DO YOU SINCERELY WANT TO BE RICH?
by Uwe Reinhart, Dept. of Economics, Princeton University
“Get a life! Don’t go to med school. Just buy and sell docs, at a profit, of course”
Sometime during the 1980s, investment bankers on Wall Street hit upon the brilliant idea of purchasing thousands of individual mortgages from local Mom & Pop banks, pooling the monthly cash flow from those mortgages, and then selling in the open market the rights to distinct tranches of that pooled cash flow. The rights to these tranches are conveyed by so-called derivatives called mortgage-backed securities. The investment bankers who engaged in this business grew fabulously wealthy on the arbitrage profit inherent in it. That profit consisted of selling the pooled future cash flow to pension funds, mutual funds and other investors on Wall Street for much more than the price that the bankers had paid the Mom & Pop banks for that same cash flow. It is nothing other than the old buying-low-and-selling-high shtick.
In principle, absolutely anything (or anybody) that throws off a future cash flow can be securitized in this way and, in our increasingly commercialized world, is now being securitized and traded in the market. For example, what had tradition-ally been known as a patient is now known as a BSYC—a Biological Structure Yielding Cash. Because BSYCs throw off cash, they can be securitized, and the most efficient way to do that is to securitize and buy the physicians to whom the BSYCs tend to cling, like bees to a honeycomb. ‘Securitizing patients and buying a doc!?’, you will query incredulously. Sure! It is done. Practically, it means that one buys the physician’s ongoing practice (replete with the list of his or her patients), ties the physician to that practice through a long-term employment contract, and also commits the physician to a long-term non-compete contract that precludes him or her from competing with the buyer of the practice within a carefully specified market area. ‘Long-term’ in this context can mean up to 40 years.
All over America physicians are now busily securitizing themselves in this way, by selling their practices and their future labour to perfect strangers who operate so-called Physician Practice Management Companies (PPMs). The PPMs bundle into one giant cash flow the individual cash flows expected to be yielded by the BSYCs that are expected to cling to the purchased docs. That giant, bundled cash flow can then be re sold on Wall Street at truly handsome arbitrage profits, which can be so huge as to convert the founders of a PPM company into instant millionaires. Sometimes the PPMs may pay the selling docs with cash. But cash is hard to come by, and that could cramp the PPMs style. Therefore, most PPMs prefer to pay doctors with their own stock certificates, which they can print at will. In effect, then, the PPMs can buy doctors with mere hope-and-prayer paper, because the value of a firm’s stock certificate rides on nothing other than the pure hope that the firm will be able to pay future cash dividends that are large enough to justify the current market price of the stock. It is common sense that the more rapidly investors believe the PPMs earnings per share to grow in the future—and thus its ability to pay cash dividends—the more investors are willing to pay today for a share of that stock and the higher will be its P:E-ratio, defined as the ratio of the firm’s current market price per share divided by the firm’s current earnings per share. If Wall Street [temporarily] graces a PPMs stock with a high P:E-ratio, he PPMs management effectively can buy doctors with ‘funny money’, as long as the docs have faith in that funny money. For a while, this can work like a charm.
A major objective in this funny money game, then, is to persuade investors on Wall Street that the PPMs future earnings (and its ability to pay cash dividends) will grow very rapidly, for many years to come. We shall see below how that felicitous imagery can be manufactured with mirrors, at least for a while, and how that manufacture has created many of the new health care millionaires that have, of late, sprouted up all over America’s health care landscape. Alas, naturally the game also has begotten numerous impoverished health care shareholders (widows, orphans and doctors) who ended up with near worthless funny money.
To illustrate this funny money game with some contemporary, real-life numbers, assume that a doctor’s annual gross income (prior to the deduction of practice expenses) were $600000, leaving a net practice income before taxes (but after practice expenses) of, say, $350000. If the PPM bought this doctor and offered him or her an employment contract at a firm annual salary of, say, $300000, then the earnings before interest and taxes (the well-known EBIT) yielded by the doc to the PPM would be $50000 per year. Right now (in 1997), the going market price of a doc appears to be about four to six times the EBIT that he or she will yield the buyer. Therefore, the PPM might pay that doctor $200000–$300000 cash up-front (or much more paper value, if the doc is willing to accept the PPMs stock instead). In return for that up-front payment, the doctor promises not to compete directly with the PPM in the relevant market area for several decades. The PPM pays additional money for the physical assets in the doctor’s practice and for the practice’s accounts receivable. Upon consummation of this deal, the doctor becomes the PPMs salaried employee.
