Key points when private equity funds invest in private hospitals

By Wang Zhijian, Song Cheng, Cao Yang , Zhonglun W&D Law Firm
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With the large flow of private capital into the medical industry, an increasing number of private equity (PE) funds have been taking their places at the banquet. This column will look at four key points warranting attention when PE funds invest in private hospitals.

Nature of private hospitals. Pursuant to the Notice on the Issuance of the Implementing Opinions on Classifying Urban and Rural Medical Institutions, medical institutions are on the whole divided into non-profit medical institutions and for-profit medical institutions. Income of a non-profit medical institution is used to cover medical service costs and the balance of income and expenditures may only be used for its own development.

王志坚 Wang Zhijian 中伦文德律师事务所 医药健康法律专委 Member of the Healthcare Practice Zhonglun W&D Law Firm
Wang Zhijian
Member of the Healthcare Practice
Zhonglun W&D Law Firm

The profits derived from the medical services provided by a for-profit medical institution may be used as economic returns to investors. Whether it can smoothly sell the shares it holds and profit thereon is one of the key points of attention for a PE fund manager, whereas in practice, due to the frequent reports of private capital meeting frustration when attempting to divest from non-profit hospitals, such hospitals obviously offer little draw for PE.

If a non-profit private hospital can be converted to a for-profit private hospital, subsequent to administrative approval, it may attract some attention, but a certain degree of difficulty exists in practice.

Types of entities that can establish for-profit private hospitals. The Implementing Rules for the Administrative Regulations for Medical Institutions specify that legal persons, other organisations, individuals and two or more partners may apply to establish hospitals. In private hospitals organised in the form of companies, investors can incorporate special provisions, such as those for a preferential right to dividends, special voting rights, joint sale right and anti-dilution, to protect their interests by revising the articles of association, and can flexibly opt to use a variety of divestment means, such as listing, acquisition, buyback, etc.

宋成 Song Cheng 中伦文德律师事务所 医药健康法律专委 Member of the Healthcare Practice Zhonglun W&D Law Firm
Song Cheng
Member of the Healthcare Practice
Zhonglun W&D Law Firm

Partnership relationship

As for a private hospital organised as a partnership, after the entry of PE, a partnership relationship is created, potentially exposing it to unlimited joint and several liability. Furthermore, the protective terms provided by a partnership agreement are weaker than those that can be provided in articles of association. Listing is not available as an option for divestment and, in practice, there are also numerous obstacles to acquisition by others in the industry. Accordingly, if a for-profit private hospital organised in a form other than as a company wishes to attract PE, it should convert itself into a company, but a partnership or other organisation cannot be directly converted into a company at the administration for industry and commerce. The only option to attract PE must involve a change in the hospital establishing entity.

However, the Administrative Regulations for Medical Institutions specify that a medical institution practice licence may not be forged, altered, sold, transferred or lent. Since a change in the establishing entity would constitute a transfer of the licence, the only legally practicable method is to first cancel the licence and obtain another one after new establishment – a possibility in practice, but one that also presents numerous complications.

Commercial value

The intrinsic commercial value of a private hospital influences the success or failure of a transaction. In a medical market in which public hospitals occupy a monopoly position, it is very difficult for a private hospital to maintain growth in the near and long term. Accordingly, only a small number can be listed. The major reason that Aier Ophthalmology was able to list lies in its establishment of a “chain plus stepped” business model, raising the competition threshold, and its success in hitching on to the express train of ophthalmologic market expansion, which ultimately saw Fortune Capital achieve returns of more than 20 times its equity interest in Aier Ophthalmology.

In contrast, some private women’s hospitals and men’s hospitals operating as chains have been unable to list, because their business model does not present growth prospects over the long term. There are also a number of hospitals that considered a future listing when planning their establishment. Angel Women’s and Children’s Hospital provides tailored high-end services, and in January 2014 secured B round investment from Sequoia Capital. Its long-term growth prospects require comprehensive consideration of government policies, details of the hospital’s medical land, market share and competitiveness of its core services, the percentage of its profits accounted for by medical insurance payments, percentage of its revenues accounted for by drugs, etc. Of course, if a hospital is under the control of a group and the group also has pharmaceutical and medical apparatus, and instrument logistics and supply capabilities, its profitability will be greater.

Situation with physicians in a private hospital. Whether the team of physicians in a hospital is complete, stable, and able to sustainably grow becomes the core of what constrains the growth of the hospital. A complete team of physicians refers to a pyramid-shaped team that covers all the disciplines. Frontline physicians handle the majority of work tasks, and are relatively numerous in number; the department directors are the heads of departments and are found at mid-level; and senior managers that commonly have a medical title and modern hospital management philosophy form the top of the pyramid. The stability of the team of physicians mainly rests on a balance between the effort expended by the physicians and the incentive mechanism. If the work demand is too great and there is little succession between old and new, team stability will be impossible to realise, regardless of how good the incentive mechanism is.

As for sustainable growth, the question of policy needs to be considered, e.g. the feasibility of bringing in talent, an innate advantage enjoyed by large cities. If a material change in the operation and management of a hospital results in resistance from the physicians – a so-called cultural conflict – then the sustained development of the hospital will be compromised. Accordingly, the handling of such an issue is often tricky.

Capital chases profit, and PE funds are no exception. However, the investment/financing parties need to rationally analyse and be fully aware of the above issues. The secret to getting the best results with minimum effort is good due diligence and good planning.

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