China hospitals: Complicated prescription

Delta Health, a brand new hospital group controlled by Fidelity Growth Partners Asia (FGPA) and its affiliates, will open its flagship facility - Shanghai Delta Hospital - within six months. It has taken nearly seven years to design, construct and commission this cardiovascular healthcare unit.

Located in Qingpu District, five miles from Shanghai Hongqiao Airport, the 50,000-square-meter facility currently holds 230 beds and provides end-to-end service for cardiovascular diseases, from early diagnosis, to prevention, intervention and rehabilitation.

"We spent significant capital and it has taken many years to come to fruition. The reason why we want to own and control this ambitious initiative is because we are committed to controlling our destiny and making certain we create something of the absolute highest quality," says Daniel Auerbach, managing partner and senior managing director of FGPA, and chairman of Delta Health.

The firm works with stakeholders including The Shanghai Health Bureau, the Qingpu District Health Bureau and several specialist public hospitals, as well as Columbia University with a view to providing international standard services. Moreover, FGPA has plans to obtain additional land and licenses to expand into a comprehensive service provider.

In Auerbach's view, Delta Health cannot be classified as a traditional venture capital or private equity investment; FGPA has something longer-term in mind. It wants to participate in Chinese healthcare reform over the next two decades, working with stakeholders throughout the system.

"We have the capital and we have the patience, and we will indeed have patients," Auerbach adds. "We have very little interest in rolling up or consolidating assets with a view to a quick public listing."

The Chinese government has introduced policies encouraging private capital to play a role in improving healthcare services, and financial investors, including private equity, are looking at potential opportunities with interest. There are numerous possibilities in the hospital space: building new facilities or consolidating existing ones, entering the general hospital segment or focusing on specialty hospitals and clinics. However, the overriding concern remains whether investors can turn a profit from healthcare service delivery.

"There are two questions around foreign private equity investment in hospitals. First, why does China need foreign money? It has a lot of money, but there is a need for foreign expertise. Second, is the private equity investment horizon long enough to allow hospitals to become profitable?" says Benjamin Shobert, managing director of healthcare consultancy Rubicon Strategy Group.

The door opens

Moves to liberalize China's healthcare service industry were announced in late 2013. Last August, the Ministry of Commence further opened up the space by allowing 100% foreign direct investment in hospitals in seven cities and provinces, including Beijing, Tianjin, Jiangsu, Guangdong, Hainan and Fujian. Public hospitals currently account for over 90% of the national medical services delivery market, but FGPA expects the private sector share to reach 25-30% over the next few years.

The successful IPO of iKang Healthcare Group, China's largest operator of medical examination and disease screening centers, last year suggests that public market investors are buying into the growth story. IKang raised $150 million through its public offering, facilitating partial exits for NewQuest Capital Partners and GIC Private. It is currently trading up 20% on the IPO price at a valuation of $1.1 billion.

On the private investment side, a total of $607.2 million was deployed 10 deals in the service provider space last year, the most since 2010, AVCJ Research shows. While these include some investments in general hospitals, the bulk of the capital has focused on privately-owned specialist clinics and hospitals.

Last April, Fosun Pharma teamed up with TPG to buy Chindex International, operator of United Family Healthcare hospitals and clinics, a chain that specializes in female health and child care services, in a deal worth more than $450 million. A few months later Hony Capital made invested in privately-owned Shanghai Yangsi Hospital, and the GP has indicated there will be more acquisitions to come.

"In the early wave of investments, most financial investors focused on a repeatable type of retail format, such as healthcare check-up centers or dental chains," says Vikram Kapur, a Hong Kong-based partner of Bain & Company. "Recent liquidity events have given people confidence and they're seeing the value creation opportunity. There is growing interest in specialty hospitals and clinics, as well as to ‘take-privates' of public hospitals with a view to restructuring them."

Several private equity firms want to acquire hospitals as part of a roll-up strategy. Hony has formed a dedicated platform, called Grand Accordia Healthcare, which is intended to acquire a dozen local hospitals in the next three years from both private and state-owned sellers.

