Ponzi Hospitals and Counterfeit Capitalism
Ponzi Hospitals and Counterfeit Capitalism
The end of cheap money in our monopoly-heavy economy is going to make things very weird. Big private equity shops could be in trouble.
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One big theme this coming year is the Federal Reserve’s choice to get rid of easy money conditions. Throughout most of 2021 and 2022, easy money meant speculators could borrow virtually without limit or cost, leading to a lots of strange forms of fraud. With Fed Chair Jay Powell taking the punch bowl away in the middle of last year, many such arrangements are now falling apart.
Today I’m writing about one such collapsing scheme. It’s a firm known as Medical Property Trust, and it’s embedded in our hospital system.
In addition:
In a Veep-like error, corporate-friendly Senate leaders accidentally strengthened antitrust enforcement more than intended.
Two private equity firms ruined password manager LastPass and just kind of gave your bank password to hackers.
Why do analysts and CEOs keep calling for consolidation?
And now…
Two months ago, as T-shirt wearing crypto fraud king Sam Bankman-Fried’s empire collapsed, one of the smartest antitrust lawyers I know gave me his theory about why SBF was able to convince so many elites he was a legit genius. “SBF sounds exactly like every other financial operator in charge of a major corporation,” he said. “Uber offered subsidized rides instead of 20% interest accounts and Uber insiders cashed out by selling stock instead of magic tokens. But it's basically the same thing.”
That theory made sense. Consider pre-crypto scams such as WeWork, the money-losing real estate leasing company that temporarily became a high-flying ‘unicorn’ company in 2019. WeWork CEO Adam Neumann, who wore T-shirts that suited his ‘quirky’ personality, parralleled Sam Bankman-Fried. Like SBF, he raised billions for an obviously unprofitable idea - they even shared Softbank as an investor. Neumann, like SBF, was feted by Wall Street, and both cashed out even as the venture bled money.
Firms like firms like WeWork and FTX aren’t isolated instances, but represent a late stage of the business cycle. The great economist Hyman Minsky called it the Ponzi finance stage, and it is based on the interplay between asset prices, debt, and revenue. Here’s how it works.
In the initial economic stages coming out of a recession, asset prices are low and people are cautious about borrowing. Firms make enough money to pay back their debts and then some. As firms get more confident, they start to borrow and invest more. Asset prices go up. Yeah you have more debt and can’t pay it down out of revenues, but your portfolio is up and you’re getting kind of rich. In the final blow-off top, speculation becomes extreme, and asset prices skyrocket. Now you feel really rich. Sure you have to continually bring in more investment or borrowing simply to stay out of bankruptcy, but who cares if you can still service your debts out of cash flow? You can always sell your richly valued assets in a pinch.
The Ponzi finance stage is that moment when firms are insolvent, but financiers haven’t stopped lending to them because asset prices are at bubble levels. People feel wealthy, even though it’s all on paper. It is unsustainable, and ultimately blows up. This is the point where FTX is worth $32 billion, and WeWork is worth $47 billion. These aren’t an isolated set of firms; if you don’t borrow and speculate, your competitors will. So if WeWork didn’t engage in Ponzi financing, some other company would have done it and we’d be talking about a different T-shirt wearing narcissist.
In the Ponzi finance stage, especially when forms of cheating and monopolization are legal, firms destroy enterprise value as insiders cash out. In 2019, I called it ‘Counterfeit Capitalism.’ Part of the cause was a policy framework that allows for below-cost selling known as predatory pricing, such as WeWork selling real estate leases below what they cost. An accelerant was free capital from the Federal Reserve, which forced investors to find ever riskier investments just to generate some sort of return. During the Ponzi finance stage, financiers put charlatans in charge of our corporations, because the key job criteria is telling a story to investors justifying losses as gains. That’s why SBF, despite being a fairly dumb drug addict, managed to get on the cover of so many magazines.
