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SAN FRANCISCO – In his opening remarks at this, the 28th edition of the J.P. Morgan Healthcare Conference, Doug Braunstein, head of investment banking for the firm, briefly waxed nostalgic with a look back at the first edition of the conference back in 1983. He noted that that first edition of the conference had only 21 presenting companies and the U.S. spent about $350 million on healthcare.

“Here we are 28 years later with almost 349 of the most important and influential healthcare companies on the globe are here today. We have almost 1,400 public investors and almost 1,400 private equity and VC investors and over 7,000 one-on-one meetings, the most we have ever set and U.S. healthcare expenditures are eight times what they were 28 years ago, and the debate obviously rages in Washington around that expenditure.“

Braunstein said if one steps back and looks at how things have been over the past 18 months “it's been a rather tumultuous time, certainly for the financial services industry.“

Looking ahead, Braunstein presented a slide that displayed the global consensus estimates of economists of what growth rates look like in the U.S., UK, Japan and Brazil. All of those markets showed a positive trend between the first and fourth quarters of 2009 and the first quarter of 2010. “We believe strongly that we are beginning to see the turns in the economy and certainly the economic community believes that the evidence is mounting for that.“

Sounding a cautionary note, however, Braunstein said that in the U.S, unemployment continues to be an area of concern, with a rate of 10% as of December, the highest level in more than 20 years. He also said that the slumping housing market continues to be a problem, with housing starts still hovering at around 600,000, one quarter of what they were when they peaked in 2007.

On a more encouraging note, he said that asset valuations and asset pricings from January 2008 to December of 2009 have improved dramatically across the globe. Most interestingly, he noted is that while the S&P is down 23% over the past two years, it has rallied almost 80% from its low on March 9, 2009. He also said that the NYSE has rallied more than 60% this year “and we've seen rallies in almost every asset class.“

Healthcare (pharmaceuticals, medical technology, biotechnology, and services), Braunstein said, has preformed favorably when compared to the above mentioned benchmarks. Almost all these businesses have rallied much greater than the S&P has rallied. In the course of 2009, while the S&P was up 20% year-over-year, companies presenting here were up over 40%, biotech up 51%, services rallying, recovering almost there complete loss at 50%, medtech up about 40% and pharma up about 70% year-over-year.“

Braunstein said that 2009 was the largest year in equity issuance in U.S. history, largely driven by the recapitalization of corporate America, principally financial institutions and a number of industrial companies. Perhaps most interesting of all was his observation that the IPO markets began to open up in the second half of 2009, after a long dry spell. “Where we sit today, there are almost 50 IPOs on file at the beginning of this year and a great expectation around the ability for new companies and new investors to tap that marketplace.“

Another area that Braunstein said has shown substantial improvement is the mergers & acquisitions market. Between 2008 and 2009, that business was off substantially, with a nearly 60% decline from its peak in 2007. The fourth quarter of 2009 “saw the greatest level of activity we have seen [in M&A] in almost six quarters.“

In comparison to the other capital markets, healthcare represented about 31/2% of the global equity issuance in 2009 and about 2% of the total debt issuance. Importantly, he said, “equity issuance between 08' and 09' was up and debt issuance was up as well.“ Strategic activity across the globe in the sector represented roughly $2.4 trillion in activity for 2009, down considerably from the peak in 2007. M&A activity globally for 2009 was up for healthcare at a little more than $200 billion.

Putting all of these pieces together, Braunstein said he believes the capital markets “did a great deal to actually position companies to take advantage of what we hope will be an improving economic situation.“

Dimon: major overhaul of regulatory system

Is history doomed to repeat itself? That notion was not lost on Jamie Dimon, chairman/CEO of J.P. Morgan in his keynote remarks Monday at this year's healthcare conference as he attempted to sort out what went wrong with the financial system in the U.S., and determine what can be done to prevent a similar or worse event in the future.

