Oct. 23 (Bloomberg) -- The California Public Employees’ Retirement System, the biggest U.S. pension fund, is betting as much as $1 billion that it can remake the $2.5 trillion health- care industry one startup at a time.

Calpers is the sole investor in Health Evolution Partners, a two-year-old private-equity firm in San Francisco run by David Brailer, a first-time money manager and former aide to President George W. Bush. Brailer, 50, coordinated Bush’s planning for an electronic health-records network; Calpers is counting on him to earn its members 20 to 30 percent returns.

So far, Brailer has invested more than $120 million in 30 companies, and said he plans to spend $150 million to $200 million a year beginning in 2010. One company aims to save hospitals up to $1.6 million a year each, using a centralized center to read radiology images. Others make electronic chemotherapy pumps that save time and curb treatment errors, run pharmacy chains that blend alternative therapies with traditional drugs, or match consumers to insurance plans based on their medical history.

“What Brailer and Calpers are doing is unique and possibly revolutionary,” said Robert Galvin, chief medical officer of General Electric Co., which buys health care for 152,000 U.S. employees. “We hadn’t seen capital going into opportunities to both provide new treatments and also promote efficiency and quality.”

‘Pain Points’

Brailer said his investments focus on areas of the health- care system where waste and inefficiency are rampant. These systemic trouble spots, which Brailer calls “pain points,” cost the U.S. medical system about $700 billion a year, according to the New England Healthcare Institute, a nonprofit policy research organization in Cambridge, Massachusetts.

“We look for big pain points, really big, important pain for really big money,” Brailer said. “The broad cultural trend is for people to take more responsibility for their care.”

Five congressional panels have passed bills to extend health-care coverage to as many as 37 million uninsured Americans, through a mix of taxpayer subsidies and restrictions on insurers. Debate may begin as soon as next week on one measure being crafted by Senate leaders and aides to President Barack Obama.

Americans will have to navigate a more complex system even if Obama’s health-care overhaul doesn’t pass, Brailer said. Patients and doctors will need help controlling costs without sacrificing the quality of care, which offers an opportunity for companies with technologies that help doctors manage work better or let consumers comparison-shop, he said.

10-Year Trends

“There are 10-year trends that will change decision- making in health care, change drugs, change our entire conception of disease,” said Brailer, a physician who also has a Ph.D. in economics from the University of Pennsylvania’s Wharton School. “Legislation won’t affect secular trends, so the best way to put it is that we’re looking past it.”

Some of Obama’s proposals build on Brailer’s work for Bush. Brailer worked as National Coordinator of Health Care Information Technology in the Bush administration from 2004 to 2006. He planned a national electronic medical-record network, which is now being built out with money from Obama’s stimulus plan. The network will help control medical inflation and expand coverage, Obama has said.

Registered Republican

Brailer, a registered Republican, said he chafed at some Bush administration policies, including its opposition to universal health insurance. He said some party members also privately criticized his work to create a national health- records network, using agreed-upon technical standards coordinated by the government, as interfering in free markets. Congressional Republicans cut his office’s budget to zero for fiscal 2005, before the President used his executive authority to reallocate other money for the Department of Health and Human Services to keep the project going, Brailer said.

Brailer’s White House work was one reason the California pension system bet on someone who had never run a fund, said Calpers portfolio manager Mike Dutton, who helps oversee $42.3 billion in private-equity commitments.

“We wanted deep medical and policy expertise, working with our existing private equity but positioned a little different,” Dutton said. Brailer and his 12-person team at Health Evolution Partners are “more attuned to health-care operations, policy, trends, all the elements in the witches’ brew,” Dutton said.

Largest Investment

Calpers’s portfolio lost 23 percent of its value in the year ending June 30, the worst year since its founding in 1932. Its private equity bets dropped 31 percent in value, the system said July 21. It responded by raising the percentage of its $180.9 billion in assets it plans to put into private equity, taking advantage of a time when prices for the investments were low, Dutton said.

The system’s investment in Brailer is among the largest it has ever given a first-time private-equity manager. The commitment is bigger than virtually any Calpers has made to firms other than veteran buyout groups such as the Carlyle Group, Blackstone Group LP and Texas Pacific Group Ltd.

“No matter how you look at it, $1 billion is a lot to allocate to someone with no track record,” said Susan Mangiero, a Trumbull, Connecticut-based pension consultant.

Calpers officials expect Health Evolution Partners to return 20 percent to 30 percent a year, said a person familiar with the system’s decision making.

To come up with companies to invest in, Brailer organized task forces of employers and hospital systems to identify areas where waste is rampant. Executives at Calpers, the largest purchaser of medical care in the U.S. after the federal government, also wanted Brailer to find companies that can hold down the health spending of its 1.3 million members, Dutton said.

‘Double Bottom-Line’

“Calpers had a tremendous interest in a double bottom- line opportunity,” said Lisa Suennen, managing member of the venture firm Psilos Group in Corte Madera, California.

Other health-focused investors expressed skepticism about Brailer’s approach. Palo Alto, California-based venture capitalist Bryan Roberts of Venrock, the top-rated health-care venture capitalist by Forbes magazine, said he wonders if Brailer has the right contacts among technology entrepreneurs. Brailer is also bucking a trend toward smaller funds that need fewer hits to make money, said Mike Kwatinetz, a partner at Azure Capital in San Francisco.