So basically SBF and crypto, high-finance without purpose, was a natural outcome of our policy regime. And it also fell apart, as I predicted it would, when the Fed stopped handing out free money to Wall Street and began raising interest rates. All of a sudden, when capital cost something and bubblicious asset prices fell, the underlying investments had to generate real revenue. Without a continual stream of Ponzi finance, money-losing enterprises began collapsing. The ‘Minsky moment’ arrived.
And it’s not just FTX, or crypto. Across the economy, a lot of ventures set up under a free money regime, in which insiders cash out while the bagholders are left with worthless magic beans, are falling apart. For instance, private equity giant Blackstone has a $68 billion private real estate investment trust, or BREIT, which lets investors buy into a pool of random assets, like shopping malls, housing, and commercial real estate, precisely the stuff you don’t want to own at this economic moment. BREIT has a structure controlled by insiders, just like FTX or WeWork. The value of BREIT doesn’t go up and down with the stock market or similar assets. It is privately assessed by Blackstone’s accountants, which gives the firm control over investor capital, or rather, the story it tells to investors.
Then comes the skimming. For the favor of buying into an overvalued set of deflating assets held in an opaque entity, Blackstone takes about 3.6% in annual fees, or over $2 billion a year. That’s an insanely high fee. The model is no different than the crypto craze or WeWork or Uber, only in this case it’s Blackstone cashing out as the insider while investors get hosed. Blackstone is considered immensely prestigious and smart, similar in some ways to SBF and his math pedigree from MIT. Some key differences are that Blackstone CEO Stephen Schwarzman doesn’t wear a T-shirt, and that prestigious investors are willing to bail him out for a large fee.
These Ponzi-like schemes are pervasive at this point in the U.S. economy, and they are going to unravel over the next year. And that brings me to health care, and in particular, hospitals. This is not an area where you would expect Ponzi financing. Most Americans think highly of hospitals and doctors, imagining them as the good guys you see in TV shows like Scrubs or Grey’s Anatomy, caring professionals doing the best with what they can. A lot of hospitals are nonprofits, and many hospitals in the U.S. - especially ‘safety net’ hospitals that serve poor or rural communities - are on the brink of insolvency. Since 2010, 140 rural hospitals have closed.
Despite this dynamic, the amount of cash pouring into health care is quite high. In the U.S., we spend about 20% of our GDP on health care, which is between two to three times as much as other countries. But we get worse results. Why? The answer is monopolization and cheating. As one article in 2003 noted, “It’s the Prices, Stupid.” In terms of hospital beds, physicians, and nurses, we provide fewer than most rich countries for our citizens. We pay more, and get less, because of insider skimming.
Over the last five years, the public has wizened up to the game, helped in part by the media and the failures during Covid. There’s been a tremendous amount of good reporting on corruption in the hospital sector. For example:
At the height of the pandemic, Bloomberg came out with a long report, “Life and Debt at a Private Equity Hospital.” Reporters raced how private equity group Cerberus Capital helped ruin St. Elizabeth’s Medical Center in Boston, as well as dozens of other hospitals. Maintenance problems, supply shortages, and inadequate staffing led to above average rates of hospital infections. (Cerberus is also the PE fund that is trying to loot the Albertsons supermarket chain.)
ProPublica wrote a story on private equity group Leonard Green and Partners, which bought 17 hospitals and loaded them up with debt to pay itself dividends. Now some of these hospitals are closing, and administrators often refuse to pay vendors for the gas in ambulances. Some of these facilities “have had bedbugs in patient rooms, rampant water leaks from the ceilings and what one hospital manager acknowledged to a state inspector “looks like feces” on the wall,” along with “dirty, corroded and cracked surgical instruments in the operating room.”
Earlier this month, CBS did a story on Prospect Medical Holdings, a fund that owns over 20 hospitals, and engages in extractive arrangements, such as shutting down critical care facilities so they can generate cash. In 2018, Prospect took out a $1.12 billion loan and paid itself a $457 million dividend, saddling the hospital with the debt. The CEOs take was $90 million. The title of the story says it all: "What they've done is extremely evil": Pennsylvania hospital shutdown spurs questions about private equity in health care
What is interesting about this dynamic isn’t that private equity firms are grabbing whatever they can. That’s what they do. What’s weird is that some of these financing arrangements aren’t profitable. Yes, the PE fund pays itself and its investors a large slug of cash, but it now owns a weakened hospital it bought with good money. So what’s going on? The answer is Ponzi finance, a series of financial games to dump losses not just onto patients and communities, but onto investors/taxpayers. I’m going to focus on one real estate called Medical Properties Trust, exposed over the last year by investigators at Hedgeye and the Wall Street Journal.