The fundamental causes of the most recent economic slump “were all known beforehand,“ said Dimon. “When I talk about some of the [potential] future problems, they are not a secret either,“ he added.

Dimon acknowledged that many want to place blame on big banks and big business as well as big government, but in the final analysis. “None are solely to blame, and none, in my opinion, are absolved from blame.“ What is obvious, he said, is that “we need a major overhaul of the regulatory system and we have an opportunity to develop a better, more cohesive, comprehensive and forward looking system, though I would urge regulators that we need good regulation, not just more.“

He said that the bank believes that derivatives need to be better regulated. “We do not believe they caused this problem, but I do with part of the interconnectedness that affected other parts of the financial system.“ He said his bank has supported for years the idea of submitting most of these derivatives to clearing houses.

The idea that no bank is ever too big to fail should be set aside, according to Dimon. “Long term policy should not be to protect banks from failure. There's nothing wrong with failure as long as it doesn't sink the country.“ A mechanism needs to be put in place, he said so that “regulators can handle failure.“

According to Dimon, regulators actually already had the authority to handle these types of failures, and he argued that they did not however, have the authority or the ability to take over and finance Lehman Brothers or AIG. They didn't have the time or the ability to do it.“

Dimon also acknowledged the issue of compensation. “It's quite clear there are cases where some people walked away with a lot of money right before their firms failed and virtually took down the system. That ticks me off too.“ He said J.P. Morgan pays out its employees based on long-term performance as opposed to short-term gains. The bank, he said, also eschews change-of-control agreements, special executive retirement plans, golden parachutes or merger bonuses.

The timing of Dimon's comments on compensation were especially noteworthy given a recent report in the New York Times that President Obama was debating taxing banks as a method of cutting the deficit. It is believed that the tax is politically motivated and is designed as a response to the anger building across the country as big banks, having been rescued by the taxpayers, report record profits and begin paying out huge bonuses while millions of Americans remain unemployed.

As for healthcare, Dimon echoed sentiments that he espoused at last year's event. He said that it's inexcusable that “a country as wealthy as the United States should not have so many people uninsured. We would like to see them all get insured and we believe it can be done rationally.“

He asserted that too many Americans allow themselves to live unhealthy lives through obesity, smoking and drug use, that lead to lead to much higher costs “that we all pay, and I'm not sure that's completely fair.“ He also said that individuals need to be more involved in managing their own healthcare. “I think until we fix that, we'll never completely fix the system.“

J.P. Morgan is attempting to be progressive with its own employees by actively engaging them in the process. The bank has a number of health and wellness programs in place, including cash incentives for all healthy behavior like getting screenings and tests and quitting smoking.

While Dimon said he partially agrees with the statement that, “we should not let a good [financial] crisis go to waste,“ he said he is personally uncomfortable “that we wait for a crisis to solve our problems.“ In the short run, he expressed confidence that the U.S. would emerge from its difficulties, but in the long run, “the United States needs to focus on solving an additional set of problems to make sure we're successful. Some of these looming problems, aside from healthcare he said, include an energy crisis, the education system, infrastructure policy, long-term fiscal discipline and immigration policy.

“We do not have the divine right to success,“ said Dimon, noting that, “these are problems we are going to have to face which will have serious consequences in the next 30 to 50 years.“

Ride the wave now, pain for healthcare coming

Fearing all the dire consequences coming to the healthcare sector with the Congressional winds of change stirring in Washington? No need to be afraid in the short term, unless you pay taxes or happen to be an insurance agent that is.

Former CMS administrator Tom Scully offered this, and other partially comforting observations in a luncheon keynote speech in which he discussed at length the coming changes to the U.S. healthcare system, with the most interesting observation that both the Senate and House bills really won't impact the healthcare system all that much, at least not directly.

