Hospitals & Financial Engineering

I haven't written much on the business of healthcare lately, but this Steward Healthcare situation is both fascinating and troubling. For those that haven't been following, Steward recently filed for bankruptcy and is threatening to close hospitals in high-need parts of Massachusetts, and a formal federal investigation into the actions of the CEO and private equity firm that formerly backed the health system seems likely. This news raises real questions about the appropriateness of hospitals operating as private equity-backed for-profits and the financial engineering that comes with such transactions, especially hospitals that operate in underserved communities.  

Steward Healthcare

Steward Healthcare, a for-profit hospital chain, launched in 2010 when private equity firm Cerberus Capital Management (named after Cerberus, the three-legged dog that guards the gates to hell) acquired the failing non-profit Catholic healthcare system Caritas Christi located in Massachusetts. The CEO of Caritas, Ralph De La Torre, became CEO of this new health system. Steward’s name was a symbol of how it promised to be a good steward of the hospitals formerly owned and operated by the Catholic church.

Steward's Strategy

Hospitals might not strike you as a great investment for a private equity firm, so you might wonder what the appeal was for Cerberus. Hospitals have very low margins (generally less than 5%) and sometimes operate at a loss through government subsidies. But Cerberus saw that one could think of Steward, or any hospital chain, as two separate things: 1/ a large hospital operation serving patients and 2/ a highly valuable set of real estate located in population centers that the hospitals sit on. 

Real estate as an investment is a much more lucrative business than a hospital operation. A real estate investment trust (REIT), a company that owns, operates, or finances income-producing real estate, sees 25% to 50% margins. Cerberus saw that Steward could get significant and quick liquidity by selling the real estate that the hospitals were sitting on to a REIT, in this case, a firm called Medical Properties Trust (MPT), and then leasing the property back. This is known as a sales-leaseback. To juice the price of the real estate, Steward agreed to very favorable leases. MPT paid $1.2 billion for the initial properties and also took a 5% stake in Steward. All of the details of these leases aren't clear, but these were expensive, long-term leases with escalator clauses and with other terms that MPT must have liked, including a triple-net lease where Steward would be responsible for the cost of insurance, property management, and maintenance, in addition to the rent.

The strategy was clearly great for MPT as it immediately expanded its assets under management with reliable, lucrative leases. And it was also good, in theory, for Steward. Steward would gain instant liquidity to help it pay down its debt from the Caritas Christi purchase and acquire more hospitals and medical offices across the country. The properties, as they were acquired, were promptly sold to MPT and leased back. And by not being burdened by managing the real estate, Steward could focus on optimizing its hospital operations. 

Steward aggressively pursued this strategy, growing up to 40+ hospitals across multiple US states and even expanding the strategy internationally into Colombia, Malta, and the Middle East.

The problem was that as Steward was rapidly acquiring and selling real estate, much of the proceeds from these real estate sales never got to Steward. Some of it went to hospital operations and paying down debt, but large amounts of it went back to Cerberus in the form of management fees and dividend payments. And that left Steward without much of the proceeds of the sale and with highly burdensome lease obligations. 

Cerberus Exits 

In 2020, Cerberus exited its position in Steward by selling its stake to De La Torre and other Steward physicians via a loan from MPT. Over the course of its ownership, it was reported that Cerberus made a profit of $800M. 

It was downhill from there. Steward quickly began to downsize, selling off hospitals across the country. By January of this year, Steward was facing a financial crisis. It owed MPT $50 million in unpaid rent, among several other vendors. MPT, presumably to keep the gravy train running, stepped up and offered several loans to Steward to keep the health system solvent. It was soon reported that Steward would be forced to file bankruptcy and close a number of hospitals, which then launched a series of investigations into Steward's operations and financials, which brings us to today, where hospitals in high-need areas are at risk of closing, creating a potential public health crisis in Massachusetts. 