MPT specializes in a specific arrangement that damages health care delivery. It’s called a sale-leaseback. In a sale-leaseback, a private equity firm will buy a hospital, sell the land underneath it for cash, and pay itself a dividend, leaving the hospital saddled with high rent payments going forward. Basically, it’s a shift of assets, from a community hospital to a banker in a distant city. A corporate landlord now has a stream of promised rent payments, a PE fund gets a bunch of cash upfront, and a hospital, often financially weakened, owes a bunch of rent where before it didn’t.
Still, someone has to provide the cash to buy the land, and that’s what MPT does. It is a $20 billion real estate investment trust, or REIT, that helps private equity firms like Cerberus or Leon Green do sale-leasebacks by buying land under hospitals. According to the Wall Street Journal, MPT is “one of the biggest owners of U.S. hospital real estate, with hundreds of properties around the country and more than $20 billion of assets.” It specializes in smaller cities where struggling hospitals serve poor populations.
But how can such a model be profitable? The answer is that it probably isn’t. Like WeWork or FTX, MPT is likely burning through cash to show the appearance of growth. It buys land from private equity-owned hospitals, and then gets rent payments. But when those hospitals can’t afford to pay the rent, MPT will effectively lend money to help those hospitals make their rent payments. That way, it doesn’t look like there’s a default. Sometimes this lending takes the form of MPT helping to finance the purchase of hospitals outright by dummy corporations. If such corporations can’t pay rent, no problem. MPT can lend to keep the rent money flowing back to itself.
So if it’s losing money, where does MPT get its cash? The answer is that it brings in outside investment to make up the difference. MPT issues bonds and stock in the capital markets, and tells a story to investors that it is growing fast and there are very few defaults on the land it owns. This is technically true, because MPT is paying rent to itself. The firm then uses this outside financing to keep the rent payments to itself going. What’s the end point? It’s the same as WeWork or FTX, to let insiders extract cash. As the Wall Street Journal detailed, MPT executives have compensation “linked to the volume of acquisitions completed by the company and other growth metrics.” Its CEO, Edward Aldag, earned $17 million in 2020, and sold $15 million of stock last year. The firm also owns three Gulfstream jets which regularly go back and forth between Birmingham and the location of Aldag’s waterfront home.
So there we go. Now that liquidity is down and skepticism is up, investors are learning the truth about where their money is going. Over the last year, because of investigators at the Wall Street Journal and analysts at Hedgeye, the value of MPT has been cut in half. The Minsky moment is nearing.
But MPT isn’t isolated, it is interconnected with funds that buy hospitals. As MPT loses its ability to get the cash to buy out private equity-owned hospitals, what happens to those private equity funds who rely on it? That’s where this gets more interesting. Hospitals, especially safety net hospitals, are just not good investments. Some things just can’t be profitable, like taking care of sick poor populations. But investors in private equity firms can’t see that their investments are losers. It’s easy to tell what a public stock is worth, because shares are bought and sold many times every day. But how do you tell what a private firm or piece of real estate is worth? You can’t, instead you have to rely on the insiders managing that asset to value it.
Private equity firms, who buy up illiquid assets like companies, hospitals, land, etc, report results to their investors, using something called the “Internal Rate of Return.” They basically guess what their portfolio firms are worth, and then annualize that as a return. Pulling cash out of an investment today helps boost their IRR, versus pulling cash out tomorrow. It also lets private equity fund managers get incentive bonuses. Meanwhile, the story of the valuation told to investors is controlled by insiders, as opposed to investors just seeing what their stock is worth in the public markets.
