Asset owners are converging around standards for managing portfolio and real-world climate risks, with net-zero targets and greater expectations for private equity fund managers.
Such standards have not yet been applied to the healthcare sector, which increasingly represents a source of both alpha and risk-exposure in private markets. The financialization of healthcare has caused prices to soar, hospitals to close down, and patient quality to fall as private equity fund managers have saddled their healthcare assets with unsustainable debt to juice their returns and carried interest — often at the expense of patients and providers.
Thanks to the investigative reporting by many journalists and advocacy groups, including the Private Equity Stakeholder Project, these practices have drawn bipartisan investigation — and condemnation —at the state and federal level, increasing the materiality of these headline risks.
What’s a responsible investor to do?
For the last few months, I have spoken with asset owners, advocacy groups, researchers, and field builders about the role of private equity in healthcare. From those conversations, I have devised a series of diligence questions to help asset owners assess whether their PE managers are engaging in predatory behavior towards the US Healthcare system.
My aspiration is for the asset owner community to develop their own standards for investing in healthcare that are comparable to those emerging for climate change and workforce management. The eight questions that all asset owners should consider when making a healthcare investment are:
Screen out or screen in?
Some foundations have decided up front that they will not touch operating healthcare facilities (where physicians and nurses provide patients directly with care) because the headline risk of hospital bankruptcies and price gouging is far too great. If that is the case, make sure to enshrine it into your investment policy statement and actually ask GPs in your portfolio or those who seek your capital what kinds of assets they invest in.
The same way climate-conscious allocators avoid investments in coal, while still maintaining exposure to transitioning oil & gas assets, a policy could seek to limit the exposure to healthcare operating assets while still investing in medical devices, medical software, and digital health services.
Is the debt excessive?
Part of the private equity buy-out strategy is to finance an acquisition through debt in hopes of growing the business. This is not inherently a bad thing. But we must acknowledge how perverse these incentives can be. While the credit quality of the PE Sponsors and operating company are assessed together to obtain leverage, only the operating company is responsible for paying it off. So, if an operating asset, say, a healthcare chain, takes on excessive leverage at the PE’s behest, this could indicate that your GP is employing aggressive tactics that are unsustainable. If the ratio of debt to EBITDA is above, this could suggest the PE is aggressively leveraging their assets.
Are there noticeable changes in staffing ratios and patient quality?
To pay off excessive debt, many healthcare facilities reduce the size of their workforce. It’s important to scrutinize staffing ratios, specifically how many patients at maximum can be assigned to a single nurse. While there are no federal regulations mandating such ratios per department, California and Massachusetts have set fixed requirements per department and other states mandate the establishment of a staffing committee composed of providers and executives.
Allocators should request data on staffing ratios for each department both pre- and post-acquisition. If the teams have become more “lean,” then this is a red flag. You should also assess whether physicians are being replaced by Physician Assistants or Advanced Practice Registered Nurses (APRNs). Relying on APRNs is not necessarily a bad thing, as they expand access to healthcare services amid a national doctor shortage, but you should inquire as to why the changes were implemented.
Has the GP been sued for violating the False Claims Act and/or have a history of insurance fraud?
The False Claims Act seeks to prevent public and private providers from inflated billing, or “upcoding,” unlawful referrals and other fraudulent claims for insurance reimbursement. You should try to understand whether there are any FCA considerations during sourcing or post-investment.
Some GPs who would have failed this line of questioning include The Gores Group, which was fined $11.5 million for promoting a medical device unapproved for use with pediatric patients. Ancor Capital Partners was a co-defendant alongside one of their portfolio companies for submitting false claims for tests that didn’t occur and then giving kickbacks to physicians. They settled for $1.8 million with the Department of Justice, which accused them of uncovering kick-backs during due-diligence, and doing nothing to stop it. And finally, H.I.G. Private Equity received the largest fine in the industry in 2021 of $19.95 million for submitting claims to state agencies administered by unlicensed providers.
Do they conduct sale-leasebacks for healthcare facilities?
Sale-leasebacks occur when hospitals sell their real estate to private investors to raise cash to stabilize their balance sheets, only to then lease the same property back from the investors. In Massachusetts, Cerberus Capital Management purchased Caritas Christi Health Care, a struggling eastern Massachusetts hospital system, and rebranded it as Steward Healthcare in 2010. Six years later, Steward signed a sale-leaseback agreement with Medical Properties Trust (MPT) for its real estate at nine-times the original price that Cerberus paid in their buy-out. This resulted in highly inflated annual rent prices that were tied to a 30-year masterlease – even if the hospital closed down.
By 2024, the hospital was $50 million behind on rent payments and was forced to file for bankruptcy later that year. Steward’s CEO was subpoenaed by Congress to testify over his record but refused to show up. You should ask GPs whether they would consider employing lease-buybacks in their investment process and how they would avoid the mistakes of Steward Healthcare and Cerberus Capital Management.
How has the GP historically employed dividend recapitalizations?
Dividend recapitalizations occur when companies take on new debt to pay a special dividend to their investors. While this increases the IRR for the PE-Sponsor (and subsequent carry), it results in little operational improvement to the company. During its ten year ownership of Prospect Medical Holdings, a safety net provider in Texas, Leonard Green & Partners paid themselves $658 million in dividends.
During that same period, Moody’s declared that the company had no unrestricted cash, the funded ratios for Prospect’s pensions shrank, the real estate was sold to a REIT and a hotel developer, hospitals in the chain closed down, patient quality fell, and employees were laid off. Leonard Green finally tried to sell its majority stake for just $12 million, a severe devaluation. Any GP who employs this tactic of dividend recapitalizations with healthcare assets should be avoided all together. Private Equity managers should win mandates from allocators on their ability to make operational improvements to their underlying assets, not financial engineering.
Request access to their regulatory disclosures.
Private companies are required to fill out annual disclosures to the Occupational Safety and Health Administration on workplace injuries and illnesses. The OSHA Form 300 details these annual totals. Allocators should assess this data from the GP’s portfolio companies from pre- and post-investment for any upward trend.
What are the lessons learned from industry failures?
Over 20% of healthcare bankruptcies in 2023 were at PE-backed entities. The Private Equity Stakeholder Project has mapped all of these bankruptcies to their relevant GPs. If a GP who is in your portfolio or is looking to raise capital from you is on this list, ask them what happened, why, and what serious steps they’re taking to course correct. Even if a manager in consideration is not on this list, any GP who has a comparable asset in their portfolio should be knowledgeable about the failures of their peers. If they have not studied any of these bankruptcies that are relevant to their investment process and cannot tell you what they are doing differently, then you should pass on the opportunity.
The LP-GP relationship lasts across decades and GPs are highly motivated to curry favor with their current and future allocators. If LPs are willing to tighten the screws and use their power by asking better questions, pushing back on predatory policies, and refusing to invest in those unwilling to change, then we may be able to reign in some of the worst excesses of plundering in the US healthcare system.
Ibrahim Rashid is the Founder of Rashid Impact Strategies and a contributor to ImpactAlpha.