What's Next

What happened here, in short, is a smart private equity firm saw an opportunity to buy up a struggling health system for small dollars, sell off the valuable real estate it sat on, and maximize those sales by saddling it with costly leases and using the proceeds from the sales to pay itself and expand this strategy across the country and the world. Then it sold off the entire asset, leaving the real estate owner (MPT) and Steward's management and employees in the lurch.

To be clear, It's not obvious that any of this activity is illegal (it's probably not). And in most industries, you could argue business is working as it should. Steward likely wasn't a great business at the start, and finding a way to maximize the assets of an investment seems like good old-fashioned capitalism. If Steward was a tech company or an apparel company, it’s likely nobody would know about this mess.

But it's not. It's a health system that operates dozens of hospitals in high-need areas. Hospitals that represent our society at its best. These are places of healing for humans facing the worst moments of their lives. They restore health, reduce human suffering, and support the overall well-being of the communities in which they operate. Not to mention, they generally receive at least half of their revenue from tax payer-funded healthcare. Because of that, I think regulation of these kinds of transactions and even for-profit hospitals, in general, are set to receive some intense scrutiny from regulators in the coming months. De La Torre is scheduled to testify in front of Congress in September.

I'm a big fan of capitalism, and I generally support the work of private equity firms in delivering returns to their shareholders, many of which are large pension funds, endowments, and foundations. But Steward's collapse is an important signal that our most important and prized institutions shouldn’t be operated as attractive targets for short-term, financially engineered profits.

Hospitals are different. They're a special thing. And regulators should ensure they're treated that way.

Risk, Reward, And Working In Tech

The other day, I was chatting with a guy who works at a restaurant down the street in the South End of Boston. He was telling me it was his last couple of months at the restaurant as he had just graduated from college.  He said he wanted to get his money's worth for all the money he spent on college, so he was going to get a higher-paying job in residential property management. He seemed like a sharp guy, so I had this impulse to tell him to get into tech. But I hesitated and decided not to. 

I sometimes forget that tech requires a certain personality. A high tolerance for risk. And I didn't really know the guy, so it didn't feel right to try to direct him one way or the other. 

With the relatively high salaries in tech, flashy products, and nice perks, it's easy to forget how volatile and risky the space actually is. It's definitely not for everybody. And if you're not the type of person who can handle booms and busts, stay away. There are plenty of other less lucrative but far more stable jobs to get into. 

It's worth remembering why this is. Tech companies, by definition, are investing in high growth that comes from new ideas. Investing in new ideas is risky. They often don't work. The greater the risk, the greater the potential reward. In boom markets, working in tech is great. In busts, it's not. I’ve been through 4 of these downturns in my career — the 2000 dot-com bust, the 2008 Great Financial Crisis, Covid in 2020, and the end of the low interest rate period in 2022. None of these were fun, and all of them came with a great deal of professional stress and anxiety.

Because of things outside of your control, such as interest rate changes, investor sentiment changes, geopolitical events, new technologies, government policies, etc., tech markets are inherently cyclical. And the risk takers that are putting capital into new ideas always feel downturns first, because that's the capital that investors will pull out and put into safer, less risky investments.

Before embarking on a new career in tech, make sure you understand this reality and are up for the dramatic ebbs and flows in your day-to-day life that are a natural, unavoidable part of working in this field. 

Investor Alignment

Managing different investor priorities, objectives, and incentives is one of the most difficult things to do when leading a company. I wrote about the importance of understanding your investor's context and incentives a while back. Even at the venture stage, your angel investors and VCs may have very different ideas on how they define a good outcome. Depending on their own situation, some may be taking a very long-term view of the investment; others may want a shorter-term win. This intensifies significantly as you transition into the growth stage and, ultimately, an IPO, at which point you can literally have millions of investors with competing needs and priorities.  

