In the early 1980s, the smart money was betting that investor-owned hospitals would come to dominate the industry. Millions were wagered on that bet in the casino that is Wall Street. Many of those millions were lost.
What was expected to be a tidal wave of conversions has been more of a trickle. In 1976, the number of investor-owned hospitals in the U.S. stood at 752, according to figures compiled by the American Hospital Association. Twenty-five years later the number stood at 754. The peak year, in absolute terms, was 1986, when the AHA counted 834 for-profit hospitals (See chart, p. 53).
But look at the percentages. If you set aside the exceptional year of 1997, when the former Columbia/HCA Healthcare Corp. was at its acquisitive heights, investor-owned hospitals as a share of the country's acute-care facilities hit the high-water mark in 1998 and again in 2001. As investor-owned hospitals have held their own, the numbers of both not-for-profit and government-controlled hospitals have dropped dramatically during the past 25 years.
Last year, the trend continued. In 2002, investor-owned companies acquired 41 not-for-profit hospitals, according to Modern Healthcare's ninth annual mergers and acquisitions report (Jan. 20, p. 36). Companies signed still-pending deals to acquire 11 others-including HCA's $1.1 billion deal to acquire Health Midwest, Kansas City, Mo. Not-for-profit hospitals acquired four investor-owned hospitals in 2002.
Already this year, another giant conversion deal is on the horizon, as sources indicate that 10-hospital Baptist Health System, Birmingham, Ala., is being pitched to for-profit hospital companies in a deal that could be worth $700 million or more (March 3, p. 12).
Has the hospital industry reached a tipping point, where the balance increasingly will favor investor-owned facilities? No one is ready to make the bold predictions of two decades ago. But notwithstanding the troubles that have plagued Tenet Healthcare Corp., Santa Barbara, Calif., a lot of industry trends are favoring the for-profit chains. Some of those same trends are buffeting not-for-profit hospitals and making them more likely to sell.
"I've never seen this many hospitals that are in this much trouble," says Joshua Nemzoff, a transactions consultant who works with both investor-owned and not-for-profit hospitals. "And based on the numbers that I'm looking at, I don't think you're talking about 20 or 30 hospitals that are in financial difficulty. I think you're talking about a few hundred of them."
His firm, Nemzoff & Co., New Hope, Pa., primarily monitors hospitals of 250 beds or more. In the past two years, Nemzoff says, the firm has seen a key financial ratio known as debt-service coverage (cash from operations over a given period of time divided by debt-service payments during that same period of time) fall dramatically for some previously solid hospitals. For instance, he says one Northeastern hospital had a debt-service coverage ratio of 2.31 on Sept. 30, 1999, but two years later, the ratio was less than 0.6.
Struggling hospitals quickly find themselves caught in what Nemzoff calls "the debt spiral." When cash earnings fall, these hospitals lose access to capital, making it harder to recruit physicians and upgrade equipment. Those problems lead to a loss of volume that hits earnings even harder, and the spiral continues, he says.
"They try some strategic planning," he says. "They try some cost-cutting. When things go real bad, they call in a turnaround specialist."
Better than it looks
The credit profile of not-for-profit hospitals as reflected in ratings set by Standard & Poor's suggests a steady deterioration over the past two decades (See chart, p. 52). On a percentage basis, more than twice as many hospital issuers received speculative-grade ratings from the agency in 2002 as in 1984, though the level has held steady since 1990. The percentage of A-rated issues has fallen 25 percentage points, to 43%.
Martin Arrick, director of the not-for-profit healthcare group at S&P, cautioned the numbers aren't telling the entire story. For one, bond insurance became common in the hospital industry in the early 1990s, Arrick says, and the insurers targeted the A-rated issuers, so that explains a lot of the drop in the A category. For another, although downgrades have outpaced upgrades three years running, many of the hospitals were downgraded because they issued more debt, Arrick says. Their operations are still solid, but the higher level of debt makes their bonds a little more risky, he says.
More than half of the investor-owned chains are rated speculative grade-the exceptions being Health Management Associates, Naples, Fla.; HCA, Nashville; Tenet; and Universal Health Services, King of Prussia, Pa.-or are not rated at all, but those ratings don't keep them from obtaining financing, Arrick says.
Arrick contends that the debt-issuing hospitals S&P rates have better balance sheets than they did a decade ago. The margins are about the same and debt is up only slightly, he adds.
"Why is the noise so negative? I guess there's certainly a perception, and reality, that the sector is a lot more volatile," Arrick says. "You can get much bigger swings in a short time. The systems are generally bigger and there are more systems-and that adds to the volatility." Still, Arrick doesn't predict any great swings in the makeup of the hospital industry.
The AHA certainly agrees that not-for-profits face a grim financial picture when it pushes for provider relief in Washington. Its figures show hospitals in 2001 posted their lowest profit margin-4.2%-since 1993 (Dec. 23-30, 2002, p. 8), with one in three hospitals losing money in 2001. The AHA wasn't shy about pointing out the differences in financial performance when Tom Scully, administrator of the Centers for Medicare and Medicaid Services, cited the bulging profits made in the investor-owned sector last year to argue against a bill boosting Medicare reimbursements.
Tough fiscal environment
James Bentley, the AHA's senior vice president of strategic policy planning, says all hospitals face myriad projects that require more capital, such as information technology and medical safety. But Bentley argues that the corporate form a hospital takes isn't the important thing. "If there's not sufficient revenue streams, then both (sectors are) going to be in trouble," he says.
Bentley also argues that the investor-owned chains may have trouble persuading investors that they are growth companies. The tough fiscal environment for the federal and state governments is likely to keep Medicare and Medicaid payments steady or declining, while employers are balking at premium increases and shifting costs to employees, he says. "You can make the argument that those are not the underlying dynamics that the stock market would see as a growth industry," he says.
