The healthcare system is one of the most fragmented industries in the United States. But as strategic players begin consolidating through mergers and acquisitions, private equity investors are seeing growth opportunities in the industry. 

On this episode of The Banker's Corner, McGuireWoods' Geoff Cockrell invites Rex Burgdorfer, Partner at Juniper Advisory, to discuss M&A trends, consolidation, and activity in the healthcare sector. 

The hospital industry presents challenges for private equity in terms of regulation. This limits investors’ ability to exert control and influence over management compared to other sectors. A successful model that has emerged is the partnership between private equity firms and high-quality academic medical centers. 

But how is this changing business model impacting investors’ interest? According to Rex, fewer well-capitalized investor-owned companies are available today. What he has seen is nonprofits holding an advantage in making acquisitions due to tax exemptions, participation in programs like 340B drug pricing, and lower cost of capital from the tax-exempt bond market.

This trend may change in the near future as nonprofits struggle with access to capital and rising interest rates. 

Geoff and Rex also discuss trends for private equity and health systems, regulatory scrutiny in the industry, creative competitors, and how a looming recession could affect the industry. 

Featured Guest

Name: Rex Burgdorfer

What he does: Rex has over two decades of investment banking and strategic financial advisory services experience. He has advised all forms of nonprofit hospital systems on M&A transactions, including academic, community 501(c)3, faith-based, and local government entities. Rex was previously with Morgan Stanley and holds an MBA from the Kellogg School of Management at Northwestern University.

Organization: Juniper Advisory

Connect: LinkedIn

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Banker's Corner, a McGuireWoods series exploring investment trends, solutions, and business issues relevant in today's private equity and finance industry. Tune in with McGuireWoods partner Geoff Cockrell as he and specialists share real-world insight to help enhance your knowledge.

Thank you for joining another episode of the Corner series. I'm Geoff Cockrell, partner at McGuireWoods and your host. Here at the Corner series, we try to bring together thought leaders and deal-makers in healthcare M&A and in particular the intersection with private equity. Today I'm thrilled to be joined by my longtime friend and collaborator, Rex Burgdorfer from Juniper Advisory. Juniper's, one of the preeminent kind of boutique M&A specialists for hospital and health system M&A. Rex, before we jump into some questions, if you could introduce yourself and Juniper a little bit?

Sure. Thanks for having us and have appreciated your friendship over the years. Juniper's a very specialized investment banking firm that for 30 years has done nothing but provide merger and acquisition advisory services to the acute care hospital market, so very specialized, one product, M&A advice delivered to one industry, the acute care hospital industry, and we've worked I think on about 250 projects around the United States from Alaska to Florida and have followed with interest the structure of the hospital industry over that period of time its trend toward consolidation and the role that private equity has played in that consolidation.

That's probably a good place for us to launch. A lot of the consolidation in health systems is kind of strategic players acquiring or merging with other strategic players. What has been and is the intersection of that universe with private equity and why?

Well, the hospital industry remains the most fragmented of its sort in the US economy. It's a large share of our gross domestic product spending is in aggregate pretty ineffective in terms of the costs we're paying for services and the value received. Well, one of the reasons that's being cited as a contributor to that challenge is its level of fragmentation. There are 4,500 hospitals in the United States still controlled by over 2,000 companies. If you were to add up the market share of the top 50 hospital companies, it commands less than 25% of the overall market. In any other industry, that's capital-intensive, regulated, and complicated, you expect it to be the exact inverse, the top 50 largest companies in the autos, airlines, or food beverage and tobacco industries would command more than 75% of the market share, so there's movement afoot to form more rational health systems.

There are a lot of reasons that that has been slow to occur. There are only about 80 transactions occurring on an annual basis in the hospital industry, and so for 80 transactions a year to make a dent in an industry with 2,000 companies, it's been slow. One of the reasons we think is that the not-for-profit systems that command 90% of the market are backed entirely by debt and debt investors are really only incentivized to ensure that the company makes timely payments on its interest in principle to hoard hundreds of days of cash to have the best possible credit rating and almost disincentivizes growth projects, so the investor-owned sector, which was 10% of the industry in 1990 and is still 10% of the industry today. We think those backed by equity whose investors are seeking growth projects hold an interesting opportunity to help restructure the industry. Private equity's come and gone in terms of their interest in sponsoring hospital systems and we can talk about that as this conversation continues.