To help manage this, someone once told me that in a board meeting, I should try very hard to step out of my own incentives and not behave on behalf of Brian Manning but instead behave on behalf of the company. The company has no voice. Everyone in the room has their own incentives and that's typically what they represent. It's important for someone to step up and speak for the company. 

This sounds like great advice, but it's almost impossible to do because how does one define the incentives of the company when the incentives are really a bundle of competing self-interests? This makes driving investor alignment extremely difficult. 

As a leader, your job is to maximize shareholder value, but on what timeline? Should you optimize valuation for a year from now or 3 to 5 years from now? Depending on your answer, your short-term goals and actions will vary significantly. You might say your job is to drive value over the long term. But what is the long term? Should companies seek to stay in business forever at the cost of shorter-term returns?

In the early stages, to help manage this, I've found it's enormously useful to optimize around funding rounds — seed, Series A, B, C, etc. Leaders should set specific goals associated with the next raise. As an example, a team at a high-growth startup might say they want to raise their Series A in December of 2025, and by that point, they want to have:

• $X in the bank

• $X in revenue

• $X in monthly burn rate

• X% growth

• X in headcount

• X in number of customers

• X, Y, and Z in product milestones

• $X in company valuation (this one will obviously be a loose estimate based on some market-driven multiple)

• X gross margin, Y operating margin (though these should be prioritized after product/market fit, burn rate, and cash are more of the focus early on)

Leadership should then be transparent with the board and investors about these metrics so everyone knows what the company is chasing. Leaders and even front-line employees should know these metrics and keep them top of mind. While this approach is far from perfect and won't align all of the different competing interests, transparency and disciplined tracking against clear metrics is a huge step forward in managing the day-to-day tradeoffs and difficult decisions that come with running a company. 

Capital Markets & The Technological Surge Cycle

As the stock market continues to reach record levels despite a number of economic headwinds, I can’t help but think back to a framework offered by Carlota Perez known as the Perez Technological Surge, first introduced to me by Fred Wilson. Perez studied all of the technological revolutions of the past and found that there are two phases in every major technological revolution: the installation phase and the deployment phase. The installation phase is when the technology comes to market and is often coupled with a big boom as investments pour into the hot new thing, followed by the deployment phase, where all kinds of applications are built on top of the underlying technology that actually delivers on its promise. But between the two phases, there’s a turning point that leads to a substantial crash in capital markets associated with the technology as the hype and capital inevitably get ahead of the practical use of the technology.

I started my career almost right in the middle of the turning point of the internet’s deployment and installation. Everyone knew what the internet was, and the world was enormously excited about it. The cables had been laid in the ground, broadband was widely available, and the NASDAQ was at its all-time high as capital poured into unprofitable and pre-revenue internet companies. I had recently graduated from college and was living in San Francisco when the turning point hit: markets crashed, we felt lots of pain, and then we moved to the deployment phase where all kinds of applications that we never could’ve imagined and, in many ways, changed our lives were built on top of the rails of the internet (Uber, Airbnb, Netflix, Zoom, etc.).

The most interesting thing about the deployment phase is how many applications and businesses you never would’ve imagined or associated with the technology get built on top of the technology. Perhaps the best example of this is the automobile. With the deployment of the automobile came the typical hype and over-investment and then a long and fruitful installation phase where an enormous number of applications were built thanks to human creativity and ingenuity. Consider Walmart, which at one time was the largest US company. Walmart was an output of the deployment phase of the automobile. Without the automobile highways couldn’t have existed and without highways suburbs couldn’t have existed and without suburbs Walmart and large shopping centers couldn’t have existed. Surely, Henry Ford wouldn’t take credit for inventing Walmart, but perhaps he should have.

Coming back to present day, the stock market continues to thrive through all kinds of headwinds and setbacks and I can’t help but think much of this is still the exhaust of the technological deployment of the internet that may be more impactful than any other technological revolution in world history, especially given its size, speed and global nature.

And, of course, now the internet has led to things like crypto and artificial intelligence, which are going through their own Technological Surge.

