Professor James R. Repetti ’80 examines how federal tax rules can encourage private equity investment in hospitals and nursing homes, where the debt used to finance acquisitions can put added financial pressure on institutions providing patient care. In his article, Private Equity, Health Calamity: How Our Tax Laws Aid Private Equity Investment in Hospitals and Nursing Homes, the William J. Kenealy, SJ, Professor of Law at Boston College Law School focuses on tax-exempt institutions on both sides of these transactions.
Nonprofit hospitals and nursing homes generally do not pay income tax on gains when they sell facilities to for-profit purchasers. At the same time, university endowments, pension funds, foundations, and other tax-exempt investors can invest in private equity funds that use borrowed money without triggering the tax that can apply when those institutions borrow directly. Repetti examines how those rules shape private equity acquisitions and why the resulting debt can matter for health care providers and their patients.
Q: Your article begins with a striking mismatch. Private equity has produced gains in productivity and innovation in some sectors, yet the evidence you review on health care is much more troubling. What first made you look to the tax system to explain that difference?
Repetti: I was curious about why tax-exempt institutions, particularly university endowments and pension funds, were investing so heavily in private equity funds. Over roughly the past five years, private equity returns have not kept pace with the S&P 500. That suggested to me that investment returns might not fully explain why tax-exempt institutions were putting so much money into these funds.
One possible incentive is the way the tax rules treat investments made with borrowed money. A tax-exempt institution generally does not pay income tax on its investment income. But if it borrows money to make an investment, the portion of the income tied to that debt can become taxable. Private equity offers a convenient way around that problem. In a leveraged buyout, meaning a purchase financed substantially with borrowed money, the debt is placed on the company being acquired. The tax-exempt investor gets the benefit of the borrowed money, but the debt is treated as the target company’s debt, not the investor’s. That can allow the tax-exempt investor to benefit from leverage without incurring the tax that could apply if it was borrowed directly.
Q: You point to features of health care that make ordinary market discipline difficult, including the information gap between patients and providers. What makes the private equity model, and particularly its use of leverage, more consequential in health care than in other industries?
Repetti: Economist Kenneth Arrow identified this fundamental problem in health care. Patients generally cannot judge the quality of the medical care they are receiving in the same way a consumer can judge the quality of an ordinary product. There is an information imbalance between the provider and the patient.
That matters when you combine health care with a business model that relies heavily on debt. Private equity can leverage these investments to such a large extent that cost cutting becomes a necessary part of the business plan. In a hospital or nursing home, those cuts can affect staffing, equipment, supplies, and other expenses directly related to patient care. I was also struck by how frequently hospital real estate is sold to a real estate investment trust, or REIT, and then leased back to the hospital. The sale generates cash, but the hospital then has to pay rent. The REIT is in business to make a profit, so that rent becomes another cost the hospital has to meet along with all of its other expenses. That can make it very difficult to maintain the same level of care.
Q: The health care studies you examine do not all reach the same result, but most report harmful or mixed outcomes after private equity acquisitions. One study found an 11 percent greater probability of death during and shortly after stays in private equity-owned nursing homes. What made those findings more than an abstract financial or statistical problem for you?
Repetti: I was struck by how the numbers were masking human pain. What started me down this path was what happened at St. Elizabeth’s Medical Center in Brighton, Mass., which was part of the private equity-owned Steward Health Care. A woman was delivering a child, and what should have been a routine procedure using a commonly used instrument resulted in a disaster because the instrument had been repossessed by the hospital’s creditors. I found that heartbreaking. When we read a statistic about increased mortality or another adverse outcome, it is easy to see only a percentage. Sometimes we fail to appreciate the human pain those numbers represent.
Q: One part of the tax story begins with the seller. When a tax-exempt hospital or nursing home is sold to a private equity-backed for-profit buyer, the nonprofit generally does not pay income tax on the gain from the sale. Why does that exemption become significant once the facility itself is leaving the nonprofit sector?
Repetti: When I first started thinking about this, I was looking for ways to encourage tax-exempt hospitals and nursing homes to sell to other tax-exempt organizations rather than to for-profit purchasers. Taxing the gain on a sale to a for-profit buyer was one possible way to do that. But as I thought more about it, I realized there was also a tax-policy reason for imposing the tax.