What has been the driver of the heavy debt financing as opposed to equity? Is it the nature of the types of borrowing they can do, the assets they have to secure them? What's been the driver?

Well, since 90% of the industry is nonprofit, there are really two forms of external capital that a nonprofit can finance itself with. Number one is those fortunate enough to secure philanthropy and most of that is in urban settings where wealthy and generous individuals have helped hospitals construct cancer hospitals, et cetera.

The other source is outside capitals, the tax-exempt municipal bond market, and the municipal bond market used to be composed of individual investors buying credits for their retirement portfolio. As that sector has institutionalized and now Mr. and Mrs. Smith aren't directly buying the water and sewer bonds of their local township and instead it's fidelity buying large shares for its enormous 401(k) portfolios, there's more pressure being placed on hospitals for larger offerings and higher ratings, and that's proven challenging to some community hospitals in terms of their access to capital.

What has been the driver for why private equity ownership in that industry is hovered around 10%? It would seem that fragmented industry, lots of things to buy. There's lots of opportunity in there. Why is it hovered at 10%?

Well, I think from a private equity standpoint, the hospital industry is very capital-intensive, very regulated, and the ability of private equity to exert control and influence on how companies are managed is less than they are in other sectors. Most all of the activity has been buying and selling hospitals that have already been investor owned rather than converting the tax status.

As you and I have worked on directly, though, a interesting model that kind of emerged a decade ago that has been shown to work pretty well in practice is the marriage of private equity and high-quality, often academic medical centers pursuing growth together. Best example of that nationally is probably Duke LifePoint. LifePoint's backed by Apollo, 70 hospitals in 20-plus states seeking growth, and what those two participants, private equity and academic brought together to the community hospital market is often pretty attractive to boards of hospitals that are joining larger companies.

One of the areas where your world with hospital M&A intersects with mine where I do a lot of work with larger provider platforms is the impact of kind of vertical consolidation in the hands of the hospital where they're encroaching into things that might have been more the domain of large provider groups. How does that impact what you're seeing?

Significantly. Most of the hospital systems that were built or constructed in the 1990s and two thousands were done so as hubs and spokes whereby the spokes a community hospital would feed the downtown hub tertiary referrals and the traffic patterns were pretty much one direction. COVID really changed both medical and financial incentives for those hub-and-spoke systems to reverse the patient flow. The downtown hospitals are full. It's the highest cost setting, by far, and as more research emerges that patient outcomes are improved if they can seek care close to home and be supported by family members and have regular follow-ups with their physicians, outcomes are better, so hospital systems that used to be content being ivory tower research institutions are now seeking growth for the first time both horizontally and vertically.

We're both in Chicago. We were fortunate to advise the University of Chicago a couple of years ago on its first acquisition of a community hospital 30 miles southwest of their headquarters in Hyde Park and the motivation for that was to grow the population that they were serving horizontally, have a larger network of activities, perhaps be less reliant on traveling. Physicians and nurses have a larger group to weather bundled payments to be accountable for the care that they provide and when one receives a bundled payment or is it accountable for the care they provide, there's incentive to control the vertical continuum as you're describing so that when a health system receives one check from a managed care company and it's incumbent on them to figure out internally how to compensate the nursing staff, the anesthesiologist, the surgeon, the step-down levels of rehab and post-acute, if that's all controlled within one enterprise, their ability to be successful and still earn a positive margin is greater.

You mentioned the hospital as the most expensive location of care. Another intersection with large provider groups is in joint ventures surrounding ASCs. That's been a significant and expanding arena with often intricate and complicated structure. When you're advising health systems, how central are those strategies?

Pretty significant, but again, the group of participants that we would go to in a marketing process for a community hospital seeking a larger partner, that universe has shrunk. If we were managing a competitive process 15 years ago, we might have been able to go to a dozen good quality, highly considered, well-capitalized, investor-owned companies, some public, some backed by private equity.

That's now really down to less than one handful and there's been a pretty significant shift in the advantage that the nonprofits have on making acquisitions, so nonprofit systems that are trying to buy a community hospital don't have to pay taxes, obviously. They can participate in things like the 340B Drug Pricing Program. Their cost of capital is lower thanks to the size and liquidity of the tax-exempt bond market and so it's been interesting to see in the past there would be huge disparity between the proposals put forth by an equity-sponsored company, which might have several tens or hundreds of millions of dollars of value associated with it and a nonprofit via a cashless membership substitution. Today, the nonprofits have really awoken to conclude they need to grow and are pursuing those aggressively and performing much better in competitive processes.

