The role of private equity in healthcare has received a great deal of attention in recent years, with some lauding its potential to improve operational efficiencies and speed the adoption of new technologies and others asserting that its very nature is in opposition to the principles of healthcare.
The discussion has frequently lacked common definitions or reference points. This month Applied Policy looks at the larger picture.
What is private equity?
Private equity (PE) refers to company ownership or investment that is not publicly traded. While many associate the term with Wall Street tycoons, PE includes some of the mutual funds and pension funds in which many ordinary Americans have individual investments or retirement accounts. And some PE firms are themselves publicly traded.
PE can take one of several forms, including venture capital investments in startups, buyouts of established private or public companies, and mergers and acquisitions (M&As). One of the most significant—and talked about—PE models in healthcare in the last three decades has been the leveraged buyout or LBO, an investment strategy with roots in the 1980’s.
In an LBO a PE investment fund comprised of a general partner and investor partners puts up 20- 30% of the purchase price for a targeted company. The remaining 70- 80% of the capital for the acquisition is supplied by lending institutions and is secured by the assets of the acquired—or “portfolio”—company. The PE fund effectively “leverages” the acquired company’s assets in its purchase.
A PE fund typically holds a portfolio company for a period of three to seven years, at the end of which it exits the relationship by selling the company through an initial public offering (IPO) or private sale.[1] A recently popular exit strategy has been acquisition through a special purpose acquisition company (SPAC).
To achieve specified financial goals within defined holding periods, PE funds have previously assumed especially active roles in both the management and governance of their acquisitions. This frequently included appointing new members to a portfolio company’s board of directors and replacing its CEO with an individual deemed capable of helping the fund achieve its specific financial goals. This practice is less common today, with major PE funds such as American Securities citing their “CEO finish rates” and support for existing management teams.
Why healthcare?
According to the Centers for Medicare & Medicaid Services, healthcare spending in the United States in 2020 was $4.1 trillion or $12,530 per person, representing 19.7% of the nation’s gross domestic product. Based on size alone, it is not surprising that the healthcare sector has become particularly attractive to private investors. Add the fact that healthcare investments have outperformed investments in other sectors in the last decade, and the industry is ripe for private capital.
Bain Capital, a major international financial firm, estimates that $151 billion in PE capital was invested in disclosed healthcare transactions globally in 2021, a stunning 100% increase over 2020. While a percentage of this year-over-year growth can be attributed to the clearing of deals backlogged from 2020 shutdowns and to investments specific to COVID, it follows a trend that predates the pandemic.
Bain sums up the incentive for many investors when it cites the healthcare “industry’s recession resilience.” Aging populations and increases in chronic diseases are expected to drive continued spending, keeping the sector a focus of investors.
A brief history
PE first entered the healthcare sector in the 1990’s with purchases of nursing homes and hospitals. These were attractive targets because they had steady streams of income from third party payers and extensive physical assets.
One of the earliest “mega-deals” in healthcare was Forstmann Little & Co.’s acquisition of Community Health Systems in 1996 in an LBO ultimately estimated at $1.63 billion. While held by Forstmann Little, Community Health expanded to become the country’s largest operator of rural hospitals. Its growth was characterized by a centralized management program which held costs down even as the company increased its product lines and adopted emerging technologies.
The size of PE investments grew significantly in the following decade. In 2006, Bain Capital, Kohlberg Kravis Roberts Co. (KKR), and Merrill Lynch Global Private Equity acquired Nashville-based hospital and healthcare facility operator Healthcare Corporation of American (HCA) in a deal which market tracker PitchBook valued at $33 billion, and in which Bain invested only $64 million of its own money.
The fund held HCA as a private company until March of 2011, a year after the passage of the Affordable Care Act and long enough for prospective buyers to sort out the impact the legislation would have on the hospital sector. When Bain, KKR, and Merrill Lynch returned HCA to the market, the company had a capital valuation of $15.5 billion.
According to Forbes, between proceeds from the sale and the $4.25 billion paid in dividends in 2010, investors realized a 33% annual return on the deal.
Despite the dollar amounts associated with some PE investments, PE neither now nor ever has dominated the healthcare sector. In 2021, MedPAC reported that PE firms owned approximately 4% of U.S. hospitals and 11% of U.S. nursing homes. For-profit hospitals and those in urban areas have been most likely to be targets of PE acquisition with the preponderance of investments between 2003 and 2017 occurring in the mid-Atlantic and Southern states.