A hospital can build substantial value while operating as a tax-exempt organization. It has assembled the facilities, employees, systems, relationships, and other assets that allow it to function as an ongoing enterprise. Tax lawyers call that its going-concern value. That value was created while the hospital benefited from a tax exemption because it was supposed to be serving the public. Once the hospital is sold to a for-profit purchaser, that value will no longer necessarily benefit the public in the same way. It can instead generate returns for private investors. I think that is an appropriate time for the government to recapture some of the tax benefits it provided while that value was being created
Q: You argue that some of the value of that tax exemption can effectively be shared with the for-profit purchaser through the sale price. How should we think about where the benefit of a charitable tax exemption ought to end when charitable assets are transferred into for-profit ownership?
Repetti: A taxable seller has to think about the tax it will owe on a gain when deciding the minimum price it is willing to accept. A tax-exempt seller does not face that same tax cost. So the tax-exempt seller may be willing to accept less and still end up with the same amount after taxes. That is the basic idea behind the lock-in effect.
There has only been one empirical study specifically examining hospital sales, so I am cautious about relying too heavily on the evidence. Hospitals are useful for studying this question because they give us examples of valuable operating businesses owned by tax-exempt organizations and then sold to taxable purchasers. The study found evidence consistent with tax-exempt hospital sellers demanding less than comparable taxable sellers. If that is happening, part of the value of the tax exemption is effectively being passed to the for-profit purchaser through a lower sale price. There is also a strong policy reason for concern: the public helped support the creation of that going-concern value through the tax exemption, so a sale to a private purchaser may be an appropriate time for the public to recover part of that investment.
Q: There is another tax-exempt actor on the investor side of the transaction: university endowments, pension funds, and other exempt institutions are significant investors in private equity. What is it about the structure of private equity that makes it particularly attractive to institutions that ordinarily face tax on debt-financed investments?
Repetti: It basically shields them from the tax liability associated with making investments using debt. Tax-exempt institutions generally do not pay tax on their investment income. But when a tax-exempt institution borrows money to make an investment, the debt-financed income rules can make part of that investment income taxable.
Private equity changes where the borrowing occurs. In a leveraged buyout, the tax-exempt institution invests in the private equity fund, but the debt used to finance the purchase is placed on the company being acquired. Because the target company assumes the debt, it is not treated as debt incurred by the tax-exempt investor. The investor therefore gets the economic benefit of a leveraged investment without the tax liability that could result if it borrowed the money directly. It is a very convenient way to make an end run around the debt-financed income rules.
Q: Under the debt-financed income rules, a university that borrows directly to make an investment can owe tax on the resulting gain. But, as you explain, a private equity fund can place much of the acquisition debt at the target company, allowing the tax-exempt investor to benefit from leverage without borrowing directly. What does that distinction allow the investor to accomplish?
Repetti: It allows the investor to increase the potential return on its own money through leverage without incurring the tax that could apply if it was borrowed directly. If a tax-exempt university endowment borrows money to make an investment, the debt-financed income rules can tax the portion of the return attributable to the borrowed money.
But if the university puts its money into a private equity fund, the fund can buy a company using debt and place that debt on the company being purchased. The university still has an economic interest in a highly leveraged investment, but it has not borrowed the money itself. So the investor gets the benefit of the leverage while someone else is formally responsible for the debt.
Q: You also describe the increasingly common use of “blocker” corporations, which can allow tax-exempt investors to participate in funds that themselves incur debt without triggering the same debt-financed income rules. What role do blockers play in the larger tax incentive you are concerned about?
Repetti: A blocker provides another way for a tax-exempt investor to participate in a leveraged investment without being treated as having incurred the debt. The tax-exempt institution invests in a corporation, often a Cayman Islands corporation, and that corporation invests in the private equity partnership. Because the blocker is treated as a separate entity, the current rules do not look through it and attribute the debt behind it to the tax-exempt investor.
That means the private equity partnership itself can also incur debt, not just the company being purchased, while the blocker shields the tax-exempt investor from the debt-financed income rules. If those rules are supposed to limit the tax advantage of leveraged investing by tax-exempt institutions, blockers have to be taken into account. Otherwise, they provide a relatively easy way to avoid the rule.
