Becker's Hospital Review

Transaction & Valuation Issues 42 What's in it for private equity? The latest deals are still new, and there's not enough historical data of private equity firms throwing their hats into the nonprofit hospital ring to know what a typical return on investment would be, but in other industries returns yield 10 to 20 percent annually to private equity investors, Mr. Spees says. That's a much higher operating margin than many small nonprofit hospitals clear. "Changes in reimbursement methodologies does make it riskier than in the past, in my opinion," he says, but "since they're definitely contributing capital to this industry, they've concluded that it's not too risky." Although it would seem nonprofits with charitable missions or uncompensated care requirements would be unattractive investment picks, Mr. Pilch says "Private equity doesn't necessarily balk at these opportunities because some people will only go to a nonprofit, religious, academic or charitable system." The turnaround time for these deals ranges from three to 10 years, with the average falling somewhere between five and seven years, he says. That short turnaround time and high margin means private equity enters agreements with a detailed exit strategy, building the features future buyers will want and pruning what they don't. That way, when the purchased hospital or system is sold, the short-term private equity partnership can be replaced with a long-term and sustainable one. For that reason, Mr. Spees says, nonprofits may consider private equity to help dress them for a future partnership deal. "Every nonprofit who's considering entering into this path establishes the guiding principles that they'll use to guide a pending transaction, review the proposals they'll receive, and the transaction is outlined in their guiding principles." The case against private equity But private equity deals are not simply a windfall for failing or cash-strapped hospitals. David Kirshner, director and senior CFO consultant at Warbird Consulting, said he's skeptical private equity will become a big and growing trend for nonprofit health systems. "Eighty percent of hospitals are tax exempt, and the primary reason they stay that way is because they're able to acquire capital at low-cost rates [through debt markets] and pay no property or sales taxes," he says. "The lion's share of reasoning is that there's a huge advantage to staying nonprofit…Private equity is going to be much more expensive." Selling a hospital's controlling interest to a private equity firm that aims to earn a tidy profit in a short time horizon may compromise a hospital with a faith-based or charitable mission, Mr. Kirshner says. "Generally speaking, for the trustees, there's a lot of soul-searching that is done, one reason why it hasn't been done much yet." However, Mr. Pilch of BDO maintains private equity ownership can allow for nonprofit hospitals and health systems to revert to nonprofit status and such an agreement to do so can be made prior to the deal's closing to maintain the hospital's mission. Furthermore, agreements can be made before the deal's closing to maintain the hospital's mission or even grant original operators commanding governance on some issues. While nonprofit health systems currently have access to cost-effective capital through the issuance of municipal bonds, Mr. Buchanan notes Moody's Investors Service downgraded $20 billion of debt in this sector last year. Lower credit ratings make it more difficult and expensive to issue tax-exempt bonds, and capital needs are great. Considering more than 60 percent of the downgrades occurred at hospitals with less than $500 million in top line revenue, and that Moody's has maintained a negative credit outlook for nonprofit hospitals since 2008, Mr. Buchanan says private equity is likely to remain a consideration for nonprofits looking at partnership possibilities. "CEOs, CFOs and boards should look at all partners and available sources of capital, assess them and make sure that any arrangements make sense for their hospital, their system and their communities," Mr. Pilch says. "One size does not fit all. The decision needs to incorporate and address such questions as, 'What is our strategy, what is our mission and what are we going to be?' "I do believe private equity-backed firms can offer a viable model for nonprofits to consider. They can be a win-win opportunity where the nonprofit legacy continues to be involved post-transaction," Mr. Pilch adds. "In many cases, the discipline operationally and capital-wise that's brought by a private equity firm can be a major factor in keeping the system healthy and sustainable." n Register Today! Becker's Hospital Review CEO Strategy Roundtable November 14, 2013 • The Ritz Carlton Chicago Co-chaired by Scott Becker, Publisher, Becker's Hospital Review, and Chuck Lauer, Former Publisher, Modern Healthcare To register, visit www.BeckersHospitalReview.com/novhospitalevent.html, email registration@beckershealthcare.com or call (800) 417-2035.

• Cover