The axiom “size and scale matter” has become a business truism for good reason.
Greater size is equated with economies of scale that generate larger cash flows and easier access to lower-cost capital. A healthier bottom line, in turn, provides protection against volume shifts and the ability to invest in capabilities that meet market demands and spur growth.
Relevance is just as important as size and scale. As value-driven population healthcare takes hold, the most sought-after health systems will be those that can offer superior quality, access, and patient experience at an efficient cost for a continuum of services within a region. For systems that are looking to add services or capabilities to become high-performing regional networks, buying typically is faster than building.
The healthcare industry has been pursuing size/scale/relevance opportunities with gusto; hospital and health system acquisitions and mergers have been occurring at an historic pace during the past decade. The number of transactions has increased nearly 76 percent since 2007, with continued growth expected during the next several years, according to Kaufman Hall’s research and databases.
Given the high stakes inherent in hospital acquisitions, system leaders need to follow a deliberate process, such as the one presented below, to increase their chances of finding a partner that is a strategic match and to ensure that the two organizations achieve the anticipated benefits of integration.
1. Set goals and objectives
Health system leaders should be as transparent and specific as possible about their goals objectives, and actively manage expectations throughout the partnering process. The goals and objectives likely will start out as broad statements and become more defined and detailed as the acquisition progresses. Leaders might begin with a 10,000-foot strategic goal to guide initial discussions about potential partners, such as: “The acquisition will help position our health system to effectively manage population health in specified communities under a value-based care model.”
Then at the 1,000-foot view, when health system leaders are drafting a letter of intent with an identified partner, they will need to develop specific objectives to guide the transition and integration, such as: “The combined entity will migrate to one vendor’s IT platform within three years.” Finally, at the 100-foot view, specific and enforceable legal terms must be included in the definitive agreement to finalize the partnership. These will govern the partnership consistent with the overarching goals and objectives of both parties.
2. Proactively pursue partners
While the number of independent hospitals or health systems that might be interested in partnership opportunities is declining, some systems and hospital operators have been divesting hospitals, creating unexpected opportunities. Tennessee-based Community Health Systems is well on its way goal of divesting 30 hospitals, most recently selling five hospitals in Pennsylvania.
Because acquisition opportunities are narrowing and competition for well-positioned hospitals is stiff, health system leaders need to be strategic about how they approach and pursue potential partners. Having a skilled advisory team to handle the financial, technical and legal aspects of acquisitions is critical. The sooner the team is put together, the smoother the process will go.
The nature of initial discussions with potential partners will vary, depending on the previous relationship between the parties, the preferences of leaders, and other factors. For instance, the health system CEO may begin by directly contacting the hospital CEO. This conversation might be followed by a meeting with key members of the hospital’s senior leadership team and external advisors.
In other cases, the exploratory process may be more formal and start with the development of a detailed proposal. A well-designed partnership-exploration process allows for appropriately timed and confidential interactions and meetings between key constituents, including boards, management, and physicians.
3. Evaluate strategic fit
If a health system has had a successful clinical or operational partnership with a hospital in its region, it may make sense to pursue an exclusive negotiation with that single prospect. Otherwise, multiple potential partners should be identified, both obvious and outside-the-box candidates. Consideration of multiple partners as a starting point allows health system leaders to think broadly. Each candidate should be assessed individually and comparatively, based on its potential to help the health system meet prioritized goals and objectives.
The key elements for ensuring good-fit partnerships include:
• Strategic position: The acquisition must improve the health system’s ability to meet core goals, such as entering into risk arrangements. Service line performance and utilization, quality statistics, payer mix and historical credit analysis also should be evaluated.
• Cultural compatibility: The top reason cited for nearly half of partnership terminations is lack of cultural compatibility. Enough said.3
• Financial considerations and projections: Baseline financial projections will help the health system understand potential benefits and risks associated with the acquisition. Details on the amount and timing of any of the potential partner’s capital commitments, as well as any debt obligations the system would need to fulfill also must be evaluated.
• Governance structure and control: The two parties need an understanding of the level of control each organization and its physicians expect to have in strategic planning, budgeting, and other issues, as well as whether specific clinical services will be enhanced, consolidated, or discontinued.
• Execution/implementation of operational and strategic changes: Health system leaders need to estimate the investment of time and money required to integrate with the potential hospital and implement desired changes.
While some of the potential strategic and financial synergies can be quantified (e.g., projected financial performance, service utilization), other factors, such as cultural compatibility, are qualitative in nature. Seeking input from all members of the organization’s full leadership team is recommended.
4. Identify the best acquisition structure
When the goal is full integration with an acquired hospital, health systems commonly structure the transaction as either an acquisition (also known as an asset acquisition or stock acquisition) or a merger/membership substitution (also known as a change of corporate membership). Which partnership structure is most appropriate depends in large part on whether the organizations are for-profit or not-for-profit.
