The healthcare industry affects our lives every day, and although it is growing at a faster rate than the U.S. economy as a whole, it has undergone increasing distress in the last few years. In their article, Barak Tulin and Michael Sandnes draw on CR3 Partners’ experience with healthcare organizations and their capital providers to explain why is this happening and what can be done about it.
Few industries affect our daily lives with greater frequency and magnitude than healthcare. The current expansion of the U.S. economy is on track to become the longest since the end of World War II, and the healthcare sector has grown along with it: combined healthcare spending in the United States is expected to reach $4.0 trillion by 2020, up from $3.2 trillion in 2015, a compounded annual growth rate of 4.6%. Healthcare spending continues to be driven by an aging and growing population, developing and expanding markets, clinical and technological advances, and rising labor costs.
At the same time, technological change is taking place in both the provision of care and the way consumers engage with their healthcare providers. Advances in consumer-directed health and wellness and in healthcare information technology (IT), fueled by both public and private-equity investments in the sector, have created exciting opportunities for consumers to become more involved in monitoring and taking charge of their care, a welcome development in an industry that for years did little to increase transparency between the patient and the provider.
In spite of these positive trends, the healthcare industry has recently undergone increasing distress. The number of healthcare-related corporate bankruptcy filings has increased dramatically in the past few years and their proportion of all corporate bankruptcies has climbed as well: in 2018, healthcare-industry bankruptcies comprised an average of 9.9% of total corporate bankruptcies, compared with an average of 2.9% of the total in 2015; and ended the fourth quarter of 2018 at 12.7% of the total. Rural hospitals and nursing homes, whose local populations are not creating enough demand for their services and whose local labor pools are not sufficient to keep facilities properly staffed, are closing in greater numbers and forcing patients to move farther away from their homes in order to receive essential care. More recently, subsectors in the healthcare industry such as skilled-nursing facilities (SNFs), continuing-care retirement communities (CCRCs) and long-term acute-care facilities (LTACs) have suffered from disproportionately more distress than the rest of the healthcare industry, as evidenced by recent bankruptcy filings and out-of-court restructurings. Even behavioral-healthcare facilities, whose services are in high demand partially as a result of the opioid epidemic and whose enterprise valuations have increased significantly, are not immune to this distress.
How do we explain these seemingly contradictory trends? Is this yet another instance of high growth killing certain industry participants that are unprepared to manage it, as we witnessed in the 1990’s dot-com bubble? Are the current capital markets, in which ever more debt and equity providers are competing for the same transactions, insufficiently accounting for the risks of allocating capital to the healthcare industry? Or is something else at work?
Recent trends in the healthcare industry, along with our experience advising healthcare clients and their constituents, suggest four causes of distress for healthcare providers in the face of growing demand for their services:
Transition from a volume-based to a value-based treatment model: In the volume-based model, healthcare systems generate more revenue as patient volume increases. The value-based model replaces this fee-for-service model by linking payments to the quality, efficiency and effectiveness of the care provided. Put another way, a patient who arrives at an emergency room or doctor’s office can be thought of as initially generating an expense rather than revenue, and the patient’s treatment outcome becomes the driver of reimbursements rather than the number of visits and the services provided. In 2019 and beyond, we expect health systems and hospitals to move toward the value-based model at a faster pace than in previous years, due in large part to the U.S. Department of Health and Human Services’ explicit goal of tying most of its reimbursements to patient outcomes. If providers do not have their operations in order, this shift may lead to reimbursement rates not fully covering the actual costs those providers incur.
Disruption in the delivery of primary care: If you received your last flu shot at a drugstore or an airport instead of at a doctor’s office, recorded the event in your iPhone Health app and shared it with your physician, you have both benefited from and participated in the disruption of the delivery of primary care. Retail health clinics such as CVS Health aim to provide patients with acute-care services at a lower cost, eliminating the need to visit a hospital for primary care. This shift in the delivery of care has caused traditional hospitals and health systems to reevaluate how they use primary-care physicians (PCPs) and has led many systems to direct more resources toward the development of urgent-care facilities. Although these facilities are typically unable to address the patient’s long-term health issues, retail clinics have begun to partner with PCPs and larger hospitals to begin providing urgent-care services. Even companies outside the industry have identified opportunities to benefit from disruption: in 2018, Amazon, Berkshire Hathaway and JPMorgan announced the formation of a healthcare joint venture to disintermediate the industry and reduce waste for the benefit of employees and the companies that pay their premiums; and the Apple Health app is allowing consumers to record their health-related activities as well as access and share their medical records with a growing list of healthcare providers.
Operational performance trailing the needs of the industry: Although revenue-cycle management, labor-staffing optimization, payor-mix management, strategic sourcing and inventory management are not new concepts to the industry, there are still hundreds of operators who have not fully adopted them, have not developed organizations that are accountable for results and have not mined their data to help them execute and track initiatives to improve operations and generate cash flow. This is explained partially by the not-for-profit structure of a large proportion of operators, in which efficiency is not always rewarded and successful patient outcomes are not always seen as compatible with the efficient delivery of patient care. As in the education sector, most practitioners we have worked with often feel personally and professionally committed to and proud of their mission, but have not had to reconcile the realization of that mission with managing the resources of their employers. An additional factor is the recent high executive turnover in hospital systems resulting from provider consolidation, merger-and-acquisition activity and forced early retirements; this turnover has reduced the time in which operational initiatives can become fully embedded within the organization.
