The Risks and Rewards of Healthcare Leasing

by Martin E. Zimmerman January/February 2008
If you’re thinking of entering the healthcare leasing market, you might want to talk to a doctor first. This market is not for the faint of heart. All kidding aside, any doctor will tell you that the financial rewards are not what they once were. You won’t find any easy money in the medical field.

The healthcare industry has become extraordinarily complex and highly competitive. In short, it is difficult to enter. Margins are being squeezed everywhere, and the yields from financing are low relative to the risks. Healthcare delivery has become dependent upon the latest technology, which is subject to constant change, requiring large amounts of capital to remain competitive. Nor is every healthcare provider in good health from a balance sheet and liquidity perspective. In some cases, while it may be rather easy to lend, it can be considerably more difficult to get repaid in a timely fashion.

Nevertheless, as one of the largest markets in the U.S. economy, healthcare offers rewards of immense scale for the knowledgeable player.

What does it take to succeed? For openers, it always helps to have a low-cost source of funds. However, this capacity alone is no longer a guarantee of success. As the market has become more specialized, success now depends upon the ability to provide well-structured financing, and that takes a deeper understanding of the market. New entrants would do well to study the market carefully and choose a niche where there is an opportunity to add real value. You also will need a good grasp on the very real risks that should be reflected in your pricing.

Healthcare Market Risks
Over the past 30 years, the only predictable constant in the healthcare industry besides its growth has been unpredictable change, and that adds to risk.

Rapid Technological Advances
Healthcare providers now must have highly advanced diagnostic and treatment equipment as well as IT systems, in order to compete successfully in most markets. This demand has led to incredibly swift innovation by technology manufacturers. Indeed, the economic life cycle of healthcare equipment — and its attendant financing — has moved from five to seven years or longer in the past, to five years or less today. The largest providers frequently turn over their equipment in three years or less.

The risks of obsolescence have increased with heightened technological change, which is problematic for the lessor that assumes equipment (residual) risk. For example, CT scanners have evolved seemingly overnight from single-slice to multi-slice capability. Even though not all applications require the higher capabilities, the market for single-slice machines has literally dried up, and related secondary market values are a shadow of what they once were.

Declining Reimbursement Rates
Government funders and private insurers alike are continuously slashing the amounts they are willing to pay for healthcare services and procedures such as diagnostic imaging. According to the American Hospital Association (AHA), Medicare and Medicaid account for 55% of all care provided by hospitals. They estimate that underpayments to hospitals from both programs totaled nearly $30 billion in 2006. Not only are payments not equal to providers’ costs, but government and other payers also can be slow to reimburse for services. As a result, operating margins are squeezed continuously and lower profits are virtually guaranteed on an annual basis for the provider who doesn’t move quickly to both contain costs and increase revenues from new business.

Increasing Costs
At the same time that reimbursement rates are going down, costs are going up in every area. Technology is an absolute requirement, but maintaining that equipment may be even more expensive than acquiring it. Manufacturers have structured their pricing so the purchasing decision is easier by virtue of lower upfront costs, while their profits are enhanced from costly replacement parts and maintenance services over the life of the asset.

At the same time, providers want new equipment financing that provides them with the lowest monthly cost. Add to that the fact that IT and other technology costs, as a percentage of total overhead expenses, will increase due to government requirements for electronic medical records. Shifting from paper to electronic records will require an immense investment in IT systems and support staff, which presents a real challenge to providers of all kinds.

Competitive Pressures
More and more, consumers are demanding the most advanced equipment for diagnosis and treatment or they will take their business elsewhere. Equipment assets are now becoming obsolete from an economic standpoint long before their technical lives are over. Even the smallest hospitals are feeling the heat to acquire the latest and greatest technology, even though their patient volumes may not support the investment. Acquiring refurbished equipment at a substantial discount to new is often a smart move for smaller hospitals, although competitive pressures tend to push users toward new equipment. Another challenge with refurbished equipment is the tendency for providers to want to finance the equipment over a five-year or longer term to keep monthly payments low, a longer-than-optimal period that impedes timely upgrades.

