LONDON, England / The Economist / Business & Finance / / June 16, 2011
SOUTHERN CROSS, a British operator of care homes for the elderly, is battling for its corporate life. This week it arranged a deal on rent reduction with its landlords in an attempt to reduce its operating costs.
Why is the model used? Clearly it costs money to build a nursing home or a supermarket. A business has the choice of borrowing money to finance its construction or leasing the home from a property group. There can be tax advantages either way: leasing payments and interest costs are both tax-deductible. But the opco/propco model fits the modern fashion for making businesses a “pure play” on a particular trend. One group of investors will be interested in the potential for nursing-care demand to rise as the population ages, and buy shares in the operating company. A second group will be attracted by the security and steady income of bonds issued by the property company.
Specialisation involves some risk. As an operating company Southern Cross had to assume that its income from residents would rise faster than its lease payments, which had annual increases built in. The owners and bondholders of the property company had to assume that Southern Cross was able to keep its part of the bargain and that property values would not plunge.
In the case of supermarkets such a strategy may well pay off. Consumer demand for groceries is pretty consistent, whatever the economic conditions. Those who owned care-home operators clearly thought that they too had a recession-proof model. After all, the British population is steadily ageing and children are less willing to look after their parents than they used to be.
But there were two potential snags. The first is that the elderly are making more effort to stay in their own homes for as long as possible. By the time they go into nursing care, their condition has often deteriorated to include immobility, incontinence and dementia. Caring for such people is more expensive.
The second is that care is beyond the private means of all but the affluent, and even their savings can quickly run out. The cost of funding then switches to local councils, whose finances are under huge pressure. They have become hard negotiators, driving down the fees charged by homes. This seems to be the thing that caught out Southern Cross.
It is hard to see the strains on British public finances easing soon. That may create a long-term problem. If caring for the elderly looks like an unattractive business, some homes may close and new homes will not be built. In the long run this could lead to a shortage of places.
But the saga also raises more general questions for the corporate sector. A geared business model or balance-sheet (one that is sensitive to small changes in revenue or asset prices) made sense in the pre-crisis era, which was marked by steady growth and easy credit. Such a model does not work in a stop-go economy with frequent recessions. Companies have to be very confident that they will not be sabotaged by a sudden dip in revenue, or by a loss of confidence among creditors that makes them unwilling to keep extending funds.
There are also echoes of the subprime crisis. Just as investors assumed that American house prices would always go up, elderly-care investors thought local councils would always underwrite their fees. A complex business structure added to the problems. Had Southern Cross built its homes via loans from banks, it would now be negotiating with a few bankers rather than with a dispersed group of landlords.
Another issue is the moral hazard that arises from an implicit public subsidy of a business. On top of the existing funding role played by local councils, no government could stand by and let such a vulnerable group go without care. There is thus a legitimate public interest in ensuring that the nursing-home industry does not take on too much risk.
Copyright © The Economist Newspaper Limited 2011