Scully, who is currently a partner at private equity firm Welsh, Carson, Anderson & Stowe (New York), as well as being a senior counselor at Alston & Bird (Washington), said that the bill is not really a reform bill, “it's a giant expansion of spending bill, and there are huge expansions of coverage. There's not a lot of pain here for anybody [in healthcare].“ He said that this coming bill has none of the more severe reforms of any of the major healthcare bills of the past 30 years. “It's a universal coverage bill, and there's a lot of merit to that, but it's very expensive, it's not really a healthcare reform bill.“

While he does think the bill will ultimately pass, Scully predicted that it will likely not happen within President Obama's desired timeframe of early February before his next State of the Union address. “There are huge differences in the Senate and House bills.“ That being said, he acknowledged that the Democrats do have the requisite number of votes in both chambers. “I think they will pass it, [but] I've said for many months I think it will take until March 1. He added that there is still a 5% chance the bill will not pass at all if the process drags on past that date because there are a lot of moderate Democrats in the House and Senate that might change their minds if it starts getting closer to the next election cycle.

One of the biggest fights left between the two chambers has to do with how to structure the health plan, with the House favoring having one national exchange run by a healthcare czar, while the Senate favors leaving these exchanges up to the individual states, which Scully thinks will prevail.

By 2019, the House bill is projected to cover 96% of all Americans and the Senate bill, about 94%. The pushback here is that all this money that the House, in particular, wants to spend has got to be raised somewhere. “If you want to spend more money, guess what, you've got to raise more money. This means taxing device companies more, taxing drug companies more and raising revenues. The House wants to spend more than the Senate does, and how are they going to do it, by raising taxes. That's what they're going to fight about for the next month.“

Scully said he does like the idea of more regulation of private insurance companies that is featured in both versions of the bill. “The commercial insurance market is, in my opinion, massively underegulated,“ he said. He said in the long run “it's going to be good for commercial insurance companies, especially the bigger ones, to have more rules.“

The underpinning of this bill, and its Achilles' heal as well, is the massive expansion of Medicaid benefits, according to Scully. The Senate bill would add 15 million people and the House bill would add 21 million people to the rosters. “It's a huge increase in Medicaid spending, a giant expansion of the entitlement program, the biggest one ever probably.“

According to Scully, what's really happening with this bill is that money is being pumped into healthcare that might normally be used to fuel the rest of the economy. The financing of the bill, he said, which will largely be on the backs of taxpayers, “ain't pretty.“ He noted that the idea that this is somehow scary for the healthcare system is false. “It is a giant slug of federal money into the healthcare system.“

The “gigantic winner“ in this new bill, Scully said, is unquestionably hospitals. It would seem like a no brainer to look at hospitals as a logical place to reduce costs since that is where most of the money is, but Scully noted that “there are virtually no reductions in this bill for hospitals, it's very, very small.“ In fact, he said, the government is going to give insurance cards to 30 to 35 million more people and is only taking away about 10% of the insurance subsidies that they were getting before this new windfall came to pass. “Can you say double dip? This is a bonanza for hospitals“ if the bill stays as written, he said. One of the strategies to gain passage of this bill was to get early approval from the hospitals and drug companies, and both of those groups made off very well indeed.

Other winners, according to Scully, include hospice programs and acute care hospitals

Medical devices were scored as neutral by Scully, who noted that while they will be assessed around $20 billion in fees, but that was cut down from $40 billion. “It's a pretty high number, but it could have been a lot worse,“ he said. He also noted a coming big redistribution between high tech device and low tech devices as well.

While he scored pharmaceutical companies as neutral, Scully said they unquestionably got off easy. He noted that the $80 billion in cuts that they volunteered in the so-called doughnut hole were for giving seniors 50% discounts on name brand drugs via Part D drug plans. “Seniors don't buy name brand drugs in the doughnut hole, they buy generics.“ He called these cuts “laughable,“ but acknowledged that they probably had to get done in order to get drug companies to sign off on the legislation without a big fight.

Also in the neutral zone were clinical labs, dialysis centers and disease management and home health, though Scully said home health is probably coming out somewhat on the losing end because Congress perceived that their margins were too high.