Suppose now that you and a few of your class-mates founded such a PPM and acquired a few hundred docs, either with borrowed cash or, preferably, in exchange for your PPMs own stock certificates, 10 million of which you had printed up earlier. After acquiring the docs and promising Wall Street that you will buy ever more of them, you can sell, say, 7 million shares of your PPMs stock to mutual funds or individual investors in a so-called initial public offering (IPO). Of the re-maining 3 million shares, you might distribute up-front 1 million to yourself and your buddies, as a reward for your visionary entrepreneurship. You might keep the final 2 million shares in reserve as ‘authorized, but unissued’ and use them subsequently as part of the handsome, non-cash compensation that you, as the CEO of this new PPM, richly deserve. Of course, you can always print up more shares when the initial batch of 10 million has been issued. Now it turns out that a PPMs common stock tends to sell at six to eight times EBIT for ‘same-store earnings’, i.e., assuming that there will be no further doc-acquisitions and that the PPMs future cash flow will come strictly from the docs already owned. But if you had bought your docs’ cash flow at, say, five times EBITDA and then resold the bundled cash flow at, say, seven times EBITDA, that already would yield you a neat arbitrage profit.
Yet you could do ever so much better by seducing Wall Street into the belief that you will keep buying more and more docs from here to kingdom come (a process Wall Street calls a ‘roll-up’). If you can keep that game going for, say, 2–3 years, then our ‘efficient’ stock market will believe (or pretend to believe) that your PPMs earnings per share will soar at an annual growth rate, say, 20–30% from here to kingdom come, or at least for a long, long time. On that expectation, the research analysts on Wall Street will sing your PPMs praises, and many managers of mutual funds will be content to pay for your stock a price-to-earnings ratio (P:E-ratio) of between 30 and 50 times your PPMs current earnings per share.3 If your current earnings per share were, say, $2, investors might be willing to pay $80 per
share of your PPMs stock. Thus does Wall Street create the temporarily powerful funny money alluded to above. The trouble is, of course, that to keep the game going you will need to buy an exponentially increasing number of docs, year after year. First, as your PPMs total earnings grow, it will require an ever larger infusion of additional aggregate earnings to keep the PPMs earnings per share of stock growing at 20–30% per year. You can get these ever larger additional earnings only by buying an ever larger number of docs. In the process, of course, you will keep pumping out ever more newly issued shares of stock, which by itself would depress earnings per share, unless total earnings were made to rise commensurately. Because of the need to purchase an ever larger number of docs—each with their own clinical and managerial habits and with a more or less developed information system—there will be no time to integrate all the practices your PPM owns into a co-ordinated clinical network, bound together by well-functioning marketing-, management- and information-systems. All that will come ‘later’, you will assure the analysts on Wall Street. Alas, ‘later’ in this context may mean ‘never’.
Luckily for you, when the game is still relatively young, the stock market seems not to mind, as long as earnings per share keep rising in the short run. On Wall Street, only timid sages take a long-run view, and even they rarely think of the long-run as more than 5 years. In your frenzy to keep earnings per share of stock growing you will find yourself paying top dollars per doc (in terms of your stock’s paper value). As long as Wall Street keeps putting a
high P:E-multiple on your stock certificates; how-ever, this is not a BFD,4 for you can afford to pay each doc several million dollars in stock value without increasing unduly the number of shares of stock outstanding—that is, without seriously ‘diluting’ your PPMs stock. Many docs appear to cave in at the mere mention of an offering price in the millions, even if it is in the form of hope-and-prayer paper. The stock market, for its part, will believe (or pretend to believe) that you have created a veritable growth engine that spews out millions and billions in newly created ‘value’, when in fact you have merely reshuffled pre-existing economic value without creating much if any new economic value. Luckily for you, Wall Street is not set up to distinguish between reshuffled and newly created economic value. Wall Street reacts strictly to hoped for cash flows, regardless of the process that creates these cash flows.
At some point, of course, this funny money game will come to an end. It will end in part because the docs you bought are now your salaried employees. Many of them will have lost the high motivation and productivity that characterizes self-employed owner–operators of business firms (which is what a medical practice is). The salaried physicians will not work as hard as they did before. This will be particularly so as they begin to chafe under the unaccustomed managerial edicts raining down on them from a distant ‘corporate headquarters’ that is run by non-MDs. Some of your doctors will quit outright, to re-establish themselves in another market area. Even-tually, also, you may run out of cheap docs to buy. Either way, eventually ‘disaster’ will strike: even with all of the accounting gimmicks you can purchase from your own flexible accountants and from your flexible external auditors, the time will come when your reported quarterly earnings per share fall a shade or two below the high earnings growth that the stock market had come to expect from your PPM. Even small dips in your quar-terly earnings could trigger a veritable panic among stock analysts and investors, because it might awaken them from the reverie into which you have lulled them with your rosy road-show presentations in prior years. When that happens, your stock’s price will take a steep nose dive, as reality seeps in or as investors, feeling betrayed by you, angrily purge their portfolios of your stock. Once your stock’s value has tanked, it will be much more difficult to purchase ever more docs for funny money, because at a lower price per share you must pump out so many more shares to achieve a given acquisition price per doc. In addition, news of your problem may seep into the financial press, and many physicians will begin to distrust your funny money. Thus starts a down-ward spiral that eventually may cut the value of your PPMs stock to a mere fraction of its all time high.
