Caritas Christi Health Care in Boston and Detroit Medical Center are like formerly broken-down cars that run again, but are stuck in third gear.
Caritas Christi, Detroit Medical Center turn to for-profit partners to deliver the cash they need to modernize and compete
Both systems have turned around their operations after struggling financially. Neither system, however, can shift into fourth and fifth gears to accelerate to the highway speeds required to compete with the better-capitalized systems in their markets.
So these not-for-profit systems turned to two very different for-profit mechanics to repair those transmissions. Cerberus Capital Management and Vanguard Health Systems have agreed to supply the transmission fluid—hundreds of millions of dollars in capital—to lubricate those faulty gear boxes. Their capital also will remove some heavy weights that Caritas Christi and DMC have been hauling around: their underfunded pension plans. Cerberus announced its Caritas Christi offer, valued at $830 million to $850 million, on March 25; Vanguard announced its DMC offer, valued at $1.27 billion, on March 19.
“I see the events of the last two weeks as transformative,” said David Cyganowski, co-head of healthcare investment banking and a managing director at Citigroup. “I’ve been in the business since 1982, and it’s hard to remember a couple of weeks like this, both in terms of the healthcare reform law and these deals.”
At the same time, some of deals that for-profit hospital companies and deal advisers have been alluding to for months are starting to come to fruition, with four potential deals announced within the space of 24 hours last week. And not-for-profit hospitals aren’t just targets—they are also acquirers (See related story, p. 7).
Josh Nemzoff, a transactions consultant to not-for-profit hospitals, said both for-profits and not-for-profits are looking to make acquisitions, but, “It’s always hard to tell if this is the leading edge of a wave.”
Keith Pitts, vice chairman of Nashville-based Vanguard, noted that in 2003, Vanguard and HCA made large acquisitions of not-for-profit systems based in San Antonio and Kansas City, Mo., respectively, that seemed to be the start of something big, and then that was it for acquisitions of big tax-exempt systems until these deals.
For years, capital availability to fund plant, equipment and technology investments has been the crucial question for not-for-profit hospital boards considering whether to sell their hospital or system. The tighter credit conditions that have prevailed since about the middle of 2007 have only exacerbated that long-standing trend, healthcare transactions advisers said.
The time is now
Not-for-profits seem to recognize that they need to decide pretty soon whether their capital access will meet their needs, Citigroup’s Cyganowski said. Systems with sufficient cash reserves, good management teams and high bond ratings will be able to remain independent, he said: “Those that are less fortunate—they’re looking to become part of something bigger.”
In significant not-for-profit conversions like these two deals, said Carsten Beith, a healthcare investment banker with Cain Bros., which advised Caritas Christi on its deal, “Capital is almost always the primary driver.” He added, “There isn’t a system in the country that isn’t capital-constrained. You don’t need to be a distressed hospital to come to the conclusion that a transaction might be in the hospital or system’s interest.”
Both Caritas Christi and DMC said that their transactions were driven by their unmet capital needs.
“We haven’t been able to access the capital to modernize our hospitals in many years,” Michael Duggan, DMC’s president and CEO, said in an interview when the deal was announced (March 22, p. 4).
Caritas Christi faces Boston’s famous academic medical centers as competitors, but even without them, the capital needs were there. “The more capital you have, the more you can do in terms of adding service lines or recruiting more high-quality, world-class physicians,” Caritas Christi spokesman Chris Murphy said. “If you don’t have access to capital, doing those things is more challenging, whether you have academic medical centers in the market or not.”
Cyganowski said he believes that healthcare reform keyed both deals. “The deals announced at DMC and Caritas were not accidents. They were in anticipation of the legislation,” he said.
Rob Fraiman, CEO of Cain Bros., said Caritas Christi’s capital needs transcended even healthcare reform. “If there were no healthcare reform, I think this transaction would be happening anyway,” he said. “Caritas has capital needs.” That said, Cain’s Beith does see healthcare reform as a catalyst for other not-for-profits that think that the benefits of tax-exempt status are diminishing. The Illinois Supreme Court’s ruling upholding the revocation of Provena Health’s tax exemption is a factor in that calculation, Beith said.
Vanguard’s Pitts said the reform law is just the start of efforts to change the delivery of healthcare that will push providers into “more-organized systems of care that require a greater level of integration than we’ve seen in a lot of places. Having scale and capital access help with changes in payment and delivery reform, which we think will be addressed over the next several years.”
Beith also pointed out that physician integration is yet another strategy that requires capital.
Rolling the dice on Detroit
Nemzoff, with more than 25 years of experience as a transactions consultant, said he was shocked by both deals. “Some people are getting so aggressive in terms of trying to buy hospitals, like Vanguard and like Cerberus,” he said. “There’s a difference between being willing to take risks and gambling. I think those two deals have gone into the realm of gambling.”
