Part 3: McKinsey Evaluates the Private Hospital Market in China

Among the many opportunities to deploy capital into China’s healthcare space, few may be more exciting than the potential of private hospitals.  Equally, few sectors may be more susceptible to the vagaries of change as China’s ongoing healthcare reforms upend the status quo, both to the benefit and detriment of investors who hope to capitalize on China’s hospital market.  I have discussed this opportunity previously here and for CNBC here, and have suggested that one way to approach the opportunity in China is to think about two distinct approaches:  the first is to pursue greenfield expansion into specialty hospitals, the second is to take advantage of the public-to-private mechanism China’s Ministry of Health has recently set in motion.  Different sorts of capital are attracted to either opportunity, both because of the inherent and distinct risks of each as well as the different upside potential they respectively represent.

As part of our ongoing review of McKinsey’s new report on China’s healthcare reforms and how these will impact business, I had the distinct pleasure to spend time speaking with and both in McKinsey’s China Healthcare practice.  Alex, Claudia and their colleague collaborated on the section of the McKinsey report that focuses on private hospitals in China.  Their chapter makes an interesting point early when they write, “The contribution of the private sector is set to double over the next 5 years, with the Ministry of Health (MoH) setting a target:  by 2015, private hospitals should be managing 20 percent of China’s bed and inpatient/outpatient volume which is an ambitious increase from 11 percent of beds and approximately 8 percent of inpatient/outpatient activities today.”  Wow.  From 8% to 20% in the space of basically 2.5 years.  Admittedly, China is a country that can (and has) achieve a lot in a very short period of time; but to accomplish this goal, what has to happen?

I wanted to confirm my suspicion that in order to achieve this significant increase, the MoH needed to see a large group of public hospitals become private entities.  Such a swap would address the quantitative goal China’s MoH has established without the sort of massive build-out of greenfield private hospitals that would otherwise be necessary to hit their target.  Alex confirmed this:  “People believe that if you had to achieve the MoH’s goal by building new hospitals, it would essentially be impossible.  We see a raft of privatizations being necessary in order to achieve that goal and these would no longer be directly funded publicly. But there would still be greenfield private hospitals as China still requires additional capacity to meet the growing healthcare needs.”  In terms of how China approaches the crafting of policy, achieving their increase in inpatient/outpatient visits through private hospitals could obviously be achieved simply by brute force:  turn over enough of the existing infrastructure to private actors and the goal is achieved.  But, as long time China watchers know, this will not ultimately be enough to attract the necessary investment or expertise to truly reform China’s hospital industry.

On this point, Claudia was quick to add that the MoH understands it needs to undertake additional reforms that will encourage privatization.  She shared, “Alex and I attended  the annual MoH China Health Forum end of August where there was a very clear discussion on how to improve the situation for private hospitals.  Reimbursement is one area, improving the quality of private clinics, and talent.”  The last point, one that continually comes up when evaluating bottlenecks in China’s healthcare and senior care industries, has a more specific application in China’s hospitals.  As Claudia made clear, “there is a rule now that a doctor can work in two or more hospitals, but the reality is that physicians who want an academic career are going to stay in the public sector, so the government needs to [continue making] their ability to move more fluid.”  The question of reimbursement is particularly important if the private hospital industry is going to transition from being primarily for ex-pats and VIPs.  On this, Alex added, “some private hospitals can get the national insurance, but when they switch [and become private] can they still receive reimbursement from the national insurance plan systematically, rather than on a case by case basis. A truly national insurance system should decide coverage based on quality of service and not ownership status?  That is key.” In what may surprise outsiders new to China’s healthcare space, the last round of hospital privatizations resulted in a number of problems, not least of which were terrible quality standards.  This time round, the MoH is focused on ensuring private operators maintain acceptable quality standards so the “brand” of private healthcare is not tarnished.

Assuming none of this scares a potential investor off, the question of how capital can be extracted from a healthcare entity in China is one of the next concerns.  In some ways, these concerns are not specific to healthcare operations; there are limitations that all WFOE and JV structures have to live within.  However, in other ways, healthcare has some unique limitations.  Alex noted, “how you extract capital – whether as dividends or management contracts needs to be clarified – no one has actually given the hospitals a clear rule book saying what you can or can’t do … healthcare had such a bad start in the previous round [of healthcare reforms in China 10-15 years ago], and some extra clarification will be required.”  Admittedly, questions or lack of clarity on how to extricate capital from a healthcare entity (in particular one created when a formerly public institution becomes private) are troubling.  This suggests more risk forward capital will likely be the sort that initially pursues the public-to-private opportunity.  Alex added, “The sources of capital able to extract a meaningful return from a hospital are those who are thinking long-term.  From a western point of view, rather than short-term venture capital or private equity funds you need investment funds that have long-term horizons.  Private equity in particular looks at an investment horizon of 3-5 years.  In order to extract value within that horizon is hard.  If you want to sell within that time frame, that is hard because things don’t change that quickly, and you are not going to get a 2-3x return on your investment.”

