Saturday, July 24, 2010

When Docs Take On Economic Risk

Misaligned incentives distort how health care's participants interact with each other, aggravating patient frustration and worsening trends in care delivery.

Payers reimburse physicians based on volume, not value. Payer risk pools, in turn, favor well beneficiaries over sick beneficiaries. And employers, instead of employees, decide how to consume health care.

At no point do supply and demand actually transact. Rarely are consumers able to make informed decisions.

To the extent that health reform legislation realigns incentives where at least payers and providers operate closer to the same page, efficiency levels could rise.

According to the actuarial consultancy Milliman, the force driving this could be provider risk-sharing.  In a recent briefing paper, the consultancy describes this as a process of re-adjusting "health plan payments, provider payments, and individual or group premiums to reflect the health status of plan members".

Think of it as two entities, normally opposed to each other, owning an economic opportunity, in this case a better, more cost effective patient outcome. By owning it, they both share in the upside—and the downside—while utilizing resources more efficiently.

"Instead of fee-for-service," write the paper's authors, "compensation may come in the form of a per-member basis, with bonuses paid depending on the provider's achievement of specified targets and goals. Savings will be shared between providers and payers according to their effectiveness and efficiency. Pay-for-performance components within this overall approach will reward improved patient outcomes as well as straightforward savings." Read paper here (PDF).

By endorsing programs such as accountable care organizations and evidence-based medicine, health reform legislation potentially eases the restraints on factors necessary for risk-sharing to take place. And with advancements in electronic health records providing key technological support, provider risk-sharing stands a reasonable—if not excellent—chance of revival after faring poorly in the 1990s.

(For information about Medicaid risk-sharing projects in the 90s, read here. These projects followed a capitation, or set fee-per-patient, payment model where health plans transferred percentages of government payments to providers based risk assumption.)

As the authors note, failure resulted from:
  • poor quality measures
  • insufficient documentation and coding procedures
  • non-pervasive best practices
  • weak information technology
  • unsophisticated risk assessment techniques
Many of these factors, however, have improved considerably.

Regardless, risk-sharing faces a big challenge in overcoming entrenched inertia and the fear of another disappointing failure. Both providers and payers will need to trust the new system before shedding the old one, and any number of successful demonstration projects may not motivate wide enough adoption to bend the cost curve.

Risk sharing, though, is an intriguing concept, and could easily apply to provider practices beyond the scope of government programs: concierge and retail-based care delivery, for example, where consumers align their own dollars with providers' dollars to ensure the best possible care.

Not matter what, it comes down basic economics. At this point, we can expect large government deficits and profit constraints on payers and providers to overwhelm trust and fear issues, and motivate consideration of alternative systems.

Any economic improvement or good standing, especially among providers, would likely diminish risk-sharing's chances for adoption.

Tuesday, July 20, 2010

In Health Care, It's David Versus Goliath

"You can't teach an old dog new tricks," so the saying goes. And for incumbent business models in health care, nothing could be more true.

If anything, federal health reform is a catalyst for industry consolidation, where increased regulation will force payers and providers to seek scale advantages as profits decline.

While government subsidies might target alternative payment models such as bundled fees and care delivery platforms such as accountable care organizations ("ACOs"), business leaders will have to utilize external—non-government tethered—strategies for sustained organic growth.

Writing in the Lyceum newsletter Perspectives, health care consultant Erik Swanson notes:



In order to survive, existing participants in the health care system need to change how they make money. Smart new entrants stand to capture substantial profits if they can achieve disruptive change.

The biggest opportunity is in customer experience. Make it better, and your product or service will do just fine, thank you.

Swanson, who cut his teeth running corporate strategy for WellPoint and advising the health care industry as a partner at Accenture, observes:



The introduction of insurance exchanges and a newly accessible individual market, for example, could ignite a consumer-driven revolution in how health care is financed and delivered by emphasizing retail-based models and customer experience.

Another opportunity is in information and advice. Health care data is already plentiful, and will continue to grow exponentially. Until businesses can move beyond just selling formatted data, and turn it into interactive advice, data will only clog space in some vast server farm.

Swanson points to efforts by Walgreens and Averde Health that target improved customer experience. He also gives the example of Blue Shield of California, CALPERS (a large employer), Hill (a physician group) and Catholic Healthcare West (a large hospital system) partnering to create an integrated system, which other participants elsewhere in the country might seek to imitate.

Read his article here.

