A Louisiana hospital is slated to be the first to finance a major new facility by selling bonds to its doctors, launching a potential model for aligning the interests of physicians and not-for-profit hospitals.
Lafayette (La.) General Medical Center plans to sell $2 million of tax-exempt participating bonds to about 40 of its admitting physicians in a private placement this summer. The transaction is part of a financing package for a $75 million not-for-profit heart hospital expected to open in early 2005.
The participating bonds will be subordinated to senior bonds and will pay interest only if the facility is profitable. But in exchange for those and other risks, the bonds will offer higher returns than traditional fixed-interest bonds. In this case, the interest is expected to be 10% to 12%. The deal also gives physician investors half the seats on the heart hospital's board.
The economic return falls short of those promised by proprietary companies that do equity joint ventures with physicians. Nevertheless, the structure is being described by attorneys and investment bankers who crafted it as a viable alternative to equity deals that allow physicians to share in facility profits but carry significant financial costs and legal risks that some not-for-profit hospitals have been reluctant to bear.
If the Lafayette General sale is successful, a flood of similar deals could follow. The chief architect of the structure, Robert Rosenfield, a partner in the Los Angeles office of McDermott, Will & Emery, said his firm is working on 25 to 30 additional deals, including several hospitals that want to convert existing equity ventures.
The participating bond model "has the power to change how hospitals and physicians deal with each other," said David Johnson, managing director of the healthcare group at Citigroup Global Markets, formerly Salomon Smith Barney, which is co-managing the Lafayette General bond issue with Merrill Lynch & Co.
Rosenfield advocates a carrot-and-stick approach to what he calls the "very serious threat" of physician competition. For example, he advocates that hospitals only sell bonds to physicians who are willing to sign noncompete agreements. If physicians resist, he believes hospitals should consider an array of responses, including the extreme measures of terminating medical staff privileges or even approaching the city council about adopting a local certificate-of-need ordinance. In the case of Lafayette General, bond-holding physicians have agreed not to compete, although the hospital waived its right to seek injunctive relief against those who do.
When it comes to physicians investing in competing facilities, "I don't think hospitals should be pleasant," Rosenfield said. "Boards have a fiduciary duty to fight to protect the hospital's business."
The emergence of this new strategy comes as hospitals are fighting back against a proliferation of physician-owned facilities that are diverting profitable revenue streams (See sidebar, this page). Recently introduced federal legislation would prohibit physicians from referring patients to for-profit specialty hospitals in which they hold financial interests. At the same time, a handful of state hospital associations are advocating legislation at the state level to curtail physician referrals to organizations in which they have an ownership stake.
Last week, for example, the Louisiana Hospital Association lobbied for legislation, albeit unsuccessfully, that would enact new requirements for specialty hospitals such as a 24-hour emergency room and a transfer agreement with a full-service hospital in case of an emergency or an adverse outcome.
Rosenfield said he believes that participating bonds could create a new "social contract" between not-for-profit hospitals and doctors.
"I see this as one way of trying to respond to the physicians' need for (a greater role in governance and) some kind of supplement for what they can make in medicine, but in a way that's much less damaging to the not-for-profit hospital and to healthcare costs in the community," Rosenfield said.
Participating bonds preserve assets in a not-for-profit structure. Rosenfield contends that higher financing and supply costs and taxes on property, sales and income sap 10% to 15% of revenue collected by for-profit facilities such as surgery centers and specialty hospitals. Those higher costs are shifted to local employers, not Medicare or Medicaid, which pay fixed rates, he notes.
Further, Rosenfield asserts that the vast majority of physician-owned facilities, of which there are estimated to be at least 4,000 nationally, may be at legal risk because they fail to comply with safe harbors for antikickback provisions of the Medicare and Medicaid fraud and abuse statutes. Those statutes dictate felony criminal penalties for any remuneration to induce patient referrals. So far, HHS' inspector general's office has not taken enforcement action against any physician-owned venture on antikickback grounds, but the possibility looms that it will.
Participating bond transactions were designed to comply fully with those safe harbors and other federal laws, said Rosenfield, who began investigating alternative physician-hospital strategies after the inspector general's office in July 1999 issued a bulletin expressing concern that specialty hospital investments by physicians might violate federal law.
As part of a prior corporate integrity agreement, Lafayette General has provided information about the heart hospital transaction to the inspector general's office. But Rosenfield said, "We have no reason to believe that they are concerned about it."
The fact that every detail was painstakingly crafted to comply with federal physician antikickback laws could add to the cost of the transaction. For example, compliance requires physicians to own no more than 40% of any class of investment in a facility, so some $3 million of identical participating bonds will be sold to investors who are not physicians, potentially costing the hospital $150,000 a year in extra interest. The cost could be offset by better pricing on senior bonds that will be issued to finance the majority of the facility's cost; bond investors are expected to view the bonds as less risky because of physician investment.
Fitch Ratings analyst Craig Kornett said physician investment could be a positive for Lafayette General's credit rating because it fosters physician loyalty. "If the heart hospital does well, that helps the organization's profitability," he said.
Lafayette General hopes its new 92-bed heart hospital and the participating bonds that will help finance it will improve its competitive position. Lafayette General decided to pursue the strategy a little more than two years ago, after several cardiologists on its medical staff signed agreements to negotiate with MedCath Corp., a Charlotte, N.C., company that co-ventures with physicians on specialty hospitals. A new 32-bed MedCath facility is slated to open in Lafayette this fall. But hospital officials said they do not know of any of their key physicians investing in the MedCath facility.
While Lafayette General had no trouble attracting physician investors, participating bonds could become less attractive to physicians if the stock market picks up and better investment opportunities become available. Already interest rates have dropped since the physicians were offered opportunities to invest, and it's possible that some could exercise their option to withdraw within 10 days of the pricing if they are not happy with the yield.
Still, no one expects that to happen.
Lafayette General President and Chief Executive Officer James Thaw said the hospital is not trying to match MedCath's equity returns. "I certainly think part of the appeal that we've seen (for physicians buying the bonds) is supporting Lafayette General Medical Center," he said. "I don't think they're doing this solely to supplement their incomes."
The Lafayette General bonds follow an accrual model in which physicians will receive interest payments when the hospital generates positive cash flow, probably starting a few months after it opens. The interest rate will be determined by negotiations with potential nonphysician investors.
Unlike equity transactions, which tie physicians' incomes directly to a facility's profits, participating bonds offer only a weak financial incentive for physicians to maximize a facility's profits. In the case of Lafayette General, the bond offer was open to the entire medical staff, not just cardiologists. Board representation on the heart hospital also will be open to noncardiologists. In fact, no more than one-quarter of the physician investors will practice at the heart hospital. Thaw said the fact that investment was offered to all physicians helped to cement the deal. "I think it was appreciated that the hospital was trying to engage everybody," he said.
Advocates of participating bonds say that the structure makes it easier to attract new physicians than equity deals because the price of the securities will not appreciate. They can also be structured for a variety of projects, including smaller ones that do not require a public bond sale. Rosenfield said one of his client hospitals, which he declined to identify, plans to sell up to $1 million in participating bonds to its physicians next month to finance a $9 million surgery center.
If proprietary companies are worried about this strategy to bind physicians to not-for-profits, they aren't speaking up. Alan Pierrot, a past president of the American Surgical Hospital Association and chief executive officer of FSC Health, a for-profit company that owns an ambulatory surgery center and a specialty hospital, said he was not familiar enough with participating bonds to offer a comment. MedCath did not return a call seeking comment last week.
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