“To get a private-equity return on $1 billion, you have to have home runs,” said Les Funtleyder, health care strategist at Miller Tabak & Co. in New York. “It’s harder than it looks.”

Health Investments

When Brailer left the government in 2006 to move to San Francisco, where he lives with his partner Matt Rhoa and their two children, he tried to interest established private-equity firms in his ideas for health-care investing, he said.

Calpers heard about Brailer’s plan from private-equity managers who had seen the pitch and contacted Brailer in early 2007. Neither Brailer nor Dutton will say who made the introduction. The system wanted health investments outside of biotechnology, where risks have jumped along with costs to get new drugs approved, Dutton said.

Calpers announced its Health Evolution Partners investment in June 2007. In September, Brailer disclosed he would put $200 million in early-stage startups, mostly by investing in venture- capital funds including Psilos and Louisville, Kentucky-based Chrysalis Ventures, and another $500 million in larger, profitable companies. The remaining $300 million will be direct investments Calpers may make in companies chosen by Brailer, Dutton said.

‘Space In Between’

Until last November, Health Evolution Partners was still recruiting investing executives, including former Goldman Sachs Group Inc. health-care analyst Chris McFadden and Braden Kelly, a former managing director at General Atlantic LLC. Calpers had invested just $46 million by the end of last year.

“He’s not an early-stage venture guy, and he’s not really a buyout guy,” Dutton said. “He’s working a space in between.”

Brailer has placed his biggest bets on radiological testing because radiology is a “pain point” in the health-care system, he said. Spending on X-rays, MRIs and the like take up almost 10 percent of U.S. health bills, according to the Washington-based trade group America’s Health Insurance Plans.

Medicare’s expenses from radiology tests done outside hospitals doubled from 2000 to 2006, as doctors installed more machines in their offices and may have used them for patients who didn’t need testing, the U.S. Government Accountability Office said in a report to Congress last year.

Radiology Expenses

To cope with rising radiology costs, insurers such as Medicare will eventually have to cut reimbursements to patients, Brailer said. That creates demand for companies that invent ways to deliver more cost-effective care, he said.

This year, Health Evolution put at least $28 million into Homewood, Alabama-based Optimal Reading Services Group Inc., according to National Venture Capital Association data. Closely held Optimal hires doctors to run a hospital’s on-site radiology department, and backs them up with specialists at the company’s telemedicine center in Dallas, where doctors cover night shifts and provide specialized expertise. Brailer also took a stake in Pittsburgh-based Foundation Radiology Group.

Galvin at Fairfield, Connecticut-based GE said Optimal’s clients can use its centralized billing system, implement suggestions from the company’s management consultants who study best practices at hundreds of hospitals, and send images to Dallas for interpretation rather than hire expensive temporary or part-time doctors to cover vacations and weekends.

‘Big Winners’

“Foundation and Optimal are big winners when reimbursements are cut because they have a lot more opportunity to be efficient,” Brailer said.

Optimal can also improve quality by shipping images from smaller hospitals to centralized centers where doctors trained in rarely performed tests read them, CEO Craig Parker said. The company said at an investor conference last year that one of its client hospitals is saving $1.6 million a year in radiology costs.

Palmyra Medical Center, a 258-bed hospital in Albany, Georgia, is one of 163 belonging to closely held HCA Inc. that switched from a local radiologist to Optimal. The hospital expects to cut its $12 million radiology budget by 7 percent, or $800,000, by next year, Palmyra operating chief Mat Gooch said.

“Year two is when we really get the savings,” Gooch said. “We’re not at a million dollars yet, but the potential is there.”

Tailored Insurance Plans

Other companies are using data to create insurance plans that will change patients’ behavior, Suennen said. Psilos- backed startup Triveris Inc., based in Eatontown, New Jersey, is helping craft insurance plans tailored to diabetic patients. The plans pay diabetics and pre-diabetics up to $700 a year to get preventive care that may head off expensive complications.

Minnetonka, Minnesota-based UnitedHealth Group Inc., the nation’s largest health insurer, uses Triveris software to analyze patients’ test results and spot those who need intervention, UnitedHealth executive vice president Tom Beauregard said. Companies including General Electric and Hewlett-Packard Co. offer the policies to employees, Beauregard said, with about 60 more companies set to begin in January.

The software can also identify people at risk of developing diabetes early enough to help prevent onset of the disease, Beauregard said. Diabetes, the seventh leading cause of death in the U.S., helped kill 233,000 Americans in 2005, according to the National Institutes of Health.

Diabetes Risk

“We’re linking incentives to evidence-based medicine and behavior, and giving people options that cut their out-of- pocket expenses,” Beauregard said. “We’re identifying people who are diabetics from the data, and also offering people screens so they can be diagnosed. If I go to being a diabetic, there’s no going back. When people understand that, they will be motivated.”

Closely held Triveris is one example of Brailer’s strategy of backing companies that give patients information about how their health care works, said Jack Rowe, a former CEO of Aetna Inc. who is an adviser to Health Evolution Partners.

For Calpers, the test is whether Brailer can make money on investments while saving Calpers money on health care.

Dutton said it’s too soon to judge Brailer’s performance.

“We think they’re off to a good start,” Dutton said. “The best thing HEP has done in its infancy is avoid self- inflicted wounds.”

To contact the reporter on this story: Tim Mullaney in New York at tmullaney1@bloomberg.net

Last Updated: October 23, 2009 00:01 EDT