So when we look at unemployment and inflation and productivity metrics to try to figure out what’s going in capital markets, it’s important to consider the backdrop and the larger context and the size and scale of the technological revolution and the deployment of the internet that we’re still experiencing. It’s hard to know whether we’re still in the deployment phase of the internet or if we’re in the installation stages of another revolution with artificial intelligence. Or both. When investing in technology markets, it’s crucial to have a sense of the cycles we’re living through and what phase we’re in. The Technological Surge Cycle is a very helpful framework to help do just that.

Bookings As A Lagging Indicator

Bookings (the value of contracts signed within a specific period) is a crucial metric for companies to watch. Investors watch this number very, very closely. Boards will put enormous emphasis on it. When a deal is booked, the product then gets delivered to the customer, which turns the booking into revenue generated in a specific period, which equates to the top-line growth of the company. Bookings are the tip of the spear. It’s a leading indicator for revenue.

Investors will also look closely at qualified pipeline (the pool of potential sales opportunities that are deemed highly likely to convert into bookings) as that is a leading indicator of bookings.

Bookings and qualified pipeline are watched closely and are heavily scrutinized.

The problem with placing too much focus on these numbers is that a sales and marketing team is limited in how much they can move these numbers one way or another in a specific period. If a company crushes their bookings in a period, it generally means that there was a bluebird deal or that goals weren’t set accurately or that there was an external macro event that caused a large swing. Rarely are sales and marketing teams able to swing these numbers up and beyond expectations in a major way. The reason is that bookings are capped by the TAM (total addressable market) or, more specifically, SAM (serviceable addressable market) available to them. I wrote about TAM, SAM, and SOM a few years ago, find that post here. So, the reality is that while sales and marketing teams can do great things, they are limited by the stuff they have in their proverbial bag that they can sell. To really move these numbers and continue to grow, companies need to create new SAM at a high rate. So, while pipeline is a leading indicator for bookings, SAM creation is a leading metric for pipeline.

To make this point more concise, bookings growth is dependent on product investment decisions that were made 1, 2, 3, or even 5 years ago.

So, while it’s obvious that companies should be focused on in-period bookings and retention and profitability metrics, arguably it’s more important for companies to be focused on in-period SAM creation such that the cap on bookings growth in future periods gets higher and higher. The reason this is arguably more important is that product investments made now can drive far larger swings in growth in future periods than a sales and marketing team can in the current period. If two years ago a company made large investments in new products and new SAM creation, bookings will be high in the future. If two years ago they made no investments in new products and new SAM creation then bookings will be low in the future.

So, while obviously investors should be asking companies how bookings are going in a specific period, they’re really looking at a lagging indicator for good or bad investment decisions that were made in the past. They should place equal emphasis (arguably more) on how much new SAM is being created in that same period, as that’s the number that’s going to drive material and sustainable growth.

Valuation Fundamentals

The 10+ year period of near-zero interest rates caused a lot of investors and leaders to deemphasize the fundamentals of valuing companies. As I’ve written many times, we know that a company’s value is equal to the present value of the amount of cash you can take out of it over time. That is, the amount of cash you can take out of the company over time discounted to present-day dollars. When you’re in a zero-interest environment, there is no discount rate. When there’s no discount rate (or no risk-free way to make money), investors take more risk to find a return, thus the overflow of money into venture capital and other high-risk investment vehicles during that period. When there’s no risk-free bar to clear to find a return, an investor is more open to non-traditional investments. When interest rates are high and low-risk treasury bills are paying out 6%, in order to invest in something risky, the investor has to be comfortable that any investment will exceed 6%, causing money to flow out of venture capital and other high-risk investments.

When the risk-free rate is very low, investing gets hard because there are no guarantees, so you start to use proxies and benchmarks for future returns. This was particularly true in SaaS which really emerged in a big way during the 10+ year period. Things like Rule of 40 and 35% EBITDA margins and 70% gross margins became solidified as proxies for investable software companies. We needed those proxies because they provided guidance for what to invest in in a world where almost anything “could” be a good investment.

