Insights on How Public Chinese Hospitals Go Private

Few would argue that hospitals are one of the more important aspects of China’s healthcare system that need to be overhauled.  In China, hospitals play an outsized role in the delivery of healthcare relative to how similar interventions are experienced in the West.   In the absence of strong primary care foundation, China’s hospitals are likely to continue to play a central role in achieving the Central Government’s objectives of increasing services to China’s population. The finalized planning and implementation guidelines that were part of the 12^th Five Year Plan reflect the Central Government’s acknowledgement that Chinese hospitals remain an area where additional investment is needed.

Because of this, as well as China’s decision in late 2011 to update its FDI catalog and move foreign investment in hospitals into the “encouraged” category, more interest than ever is beginning to emerge in investing into the country’s hospital sector.  Two approaches tend to characterize the sort of strategy foreign investors can pursue:  build a green-field hospital or privatize an existing public hospital.  These are obviously two very different ideas, and each brings with them unique challenges.  Relative to the former, green-field hospital investment allows for more flexibility in terms of what can be charged for procedures and a clean slate to put the right people, process, and system in place to achieve the desired financial and operational outcome.  Privatization of an existing public hospital offers the benefit of existing sources for patients and a physician workforce – both of which are key challenges for green field hospitals.  That said, the existing operations and pricing structure as well as compensation schemes and pension plans of public hospitals can be difficult to change, even when they are taken private.  As I have referenced in an earlier post, one very well-placed source with direct experience has described this as a very difficult set of changes to put through, while others have suggested that they are each changes that can be made, but have to be dealt with preemptively (i.e. as explicit terms negotiated in advance of the transaction’s close).  Because of these difficulties, many foreign investors traditionally favor green-field hospital investments as they provide more options to management to structure compensation around traditional patient outcome measurements as well as overall hospital profitability.

I know of at least one project in Beijing where the public-to-private transition has been pursued successfully; however, as I was reminded of during a meeting two weeks ago in Beijing, the public-to-private mechanism for hospitals in China has some additional baggage attached to it.  Approximately five years ago the Chinese government wanted to unload about 500 public hospitals.  This was less because they wanted to encourage private investment consistent with longer-term strategic policy issues, and more because they wanted to unload chronic under-performing hospitals and thought private hospitals owners and operators may be able to turn these hospitals around.

Even with this baggage, I know of several investors who are interested in the opportunity to take public hospitals private.  Consequently, I wanted to touch base with , the Senior Manager of PricewaterhouseCoopers’ (PwC) healthcare consulting business to understand the issues more in depth.  Located in Shanghai, with a strong background in hospital management and healthcare strategy, Christine is a wealth of experience and expertise on the public-to-private opportunity in China’s hospital sector.  One of the first points that Christine was quick to make was that “what investors need to keep in mind is the word ‘supplemental’ … the government does not intend to privatize healthcare … they want public hospitals to play the leading role in delivering healthcare, with private hospitals playing the supplemental role.”  I found this an important grounding observation:  through the last several weeks, whether I have been discussing pharmaceuticals, senior care or hospital investments in China, experts repeatedly have drawn the conversation back to being able to put on the lens of how China’s Central Government sees the need for healthcare reforms.  Align yourself with how they view what needs to be done (even if you don’t agree, or think a better way might exist) and you’ll benefit; fight it and you’ll discover the “market” doesn’t respond like you anticipate it should.  Relative to privatizing hospitals, what exactly is the Chinese government’s point of view?

Christine expanded on her comment by sharing, “the clearly says that participation of private capital is encouraged, both in the form of green-field investments, as well as to restructure, reorganize and reform existing public hospitals.”  In each case, the government is open to these entities being for-profit or not-for-profit.  Relative to private investment being used to reform public hospitals, Christine shared, “One way the government recommends is through restructuring and reorganization while maintaining the social benefit of the hospital.”  Seeing through the eyes of China’s central planners is also relevant to green-field investments.  As Christine added, “you want to build a good business strategy that has a clear public population benefit to it and/or raise the quality of care … don’t tell the government that you want to build a for-profit OB/GYN hospital in the middle of the city (even though I still see for-profit ‘international standard’ hospital licenses being granted in Beijing … anything is possible with the right connections; the question should be what allows the average investor to maintain a competitive advantage for long) … think from the point of view of a central planner … once you speak the government’s language honestly and genuinely, you can get things done … green-field still makes sense for many specialties, but where you put it, who you are going to be serving, and what the value proposition is for the government and the population are all important to communicate clearly with the government.”