Q: One of your proposed responses is to extend the debt-financed rules so that they look through the blocker and the target company and take account of the debt actually financing the acquisition. Why do you see that approach as preferable to leaving the current distinction between direct and indirect leverage in place?
Repetti: If policymakers decide that this is a problem, then the rules have to address the obvious ways around them. A tax-exempt institution that borrows directly can incur tax. But if it invests through a private equity structure and the debt is incurred by the fund, placed behind a blocker, or imposed on the company being purchased, the institution can still get the economic benefit of leverage without the same tax consequence.
I would have the rules look through those entities and take account of the debt actually financing the investment. Otherwise, the tax result depends on where the debt is formally placed rather than on the economic reality of the investment. If the rules do not deal with blockers, they leave an obvious loophole.
Q: There is a substantial counterargument to that proposal: critics of the debt-financed rules have long argued that the rules are complicated, easy to avoid, and riddled with exceptions, and some favor repealing them altogether. What makes repeal appealing, and what gives you pause about it?
Repetti: I think this is a case where perfection should not be the enemy of the good. In a perfect world, there is an argument that we should not have the debt-financed income rules so that tax considerations would not affect investment choices. But we are dealing with organizations that receive a tax exemption because they are supposed to serve the public, and there are concerns about too much debt both at the hospital level and at the level of the tax-exempt investor.
At the hospital level, the concern is the effect of debt on patient care. The hospital has to service the acquisition debt, which increases the pressure to cut costs. There are also studies raising concerns about tax-exempt institutions themselves taking on too much risk through leverage. Private equity makes the issue particularly difficult because there is so little transparency. There are estimates of trillions of dollars of private debt connected to private equity, but we really do not know how much there is. We do not have the same information about these investments that we have about public companies.
When there is that much secrecy and we cannot determine how great the risk is, I think the rational approach is to minimize the risk or at least eliminate the tax incentive to funnel money into these risky activities. I would be reluctant to repeal the debt-financed income rules without adequate safeguards.
Q: One of the more counterintuitive issues in your article is the Domar-Musgrave effect. Put simply, if investment gains are taxed but losses are deductible, the government can end up sharing part of an investor’s loss. How does that complicate your proposal?
Repetti: It does complicate it. If a tax-exempt investor knows that a loss from a taxable investment will produce a deduction, the government is effectively absorbing part of that loss. That can reduce the investor’s downside risk. That is why I would restrict how losses are treated if the debt-financed income rules are extended.
For example, I would not allow losses to be carried back to prior years. If an investor can carry a loss back, there is a high probability the deduction will have value because the investor may have taxable income from an earlier year. The loss can then reduce a tax liability that has already been incurred.
There is also a special rule that allows tax-exempt institutions to combine losses from one taxable investment with gains from another taxable investment. I would eliminate that rule for these investments. Those changes would make it harder for a tax-exempt investor to use losses from one leveraged investment to reduce taxes elsewhere, limiting how much of the downside is effectively borne by the government.
Q: Much of your argument turns on technical questions about tax exemptions, debt, and the structure of private equity investments. But those rules ultimately affect institutions providing medical care. What do you most want policymakers to understand about the consequences of the choices the tax system is making here?
Repetti: I think we need to reassess how health care is delivered in the United States and rethink the model. But I am not in the best position to say what the best approach would be. The part I can speak to is the tax system. The rules give tax-exempt institutions an incentive to invest in private equity because they obtain the benefits of leverage without incurring the tax that applies when they borrow directly. The private equity fund can then acquire a hospital or nursing home using substantial debt, with that debt ultimately borne by the institution that was purchased.
Those tax rules can have consequences outside the tax system because a hospital or nursing home still has to pay employees, buy equipment and supplies, maintain its facilities, pay rent if its real estate has been sold and leased back, and provide care. When it cannot meet all of those obligations, the pressure is to cut costs. That is why the evidence on hospitals and nursing homes concerns me the most. The numbers represent patients who are ultimately bearing the harsh effects of increased debt leverage.
Photograph by Cailtin Cunningham, Boston College