If the result of taking cash out now ends up destroying what’s left of the hospital, well, that’s a problem to deal with in a few years. For now, a large cash dividend shows high returns which they can use to get more investment money, and they can stick the rest of the investment on their balance sheet with an inflated value. Or they can sell portfolio firms to themselves, which is increasingly what’s happening in the industry. As Eileen Appelbaum and Jeffrey Hooke have shown, this dynamic - which really seems like deceptive accounting - is pervasive. Large numbers of PE investment funds from more than ten years ago still have significant amounts of unsold value. That’s a red flag. Big investors are now saying there might be broad-based Ponzi finance in private equity itself, which owns in aggregate $4 trillion of assets.
And that’s why MPT is interesting. It’s a bottom-feeder using investor capital to send cash to private equity funds, and so those private equity funds will make money on their specific investments. But ultimately, if the cash providing returns to key private equity funds is premised on Ponzi financing, then the business of private equity only exists because it can hide the real values of its portfolio firms from investors. Already, quietly in private markets, valuations for PE portfolios are coming down quickly. So these Ponzi finance-dependent models are not sustainable without low-level accounting fraud, or a bailout. Or both.
And how to hide this big quasi-fraud in plain site is going to be a big theme of 2023.
Bank Error In Our Favor
In early December, antitrust legislation got accidentally strengthened on the floor of the Senate, because a Senate leadership staffer messed up the version of the document they were supposed to include in the final legislative package. There are villains in the story, namely Senate Majority Leader Chuck Schumer and Mitch McConnell, and there are heroes such as Senators Amy Klobuchar, Mike Lee, and Elizabeth Warren. But this anecdote is fundamentally stupid.
Over the course of the last year, Schumer has controlled the Senate floor. In May, he promised Democratic Senators that he would hold a vote to strengthen antitrust laws, so they did a lot of hearings and work to write it. But Schumer, who is constantly currying favor with Google, was lying. He delayed and deferred, until everything had to get jammed into a four thousand page final funding package.
Schumer and McConnell refused to stick anything related to tech antitrust in the final package, despite overwhelming bipartisan support. But Schumer did include a bill to make changes to where antitrust cases are heard, as well as an increase in merger filing fees that would go to the antitrust agencies. That provision had already passed the House and key parts had passed the Senate, so they included it in the year-end package.
But Schumer and McConnell tried to water it down. They wanted to be sure that Federal Trade Commission Chair Lina Khan couldn’t get extra money, so they put a two-year delay into the bill. Under the version they included, the merger filing fee money won’t get to the Antitrust Division until 2025, after Biden’s first term is over. It was a way of saying that they would boost enforcement, but only if people who are aggressive wouldn’t get to touch the money.
So that’s where we stood near the end of session. The problem is, someone in Schumer/McConnell world screwed up the drafting, essentially cutting and pasting the wrong Microsoft Word file. The version that had passed the House and Senate applied to new antitrust cases filed by state attorneys general. The version they accidentally stuck in the omnibus applies not only to cases filed by state attorneys going forward, but applies to pending cases. And this is a problem for Google, because they are facing just such a case in Texas. Texas Attorney General Ken Paxton has a devastating complaint against Google’s ad monopoly, but the suit had been removed from its Texas-friendly court and combined with a bunch of other suits in New York. If the strong version of the venue bill passed, that case would get kicked back to Texas, which Google does not want.
After the omnibus became public and Google lobbyists realized what had happened, they went nuts and demanded Schumer and McConnell fix it. California Senator Alex Padilla, who tends to support the search giant, pushed to fix it as well. So Schumer and McConnell groveled to the original authors of the bill, Klobuchar and Lee, and asked if they would consent to fixing what everyone knew was a drafting error. Most Senators are lazy and weak, and would probably allow such a fix without putting up a fuss. But Schumer had treated Klobuchar with contempt, and Klobuchar is actually substantive. So she and Lee said that they would only agree to the legislative fix if Schumer and McConnell backtracked on the two-year merger filing fee delay, thus allowing extra money to flow to the agencies (mostly the Antitrust Division).