Naturally, the now salaried physicians whom you bought for the hitherto inflated funny money (and who fancied themselves multi-millionaires) will be furious. ‘Hell hath no fury like a doc financially burned’, quoth William Shakespeare (or might have quoth). Many of your docs will leave your PPM in disgust; the rest may suffer morale problems and lower their productivity yet further.
Armageddon, however, will come when your hitherto passive Board of Directors awakens from its slumber. You had carefully hand-picked this Board to rubber-stamp your every decision, and you had motivated its members to that end by paying them handsomely with the PPMs stock certificates, or with stock options that allowed them to purchase shares in your PPM at prices far below prevailing market prices. Although all of these Board members were your erstwhile friends, naturally they hate to see the value of their imagined wealth evaporate. They may also fear being sued by angry shareholders (your angry docs among them) over some of the fancy accounting gimmicks that your creative accountants undoubtedly will have employed, to meet Wall Street’s earnings expectations. Eventually, in their anger and fright, these erstwhile pussy-cats will try to fire you summarily. Fortunately for you, in their erstwhile role as your hand-picked friends, they had put in place for you a generous golden parachute that will now force them to pay you multiple millions of dollars, just to get rid of you. As you know, such golden parachutes are de rigeur all over corporate America.
Presumably, by the time your stock’s value collapses, you will have sold large blocks of your shares in the PPM for cash. Some of that cash will have been used by you to buy the obligatory mansion in your home state, complemented perhaps by a 20-room haeusele in the Bahamas. There may also be a Rolls Royce, and surely a Porsche, in your N-car garage. Long before your ‘roll-up’ collapses, you will have graced the cover of Inc.or Forbes magazine as the Entrepreneur of the Year, will have supped in the White House, and will have basked in the presence of Lou Dobbs of CNN’s Moneyline, or possibly even in the hallowed presence of Louis Rukeyser. As a highly respected person all around, you will have been invited to sit on many boards—perhaps your alma mater’s—there to dispense your evident vision and wisdom. Now, isn’t this a, like, totally awesome game?
Why then waste away your precious Princeton years in the library, as a pre-med, trying to cope with the academic effrontery called organic chemistry? Why ruin your potentially stunning love life by going to medical school? Why ruin your health and, possibly, your first marriage in the slave-labour boot-camp called residency? Why not just sit back, sip whatever nectar is legal at your age, graduate from Princeton, take a job on Wall Street, and wait a few years, until your nerdy, suffering, exhausted and deeply indebted pre-med classmates finally tumble out of the MD-production pipeline, whereupon you can buy them, bundle them and sell them to Wall Street at a handsome arbitrage profit?
Mind you, so far you can play this doc-for-funny-money game only in America. Physicians elsewhere in the world are still too proud to sell themselves for funny money—or even for cash. But their time will come! Wall Street will get to them, too, sooner or later. It always does.
By the way, you may wonder how analysts and investors on Wall Street can possibly be so gullible as to play along with this gig. How can anyone be this dense? As a general rule, Wall Streeters are not dense. Most of them have been bright students in their time, like you. They merely operate in this case on the famous Greater Fool’s Theory, which leads even smart investors to purchase stocks of dubiously high value, on the theory that there is likely to be a greater fool on whom that overvalued stock can subsequently be unloaded, at an even higher, even more dubious value. After all, a realized positive spread between two dubiously high values represents a solid, non-dubious cash profit. And should an investor on Wall Street be the last and greatest in a chain of fools, usually he or she played the game with other peoples’ money and won’t go barefoot as a result.
Finally: does anyone know of a textbook company interested in buying a little old country economist from rural New Jersey? I’m ready to be securitized. Since students have to buy the text book that I prescribe, can’t you just visualize the cash flow that I could steer to a textbook company that owns me? In fact, do you sincerely believe that making you buy just one textbook really begets high quality learning? Wouldn’t multiple textbooks per course be much better? Hm! I see potential for ‘value-creation’ right there.