"Shanghai Yangsi Hospital was privately-owned and we wanted to buy it to serve as base - or a training ground - to make sure that we understood all the nuances before we scale up. The deals we have in the pipeline are a mix of small regional hospitals, owned by private founders, and others owned by the state in one way or another. These deals are complicated because in addition to the difficulties of running a hospital, you also have to deal with historical owners," John Zhao, Hony's CEO, tells AVCJ.

Morgan Stanley Private Equity Asia (MSPEA) is adopting a similar strategy. Earlier this year it paid $38 million for a minority stake in Baijia, China's second-largest private sector maternity hospital operator. The firm also completed two control deals for hospitals in Nanjing, Jiangsu province, operating through a joint venture with Sihuan Pharmaceutical, a longstanding portfolio company.

While Baijia is a classic growth deal, the joint venture platform is a dedicated acquisition vehicle. The plan is to absorb 6-12 hospitals, exploit scale and operating synergies, and ultimately take the platform public. A total of RMB1.24 billion ($200 million) went towards the two purchases in Nanjing, one of which was already under private ownership while the other was obtained from the local government.

CDH Investments also been active in the space, completing 8-9 transactions out of its renminbi-denominated fund from 2005 onwards, including Ciming Health Checkup Management and Angel Women's and Children Hospital. There is a single hospital deal in the GP's most recent US dollar fund and a plan to create a chain a smaller clinics and hospitals, but progress has slowed due to rising valuations. Stuart Schonberger, managing director at CDH, notes that success is not easily won.

"If PE investors can find assets at the right valuation then it's a very attractive market - there is unlimited demand and very poor or limited supply in China's healthcare sector," he says. "Everyone sees the opportunity, but how do you build out a chain with all the regulatory constraints? How do you find the right doctors?"

Doctors and patients

The level of unmet demand in China's healthcare system is best expressed in doctor numbers: there are only 2.7 million serving 1.4 billion people compared to 2.2 million in the US, which has a population of 300 million. Every year 600,000 students graduate from medical training schools and universities, but only 100,000 of these go on to become fully-fledged doctors. The rest take lower-skilled jobs in small clinics and check-up centers.

The elite gravitates to the large public hospitals where they are better paid and have a clearer path to promotion. Many public hospitals also have ties to universities, and this presents teaching opportunities as well as the possibility of getting government funding for research.

The lack of supply has led some investors to target greenfield facilities, where they can build high-quality brands from scratch. This is often done in partnership with foreign healthcare groups, combining their domain expertise with the PE firms' local knowledge. Last year Hillhouse Capital Group formed a joint venture with US-based Mayo Clinic, while Trustbridge Partners drew on the consulting services of Boston-based hospital group Partners HealthCare International for its general hospital in Shanghai.

The $500 million Shanghai Jiahui International Hospital is due to be completed in 2018. The specialty private facility aims to hire Chinese doctors from the US and establish strong ties with academy schools and medical institutions in order to train and retain staff, according to Gilbert Mudge, president and CEO at Partners HealthCare International.

"We've been approached by real estate entrepreneurs who want to build the hospitals but they have a little understanding about the complexity of running a hospital," says Mudge. "The complexity is first in the politics: who is going to get the land? Then it is a question of the institution interacts with existing hospitals and medical schools in the community. Trustbridge is very committed in designing healthcare services in the long run."

Despite steps taken by the government to relax restrictions on acquisitions, securing land remains a pressing challenge for greenfield operators - the best plots are often being used for other purposes. "That's a real problem for hospitals because they are all about providing localized services within a metropolitan area," says Rubicon's Shobert.

He has seen some existing buildings, such as hotels, re-purposed as hospitals or medical care centers, offering ready access to patients. At the same time, other industry participants question the importance of location, noting that patients are willing to travel for high quality services.

Who pays?

The real problem is payment, observes Jenny Yao, healthcare partner at KPMG. Creating a universal health insurance program is part of the government's reforms and three schemes - the mandatory urban employee basic healthcare insurance scheme, the voluntary urban resident basic healthcare scheme and the voluntary new rural co-operative medical scheme - cover over 95% of the population.

