Investing in health care

“Had the company pursued the IPO route, a prospective PE multiple of 29 times would have been applied. This tells us a lot about the business of hospitals and health care.

Recently the chief executive of a conglomerate invested in diverse businesses that included forays into power, mining, telecommunications and construction announced that their fairly recent venture into hospitals and health care would be retiring capitalized debts. Plan A was via an initial public offering (IPO) to raise equity capital to replace debts it had incurred. The company instead opted for Plan B where, via a private placement, the same capital infused by specially selected investors would replace debt in the medium term.

The private placement route is akin to direct and personalized selling. It is less bureaucratic and allows for higher premiums and exit mechanisms enhanced by larger bottom lines and retained earnings. For one, a private placer can negotiate for dividends that increase effective returns. For another, synergies with an industrial private placer catalyze perceived values.

There are several ways to view these developments. One indicates a company about to retire and pay off its loans, thus reducing interest costs and increasing bottom lines in preparation for expansion. Another indicates an investor seeking to dilute ownership, monetize and pass on equity, effectively and eventually liquidating a portion of their investment. In the case of an effective “White Knight” entering via a private placement and other venture capitalists, the investment timeline might be abbreviated where three, five or seven years are the ideal holding periods that allow for a reasonable internal rate of return.

This conglomerate opting for a private placement route is a study in strategic prudence.

The strategy is to shift from debt financing to equity. The gambit is to raise incremental capital, reduce interest costs and expand in exchange for some loss of control. In terms of value, both tend to increase bottom lines and shareholder values where, for the latter, a market is created for otherwise closely held shares.

To start up a business, maintain its operations or fund its expansion, there are basically two sources of capital businessmen resort to. They either borrow money or fund it using their own.

Banks are sources for the former. As risks accrue to the creditor, these charge an interest to account for the uncertainties of a timely repayment.

Equity financing is an altogether different beast. Businesses asking equity holders to provide capital virtually invite funders to join as co-owners. As the term implies, the equity funder “shares” ownership of the enterprise. The “holder” portion of the term “shareholder” is a graphic representation signifying holding certificates of ownership.

As these certificates are traded, as ownership changes, a value is created where the certificates are either sold for less than its value, discounted as it were, or sold at par or at a premium.

Before a stock is discounted or added a premium, it is first given a value. For those listed the most common formula is the Price Earnings multiple where the stock price is the numerator and earnings before interest, depreciation and amortizations (EBITDA) per share is the denominator. This can either be a past figure, called “trailing PE,” current or prospective. By allowing the price to be the unknown variable in reference to a desired multiple, stock prices are thereby computed.

In our example, had the company pursued the IPO route, a prospective PE multiple of 29 times would have been applied. This tells us a lot about the business of hospitals and health care and the prospects of potential earnings as evaluated by current owners.

Current market PE multiples hover in the 17 to 18 times range. A 29 times PE for a hospital investment can be justified as the only public inroad investment available.

Theoretically 29 times PE requires a high 25 percent plus internal rate of return for five years. While health care services’ global average PE is 19.98 times the range is wide and standard deviation is high. Do the arithmetic. Investing in hospitals makes pretty good business sense.