Aside from the taxpayers the other real losers in this bill are insurance agents, because Scully said the new system with local exchanges will do away with the need for them. “In my opinion, insurance agents won't exist in 10 years.“

Unfortunately, Scully said, “this party can't go on forever. This is a big spending bill.“ Last year, he noted, the federal government raised $2.1 trillion in revenue and spent $3.5 trillion in revenue, essentially spending 59% of what it raised for the fiscal year. For the healthcare sector in the short term it's a great deal and there's “very little pain and lots of gain.“ In the long run, however, “these numbers don't lie and they'll come back to haunt people.“ There are, he noted, only a few moving parts of the federal budget and one of them is healthcare. “You can't just spend like a drunken sailor forever,“ he said, noting that at some point in the not-to-distant future Congress will have to take a wrecking ball to many of these entitlements, most likely Medicare and Medicaid programs.

Private equity eyes resurgence in healthcare

Looking back on what he called the “golden era“ of private equity funding that ran from about 2004 to 2007, Larry Alletto, global head of the financial sponsor group at J.P. Morgan, and panel moderator for a discussion on that sector at this year's healthcare meeting, recalled a time that was characterized by ever larger deals fueled by cheap money and the ability to acquire very large market leading businesses that would have normally been off limits to that type of funding. Contrast that with the post-credit crunch of mid-2007 onwards. He said that looking at private equity M&A during that time frame shows an 82% decline in activity. A sector that over the prior five-year period had accounted for nearly 25% of the M&A market, had shrunk to 12% of that market by 2009.

The year 2009 began what Alletto hopes was a rally of the credit markets, which has allowed portfolio companies the ability to refinance and expectations for defaults are down. Couple this with a resurgence in the IPO market in 4Q09, and the seeds for a more dramatic resurgence for private equity firms may have been sown for 2010 and beyond.

While not predicting an eminent return to the 2004-2007 high water mark for private equity in M&A, Sean Carney, a managing director at Warburg Pincus, said he envisions leverage coming back and deal flow increasing “but I don't expect that we'll go back to the days of, perhaps, excessive leverage and so many private and public deals getting done,“ as happened during private equity's previous high water mark.

Todd Sisitsky, a partner at TPG, agreed with Carney that a revival is coming: “As the markets improve, the fear of the last year or so subsides and people start to objectively think about what they might do, you'll once again have some great opportunities.“

Taking a slightly different tack was Neil Simpkins, senior managing director at Blackstone. He argued that the press likes to look at the 2004-2007 timeframe and say that private equity can't recover from that. “Really our industry has changed continuously over the last 20 to 25 years.“ He said the trick is to adapt to the current funding environment. One idea to pursue right now is investing along side corporate partners. “There's just a real shortage of risk capital in the environment we're in right now and we see opportunities in that area.“ Another thing that he said really separates private equity from the herd is its generally long-term investment timeframe. “We're focused on driving profitable growth over a five year period or so. There's not a lot of people that are really looking out over a five-year period at the moment.“

John Connaughton, managing director of Bain Capital, noted that people forget that the private equity industry has a history of weathering dramatic cycles, a constant series of peaks and valleys, but he argued that is also what makes it such an exciting place to make investments. “We do look beyond the uncertainty; we do look long term. We do look at the ability to generate an exit value not a quarterly result.“

As for opportunities in the healthcare sector for private equity, Connaughton said that the uncertainty within the sector plays to one of the core advantages for his industry “if we can evaluate that dynamic environment and see opportunities to exploit it, that's a recipe for success for us. We're contrarian by nature.“ He also noted that “not having to answer to the latest Washington report on a quarterly analyst call“ is a huge advantage too.