If that is the case, I wondered whom McKinsey saw as possible western entrants into China’s private hospital sector this early in.  Alex suggested that private equity might be interested in making a play if they could consolidate enough market share by purchasing a large group of hospitals, reforming their management systems, turning them towards profitability, and bundling them up for sale to a western hospital management company who does not have the bandwidth to do the early-stage investment themselves.  Alex added “If you can roll up a lot of hospitals you can make this a very sellable target for overseas operators who want to find a way into China.  They don’t have the time to go in and buy one or two at a time, it is not worth their management time or risk, but if a PE fund came in and rolled up 10-15 hospitals and applied their turn-around skills, it would give confidence to international hospital operators.  That is an exit strategy PE money might be interested in pursuing.”

If you are reading this and the public-to-private seems to have too many risks (many of which have been discussed and reviewed in a previous AHCB post here), then greenfield investment is the way you will want to go.  This begs a series of questions all of which are related to how to best craft your market entry strategy.  I would propose that specialization is the right strategy, without losing sight of what I have called “the highly rationalized nature of how Chinese purchase healthcare.”  The McKinsey report references research they completed which shows that, “More than two-thirds of our respondents were also willing to pay extra for some treatments, drugs, and services, specifically for treatment by highly-regarded or foreign specialists, and also for imported drugs, imported medical devices, and cutting-edge technology.  These features may be seen to be more important in critical-care specialties such as cardiology and oncology.  Patients’ willingness to pay for superior treatments, drugs and services presents an opportunity for private hospitals, especially those jointly-owned by foreign investors, because these facilities are better positioned to provide these options than are the public hospitals.”

If McKinsey is correct, then the market opportunity is offering these higher quality products and services without losing sight of the fact that the majority of healthcare expenditures are paid absent insurance reimbursement.  If you only want to sell your services to the ultra-wealthy, maybe you do not care about this.  But successful market penetration will require for-profit hospitals working their way out of the VIP-only segment into the upper middle-class.  How might that happen?  Alex suggested, “If you want to do greenfield but you have no brand, you either affiliate yourself with another existing institution or you pry a high profile physician to practice or be a figure head at your hospital.”  Claudia made one very important caveat, “in general, if you look at pharma, being a western brand has more credibility because of quality.  In the hospital landscape it is different.  There are so many private clinics and so many have bad reputations.  The consumer understands what a Class 3 hospital in China is, and that it will have very educated and competent physicians.  Private hospitals may have better infrastructure, but they don’t have as good of physicians.  I tend to think you need to make sure your international talent comes over so you can say you have the best oncologists (as an example), but that obviously means you have to manage the international talent while building up the local talent over time.”

I highly recommend grabbing the McKinsey report in general, but especially if you have an interest in private hospitals in China.  As I reflect on my time with Alex and Claudia several thoughts come to mind.  First, for the public-to-private mechanism to work, the MoH needs to aggressively clarify the framework this transaction will occur within, and that the new entity will exist inside of.  Will the new entity have any peculiar limitations in terms of how capital can be extracted from it?  Conversely, might the MoH expedite investment in this sector if it made capital outflows easier than how the Central Government has done in the past in different industries?  Perhaps this is a sector that, solely because of the singular role it plays in people’s discontent, might be worth special consideration?  Along the same lines, how will reimbursement change once the hospital privatizes?  Second, what will the break-down be in terms of public-to-private versus greenfield?  I suspect that the MoH’s intentions are well guided in the former, but that absent major clarifications in the very near future, capital will very carefully work its way into this sector which means the MoH’s goal of an 11% increase in private hospital visits by 2015 is unlikely.  Conversely, the top-level policy changes in late 2011 that opened up private hospitals to foreign investment in general makes greenfield investments more possible and therefore more likely.  Third, the public-to-private transactions that do occur are going to shed interesting light on how hospitals in China actually work.  My personal sense is that when one loose thread gets pulled the potential for much of the tapestry to unravel is fairly high.  Seemingly small changes in how or where the hospital creates revenue (drugs, devices, etc.) changes more than just their P&L, it also changes how employees are incentivized (and in some cases, how they are compensated).  What may seem to be an obvious and much needed change from a hospital administrator’s point of view could easily become something much more.

China has already attempted a series of reforms designed to incentivize private investment into the country’s hospital sector.  The last round ended badly.  Even if the outcome of the most recent round of reforms falls short of the MoH’s goals, the structural changes China made in late 2011 removing the restrictions on foreign investment into the country’s hospital sector are likely to achieve the sort of greenfield investments that will accomplish China’s objectives, admittedly in different ways than originally envisioned.  By setting up both the public-to-private mechanism and opening China’s hospital sector to foreign ownership, the country has put complimentary approaches on dual tracks.  For all the aspects of the former that still need additional clarification, the MoH’s approach is a savvy attempt at increasing investments in its healthcare sector.  As such, the country’s leadership deserves credit for its creativity in exploring both avenues.

By:  Benjamin Shobert, ,