I haven't written much on the business of healthcare lately, but this Steward Healthcare situation is both fascinating and troubling. For those that haven't been following, Steward recently filed for bankruptcy and is threatening to close hospitals in high-need parts of Massachusetts, and a formal federal investigation into the actions of the CEO and private equity firm that formerly backed the health system seems likely. This news raises real questions about the appropriateness of hospitals operating as private equity-backed for-profits and the financial engineering that comes with such transactions, especially hospitals that operate in underserved communities.

Steward Healthcare

Steward Healthcare, a for-profit hospital chain, launched in 2010 when private equity firm Cerberus Capital Management (named after Cerberus, the three-legged dog that guards the gates to hell) acquired the failing non-profit Catholic healthcare system Caritas Christi located in Massachusetts. The CEO of Caritas, Ralph De La Torre, became CEO of this new health system. Steward’s name was a symbol of how it promised to be a good steward of the hospitals formerly owned and operated by the Catholic church.

Steward's Strategy

Hospitals might not strike you as a great investment for a private equity firm, so you might wonder what the appeal was for Cerberus. Hospitals have very low margins (generally less than 5%) and sometimes operate at a loss through government subsidies. But Cerberus saw that one could think of Steward, or any hospital chain, as two separate things: 1/ a large hospital operation serving patients and 2/ a highly valuable set of real estate located in population centers that the hospitals sit on.

Real estate as an investment is a much more lucrative business than a hospital operation. A real estate investment trust (REIT), a company that owns, operates, or finances income-producing real estate, sees 25% to 50% margins. Cerberus saw that Steward could get significant and quick liquidity by selling the real estate that the hospitals were sitting on to a REIT, in this case, a firm called Medical Properties Trust (MPT), and then leasing the property back. This is known as a sales-leaseback. To juice the price of the real estate, Steward agreed to very favorable leases. MPT paid $1.2 billion for the initial properties and also took a 5% stake in Steward. All of the details of these leases aren't clear, but these were expensive, long-term leases with escalator clauses and with other terms that MPT must have liked, including a triple-net lease where Steward would be responsible for the cost of insurance, property management, and maintenance, in addition to the rent.

The strategy was clearly great for MPT as it immediately expanded its assets under management with reliable, lucrative leases. And it was also good, in theory, for Steward. Steward would gain instant liquidity to help it pay down its debt from the Caritas Christi purchase and acquire more hospitals and medical offices across the country. The properties, as they were acquired, were promptly sold to MPT and leased back. And by not being burdened by managing the real estate, Steward could focus on optimizing its hospital operations.

Steward aggressively pursued this strategy, growing up to 40+ hospitals across multiple US states and even expanding the strategy internationally into Colombia, Malta, and the Middle East.

The problem was that as Steward was rapidly acquiring and selling real estate, much of the proceeds from these real estate sales never got to Steward. Some of it went to hospital operations and paying down debt, but large amounts of it went back to Cerberus in the form of management fees and dividend payments. And that left Steward without much of the proceeds of the sale and with highly burdensome lease obligations.

Cerberus Exits

In 2020, Cerberus exited its position in Steward by selling its stake to De La Torre and other Steward physicians via a loan from MPT. Over the course of its ownership, it was reported that Cerberus made a profit of $800M.

It was downhill from there. Steward quickly began to downsize, selling off hospitals across the country. By January of this year, Steward was facing a financial crisis. It owed MPT $50 million in unpaid rent, among several other vendors. MPT, presumably to keep the gravy train running, stepped up and offered several loans to Steward to keep the health system solvent. It was soon reported that Steward would be forced to file bankruptcy and close a number of hospitals, which then launched a series of investigations into Steward's operations and financials, which brings us to today, where hospitals in high-need areas are at risk of closing, creating a potential public health crisis in Massachusetts.

What's Next

What happened here, in short, is a smart private equity firm saw an opportunity to buy up a struggling health system for small dollars, sell off the valuable real estate it sat on, and maximize those sales by saddling it with costly leases and using the proceeds from the sales to pay itself and expand this strategy across the country and the world. Then it sold off the entire asset, leaving the real estate owner (MPT) and Steward's management and employees in the lurch.

To be clear, It's not obvious that any of this activity is illegal (it's probably not). And in most industries, you could argue business is working as it should. Steward likely wasn't a great business at the start, and finding a way to maximize the assets of an investment seems like good old-fashioned capitalism. If Steward was a tech company or an apparel company, it’s likely nobody would know about this mess.

But it's not. It's a health system that operates dozens of hospitals in high-need areas. Hospitals that represent our society at its best. These are places of healing for humans facing the worst moments of their lives. They restore health, reduce human suffering, and support the overall well-being of the communities in which they operate. Not to mention, they generally receive at least half of their revenue from tax payer-funded healthcare. Because of that, I think regulation of these kinds of transactions and even for-profit hospitals, in general, are set to receive some intense scrutiny from regulators in the coming months. De La Torre is scheduled to testify in front of Congress in September.

I'm a big fan of capitalism, and I generally support the work of private equity firms in delivering returns to their shareholders, many of which are large pension funds, endowments, and foundations. But Steward's collapse is an important signal that our most important and prized institutions shouldn’t be operated as attractive targets for short-term, financially engineered profits.

Hospitals are different. They're a special thing. And regulators should ensure they're treated that way.