Despite the challenges of health reform, innovators enjoy a massive advantage unlike any other industry: incumbent inertia. Whether big insurance, big pharma or big hospital, the strategic goal of existing players is to do the same thing, just in a bigger way.

Like David and Goliath, it could only take a smartly aimed slingshot to take down a lethargic leviathan.

Consumers will be there to lavish the rewards.

Friday, July 16, 2010

Financial Market Time Periods Have Compressed, Don't Expect It To Last

Whatever happened to long term investing?

Turnover on the New York Stock Exchange is now annualizing at 110%, where the total volume of individual shares bought and sold is 10% greater than the total shares listed the exchange. 10 years ago it was 88%; 20 years ago, 46%.

In 1980, turnover amounted to one-third of shares listed.

To put this in terms of a holding period, today's market participants buy and sell the entire Big Board once every 11 months, versus once every three years 30 years ago.

And with algorithmic, or computer-driven, trading propelling most of the volume (about two-thirds of total), it would seem unlikely that portfolio-churning abates anytime soon.

For corporate management, a 100% turnover rate effectively means confronting an entirely new shareholder list every 12 months.  For some companies, this list could change even more frequently, every nine, six or—gasp!—three months. And sometimes more often.

No wonder time horizons for strategic planning continue to shrink. Expectations simply aren't what they used to be. According to a recent study by Booz Allen, the global mean tenure of departing CEOs has dropped from 8.1 years to 6.3 years between 2000 and 2009, and the forced turnover rate for CEOs is 36.7%.

Maybe we should view time compression as symptomatic of machines taking over.  Investing and code writing, after all, now appear synonymous.

Just the other day, the Wall Street Journal profiled a group of twenty-somethings trading on Artificial Intelligence. While not boasting the seconds- or milliseconds-long holding periods of the high frequency variety, this fund still claims a 300% turnover rate, suggesting a primary (if not exclusive) emphasis on technical factors.

Perhaps, a 100 years from now, machines will even operate corporate C-suites, with A.I. guiding expansive enterprise resource planning ("ERP") systems.

What about the more immediate future? Is the market heading towards such extreme time compression that company and industry fundamentals disintegrate into irrelevancy?

Don't bet on it.

Back in February 2007, we wrote a lengthy article for the Lyceum newsletter Perspectives called "A Return to Long Horizons". It considered the overriding impact of technological advancements, and how they're manifesting in reduced transaction costs.

We argued that rapid-fire traders would crowd short-term strategies and create new opportunities for more patient investors. We pointed to advancements in information technology as causing the market to shift to short-termism, and their commoditization as causing the market to rebalance—eventually—to adopt longer time frames. Read it here.

Later that year, all hell broke loose, and market turmoil waylaid any sense of measured thinking among investor classes. Panic—don't we know—begets panic, and all money runs for cover.

Now, we think our thesis (outlined below) deserves another look—especially as financial regulation courses its way across market participants. (Regulators could do much better than the infinitely complex financial reform legislation to encourage a healthier marketplace and allow different investment strategies to compete. For example, they might simply have considered forcing banks to capitalize bonuses to foster greater ownership of risk-taking.)

From "A Return to Long Horizons":



The information revolution fundamentally altered the practice of money management, with commission reductions and the rise of absolute return investing becoming its consequences, rather than its drivers. Simultaneously connected, portfolio managers could better assess a data point’s validity, especially those who could act on its immediacy. Imagine a world without your Blackberry – now imagine it without any form of electronic communication.

Better performance on better information attracted shareholder dollars. Greater buy-side power, whether under the guise of alpha or absolute return, then augmented market liquidity: sell-side transparency rose and transaction (or trading) costs declined.

While the Internet unexpectedly advanced the quality and quantity of information, its success is now commoditizing information as access points proliferate and costs decline. Together with government regulation (fair disclosure and Sarbanes-Oxley), information’s evolutionary surge has turned to level the playing field – at least for those playing the trading game.

Here's a graph we drafted to illustrate our viewpoint.

© Lyceum Associates, Inc. All Rights Reserved.

In keeping with our theme, we're thinking long term. Short-termism could continue to compress financial markets even more tightly, but at some point the long-term folks will regain the edge.

And that's what matters most: that edge, where one investor class is able to achieve better returns at less risk to capital relative to other classes.

At the very least, the 2007-8 time period made it absolutely clear that absolute return is an absolute fallacy. Investing is a relative game, and we were right about that:



As prospective shareholders begin to rank money managers more by peer performance and risk-return conditions continue shifting against portfolio churning, margin-of-safety will replace absolute return as the buzz-phrase of the next five years.

