Originally Published MX March/April
2002
INDUSTRY ASSOCIATIONS
Choking Our Own Spirit
Issues surrounding the fees and practices of group purchasing organizations should be next on industry's agenda of problems to be resolved.
Larry
R. Holden and Rene A. Torrado
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| Larry R. Holden (left) is president of the Medical Device Manufacturers Association (Washington, DC). Rene A. Torrado is a senior associate at DiamondCluster International (Chicago), a business and technology solutions firm. | |
Over the past decade,
policymakers in Washington, DC, have had an earful from medical device manufacturers.
In the early 1990s, industry concern focused on reducing review times and eliminating
unnecessary burdens in FDA's product review process—efforts that eventually
led to congressional enactment of the FDA Modernization Act of 1997 (FDAMA).
Later in the decade, industry turned its attention to the need for reforming
Medicare coverage and reimbursement policies, an area that is continuing to
attract a great deal of work.
Industry associations such as the Medical Device Manufacturers Association (MDMA;
Washington, DC) have played a key role in representing industry needs and promoting
legislation to resolve such issues. While FDA review times have dropped substantially
since the passage of FDAMA, for instance, associations are continuing to monitor
the implementation of other aspects of the legislation and to recommend additional
refinements in the agency's processes. Similarly, industry associations are
working with the Centers for Medicare and Medicaid Services (CMS) to formalize
coverage and reimbursement guidelines that will make the agency's processes
more predictable.
The reforms of
the past decade have translated into real benefits for device manufacturers,
large and small. Meanwhile, however, another more-fundamental and potentially
more dangerous problem has been developing in the healthcare marketplace, and
has gone mostly unnoticed by policymakers. That problem centers on the practices
of group purchasing organizations (GPOs), entities that work on behalf of their
member hospitals and effectively control the vast majority of medical product
purchasing by hospitals in the United States.
The role of a GPO is to coordinate collective purchasing for its member hospitals,
negotiating favorable contracts that can translate into reduced healthcare costs.
GPOs enable hospitals to save on expenditures and operate more cost-effectively
than if they each had to identify vendors and negotiate contracts independently
of one another. Each year, according to the Health Industry Group Purchasing
Association (HIGPA; Washington, DC), GPOs save hospitals and the healthcare
industry in general approximately 10–15% on the costs of medical products.
The savings that GPOs pass on to their member hospitals are achieved largely
by negotiating large-scale contracts in which medical product manufacturers
agree to reduced pricing in return for committed sales of large blocs of product.
Such economies of scale offer cost-efficiencies that no single member hospital
could achieve on its own.
Hospitals also save money by virtue of the fact that they are not responsible
for any of the costs of operating the GPO to which they belong. Instead, in
1994, Congress exempted GPOs from federal antikickback laws and authorized them
to recover the costs of their business by charging administrative fees of as
much as 3% of the value of the purchased goods. These fees are paid not by the
member hospitals, but by the manufacturers of the products purchased by the
GPO.
In spite of the apparent benefits offered by collective purchasing, the GPO
system as it has come to function today is riddled with problems. To begin with,
after a decade of consolidation among GPOs, the system is dominated by just
two purchasing groups, Novation (Irving, TX) and Premier (San Diego). Together,
these two buying groups account for approximately two-thirds of all U.S. hospital
medical device purchases. The dominance of these two groups has resulted in
a purchasing system that is operating simultaneously toward contradictory ends:
to make use of competitive forces as a means of obtaining favorable contracts
from device manufacturers; and to avoid competition that could reduce GPO purchasing
power.
In addition, to realize the greatest possible economies of scale, GPOs frequently
attempt to get all their member hospitals to standardize on a single vendor
for a given item. Wherever possible, GPOs prefer to go even further, selecting
one vendor for a group of items. By definition, this process of standardization
is exclusive; manufacturers that do not make it onto the standard formulary
are automatically eliminated from contention.
Finally, because margins in the medical device industry are traditionally very
slim, the administrative fees levied by GPOs can be an extraordinary burden
for some manufacturers—especially small medical device companies. Further
exacerbating the situation, some GPOs appear to have regularly exceeded the
maximum level of fees they are permitted to charge, putting in place additional,
unauthorized charges under the guise of "marketing fees."
The GPO system as it operates today is capable of providing significant cost-efficiencies
for the short term. In many cases, however, the system excludes purchases of
innovative technologies, thereby undermining the long-term future for such products.
So far, the attention of policy-makers with regard to healthcare GPO problems
has been focused almost exclusively on issues relating to the payment of administrative
and other fees. But the effects of limited competition and standardization among
GPOs are much more complex and subtle. This year, as pressure mounts to cut
healthcare costs while continuing to promote medical innovation, it will be
important that the nation's lawmakers look beyond the issue of administrative
fees to assess the economics of the situation as a whole.
Getting the Ear of Government
The issues raised by GPO practices have not gone entirely unnoticed. In 2000,
the Department of Health and Human Services (HHS) looked into the GPO practice
of charging administrative fees and the impact of those fees on small manufacturers.
In part because the HHS investigation was narrowly restricted to the question
of fees, however, it resulted in little substantive action.
Last year, the Senate subcommittee on antitrust, business rights, and competition
announced that it would conduct hearings to examine "the competitive impact
of hospital group purchasing organizations on smaller, innovative medical device
manufacturers trying to market their products." Unfortunately, the subcommittee
hearings were scheduled for October and, with a great deal of other business,
were postponed after the tragic events of September 11 forced lawmakers to turn
their attention to the more pressing matters of national security.
This year, the cost of healthcare has again become a topic of concern, and the
issue of GPO practices is once again on the agenda. According to recent schedules,
the Senate subcommittee is expected to hold its long-awaited hearings in April.
