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Curing healthcare

by contributor Andrew Troop, Pillsbury | Published September 11, 2012 at 1:26 PM

The healthcare industry in this country is ailing.

The constitutionality of the Affordable Care Act, with the exception of a provision concerning the expansion of Medicaid, has been upheld by the Supreme Court. Passed in 2010, it was designed to contain expenses while providing healthcare to currently uninsured individuals. Important features of the Affordable Care Act that survived Supreme Court review include: mandating that individuals purchase health insurance; creating an American Health Benefit Exchange in each state and providing tax credits to small businesses that purchase health insurance for their employees; imposing penalties on large businesses that do not offer coverage; requiring plans that provide dependent coverage to continue coverage until the dependent turns 26; requiring insurers to eliminate pre-existing condition exclusions; and finally, implementing pay-for-performance programs and quality-focused reporting requirements.

That said, whatever the future of the economy or the results of the Affordable Care Act, the healthcare industry is not going to improve without a significant dose of financial reorganization. Hospitals and similar institutions face increasing financial pressures from all directions, and those are unlikely to abate in the short term.

On the cost side, hospitals are seeing a rise in the number of patients they need to serve, in part because of demographics -- we're seeing an increasingly older, hence sicker, population. Not only are hospitals serving more patients, the cost of caring for each patient has risen. According to the American Hospital Association, the average cost per day rose from $1,149 per patient in 2000 to $1,853 in 2009, and during that time, the average cost per stay went from $6,649 to $10,043. On top of "normal" inflation due to rising labor, pension and retiree benefit costs, there are sector-specific burdens of the ever-higher costs of new technologies for tests and therapies. Most recently the drive for digitized medical records has added yet another cost stress.

The cost pressure is matched by a squeeze from the revenue side. The largest single payer is, of course, the government. As is generally known, reimbursement allowances for Medicare and Medicaid are far lower than those of private insurers. In fact, recent data indicates that Medicare pays about 80% what private insurers pay for similar services. A sinking standard of living, due to lower retirement benefits and other macroeconomic issues, has resulted in that same aging population increasing hospital costs while also cutting down on revenue. Further, we've seen many cases where state governments were less than prompt in their insurance and disproportionate share hospital, or DSH, reimbursements, and the Affordable Care Act reduces federally available DSH payments over time as well -- a restriction of cash flow that few hospitals can handle -- although there are intended to be other compensating benefits under the act.

Clearly, there's a huge structural issue here. The combination of rising costs and decreasing or delayed revenue is putting more and more hospitals into the red. In the past year alone, there have been hospitals that have closed or filed for bankruptcy in Hawaii, Indiana, Massachusetts New Jersey, New York and Pennsylvania. Some people will say, and perhaps rightly, that hospitals were never meant to turn a profit. And it is true that historically most operators thought that no community would let its hospital close, so there was no imminent threat to running it inefficiently. But no one, not even the government, can afford this kind of thinking any more. The increasing number hospitals in financial distress should serve as a signal that triage is needed.

The news is not all bad, though. Because so many hospitals have been run without adequate concern for their financial health, there is substantial opportunity to increase both efficiency and effectiveness in their business and service operations, the result being that many hospitals now facing the risk of closing could be successfully turned around.

Of crucial importance to the success of a hospital turnaround is access to capital. Frequently, when faced with cash flow difficulties, hospitals, like many institutions, attempt to economize by cutting back on building maintenance and repair and investments in technology. Not surprisingly, this creates a vicious cycle where those who cannot afford to go elsewhere continue to use hospitals requiring capital infusions, which further exacerbates the cost/revenue imbalance. Capital is also needed to modernize business processes, migrate patient records to a digital platform and institute best practices against medical errors and such preventable problems as post-operative infections. This would replace the race to the bottom with a virtuous cycle, where the better run a hospital is, the more likely it will be able to attract the kind of patients -- and capital -- that will allow for further improvements.

For healthcare organizations, the first task is to identify both ways of controlling costs and the possibilities for restructuring debts and other liabilities through a careful analysis of a healthcare organization's contractual obligations, patient mix and the competitive market in which it operates. Restructuring in this industry can be a particularly delicate matter, because for hospitals the primary creditor is often their chief source of revenue -- the government. This means not only that restructuring will involve navigating a complex regulatory environment but that in this case, the creditor has a much stronger position than in some other restructuring negotiations. Even so, there are many instances of a hospital either turning itself around or positioning itself to be acquired by a concern that has both the expertise and the economic scale to make it profitable.

Where distressed healthcare organizations are not making these shifts on their own, investors should be looking to identify institutions where thoughtful management could lead to a successful restructuring. Opportunities abound for creating viable, profitable institutions that serve their investors while serving their communities. With proper care, hospitals, like their patients, can be cured.

Andrew Troop is partner in the insolvency and restructuring practice of Pillsbury Winthrop Shaw Pittman LLP.

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