James Momtazee, a member of KKR, concurred largely with Connaughton's assessment that the complexity of healthcare gives private equity certain advantages. “It gives you a way to differentiate yourself,“ but he also noted that “it makes it very hard to shape an investment premise around the here and now because those dynamics can change, and they can change quickly.“

“I think healthcare is one of the most fun sectors to invest in probably in part because of the amount of uncertainty,“ said Sisitsky, which is brought on “by the unusual relationships between the physician, the patient and the payer.“ He said his firm's solution has been to hedge its bets by investing across the entire spectrum of healthcare, including payers, providers, devices, pharmaceuticals and pharma services. While it's difficult to say where healthcare will ultimately come out over time “most folks would agree that over time, the volumes will increase, the amount of coverage will increase and the burdens on the states are going to continue to increase and I think we all expect the pricing over time to face pressure,“ Sisitsky said.

Carney said that with medical devices, there is going to be more volume in the system and there are still a large number of unmet needs. “We made an investment last year in the stroke area which many will know as a graveyard for drugs, but we think there are novel devices that serve one of these needs and that's what we look for in devices.“

Overseas investments are another area of interest, and Connaughton said that “half our people are overseas and a quarter of them are in Asia. He said like many people in his space found, there weren't many opportunities in the U.S. in 2009, “but one area we had a lot of activity was in China and I think that represents a big part of the future.“

While Simpkins said his firm had a lot of M&A activity in China too, he said they had a lot more healthcare-based opportunities in India “on the manufacturing side as well as the services side. With the growth in capital income [in India] there's a lot of domestic demand.“

Looking back, a member of the audience asked if any of the panelists learned any lessons from the most recent panic. Simpkins said that working with private portfolio companies with streamlined governance vs. the hassles of a public company made it easier to move quickly when problems started coming. He said that the healthcare field has also given him fewer problems than other sectors he is involved with. “Healthcare in many ways has been ocean of tranquility relative to the rest of the economy. I've pretty much had no sleepless nights with healthcare this year in contrast with some other industries, but that doesn't mean that they won't be coming.“ That's why he said it's necessary to “plan for a range of possible outcomes and be ready to act quickly as they materialize.“

Hospitals need to change business models

After hearing in a keynote presentation from former CMS administrator Tom Scully that the pain of healthcare reform would be delayed for some time and that hospitals would be the chief winners in the new healthcare bill, it was an interesting contrast to hear Chas Roades, chief research officer of the performance improvement firm Advisory Board (Washington) discuss what he sees as the bleak times ahead for the hospital industry in the coming years during a presentation, particularly with the likely prospect of an increasingly jobless economy.

Roades said a survey done by his members shows that “there's still a lot of uncertainty as to future growth, future margins and future strategy, and a lot of our members, particularly large multi-hospital systems, are undergoing fairly dramatic rethinking of their strategic plans for the next five to 10 years given the impact both of the economy and the recession through last year, and most importantly, the impact of potential healthcare reform in just a few weeks now.“

Despite the tough economy, Roades reported that many of his members, especially in the large systems, had a relatively good year because they “pulled hard on a lot of the key suspect levers to try and improve margin performance.“ Some of these larger hospital groups reported that it was “one of their best year's ever, in terms of market share growth and margin growth.“

Looking forward to 2010 and beyond, Roades said hospitals are concerned that the traditional surgical growth engine that they have relied upon for the past decade or more is in jeopardy. He noted that the commercial revenue that comes from surgical procedures accounts for roughly 30% of the hospitals profits, and the other 70% comes from Medicare/Medicaid patients as well as other “low pay and no pay patients.“ That 30% figure subsidizes all the other investment that a hospital wants to make. This revenue growth stream has now been muddied by the economy and pending healthcare reforms.

“The last three or four years, cost growth has been outpacing revenue growth for most of our members so even though they've been getting relatively good pricing on the commercial side, costs (including for labor and technology) have just been skyrocketing,“ said Roades.

Now the question becomes where will revenue growth come from in the future? Especially with surgical volume decreasing due to increasing unemployment among prospective formerly insured patients. Many of these patients are what Roades called “preference-sensitive,“ or elective, meaning that that there are non-surgical alternatives available on both the inpatient and outpatient side that can substitute for the more expensive surgery.