Now that investors have raised the bar on what they’ll invest in and there are real questions about the future of SaaS margins due to the emergence of new pricing models and pricing pressure from AI duplicating SaaS products at a far lower cost, it’s time to return to the fundamentals of valuation. Remember:

Growth is just a proxy for future cash flows.
Gross margins are just a proxy for future cash flows.
Operating margins are just a proxy for future cash flows.
Net income is just a proxy for future cash flows.

None of them alone can tell an investor the amount of cash they can take out of the company over time.

Now that we’re back to desirable risk-free rates, and CIO budgets have tightened, and high interest rates have squeezed company margins, it’s time to be more flexible and get back to the fundamentals of valuation. There are numerous ways to get there that might not fit with the traditional SaaS benchmarks we’ve used as a reliable guide over the last decade.

Company Ambitions & Personal Ambitions

Interesting conversation on the Ben and Marc show on the difference between personal ambition and company ambition. You always want your team to have the company's ambition in mind and for them to get to a place where that's their top priority. Of course, very few people can completely prioritize the company's ambitions over their personal ambitions, so to some degree, this is always a bit of a tradeoff.

When someone asks me the best way to be successful inside of a company, I always point to the notion of putting the company’s ambitions ahead of your own. The irony in this is that this actually propels you forward personally more than the alternative. This is true for a few reasons:

1/ It increases the chance that your company will be successful and you'll wear that brand and benefit from it for the rest of your career.

2/ People will view you as a great leader who puts the company's needs first. You'll be admired and respected and people will want you in the room. These people get promoted.

3/ It makes you a better operator in that you're getting better training by learning how to successfully operate a company more quickly than people that are busy playing politics.

Prioritizing your company’s ambitions over your own always seems to have the ironic outcome of a faster path to achieving your own.

Incentives, incentives, Incentives

"Show me the incentive and I will show you the outcome" - Charlie Munger

I’ve found that when you think understanding incentives is really, really important, you still don’t understand how important it is. When you find yourself in a difficult conversation or challenging situation with an employee, a customer, a partner, or a vendor, pause and make sure you understand the incentives of all the stakeholders. It almost always gives you instant clarity and gets you unstuck.

Good Conversations & Good Selling

As a sales leader, I’ve often told my teams that, while I want to close every deal we can, it’s perfectly fine if we don’t, as long as we understand exactly why the buyer didn’t buy.

As a seller, I used to have this mindset during sales conversations: I wanted to be sure that if the buyer didn’t buy, I could explain why in great detail to anyone who asked.

The trick here is that forcing yourself to understand why a buyer didn’t buy also forces the right sales behaviors. You have to do a bunch of good things to be able to do this well. You have to:

• Talk to the right people.

• Understand their role.

• Understand their decision/buying process.

• Understand their incentives and priorities.

• Understand their problems

• Understand what other solutions they have.

• Understand what they like/don’t like about the product.

• Understand how they view the competition.

• Understand how they think about ROI for the product.

You can’t understand these things if you’re not having good conversations. And good conversations are the thing that drives sales. Sellers should be less interested in making the sale and more interested in deeply understanding the mindset of the decision maker, regardless of the ultimate decision. This mindset, repeated over time, leads to better and better high-quality conversations. And better conversations = higher win rates.

Beware Of The Warm Intro

Jen Abel from Jellyfish posted this great Tweet the other day.

