Healthcare Reform Paving Way for More and Different Hospital Merger & Acquisition Activity

As capital markets begin to open up and healthcare reform starts to take shape, momentum for hospital acquisition activity is building, although the buyers and sellers may have different characteristics this time around.

That's the perspective several M&A experts from Juniper Advisory, a Chicago-based independent and privately held investment banking firm, recently shared when Juniper Partner James Burgdorfer, Vice President Borislava Karageorgieva and Associate Rex Burgdorfer sat down to discuss the outlook for healthcare deals and hospital valuations in the months ahead.

Signs of an uptick in M&A activity have mounted since President Obama's healthcare reform package was enacted. From Vanguard Health Systems' proposed acquisition of Detroit Medical Center, announced in mid-March, to HCA's apparent pursuit of a $3 billion initial public offering, hospital operators are eyeing growth opportunities.

"The potential exists for a dramatically increased pace of consolidation of what is currently a very fragmented industry," says James Burgdorfer. If HCA does indeed follow through with an IPO, and it is well-received by the market, that will be one more sign that institutional investors believe the healthcare industry is ripe for consolidation, says Rex Burgdorfer.

That said, tomorrow's hospital M&A activity might look different from what we've seen in the past few years.  "Who is doing what to whom will change," says James Burgdorfer.

In recent years, the M&A market was largely driven by for-profit hospital companies  purchasing and "converting" nonprofits that were struggling to raise capital on their own. Historically, community-based not-for-profit hospitals have been less acquisitive than their for-profit counterparts.

"That is changing, as more not-for-profits are coming to the conclusion that larger scale is needed," James Burgdorfer says. More regional hospital systems are likely to blossom and expand as community hospitals look to build market share and spread their rising costs across a broader base of operations. Two examples of this trend are Advocate Health Care and NorthShore University HealthSystem, both of which have brought more Illinois hospitals under their umbrellas in recent years and solidified their positions within their respective markets.

James Burgdorfer explains that we are at a crossroads of sorts in hospital merger cycles. On the one hand, the financial crisis that began in 2008 — which reduced investment portfolio values and dried up lending opportunities — made it very difficult for hospitals to enter into or complete change-of-ownership transactions, which drove down the number of M&A deals. On the other hand, with healthcare reform recently passed, hospital operators are now trying to determine what the impact might be when many more consumers enter the system with insurance. "There's consternation in the market right now," James Burgdorfer says. "In some cases it's leading people to swing into action; in other cases it will take a year or more to net out."

The world of not-for-profit hospitals is divided into those who are in a strong enough position to acquire other hospitals and become larger regional systems, and those that may be acquired by them, James Burgdorfer says. In recent years, hospitals have become more leveraged, and their average age has risen. When the cost of technology is added to the mix, there are a growing number of hospitals that "can't afford to thrive," he says.

The growth of nonprofit acquirers is also going to affect the structure of deals and the oversight activity of state attorneys general, he suggests. Cash deals are being replaced by investment commitments, debt assumption, and the lure of more favorable payor contracts that a hospital might not have been able to negotiate on its own.  "Attorneys general will look into those deals more carefully as transactions shift money from one part of (a state) to another," James Burgdorfer says.

Within this acquisition framework, hospital valuations (as measured by precedent transaction multiples) have not changed much on paper during the past several years, dropping only slightly, says Ms. Karageorgieva. However, the data — or lack thereof — may be misleading or difficult to interpret.

Ultimately, according to James Burgdorfer, what determines a hospital's value is a combination of the quality of the market it is in, the hospital's position and reputation within that market, and the level of competition among potential buyers at the time of a deal. He believes there is not much a hospital can do to change its value, at least in terms of how it operates its business. "The wisest thing you can do is time your appearance in the market of acquisitions well," he suggests. If there is change within a hospital's market, "you want to be on the leading edge of it," he says.

One of the problems at many community hospitals is the length of time it takes to put the wheels in motion for a potential change in ownership. This derives from their governance structure and the sheer size of some volunteer boards. Often a hospital waits until it has defaulted on a maintenance provision of its bonds to consider its strategic alternatives, and by then it may have to sell extraneous assets and bring in consultants to continue operations. These efforts may stave off the inevitable, but they do nothing for the underlying problem, which is a need for capital. "They are often slow to come to grips with the landscape," he says.

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