Private equity and the transparency tempest in health care

Health care and the public markets are closely tied together. But not in the way you think they are.

The past few years have seen several scandals in health care, including the high-profile unraveling of Steward Health Care, a large hospital system, following its embrace of private equity investment. At the same time, several academic studies have made headlines suggesting that private equity investment in health care can be dangerous and lead to declines in patient care.

The result has been a storm of legislation. By July this year, there were three bills pending in Congress and more than 75 bills pending before state legislatures, all proposing to restrict or condition private equity investment in different areas of health care. The most recent, the Health Over Wealth Act reintroduced in Congress in July, would put significant disclosure requirements on private equity investments in health care and impose major penalties for understaffing. It’s companion bill, The Corporate Crimes Against Health Care Act, would create criminal penalties for “asset-stripping.”

The current reaction to regulate health care investment reminds me of a similar time in 2001, when the clamor surrounding the scandals of Enron and WorldCom dramatically changed the public stock markets in the United States (e.g., the New York Stock Exchange and the Nasdaq). That was a quarter of a century ago, and most of us in the workforce don’t remember that time or how the public markets functioned before it. And lest we repeat history, we should learn from it.

Why? Because it was in the outrage surrounding Enron and WorldCom that Congress itself brought about the preeminence of the private equity funds that are now the subject of its ire.

What am I talking about? Enron and WorldCom had been darlings of Wall Street before their downfall. In 2002, Congress enacted a law called the Sarbanes-Oxley Act (often referred to as SOX) that was intended to rein in future public company fraud. SOX made it remarkably harder and more expensive for U.S. companies to go public and to stay public, and made it risky for executives to lead public companies.

Shocking consequences of SOX

The consequences of SOX are shocking. From 1982 until 2002, when SOX became effective, the United States created more than 7,000 public companies; in the almost 25 years since, the United States has created fewer than 3,000 public companies.

The result is a number of distortions across financial markets that persist to this day. In the S&P 500 index, roughly 40% of the value sits in the stocks of the top 10 companies; if newer companies don’t go public, the markets lack the benefits of that diversification. The Wilshire 5000 Index, which is supposed to represent the entire stock market, includes only approximately 4,300 companies now, because after a quarter century of mergers and go-privates, that’s all that are left.

Since fewer companies go public, they have one primary source of raising capital to grow: private equity. Congress created a virtual monopoly for private equity in 2002 when it closed the doors to the public markets. And SOX has also contributed to the growing wealth gap in the United States, because instead of the middle class being able to invest in thousands of new companies coming to the stock market for the past 25 years, those companies have had to get their funding from private equity. Under U.S. securities laws, only accredited (i.e., wealthy) investors are allowed to invest in private equity. Congress had intended to protect the public from fraudulent investments, but what it did instead was protect the public from almost all new investments.

How should we react to private equity investment?

There are serious implications for the future of U.S. health care that hinge on how the United States reacts to private equity now. This is because there are only four types of equity to grow companies. They are as follows:

• Public market equity, such as listing on the New York Stock Exchange
• Private equity, which includes money from funds, venture funds and private individuals
• Nonprofit equity, which consists of charitable giving
• Government equity, which consists of tax dollars

If companies can no longer avail themselves of the public markets, and the United States restricts private equity investment in health care, there are only two types of equity left to grow health care companies: charitable dollars and government taxes.

But charity and taxes alone are not enough to fund innovation in health care. The health care industry is in the midst of massive disruption, including with artificial intelligence, nursing shortages, an aging population and reimbursement changes. We need substantial investment in health care to make it better, more efficient and modern.

Wanted: More sources of capital for health care

The solution? Instead of having fewer sources of capital to fund innovation in health care, the United States needs more. Instead of forcing private equity out of health care, we should be clamoring to bring back public markets, so that health care companies can also get investment dollars by going public, instead of only by taking investments from private equity. Then we let the best dollars win — sometimes the public markets, sometimes private equity, and sometimes charitable contributions or taxes.

Importantly, to bring back the public markets, the United States does not need to return to the pre-SOX environment that produced Enron and WorldCom. Instead, with SOX, the pendulum has swung to the extreme, and now it merely needs to swing back to the middle. We’ve been living in the shadow of SOX for so long now that we’ve forgotten this. Indeed, those who’ve entered the workforce after 2002 have never even known how different the financial markets once were.

There is a great irony here. All of the transparency that Congress and the states desire from private equity is already required of public companies through their quarterly reporting. Congress closed the doors on going public, and now it’s asking that private equity in health care begin providing public company-style reporting.

The United States should take care in how it handles the capital markets as it looks to fix health care. The law of unintended consequences created the private equity boom, and if we overreact in how we handle private equity investment in health care, the law of unintended consequences could quickly make U.S. health care worse, not better.

To build better health care for the future, the U.S. health care industry needs more sources of capital, not fewer.

Bobby Guy, J.D., is a health care deal lawyer with national law firm Polsinelli, and hails from the firm’s Nashville office. He is the host of The 10 Minute HealthBizCast and chair of the national Healthcare Dealmakers Conference that takes place in Dallas each May.