When a friend or colleague makes an intro, you feel somewhat burdened to take the call, to be nice, and to make it seem like the intro makes sense and that there's a deal there. But so often, this isn't the case. Sure, the person making the intro has the best of intentions in mind, but often, they have no idea whether a partnership between the two organizations being introduced actually makes sense. And they're often doing it to build up their own social capital in the hopes of leveraging that capital for themselves down the road. This is ok and sort of the way humans work, but it's crucial not to get fooled by the false momentum that comes from these connections. This is particularly difficult when the intro is centered around a more ambiguous partnership or when it comes from someone more senior than you. It takes real discipline to drive clarity and prioritize the opportunity appropriately.

Warm intros should be qualified and disqualified using exactly the same criteria as a cold outreach. Don't get caught up spending time with someone who is happy to take your call but ultimately doesn't have a high-priority problem that you can solve. 

Humility & Truth Seeking

I've always placed a lot of value on people who are humble. I've written about it here. I've always thought about humility in the context of getting better at what you do. If you have the humility to know that you aren't the best at everything, that drives you to improve. And of course it makes you much more fun to work with. 

I had a conversation with someone the other day who pointed out another reason why humility is such a great attribute: it's a signal that you see the world clearly. If you have the humility to see your weaknesses (which we all have) and to understand that whatever success you've had required the support of lots of luck and lots of support from other people, then you see the world more clearly than someone that doesn't. And an undervalued skill in the workplace is the ability to see the world clearly. To seek the truth.

An executive's job is to make good decisions. You can't make good decisions if you're not seeing the world as it is. Being able to see the world as it is might be the most important thing an executive can do. Often once you know the truth, making the decision is often the easy part. Humble people are naturally better at this. and this is just another reason why that value is so important in the workplace. 

Rule of 40 vs. Real Cash

It seems like whenever we go through a shift in the economy, the fundamentals of finance become increasingly important. During the near-zero interest rate environment we had for more than a decade, growth was rewarded in an outsized way. 10x and 20x revenue multiples were common for startups. Because the risk-free rate of return was near zero, there was no real opportunity cost in investing in something risky. That drove up the value of companies that were investing in big growth. Today, this has changed quite a bit. There is an opportunity cost to investing in something that might not generate cash for a while. So, a lot of the attention has shifted from growth to profitability. Investors want to see cash get generated more quickly. The Rule of 40 (ensuring that a company's operating margin % + its growth rate exceeds 40%) has become a common way of categorizing top-tier startups in this environment. Boards are pushing company leaders to get to Rule of 40 as quickly as possible. Given so many companies are coming out of the grow-at-all-costs approach, the easy thing to do is to pull back on investments, project a conservative growth rate, and drive down costs to make the company's operating margin high enough that it gets the company to 40+ in the next year or two.

This is a potentially short-sighted approach, especially for earlier-stage companies with small revenue. Returning to the fundamentals of finance, we know that the value of a financial asset is the present value of the cash that you can take out of it over its lifetime. Forecasting these cash flows is done using a discounted cash flow model. Revenue multiples and the Rule of 40 are crude proxies for understanding the present value of future cash flows. The danger of the Rule of 40 for smaller companies that aren't generating significant cash flows is that they underinvest in growth to achieve a higher operating margin at a point in time but never get to a point where the company generates high amounts of actual cash.

The Rule of 40 measures a point in time calculated using the % growth rate and the % profit. But companies are not valued on what they're doing right now. And they're not valued on their growth rate. And they're not valued on their profit margins. They're valued on real amounts of cash generated in the future. Rule of 40 can be a useful metric for investors to gauge the health of a business. But that has to be tempered with an understanding of the investments the company is making today to drive future real cash flows. 

One good way to manage this is to classify revenue and cost projections into two buckets. 1/ Core: revenue that will be generated from investments made in the past, and 2/ New: revenue that will be generated from new investments. Leaders need to really understand the future cash flows associated with their core business and whether or not that will produce adequate cash flows relative to expectations. That provides the input needed to throttle investments in new initiatives. The core should get more profitable and the new stuff should drive lots of new revenue. Blending the two and optimizing to a short-term metric runs the risk of severing the company’s execution plan from what’s best for investors over the long term.