The Healthcare Breakdown No. 022 - Breaking down financial engineering and what it means in healthcare
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What we’re breaking down: Financial engineering in private equity
What you’ll learn: The playbook for private equity to add no value but reap massive profits
Why it matters: Private equity has one goal. The easiest way to get there? Make things more expensive.
Read time: This one is short, like Lord of the Rings full trilogy plus prequals, short (8 minutes for real though)
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First, I have to apologize. There will be no green/blue (turquoise? teal?) and hot pink combo visuals this week. I hope the unending wall of text doesn’t lull you to sleep. Unless, you went to the Taylor Swift concert last night and need that mid-morning nap after too many Tequila Sunrises while belting out Anti-Hero. If that’s the case, happy reading!
Last week, we tackled the monster that is private equity in healthcare. I say monster lovingly, like your kid’s cute abominable snowman stuffed animal that he cries for if it’s not perfectly positioned under the blanket exactly right down to the 1/1000th of a degree.
Super cute, monster.
Now that you know what private equity is and the high-level mechanics of how it works, let’s move our focus to what those finely coiffed, Patrick Bateman idolizing, Yale graduates, are up to and how they make it rain.
To reset, the goal of private equity is simple: make as much money as possible. Healthcare is a great place to do that.
There are two main reasons PE targets specialty clinics in their pursuit of happiness.
It’s hard as shoot buckets to delivery care these days in a highly complex regulatory environment, not to mention individual and population dynamics, and trying to figure out how to get paid through value-based contracts
Reimbursement suuuuuuuuucks. Sorry, not sorry. CMS isn’t paying doctors enough. The end. And to boot, commercial plans don’t care about your 3 physician practice being out of network so they are going to go ahead and cut your payments 40%. Because.
That’s also why a PE buyout is appealing to docs. Not only do those headaches go away (don’t worry, new ones are right behind them), you also get a nice payout which is better than riding into the sunset with a satchel full of thank you notes.
Don’t get me wrong, satchels of thank you notes are amazing. They warm the soul. But so does a yearly vacation to the Mediterranean on a chartered yacht. The weather is positively soul warming.
The play for private equity in any of their acquisitions is to maximize EBITDA for a sale at a higher multiple in 3-5 years.
Financial returns are the name of the game.
Now, as you can imaging there are some different ways an organization can go about improving EBITDA and multiples.
The first is grow a great business. Treat people right, make good decisions, try really hard, all that good stuff.
Orrrrrr, if you’re way more awesome, use financial engineering to pump up the valuation.
What’s financial engineering you ask?
It’s basically the use of financial strategies to improve the financial position and hence the valuation of a company. Financial engineering uses financial tools.
To help think about it, here’s what financial engineering is not:
Operational improvements.
Value creation for the customer, patient, clinician, etc.
To help even more, which is the reason I spent my donut fueled Saturdays writing this, we’ll look at some perennial favorite tools of Blair’s PE fund:
Sale and lease back
This is when you sell an asset and then lease it back from the buyer. You get a lump of cash and then lease payments become an expense. You were depreciating the asset before as an expense on paper, now it’s just become a real expense. Here’s the upside:
Lower tax payments
No maintenance costs
Risk transferred to buyer
Cash available for distributions, I mean investing in the business
Optimize cashflow
Ok, this one is a little more on the up and up. Basically we are just bringing cash in faster and optimizing our outflow. The bring cash in faster makes sense, but optimizing outflow deserves a couple extra lines.
Sometimes waiting as long as possible to pay is well and good. No penalties and more importantly, no incentive to pay early. In some cases you have the option to pay within say 15 days and get a 2% discount. That might be worth it depending on your cash flow cycles.
Them PE boys will look at all that and get the cash machine humming. When you are collecting faster and paying more efficiently, costs go down and cash conversion cycle gets faster. For the distributions, I mean investments.
Financial incentive alignment
Here’s the real thorn in everyone’s side. When a PE firm buys a physician practice, they can’t employ the doctor directly. That would violate Corporate Practice of Medicine laws. And although hospitals do it all the time, Brighton’s dad’s firm isn’t allowed to.
