Private Equity and Healthcare, a Marriage in Crisis

Is Private Equity Having Its Minsky Moment?” is another excellent article from Matt Stoller’s BIG newsletter, something that anyone who is interested in PE and corporate finance should be reading (I referenced a couple of his newsletters previously).

You’ve probably been hearing about salary cuts, furloughed employees, and big losses in health systems around the country. I myself am currently experiencing a sizable pay cut. You may have even heard about the possible impending bankruptcy of healthcare megacorp, Envision. Envision is now drowning because they grew to massive size by buying companies using tons of debt. Because of that massive leverage, if those businesses do poorly, they can’t meet their debt obligations. To give you an idea of how Envision operates, they have less than $500 million in deployable cash on hand to cover $7.5 billion of debt.

Stoller gives a nice summary of why these highly-leveraged private equity companies (and other companies using the same toolbox) are ripe for failure when credit markets collapse.

Private equity is undergoing what the great theorist Hyman Minsky pointed out is the Ponzi stage of the credit cycle financial systems. This is the final stage before a blow-up. As Minsky observed, a period of placidity starts with firms borrowing money but being able to cover their borrowing with cash flow. Eventually, there’s more risk-taking until there’s a speculative frenzy, and firms can’t cover their debts with cash flow. They keep rolling over loans, and just hope that their assets keep going up in value so that they can sell assets to cover loans if necessary. To give an analogy, in 2006, when people in Las Vegas were flipping homes with no income, assuming that home values always went up, that was the Ponzi stage.

Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.

I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector.

Everyone wants to make the easy money in a bull market. It makes finance professionals seem competent in running multiple businesses across multiple industries even though their performance often has more to do with the amount of money in the pot driving valuations up. Rolling up companies in high-growth industries by paying top dollar? Piece of cake. But what do you do when the hard times hit? How can your businesses survive when you’ve saddled them to barely function in the best of times?

The business model of the 1980s has been institutionalized in ways that are hard to conceptualize. Sycamore Partners’ takeover of Staples was a recent legendary leveraged buy-out that shows how PE really works. Sycamore Partners is a private equity firm that specializes in buying retailers. Sycamore bought Staples for roughly $1.6 billion in 2017, immediately had Staples take out $5.4 billion of loans, acquired another company, and then paid itself a $300 million payment and then a $1 billion special dividend. Then, Sycamore had Staples gift its $150 million headquarters in the suburbans of Boston for free, after which Staples signed a $135 million ten year lease with Sycamore to lease back its own building.

Healthcare is different because the biggest cost center of most healthcare practices is personnel. And those providers are also typically the only source of profit. This limits the shenanigans you can pull, limits how you can grow, limits the cost floor, and—because of Medicare and agreements with other insurers—limits your profit ceiling. Taking care of people is not a software company or a tech business that can achieve limitless scale at near-zero marginal cost. And what seemed like an easy positive cash flow business isn’t as simple as selling toner.

Tens of millions of people no longer have income, and even those who do are afraid to go back to their old lifestyles. The Fed can’t ultimately can’t print a functional economy. And at the end of the day, no matter how many games you play with debt loads and capital structures, firms have to have customers, and people can only be customers if they have income.

We’re currently in process of bailing out a lot of companies, and low-interest rates will let some of these folks continue borrowing money trying to bide time until they can raise more capital or potentially grow out of their debt. That may not be feasible for long enough to outlast this downturn, especially if the money spigots shut off.

But the issue with bailouts in situations like these is that in recent history they’ve perpetuated a private-profit public-loss business model where PE firms are rewarded for taking on absurd risk because that risk is really on the shoulders of the American people. And without meaningful regulation, this perpetuates the growth of the industry instead of reining in its excesses. Our historically “strong” economy crumbled within about two weeks of the shutdown. That’s overleverage at work.

The actual underlying businesses within these organizations are often still sound once you remove the onerous debt obligations, leasebacks, and other financial machinations. A tiny silver lining of this horrible scenario may be getting some of the rent-seekers out of polluting healthcare.

Stockdale’s Reality Confrontation

Jim Collins, quoting Admiral Jim Stockdale, who called spending seven years in a Vietnamese prison camp “the defining event of my life that would make me a stronger and better person.”

This is what I learned from those years in the prison camp, where all those constraints just were oppressive. You must never ever ever confuse, on the one hand, the need for absolute, unwavering faith that you can prevail despite those constraints with, on the other hand, the need for the discipline to begin by confronting the brutal facts, whatever they are. We’re not getting out of here by Christmas.

Like a good Stoic, you should believe in yourself and focus on the things within your valence of control and stop–as much as possible–hinging your mental, physical, and even economic health on the things you cannot.

Painfully good advice for the world right now.

Anticipatory Grief, Anxiety, and—of course—COVID-19

David Kessler, co-author of one of the classic books with Kübler-Ross detailing the 5 stages of grief, interviewed in the Harvard Business Review:

Understanding the stages of grief is a start. But whenever I talk about the stages of grief, I have to remind people that the stages aren’t linear and may not happen in this order. It’s not a map but it provides some scaffolding for this unknown world. There’s denial, which we say a lot of early on: This virus won’t affect us. There’s anger: You’re making me stay home and taking away my activities. There’s bargaining: Okay, if I social distance for two weeks everything will be better, right? There’s sadness: I don’t know when this will end. And finally there’s acceptance. This is happening; I have to figure out how to proceed.