Also contributing to the lower revenues for the hospitals is the fact that the “healthcare plans have had their thumbs on the scale as well,“ Roades said. He noted that all of the major health plans have been putting in place some sort of utilization management plan for the larger employers, “such that they can be able to get a handle on some of these expensive procedural cases.“ Essentially a patient who has been tapped as a candidate for surgery is contacted by the insurers and is informed of potential side effects and risks associated with a given surgical procedure. The patient is informed of non-surgical – and cheaper – alternatives.

A second area of concern for hospitals has been the tightening of the credit markets. The hospitals have been able until recently to take advantage of cheap capital to invest in very expensive market share and service line growth strategy. This represents “a lot of expensive clinical capital equipment, a lot of facility renovation and expansion.“ He noted that philanthropy, another key area of cash for hospitals, is way down. While credit at affordable rates appears to be making a resurgence, Roades noted that a lot of hospital boards have become “spooked,“ and have become “a lot more conservative about going back and borrowing money in order to fund growth plans, particularly if there's going to be this volatility in the traditional procedural growth strategies that many hospitals have pursued.“

The net result of the procedural cuts and the lack of cheap capital have resulted in a 43% decline in profitability in dollar terms for hospitals over the past five years. Roades said that his members have now decided that “purchased growth is no longer a viable strategy or no longer a fundamental pillar of growth strategy.“ What that means, he said, “is that for most hospitals, they'll be relying more heavily on operating income to fund future growth strategy which means that they'll have to get much more serious about operating efficiency in a hurry.“ He said that “there appears to be an era of austerity headed our way and a big focus on cost control for most hospitals,“ which means less money for equipment purchases among other things.

The final pillar that will impact the hospitals, according to Roades, is healthcare reform. He said that most of his constituents aren't afraid of the short-term implications of the pending bill, but rather, what is going to happen with Medicare in the future. “Medicare is the 800 pound gorilla for most hospitals,“ as it accounts for on average of between 40% and 50% of patient admissions. The picture of what is likely to happen to the Medicare program over the next five to ten years is that there's almost complete certainty that prices will go down via payment cuts.

While it is good news that most patients coming in will now have some form of coverage due to the mandates in the healthcare bill that should help lessen the bad debt problem, the question will be how is coverage expansion done? The bad news there is that much of this new coverage will come in the form of new Medicaid patients. Medicare/Medicaid patients only pay about 60 cents on the dollar.

Ironically, the Baby Boomers, who have helped fuel the elective procedure boom of the last decade, are about to severely tax the system as they move into their Medicare/Medicaid years. They become medicine consumers as opposed to surgical consumers. “As more and more Baby Boomers move into the Medicare program, they're going to swamp hospitals with these unprofitable cases,“ said Roades. “Our estimate is that 80% to 90% of all hospital growth over the next ten years is going to come from Medicare growth,“ he added.

The picture that emerges is that the commercial hospital as we know it today will go away and most hospitals will probably follow the public model. The trick in this case, Roades said, will be to find a way to shift patients from the acute care setting to a more efficient delivery model for the Medicare business. This Medicare patient group often present with four or more chronic diseases in addition to whatever condition they present with when admitted to the hospital.

To pay for this coming onslaught of elderly, one thing that will absolutely happen over the next 10 years, according to Roades is that Congress will have to cut Medicare rates. Additionally the care model will move away from a fee-for-service model to a more total cost-focused payment system in which payments are bundled.

Ultimately, the aim of the new healthcare system will be to shift patients away from surgical sub-specialties and towards primary care physicians. This would serve to “gate keep patients out of the expensive high end centers of care by having some infrastructure that manages chronic disease.“

“Providers will be looking to build more accountability into their organizations and ultimately reduce costs and improve quality by reallocating and reinvesting to keep patients out of hospitals, particularly these Medicare chronic disease sufferers,“ concluded Roades.