Irving, Texas-based company headed by former American Medical International President and Chief Operating Officer John Casey, and American Healthcare Systems, a not-for-profit alliance headed by former AMI Chairman and CEO Robert O'Leary. Both Casey and O'Leary proposed joint ventures with Sharp, Callaway said. AMI merged with National Medical Enterprises last March to form Tenet.
Although Ewell wasn't on the special committee, the individual hospital boards were kept informed of the committee's progress, Callaway said.
"(Ewell) didn't even attend all the meetings," Ellsworth said.
And Callaway added that "I never saw Charlie Ewell as an active board member."
Ewell, on the other hand, said he missed few meetings.
When it came to the vote on Columbia, Ewell was in the minority, being the only board member to vote against the deal with Columbia. Two members abstained.
However, the situation raises questions about how a system is valued. For example, would a deal with Columbia make the system worth more or less? That's especially critical in Sharp's situation because the not-for-profit foundation will retain a 50% stake and reap half the venture's profits. If Sharp's fortunes turn downward under Columbia management, the foundation's financial condition would follow.
Who's liable? Concerns about trustees' legal liability aren't overblown. In Northern California, Consumers Union is raising significant issues about the sale of Good Samaritan to Columbia.
Although the attorney general didn't question the purchase price, it is looking into whether mismanagement led to losses at the tax-exempt system. If so, and if that meant the system was devalued as a result, the attorney general may sue the system's trustees.
"If we found that there had been a breach of trust that diminished the value, we would look at the directors' and officers' liability policy," said Jim Schwartz, deputy attorney general in the charitable trust division. That policy now insures trustees and officers for $15 million, and those funds could be tapped and contributed to the tax-exempt foundation established as part of the Good Samaritan sale, Schwartz said.
Critics such as Harry Snyder, co-director of the West Coast office of Consumers Union, say it's a cop-out for tax-exempt institutions to sell to Columbia or another for-profit company. "Rather than acknowledging that they didn't do a good job, they bail out of responsibility for turning a public charitable asset into a white elephant," he said.
Consumers Union, which has been active in the conversion of tax-exempt HMOs to for-profit status, now is looking closely at hospital sales as well.
"These assets are worth a lot of money; why should we give them away?" Snyder said.
However, some argue that these assets are being sold at market price, negotiated by a willing buyer and willing seller. That's especially true when there's more than one bidder, they say. In the Sharp deal, for example, Ewell said he and others heard Tenet had offered more than Columbia.
Most experts say that hospital value is based on a multiple of earnings before interest, taxes, depreciation and amortization, or EBITDA.
Generally, for-profit chains say they pay five to six times EBITDA. So, if a hospital is generating $10 million in annual EBITDA, it might sell at $50 million to $60 million.
East Coast example. In Framingham, Mass., Columbia has agreed to buy 80%of MetroWest Medical Center. According to documents MetroWest filed with the Massachusetts attorney general's office, Columbia will pay $60 million to $70 million for the partnership interest. The price will be based on a multiple of EBITDA for the most recent 12 months prior to the closing date. The multiple wasn't disclosed.
MetroWest hired Cain Brothers & Co., a New York-based investment banking and advisory service that has been on the other side of Columbia deals several times, to calculate its valuation. The attorney general's office has hired Arthur Andersen & Co., a national accounting and consulting firm, to do its own calculation.
At press time, the attorney general's office hadn't completed its review of the deal, so it's unclear whether the valuations varied.
However, one expert says EBITDA multiples shouldn't be calculated on past performance. "The most common mistake people make is to base it on historic EBITDA," said Josh Nemzoff, founder of Nemzoff & Co., a Nashville-based firm that specializes in hospital mergers and acquisitions.
Yet, that demands that hospital trustees be part financial guru, part fortuneteller. Ewell suggested that when Sharp officials painted a dire picture of Sharp's financial future, they were doing so to enhance the need to partner with Columbia.
Consumers Union suggested the same in the sale of Good Samaritan to Columbia. Red ink was threatening Good Samaritan's financial viability when trustees put the entire system up for sale. For the fiscal year ended June 30, 1995, the system lost $43 million on operating revenues of $361 million.
Good Samaritan retained Shattuck Hammond Partners, a New York-based investment banker, to obtain competing bids from major hospital chains and to determine the economic value of the system. "The problem with the valuation done by Shattuck Hammond Partners is that the organization simply hasn't been run well for a number of years," said Snyder, of Consumers Union, in a letter to the attorney general questioning the sale price. Snyder said the system's historical EBITDA was about $17 million, but if it had been run as efficiently as most California tax-exempt hospitals, it would have been twice as much.
Columbia completed the purchase of Good Samaritan, which was on the verge of technical default on its bonds, last month for $185 million. The proceeds will repay $129 million in debt and fund a foundation. Snyder contended the value should have been $307 million.