The subcommittee hearings will play an important role in helping lawmakers to
understand the harmful effects of GPO administrative fees and, just as important,
of the exclusive system of product standardization that is supported by current
collective and coordinated purchasing practices. Such an understanding will
be critical if Congress expects to develop effective policies to resolve the
issues of group purchasing while also promoting both cost savings and medical
innovation. In addition, to be effective, any new policy developed by Congress
will have to take into account the following characteristics of today's medical
product marketplace.
Innovation Starts Small. In the medical device industry, small manufacturers
are disproportionately responsible for much of the innovation that results in
new generations of advanced medical products. Such manufacturers typically have
fewer than 50 employees—far below the upper limit of 500 employees that
is used to designate companies within the purview of the Small Business Administration.
A wide range of critical lifesaving technologies—including pacemakers,
coronary stents, and advanced drug-delivery systems—were conceived and
developed first by small medical device manufacturers, and only subsequently
acquired by larger manufacturers.
Success Conceals Risks. Although many small medical device manufacturers
have experienced market success in recent years, their success has often been
earned in the face of conditions that are less than optimal for most companies.
Because demand for advanced medical products remains strong, device companies
are often able to eke out sufficient sales to suggest that fair-market principles
are operating as they should. But even the most successful among these companies
can rarely afford to offer a return on investment adequate to attract further
rounds of funding or support an initial public offering.
In sum, the short-term success of such medical device manufacturers conceals
the very strong risk that they will fail in the long term. As long as government
policies and market economics combine to restrict company access to potential
customers, investment funding for small device companies will remain difficult
to come by. And without adequate funding, many such entrepreneurial companies
will inevitably stop developing the innovative products that are the lifeblood
of the industry.
Market Implications
At first glance, one might be tempted to say that the current environment offers
ample support for innovation. In 2001, for instance, the public-equity markets
rewarded medical device firms such as Boston Scientific (Natick, MA) and St.
Jude Medical (St. Paul, MN) with exceptional increases in their stock prices.
Boston Scientific started the year with a share price around $13 and ended the
year at around $21—an increase of more than 50%. St. Jude Medical saw its
stock price rise by more than 25%.
Private-equity markets have been similarly responsive to medical device companies.
In 2001, the median amount of financing per round for medical device firms grew
to $8.2 million. And, even in a time of belt-tightening among most venture capital
(VC) firms, the total amount of VC capital invested in medical device companies
remained relatively unchanged.
Moreover, medical device companies are continuing to experience substantial
growth in mergers and acquisitions (M&A) activity—a key link to success
in both the private and public markets. According to some estimates, between
1996 and 2001 the average price paid for a private medical device firm grew
by more than 300%. Even more telling is the relative success that large medical
device firms have had with the companies they acquired. While studies of the
general economy have found that 70% of acquisitions fail to provide an adequate
return, large medical device manufacturers appear to have bucked this trend.
In 2000, for instance, Medtronic Inc. (Minneapolis) reported that its recent
acquisitions had grown faster than the company average and together accounted
for more than 35% of the company's total revenues. In 2001, acquisitions helped
Tyco Healthcare Inc. (Pembroke, Bermuda) increase revenues by more than 36%.
However, such short-term successes are masking vulnerabilities in the sector
that could undermine the dynamics of medical device innovation. Unfortunately,
current policies toward GPOs are serving to enforce a set of fragile market
dynamics that will ultimately undermine both innovation and the purchasing system
itself. Key areas of concern include the following.
Restricted IPO Market. Market support for emerging medical device companies
is not as strong as it seems. Most of the device companies that have gone public
in the past five years have experienced declines in their stock prices. In 1999,
in fact, the chances of a medical device company having a successful initial
public offering (IPO) were so bleak that no device companies even tried. One
result of this trend is that private-equity companies must rely on M&A activity
to provide their exit strategy. Taken to the next step, the dependence of emerging
companies on M&A means that the entire burden of funding innovation falls
on the shoulders of a relatively few large companies.
Limits to Growth. The GPO preference for contracting with large vendors
that have broad product lines artificially limits market access and growth opportunities
for small device companies. Such limits are not conducive to success in public
markets, and also tend to reduce M&A pricing for such companies.
Investment Sensitivities. Although medtech stocks are widely considered
a good countercyclical bet in times of recession, the healthcare sector can
suffer when investors turn to other industries whose growth prospects seem greater.
Such an inevitable change in the public-equity markets could have a devastating
effect on the ability of large companies to finance M&A activities and,
in turn, on small, private-equity firms that depend on acquisition as an exit
strategy.
Winner Takes All. Finally, and perhaps most dangerous of all, is the "winner
takes all" dynamic of GPO channels. In today's world, two GPOs control
two-thirds of all hospital purchasing power—and they prefer to contract
with only one or two vendors for all but the most highly specialized items.
For medical device companies, this means that the gain or loss of one contract
can represent both sizable market share and substantial revenue. As the trends
of GPO consolidation and standardization in contracting play out, it seems likely
that market opportunities for small companies will diminish severely, virtually
eliminating competition.
Conclusion
As Congress begins to look at the issue of GPO economics, special attention
will need to be paid to the effects that standardization and administrative
fees have on the industry. Congress will need to understand their potential
impact on innovation—especially as it relates to small companies. A favorable
environment should not offer unfair advantages to either small or large manufacturers,
but should provide both types of companies with equal market opportunities.
In practical terms, current GPO economics lock out small manufacturers, creating
a fragile set of market dynamics that places funding for innovation at risk.
In devising solutions to these interrelated issues, Congress should seek policies
that promote continued medical innovation by embracing the unique nature of
the industry and fostering a favorable environment in which small manufacturers
are not disadvantaged.
Copyright ©2002 MX