Christine expanded on the distinction:  “what I see more often is private investments who have a vision to build a place with better customer service and allow the patients to spend more time with physicians.  They have better facilities; they throw more bodies and labor into the equation.  This model works in certain specialties (e.g. normal healthy OB) but it can be easily copied.  To me, it’s not as meaningful from a healthcare business strategy or government’s perspective.  It’s not necessarily about better management systems or clinical processes.”

Assuming you are able to identify a public hospital that is of interest to you, what sort of issues are you likely to encounter?  First, the need to align compensation systems.  Christine shared with me that relative to the investors who want to take a public hospital private, “it really is a case-by-case basis for the government.”  She added, “They may choose to keep some of the staff currently in the public institution system, or none at all.  From the private investors’ perspective, the key benefits of negotiating to keep this designation / system are first, the government will continue to pay the salary and pension and second, it will provide some level of stability and minimize the risk of these employees leaving the newly privatized hospital.”  Christine was quick to add that there are downside risks that need to be taken into account, namely “traditionally, it was implicit that new owners cannot fire these civil servants who are essentially employed for life; however, a recent government policy change now says these civil servants can be treated just like at will employees.  It remains to be seen if that is the case.  Second, because the salary is low and incentives are often not meaningfully linked to clear quality, service and efficiency performance metrics, this poses a challenge to the new owners who are trying to create a new culture and paradigm.”  As she summed it up so well:  “new investors inherit employees who will likely have worked in a public institution all their life.  Some may not be efficient, quality, or service minded.” Christine stated, “However, we have actually seen a number of players [from outside of China] with good operational expertise really looking at governance matters; specifically, how would you change the governance of the hospital and align operational goals, incentives, and compensation strategies in such a way to compensate for the gray money that exists in the system (over-prescription of pharmaceuticals and in particular) and to improve productivity and quality of care and service. … In Taiwan it used to be this way as well, until they raised the physician pay. … physicians want to do good, but if reimbursement is so low, they have to find a way to make up the difference.”

The second issue you are likely to encounter in your pursuit of privatizing a public hospital is what sort of ownership you want to take?  Christine added, “all options [joint venture, 100% privatization, minority interest] are possible, but a minority interest is probably not right because you have too little control over the outcomes … what you want to understand is the risk profile of the investor and what their core competency is … To turnaround a public hospital, an investor with operational know-how needs at least majority control to make necessary changes.”

I found the third issue Christine raised to be one of the most important:  whether the newly privatized hospital should apply to be in the social medical insurance network and whether the hospital should be not-for-profit or for-profit.  “Many investors privatizing a public hospital want to maintain the social medical insurance designated hospital status.  The reality is that if you want a hospital of a certain size and you don’t have access to the top doctors, you will typically need to accept social medical insurance to get patient traffic. I see some international investors and operators new to China having the misconception that being included in the social medical insurance system (i.e. accepting government-set prices) means that a hospital cannot be profitable; this is not true especially if a hospital is well-run.  As for the for-profit or not-for-profit status, I have seen investors going either way.  Investors choosing the not-for-profit designation often do so for the obvious benefits in tax and land acquisition.  However, they face limitations in terms of how they can get money out of their investment.”  Christine shared that “you can’t do a profit share…some investors do something like a management contract … however, even if there is the possibility of profit, private equity firms are staying out of this opportunity because the profit margin as a not-for-profit would not meet the typical requirements of a PE firm … [profit from management contracts] may be enough for insurance companies and SOEs over the long term to get them into the healthcare provider sector investment.”

Regardless of which direction your investment interests take you, Christine’s comments and insights about what characterizes successful hospitals in China are quite valuable and shed light on what will separate those who enter China successfully and those whose efforts come up short of both their own expectations as well as those of China’s Central Government.