Unsustainable capital structures: In recent years, the capital markets have raised significant pools of both debt and equity funding, in some cases at a faster rate than the growth of the industries to which they allocate capital. In the healthcare industry, private-equity firms have been racing to commit funding to companies that develop solutions for consumer-directed health and wellness and healthcare IT; publicly-traded business development companies (BDCs) have raised debt capital to invest in SNFs and LTACs; and healthcare-focused real-estate investment trusts (REITs) have executed numerous sale-leaseback transactions with SNF and ALF owners. This has resulted in above-market equity valuations, an excessive financial burden on borrowers, an unanticipated risk for debt-capital providers, and investment bases for REITs that are no longer supportable as reimbursement rates decline, labor rates increase and SNFs and ALFs have less cash to pay the minimum rent.
How can these problems be remedied? Our experience with clients and vendors in the healthcare sector in general – and in acute-care hospitals, SNFs, CCRCs, LTACs, physician organizations and behavioral-healthcare facilities in particular – suggests there are many ways to mitigate these causes of distress and help healthcare organizations both stabilize and improve their businesses:
Execute basic operational improvements first, then continue up the value chain. We often say that you can cut your way to profitability but have to grow your way to prosperity. Immediate and easily implementable improvements can yield savings to fund growth: mobilizing physicians and staff to reduce unnecessary usage of supplies and utilities, negotiating lower unit costs and volume discounts through strategic sourcing, outsourcing functions that are not related to patient care and renegotiating key managed-care and supply contracts are all initiatives that can generate near-term savings. Even if these benefits seem like pennies, the longer you wait to act, the sooner pennies turn into dollars and more potential savings remain unrealized. The financial benefit of these improvements can then fund the longer-term initiatives of partnering with doctors to ensure they are not competing in the same facility, reviewing physician compensation on an ROI basis, increasing case volume, adding profitable services lines, increasing operating-room efficiency and improving patient mix, a particularly important initiative as Medicare and Medicaid reimbursement rates continue their downward trend.
Swim with the current of disruption. CR3’s professionals have worked with companies in many industries that encountered disruptive technology but instinctively viewed them as a threat to their business, rather than an opportunity to improve performance and to profit from it. Consumer-driven healthcare IT increases the patient’s responsibility of his or her healthcare and creates more transparency between patient and provider, a positive outcome which is on trend with the shift toward the value-based reimbursement model. Although certain large-scale technologies such as robot-assisted surgeries are expensive to implement and not fully proven, smaller and more immediately impactful technologies, such as those that reduce dosage error, can improve patient outcomes quickly and provide more time for physicians to deliver better overall care. In particular, health plans are the only players in the healthcare ecosystem that have a complete data set for each insured patient, information which will be important for both health systems and physicians as they become more responsible for the long-term health of patients – all of which can be harnessed by disruptive technology to improve the delivery of healthcare.
Embed the link between operational improvement and financial performance. Healthcare organizations are data-rich environments, but too often they do not know how to identify key operational and financial metrics or fully mine their data to support those metrics. Identifying these metrics for each function; using data-mining software, which has become progressively more affordable for our middle-market clients, to extract the information; and then tracking those metrics daily or weekly can align the organization to generate better patient outcomes and ultimately higher profit. Most important, executives must establish the link between efficient operations and solid financial performance by making departments accountable to one another for their results on both the P&L and the balance sheet, and to emphasize frequently that profitable operations must ultimately generate cash. The complexity of patient care creates multiple points throughout the process in which even the smallest mistake can impact cash flow, and therefore everyone in the organization who touches a patient record can improve liquidity, regardless of his or her function.
Let the buyer (and the borrower and the lender) beware. Publicly-traded companies that specialize in consumer-directed health and wellness and in healthcare IT have recently posted multiples of enterprise value to LTM EBITDA of 31.7x and 30.2x, respectively, and the growth of these subsectors has attracted private-equity firms to companies in this space. But what if their optimistic projections do not materialize and other buyers are not willing to purchase these investments at a higher multiple? Although expected private-equity returns usually reflect this risk, borrowers and lenders in healthcare are equally at risk when investors put pressure on capital providers to put their money to work, and borrowers are too easily enticed by less-restrictive lending covenants and the flush of cash generated by sale-leaseback transactions. We have observed many instances in which we believe lenders have underpriced their risk in favor of closing a deal, a situation that leaves little margin for error if the borrower underperforms and its operations are not nimble enough to manage through the distress. Bad balance sheets are a two-way street, and private-equity purchasers, borrowers, and lenders need to properly evaluate their risk-reward balance before closing a deal that may turn sour less than a year after origination.
Healthcare is a growth industry whose participants often do not have the tools to manage and profit from that growth and are saddled with unsustainable balance sheets – a combination of factors that invites distress. Fixing the operations with early quick hits to fund long-term change, embracing disruption as a driver of profit, investing all employees in financial and operational outcomes, and making intelligent capital-structure decisions can help mitigate or even prevent this distress. Healthcare providers and their financial constituents should seek advice to address these issues and implement it quickly – before pennies turn into dollars.
About CR3 Partners, LLC
CR3 Partners, LLC is a national turnaround and performance improvement firm that assists, guides and collaborates with management teams and their constituents facing any sort of transition, stress or distress. Barak Tulin is a Partner, and Michael Sandnes is a Director, in CR3’s New York office. Matt Lupton, a Director in CR3’s Dallas office, contributed additional research for this article.
 CNN Business: https://money.cnn.com/2018/01/30/news/economy/us-economy-boom-history/index.html
 Centers for Medicare & Medicaid Services, Office of the Actuary; U.S. Department of Commerce, Bureau of Economic Analysis; and U.S. Bureau of the Census.
 Polsinelli TrBK Distress Indices: https://www.distressindex.com/reports/
 Bloomberg Business: https://www.bloomberg.com/news/articles/2018-06-24/amazon-berkshire-jpmorgan-health-venture-takes-aim-at-middlemen
 Duff & Phelps Healthcare Services Sector Update, August 2018