So long as policy makers and regulators don't completely warp the marketplace, long-term folks will have their day once more.

Okay, we admit that might be an awfully large qualification.

For the market's stake, we're going to take it.

Saturday, July 10, 2010

Noted Health Economist Ignores the Bigger Picture

Writing in the Health Affairs blog, Uwe Reinhardt states:



The bulk of the medical benefits procured by an insurer for residents in a given market area are produced by providers within that market area. In general, both private and public insurers have only limited, if any, control over the volume of the medical benefits that local clinical decision makers ask insurers to purchase for the insured. Furthermore, the larger the number of insurance companies active in a local market, the smaller any insurer’s market share will be — other things being equal — and the less leverage any insurer will have in bargaining with area providers over the prices of health care.

His posting addresses the question of insurance concentration, and the need for larger numbers of independent insurers to compete in local markets. Read here.

He concludes:



Ideally, in my view, the market for health insurance would be oligopolistic, which means that only a few insurers — each with some market clout vis à vis providers — would compete for enrollees in a local market. What the ideal number would be is an interesting question on which economists can have a lively debate.

For such an acclaimed health economist, Prof. Reinhardt misses the bigger picture. His analysis completely ignores the unrealized economic impact of folks who actually consume health care: patients, caregivers, taxpayers—the consumer.

Health care is unlike any other industry in that buyers don't consume, and consumers don't purchase (at least not directly). And with no market-based force counterbalancing supply, value—on a transaction basis—is indeterminate. Value, instead, is something that actuaries, academics and government officials determine.

Of course, he has a point. If health care persists as is—and as health reform intends—markets will become more concentrated.

Friday, July 9, 2010

Expect States to Take Control of Health Reform

According to the Center on Budget and Policy Priorities, 46 states face budget shortfalls. With the unemployment rate averaging close to 10% nationwide and economic recovery pacing gingerly, additional spending requirements could devastate an already precarious condition.

For many states, health reform could not have come at a worse time. In the Lyceum newsletter Perspectives, Ed Haislmaier writes:

The broad effects of health reform legislation, if implemented as enacted, will be to impose significant new Medicaid costs on state taxpayers, disrupt state health insurance markets and the current coverage of tens of millions of Americans, and usurp state authority. (Read article here.)

In response, states should pursue aggressive strategies that protect their citizens and take control of health reform. Haislmaier, a senior research fellow at the Heritage Foundation in Washington DC, proposes six approaches:

  • Shift non-elderly Medicaid and CHIP enrollees into premium support.
  • Refuse to administer the new federal high-risk pools.
  • Decline federal “premium review” grants.
  • Implement state health insurance market reforms and exchanges based on state, not federal, designs.
  • Insist that federal officials explain publicly how they will administer health reform.
  • Conduct and publicize “benchmark” analyses.
Haislmaier’s article, excerpted from a longer study published on July 1st (read here), could provide an important roadmap for states as they tackle crushing budget deficits. He argues, for example, that states possess an immediate opportunity in designing their own insurance exchanges:

By enacting their own insurance market reforms and creating their own exchanges, or similar administrative mechanisms, based on their own designs now, states can make it politically more difficult for federal officials to implement provisions of the new federal legislation (such as minimum federal benefit standards) that will drive up premiums and reduce coverage choices.

Strategically, states should assume one of two scenarios: a new Congress that repeals health reform or a protected fight against implementing the legislation as enacted.

In either case, states would be wise to apply their own reform while they can. If the latter, harsh economic reality will likely force aggressive action, regardless of political intent.

Although few believe the former, political climates can shift quickly. All eyes will focus on the mid-term election.

Wednesday, July 7, 2010

Biggest Wave of IPOs Since 2007—Or Not

Despite market uncertainty, 91 companies filed with the SEC in the second quarter to sell $24 billion of shares, according to Bloomberg. The news agency reports:




Investors in U.S. IPOs lost 7.2 percent so far this year as the Standard & Poor’s 500 Index fell to an almost nine-month low. Leveraged-buyout firms, which spent $2 trillion on takeovers during the credit-market bubble, announced the biggest stock sales and accounted for at least 50 percent of the deals filed with the SEC in April through June.