What you can do is setup a management service organization (MSO) that has a master service agreement (MSA) with the practice you just bought. Then the MSO does everything except tell the doctor how to practice medicine… sort of.
Sort of, because the doctor(s) have vested interest in the financial success of their “new” practice. It’s new because the PE firm sets up a separate holding company in which the doctor receives equity on top of the buyout (that’s the MSO). Then the PE maestros will put all kinds of “incentives” in place to increase the valuation.
Ok, one tealish and hot pink picture:
That’s the gist of the structure and how not to run afoul of CPOM laws. Arms length all day! That’s a lawyer joke… Sorry.
Not saying that docs are doing nefarious things by any stretch. The usual situation is the doc becomes a minority owner in the new company with little say in how things roll. And yes, on paper the doctor still has full control over clinical decision making, but when someone else has all the operations under their control and controls the money and controls your financial future, it becomes easier to see why a private equity owned OB practice does significantly more C-sections than practices not owned by PE.
Just sayin.
Multiples arbitrage
This one is fun and ties directly into the big strategic play.
A business’s sale price is based on a multiple. Usually it’s a multiple of EBITDA. Private Equity yacht jocks love them some EBITDA.
A practice for example may sell for 2x EBITDA. The “2x” is the multiple. This completely made up, hypothetical practice is smaller and has about $500K in earnings.
Another practice in the same specialty with $4M in earnings may sell for 5x EBITDA. Bigger is better after all. It shows more stability as a larger organization, which would command a higher multiple, not to mention the gross values.
So, now, here’s the trick. Write this down. Wait, I’m writing it. Just don’t delete this email.
Buy 10 small practices at a 2x multiple on $500K EBITDA for a purchase price of $10M. Don’t worry, you only need to front $2M and load the new business with the rest in debt.
Now, you have a business with $5M in EBITDA having done… NOTHING. Well as you know, this bigger business commands higher multiples. So you can turn around and sell it at 5x EBITDA.
$25M. You only put in $2M. Nice return. The goal.
Ok, I did make one more picture:
Listen, this is a simplified version, but you wonder why every finance major wants to go into private equity and why everyone who is super rich at least plays in the arena.
Tax structuring
I’m not an accountant so I can’t give you all the nitty gritty here. And frankly you probably don’t want it. Even I can’t make tax structuring interesting.
My two cents, they do all kinds of stuff with leases (as we saw above), refinancing loans, new debt, etc. to lower the tax bill. Cause damn the man, save the Empire!
It’s very American to avoid taxes. In fact, it’s the exact way and reason this country got it’s start. Huh. I guess tax evasion is about the most American thing there is.
Raise prices
I obviously don’t need to go into this one much. Aggregate that buying power with all the newly owned practices and negotiate better reimbursement. Also raise cash pay prices.
Do what you have to do. But raise prices.
Thus concludes our stroll down Goldman Sachs lane.
Outside of these financial engineering chicanery, PE firms will do some operational things. They’ll get you a bigger, worse EMR. They’ll cut your support staff. They’ll centralize a lot of functions, firing some of your favorite front and back office team. They’ll streamline processes and make things more efficient.
All in the name of cutting costs. The goal again, improve EBITDA. That’s how you get a strong exit.
And here’s The Big Strategy: Buy practices in the same specialty and put them onto a single platform. The PE firm reaches economies of scale in the new business, has a net higher EBITDA to drive a higher multiple, and how more leverage across all it’s contracts.
It’s essentially an economies of scale play. Classic. But the real question… Is economies of scale the way to make healthcare better?
We’re not making sweater vests.
All righty, now you know what in the heck is going on with this financial engineering stuff. And just like is sounds, nothing is really happening in terms of how the business serves people. These are just activities to increase valuations to generate returns on the sale in 3-5 years.
Cool. I am going to call my friend Barron now and see if he’s hiring.
Good day to you.
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