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In this episode of Lehigh University’s College of Business ilLUminate podcast, we are talking with Andrew Olenski about a recent study he co-authored with Ashvin Gandhi of UCLA that found nursing homes in Illinois “tunneled” 63 percent of profits to related companies to inflate costs and decrease profit margins reported to government regulators.

Olenski is an assistant professor of economics whose current research focuses on the nursing home industry, using novel methods to measure provider quality, and examining the health consequences and policy implications of the ongoing contraction of the nursing home industry.

He spoke with Jack Croft, host of the ilLUminate podcast. Listen to the podcast here, subscribe and download Lehigh Business on Apple Podcasts or wherever you get your podcasts.

Below is an edited excerpt from that conversation. Read the complete podcast transcript [PDF].

Jack Croft: Your study looks at “tunneling” practices in health care, and I confess that's not a term I had come across previously. So let's start by talking about what does tunneling mean in economics?

Andrew Olenski: So I'll confess that I also had actually not come across the term tunneling before working on this paper. The term tunneling actually comes from the corporate finance literature, which is not really an area that I tend to work on. I usually work … on health care issues. … Suppose I wanted to pay out profits today. I could pay out profits in my current company where I have maybe a 50% ownership share, or I could pay out profits to a related company where I have 100% ownership share. So this idea of moving assets from one company to another as if through a tunnel is where the idea comes from.

Croft: What is it about health care, in particular, that makes tunneling advantageous?

Olenski: What's interesting about the healthcare industry is that there are actually lots of reasons why one firm might want to tunnel profits or assets to another. So at the simplest level, the problem might just be that if you have two entities, one's a health care provider, and one is some third-party company owned by the same owner as the provider. If the owner wants to avoid some sort of regulation, or if they want to try to hide profits from the regulator in some way, then shifting profits from the health care provider to a related party will effectively do that.

For instance, it might be that I'm a healthcare provider, and I'm trying to negotiate for higher reimbursement rates from the government. One really effective way of doing that might be to say, "Look how unprofitable I am. Look how low my profit margins are. You need to increase my reimbursement rates, or else I'll close."

One way of making that argument really strong is by showing how unprofitable you are, right? And so the idea here is that what you might see is providers essentially moving money from their left pocket to their right and then showing their left pocket to the regulator and saying, "Hey, look. My pocket's empty."

Croft: Without getting too far into the weeds, what information did you examine to conduct the study? How did you kind of trace where the money was going and what was happening?

Olenski: Every nursing home is required to submit annual financial data to the government. They will submit financial data on their revenues and costs of providing care, both to the federal government, as well as to each state—the states where they operate, of course. And the point of these cost report data, as they're known, is to try to give the government some idea of how much it costs to produce the care that they're paying for.

Most health care is purchased by the government. So the government is really concerned with how costly it is to produce this care. What we do is we say, "Let's look at these cost report data, where we see how much money nursing homes are spending on different categories. How much of this money is being paid out to related parties?" Where, again, a related party is just any company that shares common ownership with the nursing home.

So think about a real estate company that owns the building that the nursing home operates in. What you might have is a situation in which the owner of the nursing home also owns the real estate company that owns the building. So on the nursing home's books, they're not the owner of the facility. They just pay rent to this other company. And what we do is we look and see, essentially, how much money are nursing homes paying out to these related parties? We try to use this measure of cost to assess how much nursing homes are shifting profits.

Croft: … Real estate and management services that have the same ownership as the nursing homes are two of the categories. And they are, as your study found, the two most common areas where the inflated costs are found. So what were your key findings related to those transactions between nursing homes and the facilities that they're running and the management services that they're contracting for?

Olenski: We found that the vast majority of related party spending was on real estate and management services. And what I mean by that is, if you were to take all the dollars spent on related parties, so companies that share common ownership with the nursing home, something like 75% of them go to either real estate or management services. So we look at these two types of contracts, in particular.

And what we find is that when a facility … adopts a real estate company or a management company, their total spending on management or real estate increases somewhere between 20 to 30 percent. So that tells us that we think the payments to these companies are being inflated by about 20 to 30 percent. That's a really useful number to know because that number lets us figure out, "Well, how much should we be deflating their reported costs of real estate and management when they're contracting with one of these related companies?"

By deflating the costs by the amount that we think they're being marked up, we can try to figure out how much money is being tunneled to these related parties. And by figuring out how much of this money is being tunneled to the related parties, we can figure out what is the overall profitability of the nursing home industry. What's the true profitability of the nursing home industry, taking both the observed profits as reported to the government, plus the hidden profits that are flowing through one of these related parties?

And what we found was pretty striking. We estimate that about 63% of nursing home profits are hidden in this way. So what I mean by that is for every dollar of profits that flow to the nursing home industry, about 63 cents are hidden in a related party, meaning if you just looked at reported profits, how profitable the industry says it is, you would only be getting about 37% of the total picture. Meaning that the hidden profits are more than twice as large as the true profits, which we think is a really striking result and goes against a fairly long-running narrative that the nursing home industry is extremely unprofitable.

The consensus has been for decades that this is a very unprofitable industry that is desperately in need of higher reimbursement rates, or else, every facility will be on the verge of exit. And our results really kind of contradict this narrative.

We think this is actually very plausible for a couple of reasons. The first is that one of the hallmarks of this industry over the last 10 to 15 years has been an explosion of private equity (PE) investment. There's a lot of private equity money flowing into the nursing home industry, which we find a little puzzling if the industry is really so unprofitable.

Why are investors buying up these facilities, at generous valuations, mind you? It's not that PE is moving in and buying these facilities on a huge discount. Then it might make sense. But now, we're finding that investors are purchasing these facilities at very generous market prices, which is a very difficult fact to square with the idea that the industry is so deeply unprofitable.

Similarly, if you just looked at the reported profits, you would find that somewhere in the ballpark of 50% of facilities in a given year claim to be unprofitable. We think that this is a very surprising number, given that the exit rates, the percentage of facilities that close in a given year, are only in the 1-to-2 % range. So the closure rates are actually relatively low for an industry that's 50% unprofitable.

So we think that these two facts, that the closures are relatively uncommon, and the private equity valuations are very high, are very difficult to square with the idea that this is a very unprofitable industry. And we think that the way to resolve these two puzzles is by pointing out the magnitude of the problem with these hidden profits.

Andrew Olenski

Andrew Olenski

Andrew Olenski, Ph.D., is an assistant professor in the Department of Economics at Lehigh Business.