So that was the trade. It was a good deal. It would have been hard to get the Paxton antitrust suit moved back to Texas anyway, and Google probably would have sued on constitutionality grounds. Meanwhile, the extra money will lead to a dozen or more antitrust suits over the next few years. So while this is very much Veep, good for Lee and Klobuchar leveraging the screw-up.
Private Equity Just Gave Your Bank Password to Hackers
In 2021, I noted that LastPass, a beloved password manager for consumers, engaged in an extortion scheme against its customers.
LastPass has encouraged millions of people to replace weak passwords on retail websites, internet banks and other online services. Instead, the software handles authentication automatically using long, complex passwords that are impossible to guess — or remember.
Two investment firms, Elliott Management and Francisco Partners, acquired the service as part of their $4.3bn buyout of internet software group LogMeIn in September last year.
Now, the app is warning users that they must pay as much as $36 a year if they want access to those cumbersome passwords on all their devices.
The reason for this choice was that LastPass had been purchased by two private equity firms, Francisco Partners and Evergreen Coast Capital Corp. Typically, PE firms raise prices, lower quality, harm workers, and reduce customer service. This particular pricing move sparked a backlash from customers, and the two PE firms pledged to spin off the company and make it independent. But that hasn’t happened.
And now there’s some new information about the lovely management of LastPass. Apparently hackers have stolen encrypted password vaults, which means that users of LastPass are now vulnerable and must change every single password they have. Poor quality is common within private equity owned software firms, which means cybersecurity vulnerabilities quickly follow. We’ve seen this with PE-owned software firms facilitating the hacking of the NYC subway, nuclear weapons facilities, and criminal ransomware. And now it’s happened with LastPass. Lovely.
Why Do Analysts and CEOs Keep Calling for Consolidation?
For some reason, analysts and CEOs just cannot stop musing on how consolidation will continue.
Paramount CEO Bob Bakish: “Consolidation has been the rule in business for a long time, certainly been the rule in media. So, it’s hard for me to bet on anything other than consolidation will happen in the future.”
Reuters Breakingview: “Netflix will be next on Microsoft’s shopping list”
CFRA Research analyst Arun Sundaram: “We’ve been thinking that we’d see more consolidation in the food retail space for some time now.”
Morgan Stanley’s software analyst Brittany Skoda argues that “2023 is going be an incredibly active year for M&A. We’re calling this The Great Consolidation.”
I’ve included more examples here. At some point, as they internalize a new regulatory environment, business leaders will realize there are other possible avenues to succeeding aside from consolidation. Such as, oh I don’t know, creating better products and services.
What I’m Reading
University of California to Invest $4 Billion in Blackstone’s BREIT Real-Estate Vehicle, Wall Street Journal
‘A sea change’: Biden reverses decades of Chinese trade policy, Politico
A new world energy order is taking shape Global, Financial Times
Microsoft claims it has no idea when Call of Duty came out, The Verge
Brandon Sanderson's comments about Audible and his Kickstarter Audiobooks, Reddit
Mastercard Ordered by FTC to Help Rivals Route Transactions, Bloomberg
ESG Won’t Stop the FTC, Federal Trade Commission Chair Lina Khan
Porn, Piracy, Fraud: What Lurks Inside Google’s Black Box Ad Empire, ProPublica
Congress' last-minute $1.7 trillion omnibus package: 8 healthcare takeaways, Beckers Hospital Review
Meta to Pay $725 Million to Settle Cambridge Analytica Lawsuit, Wall Street Journal
Proposed Sanford-Fairview merger warrants serious skepticism, StarTribune
Exclusive: Bloomberg eyes WSJ-parent Dow Jones, WaPo, Axios
U.S. judge penalizes 3M, bars it from shifting liability in earplug litigation, Reuters
WTO Backs Hong Kong in Trump-Era ‘Made in China’ Dispute With US, Bloomberg
Microsoft responds to FTC case seeking to block Activision Blizzard deal, CNBC
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cheers,
Matt Stoller
You’ve really showered us with riches in this edition, Matt. Incredibly valuable reporting.
Best piece you have ever written. A MUST read. Everyone, pass it along.