KKR itself will list on the NYSE on July 15th, and later this year, together with Bain, will sell shares in the hospital operator HCA. The HCA transaction will be the largest IPO since Visa, and total nearly $5 billion in shares. Proceeds will be used to pay down $26 billion in debt, or 80% of its purchase price. At $3.5 billion market cap, Universal Health Systems is currently the largest listed hospital operator.

Since their listing in June 2007, shares in Blackstone Group, the latest major private equity firm to go public, are down 75%—40% worse than the S&P 500. See chart here.

Among the 90 other companies seeking a listing is Zipcar, a car sharing firm that rents cars by the hour. Reminiscent of the dot-com era, it hasn't earned a profit since its founding in 2000.

Complicating any IPO are uncertain conditions. The S&P, for example, is down 9% from the beginning of the year, while the VIX is 40% higher at a level near 30. And with IPOs loss-making thus far this year, investor appetite would not appear sufficient enough to swallow the entire pipeline.

The question then is: If not the entire pipeline, then how much—or little—of it?

Don't expect any easy exits for debt-financed acquisitions, especially if corporate debt costs rise.

Friday, July 2, 2010

Paper: Cost Shifting No Longer An Option

In a recent briefing paper (PDF), the actuarial consultancy Milliman outlines the urgent reimbursement crisis. Whereas, in the past, providers utilized cost shifting to offset below-cost Medicare and Medicaid reimbursement (charging commercial health plans more to compensate for lost revenue from government plans), they now face two demographic events that will negate that strategy in the next ten years:
  1. the flood of new Medicaid patients starting in 2014 as health reform kicks in
  2. the transition of baby boomers from high-margin commercial business to becoming Medicare eligible
Between 2010 and 2020, Milliman estimates the Medicare population will increase from 12% to 16% of total, and the Medicaid population to increase from 17% to 21% of total. Over this time period, the yield on billed charges (calculated as allowed charges divided by billed charges) will decrease from 44% to 39%. At the same time, health reform will impose additional pricing constraints on commercial health plans, making it more difficult for them to increase reimbursement.

Milliman concludes that providers will have no choice but to become more efficient. (Of course, many may elect to refuse government plans, consolidate or exit the business.)

It recommends various strategies, including:
  • making facilities management more efficient as demand for beds exceeds capacity
  • understanding the demographic mix in their particular area
  • investing in service sectors that afford consistent margins in the long term
  • rethinking cost structures and potential lowering expectations for future income
Just as demand for health care services crosses an inflection point, supply is likely to contract.

Thursday, July 1, 2010

Book Review: "More Money Than God"

In 1920, Babe Ruth had perhaps the single greatest season of any baseball player. His 54 home runs totaled more than any one teamexcept, of course, the Yankees. Since the game's inception in 1876, no one had hit more than 29 in a season, a record Ruth set the previous year while playing for the Red Sox. Experts reckon that if Ruth had played under modern rules, his home run tally would have been close to 100.
More Money Than  God
More than his individual feats, we can measure Ruth's significance in how he changed the game, from shifting its style of play to expanding its monetary value.

Like baseball, transcendent figures have also altered the financial market landscape. In his book "More Money Than God", Sebastian Mallaby chronicles the history of hedge funds, their economic and social impact and the larger-than-life individuals who shaped their development.

Throughout his diligently researched narrative, Mallaby carefully builds the argument that hedge funds are essential components of modern finance, and effective vehicles at making markets efficient. As such, he believes regulators should tread carefully in imposing constraints.

While no one person may have changed the market landscape the way that Ruth transformed the game of baseball, Mallaby highlights some well-know names who've come close: Alfred W. Jones, Michael Steinhardt, George Soros, Julian Robertson, Tom Steyer, and Jim Simons among others.

He views these individuals not just as savvy traders and investors, but as true innovators, like Ruth folks who brought something new to the game which later generations would replicate and execute as common practice.

Time and again, despite highly variable market conditions, hedge funds are successful because they deploy an effective, proprietary model that banks simply don't possesor no longer posses as publicly traded entities. He writes:




The very structure of hedge funds promotes a paranoid discipline. Banks tend to be established institutions with comfortable bosses; hedge funds tend to be scrappy upstarts with bosses who think nothing of staying up all night to see a deal close. Banks collect savings from households with the help of government deposit insurance; hedge funds have to demonstrate that they can manage risk before they can raise money from clients.

Mallaby, however, might want to explore the relationship between banks and hedge funds more closely. As different as they appear to be, they feed off each other. One cannot exist without the other. Banks, for example, provide prime brokerage services that finance hedge funds and facilitate their strategies. Hedge funds, in return, produce not only generous commissions, but also market-changing innovation that banks assimilate.