The poor performance of the stock market over the past three years is a major factor in not-for-profits' financial weakness, says Joseph Vumbacco, president and chief executive officer of 44-hospital HMA. The bear market has taken a large bite out of the investment portfolios many not-for-profits have used as a budgetary cushion.
"There appears to be more not-for-profits than we've seen in many years that are or are on the verge of going up for sale," Vumbacco told investors at Lehman Bros.' Global Healthcare Conference earlier this month.
By the late 1990s, even hospitals with A ratings from S&P were generating more than 60% of their total margin on investment income, though the percentage plunged below 50% in 2002 (Nov. 4, 2002, p. 34). The falling returns not only have taken away from the bottom line directly, but they have forced some hospitals to make bigger payments to fund their pension liabilities, further reducing the cash available from operations to finance projects.
That inability to finance projects from operations, or to pay off debt using investment income, comes as many hospitals face deteriorating buildings because of the post-war building boom that resulted from the Hill-Burton Act, which financed hospital construction projects from its passage in 1946 into the 1970s.
Investor-owned hospital chains also are benefiting from the absence of what has been their biggest disadvantage: the perception of widespread, systematic Medicare fraud among investor-owned chains.
HCA's progress on this front last year-an appellate court ruling that overturned the only criminal convictions ever won against its executives (April 1, 2002, p. 6), the end of the criminal probe (July 29, 2002, p. 6) and the announcement of a final settlement of the civil fraud case (Dec. 23-30, 2002, p. 6)-marked a huge step toward dissipating that perception.
A key question will be whether the federal investigations of Tenet and HealthSouth Corp., a for-profit post-acute healthcare chain based in Birmingham, Ala., will rekindle that view of the investor-owned sector.
"I think for-profits have become more socially acceptable to the not-for-profit community," says Russell Carson, chairman of Ardent Health Services, Nashville. "I think those differences have blurred a lot over the last 10 to 20 years. It's very clear that HCA delivers superb quality healthcare wherever (it is) located."
That greater acceptance has come even in the Northeast, where sentiment against for-profit hospitals has been strongest. Investor-owned companies have stepped up their buying in Pennsylvania and Massachusetts and have established new beachheads in Connecticut and New Jersey in the past two years.
The tough operating environment, Carson says, has another advantage for investor-owned chains: Not-for-profit hospitals have to be run like a business in order to be successful anyway, so why not sell to a for-profit company? "You bring in professional management with economies of scale, and then a foundation results that might be more in keeping with their mission," says Carson, who is also a general partner with the private equity firm Welsh, Carson, Anderson & Stowe, New York, which owns a majority stake in Ardent.
Although he sees the advantages that Ardent and its for-profit brethren have right now, Carson says change will be "evolutionary, not revolutionary," with investor-owned chains growing from 15% of the industry to perhaps 20% 10 years from now.
One area where for-profit chains seem to have a natural advantage is executive and physician recruitment.
Mark Smith, executive vice president of Merritt, Hawkins & Associates, an Irving, Texas-based physician recruitment firm, says doctors don't place a lot of weight on the tax status of the hospital that is recruiting them. They're looking at the financial package and how quickly the hospital's leaders can make a decision, he says. Investor-owned hospitals, he says, are "more assertive. They move quicker. Not-for-profits often have a lot of board involvement, and that can slow things down."
Investor-owned hospitals also "seem to understand pretty clearly the parallel between recruiting physicians and the revenue that they bring to a facility," Smith says. Not-for-profits do retain some advantages. They tend to have more stable ownership, Smith says. "There still is the fear of, `Gosh, I know you're an HCA hospital this month, but will you be a Tenet hospital six months from now?' " he says. Not-for-profits also tend to involve physicians more in the governance of the hospital, he says.
Another physician recruiter, Carol Westfall, president of Cejka & Co., St. Louis, says factors such as the working environment, clinical practices, the hospital's reputation and its academic affiliations are much more important than tax status.
Investor-owned hospitals offer bigger financial packages that can be tailored to the particular physician's tastes, Westfall says, while not-for-profit hospitals lag behind for-profit rivals such as group practices, hospitalist companies, cancer centers and other organizations that hire physicians. Hospitals use their investments in clinical facilities to sell themselves to physicians; because for-profits have more capital available for such projects, they tend to have the advantage here as well, Westfall says.
Thus far, these advantages don't seem to be having much effect on executive recruitment, says Jordan Hadelman, chairman and CEO of Witt/Kieffer, an Oak Brook, Ill.-based executive search firm. Both sectors of the hospital industry are able to develop or attract the talent they need, he says.
For-profit hospitals do offer better-defined incentive packages, usually including some equity options, while not-for-profits, owing to their twin concerns of mission and margin, tend to have incentive structures that are "a little bit fuzzy."
No empire building
While Vumbacco and other for-profit hospital chain executives were trumpeting their strong financial results and the excellent acquisition climate during the recent Lehman Bros. conference, they were quick to reassure investors that they won't embark on a buying frenzy. The memories of Columbia/HCA and its deal mania are still fresh in the minds of investors nearly six years after the company began to unravel the bigger-is-better strategy of Richard Scott, former chairman and CEO.
"The companies have different approaches, so it's hard to generalize, but I think most of them are generally in a mode where, if there is a system or hospital that fits into their strategy, then they'll take a look," says Chip Kahn, president of the Federation of American Hospitals, the investor-owned chains' Washington lobby group. "My impression is that these decisions are made very carefully and cautiously to make sure that any hospitals that they purchase are a good fit."
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