We have noted in the past that we publish a monthly healthcare private equity column in Law360. This month the column was co-authored with our colleague Holly Carnell (as well as summer intern Greg Barr to whom we are also very thankful!). The column is reproduced here and discusses private equity investment in the physician-owned hospital space.
Where Private Equity Meets Physician-Owned Hospitals
Physician-owned hospitals have had interested private equity investors for several years. For example, private equity firm Welsh Carson Anderson & Stowe formed United Surgical Partners International (USPI) in 1998, and since then it has taken the company public twice (in 2001 and 2012) and private once (in 2007). USPI operates more than 200 short-stay surgical facilities, including both ambulatory surgery centers and physician-owned hospitals.
Likewise, in 2011 Irving Place Capital acquired National Surgical Hospitals, which owns and operates surgical hospitals and ambulatory surgical centers in 10 states. Ardent Health Services (also backed by Welsh, Carson since 2011), Cirrus Health (affiliated with HealthCap), IASIS Healthcare (with largest stockholder TPG Capital since 2004), Symbion (owned in part by Crestview Partners and other private equity investors) and Surgical Care Affiliates (a TPG Capital investment since its 2007 spinoff from HealthSouth) all have physician-owned hospitals within their family of surgical facilities.
However, the passage of the Patient Protection and Affordable Care Act (ACA) in 2010 raised questions about whether physician-owned hospitals still present attractive investment opportunities for PE funds. Section 6001 of the ACA prevents the creation of new physician-owned hospitals if the same will submit claims for Medicare/Medicaid services referred by the owning physicians. Section 6001 also prohibits the expansion of such existing hospitals, except in rare circumstances.
These restrictions create challenges for private equity investors, particularly given the focus of many investors on platform building and rollups to create economies of scale and revenue enhancements. Investors question how physician-owned hospitals can grow if they retain physician ownership, the model on which such hospitals are founded and in many cases operate successfully. The regulatory environment facing physician-owned hospitals may be too constraining for some PE funds, but many funds — especially those already investing in a health care platform such as USPI and others discussed in this article — still view the industry very optimistically.
Physician Owned Hospitals are Still Outperforming in the Wake of Health Care Reform
Despite the obstacles put in place by the ACA, many physician-owned hospitals (which are often, but not always, specialty-focus hospitals) are finding ways to thrive. According to one estimate, “many physician-owned hospitals have enjoyed 20 percent to 35 percent profit margins in recent years,” whereas “U.S. community hospitals’ profits hovered around 7 percent in 2010.” Moreover, “[i]n 2011, the first year of the [ACA’s] restrictions, more than half of the 30 largest doctor-owned hospitals showed operating margins that either matched or surpassed their 2010 figures, and some had operating margins of more than 40 percent.”
On top of this, in many cases the ACA has actually benefited certain physician-owned hospitals. Under the ACA, Medicare has a hospital value-based purchasing program (VBP) that will pay bonuses or assess payment reductions to providers based on achievement of quality measures. By contrast, previously payment was based almost entirely on quantity. High-performing hospitals can see increases in pay rates up to 1 percent, whereas low-performing hospitals may see as much as 1 percent reimbursement decreases. In addition, hospitals will be penalized with pay rate reductions as much as 1 percent for having too many readmitted patients, an indication of ineffectiveness.
These quality-based incentives programs can be very advantageous for physician-owned hospitals. According to Kaiser Health News, “Of 161 physician-owned hospitals eligible to participate in the health law’s quality programs, 122 are getting extra money and 39 are losing funds.” By contrast, 74 percent of nonphysician-owned hospitals are being penalized under the new system. The end result is that “Medicare is paying the average physician-owned hospital bonuses of 0.21 percent more for each elderly patient during the fiscal year that ends Sept. 30 … Meanwhile, the average hospital not run by doctors is losing 0.30 percent per Medicare patient.”
Physician-owned hospitals’ dominance in this regard may reflect the high quality of care they offer patients. For example, data from the Centers for Medicare & Medicaid Services reveals that nine of the top 10 and 48 of the top 100 highest quality hospitals were physician-owned hospitals.
Critics of the physician-owned hospital industry speculate that these hospitals’ ability to outperform other hospitals in quality metrics is due to their focus on elective procedures, whereas nonphysician-owned hospitals may be directing more resources toward emergency procedures. These critics also accuse physician-owned hospitals of cherry-picking healthier, wealthier and better insured patients.
Proponents of physician-owned hospitals, such as Robb Linafelter, the chief executive of Lincoln Surgical Hospital in Nebraska, counter this claim by contending that some of the differences in quality between physician-owned hospitals and conventional hospitals may be attributed to the fact that when physicians own a hospital, they tend to direct resources in a more patient-oriented way, thus helping the physician-owned hospitals to score better in quality metrics related to patient satisfaction. Linafelter argues that “[a]t a community hospital, doctors don’t have control over where the dollars are spent.”
Likewise, Dr. John Dietz, an owner of Indiana Orthopedic Hospital in Indianapolis and a member of the board of Physician Hospitals of America (PHA), explains the success of physician-owned hospitals as follows: “It’s the difference between renting a home and owning a home: the pride of physicians in owning the hospital.” Furthermore, Dr. Dietz argues that the physician-owned hospitals’ superior performance can be attributed to their high level of specialization — 75 percent of them are specialty hospitals — and to their lower level of bureaucracy. He says that “[t]here is a short path to change. Something can be brought up on the floor at 4 a.m. and changed by 4 p.m.”
Although the Medicare pay rate bonuses are helpful, they are somewhat modest. For example, a hospital that made $20 million from Medicare cases and earned a 0.75 percent pay rate increase from Medicare’s VBP, would only get a bonus of $150,000. As Linafelter explains: “It’s not a significant amount, but I’ll take it.” He sees the bonus as “more of a recognition that we are a facility that is doing things right.”
In light of these successes, some physician-owned hospitals have chosen to respond to the ACA pressures by simply staying the course, maintaining physician ownership and utilizing the same historical operations models despite limitations on growth. These hospitals have considered growing in ways not prohibited by the ACA, such as operating for longer hours (e.g. during evenings and weekends), increasing procedures in type and number.
By contrast, some physician-owned hospitals have considered modifying their ownership structures to alleviate the restrictions imposed by the ACA, such as creating a publicly traded company through an IPO (individually or via rollup of other providers). And still others have considered alternative strategies, such as comprehensive management arrangements, converting the physician ownership piece from the hospital side to the real estate and equipment side or, notwithstanding the inherent regulatory and business risk, ceasing to accept Medicare/Medicaid patients.
While these strategies are all additional considerations for private equity investors when contemplating the strength of a potential physician-owned hospital in the current challenging regulatory environment, many PE funds still have their doubts. It is unclear if, notwithstanding the successes of physician-owned hospitals, these avenues for growth are sufficient to offset the restrictions of Section 6001. It may be a scenario similar to home health investments a few years back — investors already in the space aggressively expanding their investment with those not already in the water staying out. Time will tell.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 Alicia Mundy, “Doc-Owned Hospitals Prep to Fight,” The Wall Street Journal Online, May 14, 2013
 Jordan Rau, “Doctor-Owned Hospitals Prosper Under Health-Care Law,” Washington Post, April 13, 2013.
 Tanya Albert Henry, “Physician-Owned Hospitals Seize Their Moment,” American Medical News, April 29, 2013.
 Rau, supra note 3.