Regulation may not come down on hedge funds, but any change in how regulators target banks could yield lasting effects. What would happen, for instance, if banks are no longer able to trade proprietary accounts?

The book is at its best when describing famous trades and how titans navigated extreme market conditions. By featuring manybut no allof the industry's leading figures, it juxtaposes the different thought-processes and strategies.

Take the dot-com market mania. Both Stanley Druckenmiller and Julian Robertson scoffed at it. Druckenmiller, early on, amassed a large short position, but quickly changed directions, and rode the billowing wave. The ensuing crash trapped Druckenmiller, and caused massive losses. Exhausted, Druckenmiller would leave Quantum shortly after.

Robertson, a value-investor, tried to hold his core strategy. Also suffering big losses, he shuttered his giant fund as the meltdown unfolded. As Mallaby describes, it wasn't just Tiger's out-of-sync strategy that sank it, it was also the fund's massive size and the market's knowledge of its positions:




In 1998, LTCM had gone into its death spiral as its brokers began to call in loans, leading Robertson to write to his investors about the dangers of excessive leverage. In 1999, Tiger was in danger of unraveling toonot because brokers were calling in their loans but because investors were calling in their equity. In both cases, moreover, widespread knowledge of the hedge funds' holdings contributed to their troubles.

Other highlights include descriptions of how Steinhardt traded his way to huge gains in the 1970s and how Paul Tudor Jones adeptly timed the 1987 crash. But, as Mallaby points out, it was Soros' bet against the British Pound that elevated hedge funds to the global stage, and for the first time held legislators and central bankers to account:




The next few days [leading up to Britain's exit from the European exchange-rate mechanism in 1992] marked a watershed in the relationship between governments and markets. A financial tidal wave broke across Europe, demonstrating how huddles of traders in midtown Manhattan could have consequences globally. Druckenmiller and Soros were the central players in this drama, but they were not the only ones.

This accountability is significant because it establishes a powerful check and balance between election cycles.

Whether Robertson's swagger or Simons' secrecy, Mallaby's protagonists showcase profound idiosyncrasies that manifest in their funds' cultures. Using the Amaranth blow-up as a case study, he illustrates how funds can implode if their managers don't fully comprehend risk, and fail to impose a culture based on their own individual success. (Ostensibly a multistrategy fund, Amaranth instead concentrated its capital on a single energy trader.)

Mallaby selected mavens who began with a just a few million dollarsnot the hundreds of millions or billions in seed capital that more recent managers enjoy. They are scrappy individuals who risked time, effort and personal wealth to earn fortunes.

With few exceptions, they did not amass these fortunes over a few short years. It took 10, 20 years or more. John Paulson, for example, who made $3.7 billion in 2007 alone launched his fund in 1994 with two million dollars.

As the next generation of hedge fund managers takes root, it would be worthwhile to explore the generational contrast. Are investor and manager expectations appropriately aligned? Does the new generation need to reinvent the incentive structure?

Mallaby contends that hedge funds, unlike banks, are valuable market participants because they are not too-big-fail institutions. They bear no cost to taxpayers. While on an individual fund basis that may be the case, his argument is not altogether convincing. As he points out, hedge funds including proprietary trading desks will often converge on the same trades, forcing extreme price movements. Dominating daily trading volumes, they have alsoon a collective basisnow become default providers of market liquidity.

Any chain reaction of funds imploding would cause extreme market disruption and exacerbate price movements that could already be extreme. We could easily see, as a result, the Federal Reserve intervening and lawmakers debating support of companies ravaged by forced sales.

Among the social costs would be higher risk premiumsa de facto transaction tax that all individuals would bear.

The picture of where we go to from here is far from clear, not just because market participants must navigate financial market reform alongside socioeconomic transition, but also because a new generation of hedge fund managers is emerging.

Three generations have passed since Babe Ruth transformed baseball. As much as the game has evolved, the total change is arguably not as great from his retirement as it was from the period prior to his playinga career that began in 1914 and ended in 1935.

Will the same be said of Robertson, Soros and Simons? Much will depend on how the total market evolves, not just big banks and hedge funds, but mutual funds, pension funds and individual investors.

For the moment, at least, we can reflect on an historically significant market era that began about 50 years ago with Alfred Winslow Jones, and which is just now entering an entirely new phase.