That is especially the case with the Detroit Medical Center deal, he added, citing Detroit’s exceptionally high unemployment, shrinking population and overall economic weakness. Vanguard’s commitment to buy the six-hospital system for $417 million and commit to investing $850 million over five years in its facilities is a staggeringly good deal for DMC and Detroit, Nemzoff said.
“It’s almost as if Santa Claus has come down the chimney and left gifts for them,” he said.
Nemzoff praised Vanguard’s ability to run hospitals, but he added that there’s no comparison between Detroit and its investments in other markets. In Chicago and western Massachusetts, Vanguard made much smaller acquisitions, he said. In San Antonio, the investment was larger than those two deals, but still much smaller than what it has agreed to invest in Detroit, and the San Antonio market has much better population and economic growth than Detroit. Nemzoff predicted that Vanguard won’t complete the transaction unless the price drops significantly.
Pitts strongly disagreed. “We expect to do the deal as it’s been written today,” he said. That includes about $184 million in unfunded pension liability that Vanguard expects to fund over the first seven years, Pitts said.
The investment will unlock DMC’s potential to stem the outmigration of patients to outlying hospitals with better-capitalized parent systems, Pitts said. The remaining $350 million of Vanguard’s capital commitment is for routine maintenance.
Nemzoff recalled that Vanguard was the first for-profit company to agree to buy the Philadelphia-area hospitals of the Allegheny Health, Education and Research Foundation (March 16, 1998, p. 16). Vanguard pulled its bid before Tenet Healthcare Corp. won a bankruptcy auction of eight of those hospitals for $345 million—$115 million less than the bid Vanguard initially made to the bankruptcy court (Oct. 5, 1998, p. 2).
The DMC-Vanguard deal also got some formal opposition last week from three community groups that formed the Coalition to Protect Detroit Health Care. The coalition wrote a letter to Michigan Attorney General Mike Cox containing 25 questions about the proposed deal’s impact on healthcare, the fate of community and restricted assets, and the tax breaks the deal is predicated upon. The letter also questioned the legality of the transaction under Michigan’s charitable trust law, which gives Cox authority over the deal. In a written statement, Duggan said, “We’re 100% confident that the DMC/Vanguard deal was done legally, and we look forward to a full review.”
The commitment of Cerberus to fully fund pensions also was a key consideration for the Roman Catholic Archdiocese of Boston, which owns Caritas Christi, in agreeing to the deal, Caritas Christi’s Murphy said. In its financial statement for the year ended Sept. 30, 2009, Caritas Christi noted that its employees make up 90% of the beneficiaries of a retirement plan administered by the archdiocese. That plan’s projected benefit obligation was $327.2 million as of June 30, 2009, but its assets at market value were $245 million. The financial statement also noted that defined-benefit pension plans for two of Caritas Christi’s hospitals—264-bed Norwood (Mass.) Hospital and 190-bed Good Samaritan Medical Center, Brockton—had projected obligations of $120.3 million against assets of $63.9 million, both as of Sept. 30, 2009.
Cerberus has committed $430 million to $450 million to fund the pensions, retire the system’s debt and provide working capital and then an additional $400 million to fund capital improvements. Cerberus, which declined to comment for this story, also committed to keep all six Caritas hospitals open for three years and to refrain from taking any money out of its investment through an initial public offering, dividend bond offering or other such method, Murphy said. (See p. 32 for more on private-equity exit strategies.)
There will also be a stewardship agreement to ensure compliance with Roman Catholic ethical and religious directives, he said.
The ultimate goal is to position Caritas Christi as a lower-cost provider that will benefit as payment and delivery reform pushes patients to choose lower-cost settings for their care, Murphy said.
Alan Sager, a professor of health policy and management at the Boston University School of Public Health, questioned whether Caritas can still be a low-cost provider after Cerberus has poured $830 million to $850 million into acquiring and upgrading its hospitals. “It seems that they’re promising more than can be delivered. I think they can become modernized hospitals that earn higher operating margins, but I don’t think they could at the same time remain low-cost,” Sager said, or “keep open all six hospitals.”
Caritas has struggled for years because, unlike its competitors, it lacks sufficient scale to have leverage with managed-care players and doesn’t have links to physicians at the downtown academic medical centers, said Gary Young, chairman of health policy and management at Boston University School of Public Health. The Caritas deal is vastly different from the not-for-profit conversions that boomed in the 1990s, Young said. “I don’t throw this in the same pot as Tenet and HCA and Universal buying hospitals and converting them to for-profit status. They are in the business of healthcare,” he said. “Cerberus is not.”
Cain’s Fraiman, however, praised Caritas management for its nontraditional thinking. “We’re talking about a transaction that requires a lot of people to think very differently about the ownership of a system like this,” Fraiman said. “I think that is a characteristic that will be necessary for other systems considering a transaction like this.”
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