Private equity in the air
The air ambulance industry, which includes both helicopters and fixed-wing aircraft, has offered a unique opportunity for private investors. Because air ambulances operate under the Airline Deregulation Act of 1978—legislation adopted to foster competition in the airline industry—the prices charged for medical air transport were long not subject to state regulation or limitation. Rich with assets, the sector also offered PE a steady revenue stream.
A report by the USC-Brookings Schaeffer Initiative for Health Policy found that in 2017 Air Methods, which is owned by PE firm American Securities, and Air Medical Response, a KKR company, were responsible for two thirds of the helicopter emergency medical services helicopters available to the Medicare market.
Recent trends
PE investment in healthcare closely follows trends in the sector over time. In the past decade these have included two changes specific to the physician workforce: the consolidation of individual physician practices and the outsourcing of physician services by hospitals.
In an era of constricting margins, PE acquisition of individual physician practices offers the potential for increased administrative efficiencies, greater leverage in the negotiation of insurance reimbursement rates, and lower per provider costs for the purchase of new medical technologies and electronic health record (EHR) systems.
For weary physicians lamenting that they entered the medical field “to practice medicine not to do paperwork”, selling their private practices to PE investors can mean relief from administrative burdens. It can also be an attractive option for retiring physician owners seeking to maximize return from their longstanding investments while minimizing taxes.
PE funds also recognized investment opportunities as many hospitals chose to outsource physician staffing to third-party firms. Private investment firm Blackstone acquired TeamHealth, touted as “the leading physician practice in the U.S.” in 2016. KRR followed with the acquisition of Envision Healthcare, a provider of ED and hospitalist physician services, in 2018. PE has also made an entrance in physician specialties including radiology, anesthesiology, dermatology, and children’s services.
Bain predicts a PE focus on emerging technologies in the next few years, with money invested in processes related to biopharma development and the use of artificial intelligence (AI) to increase provider productivity.
Private means private
Because PE investments do not involve publicly traded companies, they are not subject to Security and Exchanges Commission regulations. Larger PE investments may trigger the reporting requirements of the Hart-Scott-Rodino Antitrust Improvements Act under which companies must notify the Federal Trade Commission and the Department of Justice of an impending merger or acquisition. However, smaller investments can successfully “fly under the radar.” As a result, the details of many PE deals in the healthcare sector are not fully disclosed and the collective impact of PE investment can be difficult to calculate.
The debate
In a reflection of our times, the recent discussion of PE in healthcare has become couched in the larger debates over healthcare as a public good and the “morality” of capitalism. As a result, many of the arguments both for and against PE investment are voiced in the language of societal and economic principles, rather than the metrics of quality and patient outcomes that are generally employed in evaluating healthcare systems and programs.
PE received particular scrutiny and criticism in the conversations leading up to the passage of the No Surprises Act. A report by the American Antitrust Institute and the Petris Center of the School of Public Health of the University of California, Berkley stated unequivocally that “(t)he private equity business model is fundamentally incompatible with sound healthcare that serves patients” and that private equity’s “focus on short-term revenue generation and consolidation undermines competition and destabilizes health care markets.”
However, Craig Garthwaite the Herman R. Smith Research Professor of Hospital and Health Services, and the director of the program on health care at Northwestern University’s Kellogg School of Management, believes that PE has the potential to both create and capture value in healthcare. As Brookings has noted, the availability of capital afforded by PE may drive improvements in patient care.
Eileen Applebaum of the Center for Economic and Policy Research, who has done extensive research on PE in healthcare, has identified it as a key factor in the large numbers of mergers and acquisitions in the healthcare sector in the past two decades. In turn, she cites a correlation between monopoly market structure and higher healthcare prices. But prices do not necessarily point to the value of care delivered. And the potential of monopolies to benefit consumers has been demonstrated in other sectors.
Additional research is needed to fully understand the relationship between PE and patient outcomes.
The future
PE in health care will continue to expand as funding opportunities and incentives persist. The median internal rate of return (IRR) for healthcare PE deals from 2010 through 2021 was 27.5%. This compares to 21.1% for other sectors during the same period.
Bain estimated that there was $3.3 trillion in available PE capital (known in the industry as “dry powder”) available as recently as last summer. As technological and scientific advancements–many driven by PE capital–continue, it is reasonable to expect investment in the health sector to follow.
[1] Bain estimated that the average holding period for healthcare assets was 4.5 years in 2021 and noted that a strong market might shorten this period.