Yet, falling values for hospital assets may not be uncommon. Many experts believe hospitals will be worth less in the future.
"There's too much capacity," said William C. Golz, vice president of American Appraisal Associates, Chicago. "Supply and demand would say the value of hospitals is going to go down when there's an oversupply."
Matthew Howley, national coordinator of healthcare valuation services in the Chicago office of Ernst & Young, agreed. He said the multiple of EBITDA is based on growth prospects. "The higher the growth potential, the higher the multiple," Howley said.
Growth potential contributes to an already-strong hand held by investor-owned chains such as Columbia. By bringing Sharp into the Columbia system, the financial prospects of both Sharp and Columbia would be enhanced. Shareholders view Columbia as a growth company, which buoys its stock price and access to capital. Sharp's foundation would benefit from higher profit margins under Columbia's management and improved system efficiencies.
Other factors. Obviously, other factors besides EBITDA go into the sales price. For example, a hospital building that needs extensive renovation won't be worth as much as one that is practically new with the latest equipment.
Or the high bidder may put an "emotional valuation" on the decision, said Randolph Smith, Tenet executive vice president. "Not only are they doing the right thing from a pure financial standpoint, but for the community as well," he added.
Other intangibles, such as market position, also enter the equation. In addition, the buyer may pay a "control premium," reflecting that it is buying 50% or more of the joint venture.
For example, Sharp officials said the system was offered a strong price by Columbia because it has a 30%market share in San Diego and already had formed an integrated network. In other words, Columbia wouldn't have to build a system from scratch.
"They were willing to pay a higher price for the franchise," Callaway said.
However, paying too high a price may be counterproductive.
That's because the valuation must be tempered by Medicare recapture, a formula in which a hospital that is sold must reconcile the amount of depreciation it is owed or owes to Medicare. "The first thing a hospital should do is get a Medicare recapture analysis," recommended Jon Preiksat, CEO of the Venice Foundation. The foundation was created when Venice (Fla.) Hospital was sold to Bon Secours Health System, Marriottsville, Md., last year for $85.5 million.
A high price for a hospital could result in Medicare "recapturing" more money from the hospital, Preiksat said. That means a higher price won't necessarily result in more money to the seller. The prime beneficiary will be Uncle Sam, not the community.
In both the Good Samaritan and Sharp instances, relationships with physicians also played a key role, especially because of both systems' dependence on managed-care contracts.
In the Good Samaritan deal, the system's management services organization for physicians wasn't part of the acquisition.
At Sharp, only one of three MSOs would be contributed to the joint venture. Callaway acknowledged that Tenet wanted "more commitment" from the physician groups than Columbia did.
Although Tenet officials won't provide details about the chain's bid to Sharp, they say physicians are an important component in hospital sales. "Sharp is a very unique transaction because it had a lot of capitated lives controlled by medical groups," said David "Rusty" Mayeux, Tenet senior vice president of venture development. "What we wanted to do was buy an integrated delivery system."
He declined to say how much of a commitment Tenet wanted from the physicians, but added, "We weren't talking about putting them in shackles."
fuel for a legal fire. How much a hospital is worth can be legal fodder in a litigious business world. One vivid example involves South Seminole Hospital in Longwood, Fla.
The opposing parties, Columbia and Orlando (Fla.) Regional Healthcare System, are set to go to court this month. Both organizations own a 50%interest in the hospital, yet they have drastically different ideas of what that 50%interest is worth.
Orlando Regional bought its 50%interest in 1992 for $24 million from Healthtrust, an investor-owned hospital chain that Columbia acquired last year. That would put the hospital's value at $48 million. Columbia got its 50%stake when it purchased Healthtrust.
Now, one partner must buy out the other as part of an antitrust ruling by the Federal Trade Commission. The FTC didn't want Columbia and Orlando Regional to be in business together in an area where both are already dominant providers.
But how much should one partner pay the other? Not only do the parties not agree on that, but in a real quirk of logic, Orlando Regional claims its 50%is worth more than Columbia's.
In his deposition, Gary Strack, Orlando Regional's president and CEO, contended that his system wants to pay Columbia $12 million for Columbia's half of South Seminole. That's half of what Orlando Regional paid for its 50%stake four years ago.
"The earnings of the joint venture are about a third of what they were when we initially went into it," Strack said in the deposition when asked why the value of Columbia's 50%stake dropped so drastically. Strack said the earnings were about one-third of what officials had expected.
However, when asked if Orlando Regional would accept $12 million for its 50%of South Seminole, Strack said no. The reason, he said, is "because in this marketplace, we feel that we need a presence in Seminole County. If we don't have that, I think we can be irreparably harmed."
Interestingly, the Ernst & Young-audited financial statement for the hospital places both partners' total equity at $57 million, which is a 19%increase from 1992 when Orlando Regional bought it. But Strack said he thinks Orlando Regional paid too much for its half-interest in South Seminole.