Hidden Credit Risks
Not all hospitals and healthcare providers are created equal. The healthcare industry presents a wide diversity of credit profiles, from the largest investment-grade hospitals that dominate their regions to small community hospitals, new physician group practices and independent imaging centers that are fighting for market share. In fact, nearly half of the hospital market consists of facilities smaller than 100 beds, with some 23% even smaller at less than 50 beds. For hospitals of all sizes, margins are incredibly thin. The AHA reported that 25% of hospitals had negative total margins in 2005. Almost all hospitals operate at margins of well under 10% of net revenues, while many fall under 5% or even 2%. Any shift in market dynamics, such as declining physician referrals or the defection of one or more key physician groups to another hospital, can spell disaster. Lenders need to do their homework to uncover these “hidden” but ever-present potholes, which can break an axle or even swallow the entire truck!

Healthcare Market Rewards
Having focused first on the risks, it is time to take a look at the brighter side. The healthcare industry presents a gigantic opportunity for the firm with access to good market intelligence and low-cost capital. Healthcare is incredibly capital-intensive and becoming more so every year, which is excellent news for those prepared to provide financing and deal with the challenges.

Growing Capital Requirements
The United States is unique in the world in terms of the scale of our healthcare system and our ability to produce technological advancements that greatly improve the quality of care. Indeed, one of our country’s greatest exports is healthcare technology. In contrast, those countries that depend entirely on government funding for healthcare are slower to innovate and adapt new technology. Enormous amounts of investment are required to keep U.S. healthcare growing. The very complexity of the industry and its technology needs offer opportunities for large lenders and smaller specialized financing sources alike.

High Technology Demands
The healthcare market has become increasingly consumer-driven. In regard to diagnostic imaging, for example, consumers are demanding MRI scans for non-critical injuries, and physicians often are willing to accommodate them. Not only that, but consumers are aware of technological advances and state their preferences for such new technology as open-MRI machines, which offer greater patient comfort. Naturally, physicians are more likely to send their patients to centers that have newer equipment. In an increasing number of cases, physician groups are investing in their own imaging capabilities in order to generate revenues themselves.

Industry Consolidation
With the rapid pace of change, it is no surprise that the healthcare industry is consolidating in an attempt to reduce costs and conserve capital. Among physicians in particular, once-competing groups are merging into networks to realize economies of scale in operations and to improve their bargaining power with insurers. Independent imaging centers are seeing considerable fallout, as many are no longer able to compete against hospital outpatient centers and physician-sponsored imaging centers. In a return to the past, hospitals and physician groups are forming carefully designed joint ventures to help ensure market share and generate adequate patient volumes.

Opportunities for Niche Players
For new entrants to the complicated healthcare market, establishing a market focus and strategy is the best place to start. The market is just too large to tackle it all. Biotech alone is a huge market opportunity with high capital needs and specialized financing requirements. Consider, too, that some of the most profitable healthcare providers are those that concentrate on a specialty. Specialized facilities such as heart hospitals and children’s hospitals can and often do charge more for their expertise and superior service than general hospitals. Nursing homes are another long-term growth area. They require less advanced technology than other types of healthcare providers, but have other special financing needs. Even on a micro-scale, healthcare niche markets often represent hundreds of millions of dollars of opportunity, if not billions.

Financial firms must be prepared to take risks where appropriate, including equity risks, but should limit them to situations where the rewards — in the form of annual rates of return and overall cash profits — are commensurate with the risks. Too many lenders are willing to undercut their pricing in order to enter the market and develop share. A number of lenders who have operated at breakeven or less justify their actions by expressing the hope of selling additional services in the future. Most experienced players find this approach rarely pays off in healthcare, where tomorrow is a new day with new profit challenges and where customer loyalty is likely to vanish as soon as the rates move from below market to merely low.

In healthcare financing, success requires access to capital, the flexibility to structure to the client’s needs, astute asset management and a firm grasp on risk analysis. Thinking long term is essential before taking the plunge.


Martin E. Zimmerman HeadshotMartin E. Zimmerman is president & CEO of LFC Capital, and has been associated with the company since its founding in 1994. Earlier, he founded LINC Capital, building it into one of the largest lessors in the healthcare industry. Zimmerman earned his BS degree in Electrical Engineering from MIT, and an MBA in Finance from the Columbia Business School, where he was a McKinsey Scholar. He is a member of the Business School’s board of Overseers and its advisory board for Entrepreneurship. A former director of the Equipment Leasing and Finance Association, Zimmerman also served as a trustee of Ravenswood Hospital Medical Center and chairman of its Finance Committee.

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