Private equity, health care, and profits: It’s time to protect patients

In his State of the Union address, President Biden expressed concern with the growing — and troubling — trend of private equity ownership and operation of nursing homes and the inherent risk it presents to care of their residents. Between 2010 and 2019, such equity deals in health care nearly tripled in value, from $42 billion to $120 billion, totaling $750 billion over the last decade.

That staggering number represents thousands of hospitals, nursing homes, travel nurse companies, behavioral health programs, and other health care settings in every state. The profit-making goals of private equity are, in many ways, at odds with the needs of patients and the rules of government-financed health care programs. In fact, since 2013, private equity-owned health care companies have paid more than $500 million to settle claims of overcharging government health care programs.

Though there is always a profit motive when private investors acquire a company, private equity firms in the realm of health care should be viewed with skepticism. In this industry, the “product” at issue is a person’s health, not a computer or a bicycle pump. The business model of these companies — its goals, structure, and the operation of portfolio companies — combine to incentivize short-term profits at the expense of all other considerations. The result is that patients, communities, and even entire health care systems can suffer.

Fortunately, the government, aided by whistleblowers, has an invaluable tool in the False Claims Act, which allows it to prosecute fraud and protect the interests of patients and taxpayers.

Private equity firms are asset managers that raise capital from institutional and accredited investors and use that capital to obtain significant, often controlling, equity interests in private operating companies. Using the influence granted by their equity interest to direct the major business decisions of these companies, these firms seek to improve their financial condition and business prospects with the ultimate goal of selling the companies to the public through an IPO or to a strategic buyer at a profit that generates above-market returns to the firm and its investors.

A fundamental aspect of private equity is that, unlike traditional asset managers, they play active roles in the governance of their portfolio companies, a feature reflected in the considerable fees that private equity firms obtain from their investors. While equity-focused mutual funds have management fees that generally hover around 1% of assets under management, private equity funds commonly charge “2 and 20,” referring to a 2% management fee and 20% of profits above an agreed-upon threshold. Investors pay these high fees because these firms do not merely identify companies in which to invest, but also manage the operations of those companies for their own financial benefit.

At least four additional attributes of the private equity business model are relevant to understanding the incentives that tilt these firms toward emphasizing short term profits:

Private equity firms do not acquire portfolio companies for the long haul. The funds formed by private equity firms generally have a life span of five to seven years, meaning that from the time a private equity firm makes a new investment it is “on the clock” to improve the financial results of that company to make it attractive to a new buyer.

Individuals employed by private equity firms are typically appointed to sit on the boards of portfolio companies and to fill in as, or hand pick, the CEO and other senior executives, giving the equity firm multiple means of directing key business strategies.

Private equity investments often involve raising substantial amounts of debt financing to obtain a controlling interest in a company, secured by that company’s assets, which can leave the operating company with a significant debt burden on its cash flow that increases the risk of a future bankruptcy.

The combination of leveraged investments in companies with the one-sided performance fee that rewards private equity firms for profitable investments but does not penalize them for unprofitable ones creates a distorted structure that incentivizes these firms to select risky investments and to operate them in a risky fashion.

When private equity buys a health care company, patients often pay the price. A 2021 study concluded that private equity ownership increases the short-term mortality of nursing home residents by 10%, which represents more than 20,000 lives lost during a 12-year period, likely due to lowered nursing-staff-to-resident ratios and the diversion of patient care funding to private equity owners. An investigation by USA Today and Newsy found that when private equity firms acquire an interest in dental practices treating Medicaid patients, often children, those practices tend to incentivize dentists to increase the volume of procedures, regardless of medical necessity.

Just last month the Private Equity Stakeholder Project issued a report concluding that expansion of these companies into behavioral health services for vulnerable and at-risk youth has led to safety issues, quality of care issues, and even “horrific conditions” when short-term profits trump other considerations.

The Department of Justice and attorneys general in many states have begun to police the actions of private equity firms that cause portfolio companies to submit false claims to the government health care programs, and the False Claims Act has been their chosen enforcement tool. For example, in October 2021, the Massachusetts attorney general used the state’s False Claims Act to obtain a $25 million settlement from the private equity owners of a health care company following an earlier 2018 settlement with the company itself for $4 million. The government claimed that South Bay Mental Health Center submitted claims to Medicaid for mental health care services that were provided to patients by unlicensed, unqualified, and improperly supervised staff. The allegations directed at its private equity owners were that they knew of the company’s fraudulent scheme, held a majority of the seats on the company’s board, and yet failed to take the necessary steps to correct it.

Several effective strategies exist for deterring private equity from putting profits ahead of patients. First, the Securities and Exchange Commission can impose enhanced disclosure requirements on the investments and activities of private equity funds, a concept in which it has recently expressed interest. As Supreme Court Justice Louis Brandeis observed more than 100 years ago, “Sunlight is said to be the best of disinfectants.” Stronger disclosure requirements would increase transparency and bring more wrongdoing to light.

Second, the False Claims Act can be an effective tool in policing the actions of private equity firms that cause portfolio companies to submit false claims for payment to Medicare and Medicaid. It is increasingly being successfully used by the government and whistleblowers, who are often company insiders. This trend reflects the reality that private equity can both control and be complicit in fraudulent conduct.

Third, during the investigation phase of a false claims matter in which the health care company being targeted is owned by private equity, discovery directed at the private equity firm — and not just the health care company — should be encouraged. Due diligence memos and files, monthly portfolio updates disseminated to investors, and business plans revealing the firm’s strategies and timeline for enhancing the value of the portfolio company, for example, could all be immensely useful to understanding the nature and scope of the fraud alleged and the private equity firm’s role in perpetuating and profiting from that fraud.

As private equity firms further encroach upon the health care industry, it is essential that their activity is closely monitored for fraud and patients’ best interests are protected and prioritized.

Jeanne A. Markey is partner at Cohen Milstein Sellers and Toll and co-chair of the firm’s whistleblower/False Claims Act practice group. Raymond M. Sarola is of counsel at Cohen Milstein and a member of the same practice group.