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Buying Chinese hospitals is a niche game

The nascent private hospital sector in mainland China has seen a flurry of deals recently. In September, U.S.-based Chindex International was sold for $461 million to a consortium led by Shanghai Fosun Pharmaceutical(Group), a subsidiary of China's largest private sector conglomerate. The following month, Concord Medical, the U.S. operator of the largest network of radiotherapy and diagnostic centers in China, said it would spend $200 million to build a beam therapy treatment center in Beijing and a cancer hospital in Guangzhou. In November, Seattle-based Columbia Pacific Management -- one of the largest health care providers in Asia, with 26 hospitals in India and Southeast Asia -- announced plans to start building two 250-bed general hospitals in Wuxi and Guangzhou next year.

     All told, the acquisition by Fosun and the new investments by Concord and Columbia Pacific add up to nearly three times the total investment that went into China's private hospital sector between 2001 and 2013.

     One explanation for the sudden increase could be the National Development and Reform Commission's renewed vigor towards establishing a private health care sector, which has kindled investor confidence in the market. The reform efforts of the NDRC -- a large government body that oversees the country's health care reform -- are meant to relieve overcrowded public hospitals, reduce the cost of drugs for the majority of the public, and provide a way for Chinese patients to access more costly, state-of-the-art procedures outside of the public hospital system, should they wish to do so.

     And then there's China's growing middle class. When we asked Columbia Pacific about the reasons behind the timing of their investment, Managing Director Nate McLemore put it down to the expectation that the quality of care and level of service will continue to increase along with Chinese patients' ability to pay for international standards of health care.

     But Columbia Pacific and Concord Medical are both niche players banking on specialization and novel therapies.

Not for everyone

While there is no doubt that investing in a sector that aligns with government objectives is generally a good strategy, research by my firm, Rubicon Strategy Group, and think tank CN Healthcare has uncovered that most hospitals in China have yet to figure out how to make money.

     Chindex was looking for a buyer because, like all other early private hospital entrants, it has failed to attract patients to its upmarket United Family Hospital facilities. Industry observers maintain that Chindex hospitals ran at well below 50% of their capacity for much of the first decade of the 2000s. Its positioning at the high end of the health care market meant that it relied on a narrow sliver of the local population who could pay a premium for health care, and on expatriates with private insurance. Its second-quarter net loss of $693,000, part of the last set of results announced before the deal, was more than five times greater than the same period last year.

     Perhaps the new interest in China's hospitals lies in the changes taking place in the public health sector.

     In particular, the government is trying to cut costs and is putting a cap on how much public hospitals can charge for drugs. Public hospitals have become over-reliant on drug sales to maintain their cash flows. With government subsidies covering only a small part of their costs, it is estimated that anywhere from 40% to 70% of their revenues come from drug sales. That is a distraction from the provision of services. Another problem is that patients often have to pay more than those in other countries for the same drugs because Chinese doctors receive commission for their prescriptions, which encourages exorbitant markups.

    New reforms will eventually stop hospitals from being able to tap their drug sales to fund operations, which leaves a big question of how the business model of public hospitals will be revamped to account for this large loss of revenue.

     According to Zhu Hengpeng, a scholar at the Chinese Academy of Social Sciences, at least 4,000 Chinese public hospitals will be put on the selling block in the next five years. Already, the Beijing city government has launched a pilot scheme that will allow public hospitals to sell franchises to private investors.

     These hospitals may have an uncertain future but they are nevertheless cheap enough for large investors to take a gamble on. Once privatized, a hospital would no longer come under the same pricing restrictions that control public hospitals. For pharmaceutical and medical equipment companies, buying a hospital can also be a hedge against the budget cuts being made by their public sector clients.

     This is particularly true for a company like Fosun, which owns China's largest drug distributor, Sinopharm, as well as three of the 30 largest pharmacy chains in China.

     Chindex's network of hospitals and clinics can be potentially valuable distribution channels for Fosun. A hospital can, in effect, become solely dependent on its right to purchase pharmaceuticals or disposable medical products directly from the manufacturer at wholesale prices. By buying hospitals, Fosun gets to keep the portion of the profit that previously would have gone to a distributor.

     This means that the uptick depicted in the chart above may not signal the long-awaited arrival of more private hospitals in China. Columbia Pacific and Concord Medical may be complete outliers because of their niche positions, and there are not that many well-capitalized companies that would buy hospitals to hedge against changing policies that threaten their current business model.

Damjan DeNoble is a partner at Rubicon Strategy Group, a health care business consultancy that focuses on Asia.

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