Over the past 18 months, there's been a flurry of activity in the private and public equity markets regarding for-profit health systems. At the same time, many stand-alone hospitals and smaller health systems with lower credit ratings have found it increasingly difficult to access capital. As this trend continues, and with credit agencies further downgrading many in the nonprofit sector, distressed and smaller providers are taking a hard look at their future and whether to seek a partner to provide stability. Contributing editor Bob Kehoe talked with Frederick A. Hessler, managing director, Citigroup Global Markets Inc., to get his take on these developments.

What's triggering recent growth in health care among private and public equity firms?

The big driver is weak nonprofit systems not having access to capital. Today, 17 percent of U.S. hospitals are for-profit. That percentage has been growing steadily, albeit slowly, over the last several years. The pace of activity has picked up principally because many of the lesser, lower-rated nonprofit health care systems have had challenges obtaining capital via traditional capital markets.

Many of these lower-rated nonprofit systems have turned to organizations that can provide capital, which is one of the biggest advantages that for-profit systems offer. For example, Detroit Medical Center was acquired [in January] by Vanguard, which was privately owned at that time. Subsequently, it has been offered to the public and now is publicly owned, which brought capital and a capital commitment.

Is this growth in the for-profit market historically significant?

I haven't looked at this issue specifically, but we had a huge cycle of activity in the mid- to late 1990s with for-profits acquiring nonprofits. That really tailed off and held at a fairly low rate for most of the past decade. We've seen a significant spike of activity in the last 18 months, probably comparable to what we saw in the mid-1990s.

How large is the for-profit market likely to BECOME over the next three to five years?

On the conservative side — and this is purely speculation on my part — but, perhaps up to 25 percent of the hospitals may be for-profit in that timeframe. It might be higher.

A Citi Growth Study OF 245 Health systems indicated operating revenues of for-profit systems were about one-third higher than noNprofits. What accounts for the disparity?

The data indicates total growth, which is same-store growth as well as growth from acquisitions. The for-profits have been much more acquisitive than the nonprofits. We haven't looked at the same-store growth of for-profits and nonprofits, but my guess is you would not see huge differences in same-store growth.

What about areas like compensation, profit margins and supply cost differences?

The data tend to show that the for-profits and the very large nonprofits have the same benefits of economies of scale, which are reflected in such areas as supply costs and to a lesser degree, but still importantly, in labor costs.

In comparing for-profits with the smaller [nonprofits], defined as those with less than $1 billion in net patient revenue, the for-profits have a huge advantage in efficiencies as reflected in lower operating costs as a percentage of net patient revenue. The data show that it doesn't matter whether you're for-profit or nonprofit; if you've got scale, you've got an advantage.

Are hospitals with low credit ratings finding it harder to access capital?

Since the market meltdown in 2008-2009, we've seen a definite tightening of the credit and capital markets for lower-rated, nonprofit health care systems, those rated as BBB and below. Some BBB organizations have access to capital markets, but those who do have paid a significantly higher premium in terms of higher interest rates.

A fundamental change is occurring. The outlook from the perspective of the fixed-income or tax-exempt buyer generally is bearish on the industry. A couple of the rating agencies have health care on a negative outlook. In contrast, on the for-profit side, if you look at the stock market performance of many of the publicly held companies, they have outperformed the S&P 500 since 2008-2009.

On the equity side, there is a case to be made that people are much more bullish about this sector. Also, if you review the consensus opinions of equity research analysts, many of them have buy ratings on a number of the for-profit companies. Those buy recommendations are up dramatically from 2008. There are different characteristics when you look at the nonprofit capital providers — the big tax-exempt bond funds, the retail buyers — in contrast to equity buyers.

That divergence is driving much of the activity we're seeing by the for-profits and the nonprofits in considering selling to a for-profit organization as an alternative.

How will smaller health systems and stand-alone hospitals be impacted?

Our data show that smaller systems financially have been underperforming from an operating perspective compared with the large health systems pretty consistently over the last five to six years, to the point where the large systems have roughly a 210 to 220 basis-point advantage in superior operating performance over smaller organizations.

What is becoming clear is that smaller organizations that also tend to have lower ratings have trouble accessing capital. They have not kept up with the financial performance of the large organizations.

As we look down the road to 2012 through 2014, many people are saying that the environment will be much more challenging than we've seen in the last couple of years. If you take all of those factors, this is causing many smaller health systems and stand-alone hospitals to assess their future critically.

For that reason, a number of them are saying they need a partner. That partner could be a large nonprofit system or a for-profit organization. The outlook for them generally is going to be challenging unless they have a rather unique market position — namely, if they are a sole community provider or have community financial support in the form of subsidies or a tax base. If not, it will be challenging for them to go it alone.

How are hospitals faring financially with the increased alignment we're seeing with physicians?

That's tough to answer because we have so many nonprofit organizations who for years have had extraordinarily tight alignment with their physician groups. Large, multispecialty practices that are part of systems, such as Geisinger Health, Cleveland Clinic and Lahey Clinic, that have a long and rich history of alignment, have done fine financially.

We haven't really studied hospitals without that history — those that are still in the process of creating myriad models to promote physician alignment and are studying the financial outcomes.

We have data that analyze the financial performance of recognized integrated health systems in the country. SDI annually identifies and publishes its top 100 most integrated systems and we have analyzed the financial performance of those that are consistently on this list. Interestingly enough, those organizations, particularly those in the top quartile of the top 100, have done a fabulous job of managing not just supply costs but also total labor costs, including physician compensation.

In some cases, they're outperforming the financial performance of the $5 billion health care systems. The data show that you can manage costs more effectively on the labor and supply sides if you are highly integrated.