The Wall Street Journal Interactive Edition
February 2, 1998
Entrepreneurs Look to Profit From Nonprofit Hospitals

By ANITA SHARPE
Staff Reporter of THE WALL STREET JOURNAL

Profiting from nonprofit hospitals is back in fashion.

Nearly a year after Columbia/HCA Healthcare Corp., the most aggressive pursuer of nonprofit hospitals, became steeped in controversy, at least two new well-funded entrepreneur groups are vying for control or equity positions in some of the country's major nonprofit hospital systems.

Last week, hospital veteran Charles N. Martin Jr. launched Vanguard Health Systems to convert nonprofit, multihospital systems to investor-owned companies. Backed by $1.5 billion in funding, some of which comes from Morgan Stanley Capital Partners, Vanguard is in discussions with several hospital systems across the country, mostly in large metropolitan markets. Vanguard late Friday announced its first deal -- to buy the nonprofit Maryvale Samaritan Medical Center in Phoenix.

Monday, Joshua Nemzoff, a financial adviser to nonprofit hospitals, is expected to unveil MissionHealth LLC, which he says has a $2 billion financing commitment from private sources. Mr. Nemzoff says he is in preliminary talks with about a half-dozen hospitals.

With Columbia largely sidelined by federal investigations and a depressed stock price, the upstarts, both based in Nashville, Tenn., see a wide-open playing field. Both groups, though, have learned a lesson from Columbia's troubles. Columbia often bought, or joint ventured with, weaker hospitals whose cash flow could be substantially improved. To that end, Columbia took over the management of the hospitals and tightly squeezed margins through layoffs and other stringent cost controls. In the process, Columbiaoutraged much of the nonprofit industry, which still makes up more than 80% of all U.S. hospitals .

Vanguard and MissionHealth are taking a different approach. Both are targeting primarily established, well-run hospitals, offering those systems considerable autonomy.

Indeed, their interest in the industry is sparked by a little-discussed phenomenon: Many nonprofit hospitals actually make a lot of money. Returns of about 15% on net revenue are common, thanks in part to the fact that nonprofit hospitals don't pay taxes. Consolidation and improved economies of scale conceivably could make the properties even more lucrative. But if a hospital converts to an investor-owned entity it loses its tax-free status.

Access to Capital
Why would a nonprofit hospital want to sell all or part of itself? Mostly they get access to capital to help them buy physician groups, diagnostic firms or other facilities to help them compete better in their markets. While they've long had access to the bond markets, there are strict limits on how debt financing can be used.

"The question is whether [nonprofits] are starving for capital out there," says Mack Haning, spokesperson for VHA Inc., a national network of community-owned hospitals. Moreover, Mr. Haning notes, more nonprofits are collaborating among themselves to achieve greater market power and joining national organizations that provide group purchasing benefits.

But Vanguard isn't restricting itself to nonprofits. The company initially will try to buy a hospital that is, or has the potential to be, the leader in a region. With that facility in hand, the company will grow through additional affiliations or acquisitions of hospitals, physician management firms, outpatient and other services spanning cities and suburbs. Mr. Martin says Vanguard will consider strategic acquisitions of systems now owned by Columbia or MedPartners Inc., the country's largest physician management company, if such properties were for sale. Mr. Martin formerly was head of OrNda HealthCorp., a $3 billion hospital management company that was acquired by another larger hospital owner, Tenet Healthcare Corp., last year.

"We've expressed interest to other investor-owned hospital companies about looking at assets," he says.

"Our goal is to create a big business here," says Michael Hoffman, a principal with Morgan Stanley Capital Partners, which Mr. Hoffman says focuses on investments that can provide better than a 25% to 30% return over the long term.

To improve profits, says Mr. Martin, "We'll be growing the top line with additional services and getting unit costs down through [the treatment of patients] in the most cost-effective setting."

Vanguard is going out of its way to reassure communities that they will still have strong input into their local hospitals. It's setting up regional boards made up mostly of people selected by the charity foundation -- created after the sale of the nonprofit hospital to Vanguard -- and vowing that the local boards will play significant roles in determining executive appointments, medical services offered and capital and operating budgets. But, says Mr. Martin, "We will be the managers; all employees in the system will be employees of Vanguard."

Looking to Invest

Unlike Vanguard, MissionHealth is seeking simply to become an investor in nonprofit hospitals. Relying on laws that permit nonprofits to own partnerships, MissionHealth will take equity positions in the nonprofits that will transfer the hospital's hard assets and operating profits into a partnership. Under such a structure, though, the hospital will still be controlled by a tax-exempt corporation that will not pay taxes on the income it receives. The funds distributed to MissionHealth will be taxable.

Investors in MissionHealth would probably be seeking returns on their capital of 10% to 12%, Mr. Nemzoff says.

Since MissionHealth is only looking at hospitals that already generate decent returns, the company will leave existing hospital management in place, says Mr. Nemzoff, who adds that he spent more than a year devising the financing structure. Under the company's guidelines, it has the right to step in and assist management if the hospital doesn't maintain " a reasonable operating margin based on nonprofit industry standards." But Mr. Nemzoff downplays that possibility.

"Nonprofit management expertise is as good as the for-profits," says Mr. Nemzoff, who has worked on about 150 mergers, sales or acquisitions of nonprofit hospitals.

Nonprofit hospital executives say they are intrigued by MissionHealth's structure, though none has yet agreed to an equity partnership. "We don't have a need right now, but we would certainly entertain it," says Edward Rosasco, president of Miami's Mercy Hospital. "Increasingly, the nonprofit's need for capital is going to grow as margins become smaller."

"I have had clients who have sold to Tenet or Columbia or Quorum [Health Group Inc.] who I believe would not have sold if this had been available, "says Richard D'Amaro, head of KPMG Peat Marwick's health care practice. "We have said for a long time that there had to be an alternative funding source for nonprofits."