Under an asset acquisition, the health system acquires the operational assets in exchange for cash and/or non-monetary commitments. Depending on how the arrangement is negotiated, the acquirer has some flexibility in selecting which of the hospital’s debts and liabilities to assume. Typically, at least one entity in an asset acquisition is a for-profit organization.
With membership substitution, the health system becomes the sole corporate parent of the acquired hospital. Instead of paying the hospital a purchase price, the health system makes financial and nonfinancial commitments to the hospital (e.g., facility investments, assistance in developing an outpatient network). While the hospital cedes governance and management to the health system, the two parties typically negotiate some type of shared decision-making arrangement. Membership substitutions are the most common structure used when two not-for-profit organizations want to fully integrate.
5. Determine a reasonable price/financial terms based on comparative data
A common mistake acquiring health systems make is paying too much for a hospital. Understanding the difference between a hospital’s value and price is key to avoiding this potentially costly error. Value is what a hospital is estimated to be worth to the buyer. Price is the amount the acquiring health system actually offers to purchase the hospital. Typically, the price is based on recent market prices for similar transactions and may be lower than the estimated value to the buyer. While not-for-profit transactions often are structured with no actual purchase price, financial commitments as part of a transaction will become the implied price. Extensive, up-to-date pricing from similar healthcare mergers and acquisitions is needed to determine a fair, market-based price or financial terms. An acquiring health system should seek proprietary pricing data from an advisor that is active in hospital and health system mergers and acquisitions nationwide.
6. Ensure that antitrust regulations are not impediments
The Federal Trade Commission has challenged a number of major healthcare mergers in recent years due to concerns about increasingly non-competitive markets. Even acquisitions between rural hospitals are drawing the FTC’s attention. Health system leaders should be informed early on regarding actionable alternatives for preserving competition post acquisition/merger, and understand the financial analyses regarding the proposed transaction. Both the Department of Justice and FTC focus on the Herfindahl-Hirschman Index, which is the measure of market concentration and competition among market participants. At the root of past antitrust interventions, it is a basic financial analysis that considers the competitive impact on local markets or regions. Health system leaders need transactional expertise—including strategic, financial, and legal input—early on—to assess whether a potential transaction may cross an antitrust line, and how to avoid or address any antitrust issues.
7. Conduct early and thorough integration planning
Transaction planning and execution should occur in an overlapping rather than sequential manner. To ensure the effective integration of the hospital and health system, leaders should begin planning for how the organizations will be integrated soon after a letter of intent is signed (Figure 1). Transition planning involves many people collaborating across both organizations, and is best started immediately after the parties are allowed to collaborate from a regulatory perspective.
Integration and transition planning should be driven by leadership and based on the financial, operational, strategic, and capital rationales for the acquisition. Laws and regulations regarding what activities can and cannot occur prior to transaction approvals must be followed. Various teams comprised of representatives from both organizations should develop plans for how to achieve specific goals, from combining departments to integrating IT systems. Then, following the issuance of a definitive agreement that finalizes the acquisition, the two partners will be prepared to move into full implementation mode using the already-developed plans as a roadmap.
8. Be open to other partnership approaches
One final recommendation is to keep an open mind to partnership approaches other than acquisition. While an acquisition is a common strategy for growth, particularly when full integration is the goal, many other partnership structures are being used successfully in healthcare today, from collaborative network arrangements and management service agreements to joint ventures and leases. By staying flexible about how their organizations achieve partnership goals, health system leaders will be more likely to achieve desired ends.
Authors Biographies
Kit A. Kamholz is Managing Director, Kaufman, Hall & Associates, LLC, Skokie, Ill. With more than 20 years of merger and acquisition experience focusing on the healthcare industry, Mr. Kamholz provides services related to merger, acquisition, divestiture, joint venture, and investment transactions, as well as strategic options assessments, valuations, fairness opinions, and other strategic financial advisory services. (kkamholz@kaufmanhall.com)
David Cohen is a Senior Vice President of Kaufman Hall and a member of the firm’s Mergers and
Acquisitions practice. He provides a range of strategic-financial assessment and transaction services, both on the sell side and the buy side. He also advises on joint ventures and other partnership arrangements in many healthcare sectors. (dcohen@kaufmanhall.com).
The authors can be reached at 847.441.8780.
1 Kaufman, Hall & Associates, LLC, proprietary partnership transaction database.
2 Morse, S.: “Community Health Systems to Sell Five More Hospitals.” Healthcare Finance, May 31, 2017. http://www.healthcarefinancenews.com/news/community-health-systems-sell-fivemore-hospitals-continued-divestiture
3 Morse, S.: “Community Health Systems to Sell Five More Hospitals.” Healthcare Finance, May 31, 2017. http://www.healthcarefinancenews.com/news/community-health-systems-sell-fivemore-hospitals-continued-divestiture
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