He goes on to discuss ways to manage pandemic anxiety, including focusing on the present, mindfulness, etc.

And then the bombshell: He’s adding a sixth stage (Finding Meaning) to the classic five.

And, I believe we will find meaning in it. I’ve been honored that Elisabeth Kübler-Ross’s family has given me permission to add a sixth stage to grief: Meaning. I had talked to Elisabeth quite a bit about what came after acceptance. I did not want to stop at acceptance when I experienced some personal grief. I wanted meaning in those darkest hours. And I do believe we find light in those times. Even now people are realizing they can connect through technology. They are not as remote as they thought. They are realizing they can use their phones for long conversations. They’re appreciating walks. I believe we will continue to find meaning now and when this is over.

There will be a pre-COVID and post-COVID world, and they will not be the same. The question is how much of this tragedy can act as a hard reset, enabling us to stop the distraction, infighting, and isolation and start making progress on the things that really matter to us as individuals, as a society, and as a species.

Moral Humility & The Ethical Career

From Maryam Kouchaki and Isaac H. Smith’s “Building an Ethical Career

So how can you ensure that from day to day and decade to decade you will do the right thing in your professional life?

The first step requires shifting to a mindset we term moral humility—the recognition that we all have the capacity to transgress if we’re not vigilant. Moral humility pushes people to admit that temptations, rationalizations, and situations can lead even the best of us to misbehave, and it encourages them to think of ethics as not only avoiding the bad but also pursuing the good. It helps them see this sort of character development as a lifelong pursuit.

We all have a personal opportunity to make being good an active choice. I’ve always loved the view that being an ethical person isn’t a character trait but an endless series of (often challenging) conscious choices. We see so many examples of people who are good in some capacities but not others precisely because it’s sometimes easier and sometimes harder to make what are–at least in hindsight–clearly right or wrong choices.

Preparing for ethical challenges is important, because people are often well aware of what they should do when thinking about the future but tend to focus on what they want to do in the present. This tendency to overestimate the virtuousness of our future selves is part of what Ann Tenbrunsel of Notre Dame and colleagues call the ethical mirage.

Counteracting this bias begins with understanding your personal strengths and weaknesses. What are your values? When are you most likely to violate them? In his bookThe Road to Character, David Brooks distinguishes between résumé virtues (skills, abilities, and accomplishments that you can put on your résumé, such as “increased ROI by 10% on a multimillion-dollar project”) and eulogy virtues (things people praise you for after you’ve died, such as being a loyal friend, kind, and a hard worker). Although the two categories may overlap, résumé virtues often relate to what you’ve done for yourself, whereas eulogy virtues relate to the person you are and what you’ve done for others—that is, your character.

I often wonder how many of my goals or projects fall firmly into the wrong camp.

Many factors go into choosing a job—but in general people tend to overemphasize traditional metrics such as compensation and promotion opportunities and underemphasize the importance of the right moral fit. Our work and that of others has shown that ethical stress is a strong predictor of employee fatigue, decreased job satisfaction, lower motivation, and increased turnover.

And this brings us to a nice medical dovetail. How many physician jobs now exist within a bureaucratic or corporate structure that is counter to how we feel a physician should be forced to practice medicine and that is counter to the best interests of both the practitioner and patient? How did we ever let a 15-minute appointment become normal? For anything?

And lastly, helpful litmus tests: publicity, generalizability, and mirror:

Three tests can help you avoid self-deceptive rationalizations. (1) The publicity test. Would you be comfortable having this choice, and your reasoning behind it, published on the front page of the local newspaper? (2) The generalizability test. Would you be comfortable having your decision serve as a precedent for all people facing a similar situation? (3) The mirror test. Would you like the person you saw in the mirror after making this decision—is that the person you truly want to be?

These are important things to consider before any big decision. Yes, they’re basically all the golden rule–but how often do you forget to use it?

Believing Anything and Nothing

The political theorist Hannah Arendt once wrote that the most successful totalitarian leaders of the 20th century instilled in their followers “a mixture of gullibility and cynicism.” When they were lied to, they chose to believe it. When a lie was debunked, they claimed they’d known all along—and would then “admire the leaders for their superior tactical cleverness.” Over time, Arendt wrote, the onslaught of propaganda conditioned people to “believe everything and nothing, think that everything was possible and that nothing was true.”

– McKay Coppins, writing about political disinformation for The Atlantic.

F. Scott Fitzgerald is often quoted as saying that “the test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

What microtargeting of vulnerable people has created is the opposite: minds that filter all ideas, opposing or not, through a distortion filter that makes them unable to think critically on anything. Facts don’t matter, because everything is just a predictable reaction based on a fundamental premise, world-view, or political exigency.

That article is extremely depressing. But if you’ve ever wondered what would happen if/when the internet became so drowned out by bots and misinformation noise that it becomes useless, you’d enjoy Fall by Neal Stephenson.