Private hospitals are keen to participate but local governments, conscious of the need to protect public hospitals, are reluctant to extend coverage. Indeed, the application procedure alone for private hospitals is incredibly complicated. As a result, the 11,000 private hospitals in China miss out on mass-market basic care. Even for services that go beyond what is covered by the insurance reimbursement program - and there are still holes in the system - private facilities are too expensive for most users.

The emergence of a middle class with higher disposable incomes and an ability to pay for private insurance cover are only part of the solution. Long-term reforms are required across the healthcare delivery system, from hospital ownership to regulation of medical practitioners.

In this regard, there has been some progress. Traditionally, doctors have been subject to close controls but now those working in public hospitals are encouraged to work part-time in the private sector. Although predominantly a practical measure to help address the shortage of qualified staff, it also represents the beginnings of a free market for talent.

Another recent development is the government's decision to allow public hospitals to sell franchises to private sector operators in order to give patients access to a wider range of services. Anzhen Hospital and Beijing Children's Hospital each plan to build new medical centers with private capital. This could be the short-cut that many PE investors are looking for. While they are supplying capital, the public hospitals provide reputation, brand identity and trained doctors, essentially covering areas in which fully independent facilities fall short.

"With the well-known brands, patients already recognize them so there is built-in demand," says KPMG's Yao. "It is actually setting up a new mechanism for patients who are willing to pay higher prices for better services in new hospitals. I think that's a good opportunity because it won't take 10 years before you see a return on investment."

SIDEBAR: Public hospitals - Tough targets

China's healthcare system suffers from a resource and demand imbalance, largely due to large hospitals that have a monopoly on the system - about 95% are public hospitals controlled by the government.

Last year Beijing opened the door to private investment in public hospitals and more opportunities will come as assets are sold off with a view to improving the quality of healthcare. For example, last December China Resources Healthcare Group announced the acquisition of Huaibei Miner Hospital Group, which operates a total of 17 public hospitals.

Private equity investors are less likely to follow suit. "First, we think the government will introduce a lot of policies in this sector in the long run and we don't know what they will be," says Shan Fu, managing partner at Vivo Capital. "Second, there is limited number of public assets that are available for private equity firms to look at."

Of the 600,000 students who graduate from medical training schools and universities in China this year, one sixth will pursue careers as doctors. Looking for higher salaries and a leg up on the comprehensive public sector promotion ladder, most will end up at the country's 20,000 sizeable public hospitals. These are concentrated in the cities of Beijing, Shanghai, Guangzhou and Chongqing.

"Most of these hospitals earn their income from drug sales," Fu says. "But the government has said a number of times that it wants to reform the revenue structures so that medical institutions aren't excessively reliant on drug sales from their in-house pharmacies. When this policy is implemented, net profit for these hospitals will probably be cut a half. If you were a private investor, you might compensate by hiking treatment prices instead, but this would create tension with the public."

In terms of availability, these public assets must go through a formal sale process and it can be difficult for private investors to get transactions done. Among the key criteria are the welfare of existing employees and the patient populations, as well as the stability of tax contributions to the local government, Homer Sun, CIO at Morgan Stanley Private Equity Asia, previously told AVCJ.

In this context, the background and operating credentials of the acquirer are subjected to intense scrutiny. It is not unknown for doctors, nurses and other professionals to submit objections.

"Employees in public hospitals are concerned about their future job security, the for-profit drive of private owners and their career development. As a result, there have been a number of cases in which employees have gone on strike when private investments into public hospitals were considered," says Jenny Yao, a healthcare partner at KPMG.

Other factors taken into consideration by prospective private equity investors include the healthcare management capabilities of the target institution, potential synergies with other hospitals on the same platform, and opportunities to collaborate with leading foreign and domestic healthcare groups. If a PE firm can secure the right asset at the right valuation with the right management, hospitals are highly attractive.

"What we like a lot about this sector is the barriers to entry are high if you are well positioned. The cash flows are stable and very defensive," Sun said.

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• Topics
• Buyouts
• Healthcare
• Greater China
• China
• healthcare
• buyout
• Hony Capital
• Morgan Stanley Private Equity Asia
• Fidelity Growth Partners
• CDH Investments Management
• Trustbridge