The not-for-profits awakening as buyers makes a ton of sense. What impact on that kind of evolution does the rising interest rate environment have? Given that most of their access to capitals coming through debt markets, I would think that that could make the pendulum swing the other direction again.

Yeah, I think over time, setting aside the last six months of inflationary period, their access to capital is still on a global basis really low, and so whether the interest rate on a debt insurance is 3% or 5% hasn't, I don't believe, made material impact on operations. I think the inflation on things like supplies and operating expenditures has had a greater impact. Certainly, the huge trend of the traveling workforce has had the biggest impact causing losses across the industry regardless of tax status. Most health systems, even the best-run, most prestigious ones lost money in 2021 and 2022.

You've outlined a number of reasons why private equity interest in health systems has been a little bit muted. Do you think that trendline will change anytime in the future or is that how it's going to continue?

Well, private equity funds, you would know better than I would, but the size of funds has increased dramatically. The popularity of the asset class has risen dramatically, and so the capital that resides within private equity managers' coffers is enormous and they're under pressure to put that to work. You identified some areas where it has been applied in non-acute settings, joint venturing with the construction of medical office buildings, a lot of creativity around real estate, finance. Behavioral health is a very important one, as sadly, our society is experiencing more and more addiction issues, treatment on psychiatric services, large opportunities in those fields for private equity.

Kind of changing direction a little bit. In a lot of arenas, whether it's federal or state, we're seeing a heightened level of scrutiny from an antitrust perspective where the federal regulators are taking a greater interest, but some of the biggest movement has been state regulators who are very interested in the impact on the cost of care by consolidation. In your view, or in the areas where you are working, what has been the impact of heightened antitrust scrutiny?

Significant. It's always struck us as strange that the hospital sector, which is as I mentioned, still very fragmented, received so much scrutiny, and the largest company in the industry, HCA, has less than 5% of the national market share. The insurers on the other end of the equation have consolidated to a tremendous degree where something like 80% of healthcare expenditures are now paid for by fewer than eight parties, the federal government through Medicare and Medicaid, and a small handful of gargantuan insurers, so economists would say that hospitals are price takers and to think that two small community hospitals getting together would have the ability to influence United health pricing, I think, is misguided.

It's one of the reasons, though, that you see several of the announced acute care hospital transaction consolidations occurring across significant state lines, so Advocate in Chicago and Wisconsin combining with Atrium, leaping pretty significant geography in between. One example, UnityPoint in Iowa, combining with Presbyterian in New Mexico, pretty big geographic leap. Kaiser in Oakland combining with Geisinger in Pennsylvania. Perhaps one of the reasons that those are being entered into is to lessen regulatory scrutiny of adjacent systems combining.

There's lots of discussion that healthcare, in general, is more recession-resistant than other sectors, that if you need to go to the hospital, you need to go to the hospital, but question whether or not a looming recession would have a negative impact on health system M&A, or is the original premise incorrect, some of those community and even larger hospitals will find themselves in greater stress on account of recession and make them more likely sellers? How would you describe the impact of a potential recession?

Yeah, I think hospitals are already in a tenuous position, with most having lost significant amounts of money over the last several years. The fundamental equation of increasing costs for travel errors or supplies or drug pricing combined with lower prices through reimbursement from giant insurance companies, the net effect of that is lower margins. The other dynamic in addition to the recessionary pressures might be the entrance of creative competitors, especially in community settings with companies like One Medical able to now over FaceTime video prescribe basic medicines, causing the patient to not need to go into a hospital setting is certainly on the minds of systems, worried about losing what has been a pretty durable and consistent source of business.

Rex, I think we'll probably end it there. The impact of health system consolidation is going to continue to ripple through the broader healthcare industry, and I'm sure you'll be at the center of it. It's always good to chat with you and thank you for joining.

Thanks for having us.

Thank you for joining us on this installment of The Banker's Corner. To learn more about today's discussion, please email host Geoff Cockrell, at gcockrell@mcguirewoods.com. We look forward to hearing from you.

This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty guarantee or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.