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Required Capital Ratio: A New Financial Measurement for Hospital Mergers

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There has been no shortage of merger and acquisition action in the Chicagoland area over the past year. Resurrection Health Care and Mokena, Ill.-based Provena Health officially merged in November, creating the largest Catholic healthcare system in Illinois. St. Louis-based Ascension Health agreed to absorb Alexian Brothers Health System in Arlington Heights, Ill., this past December. Northwestern Memorial HealthCare is looking to expand outside of its downtown Chicago roots in a potential merger deal with Elmhurst (Ill.) Memorial Healthcare. The list goes on.

The increase in hospital merger talks within the Chicagoland area is only a microcosm of the entire country. In 2011, healthcare M&A deals across the United States were up more than 9 percent compared with 2010.

However, what are some of the root causes of this increase in M&A activity? Why are some hospitals consolidating their markets while others try to stay independent? What is spurring some organizations to make a deal?

Adam Lynch, vice president of Principle Valuation, has a theory, and it revolves around a set of balance sheet financial data. "As I've been watching the number of transactions announced in the hospital marketplace, I've wondered why they were occurring," Mr. Lynch says. "The reasons cited for hospital M&A are often subjective, and it's valuable to understand the market and anticipate the future in an objective way."

His theory of which hospitals may be motivated buyers and which are motivated sellers is based on two hospital financial measurements that he created: contingent capital asset costs and required capital ratio. Contingent capital asset costs are the current costs that are required to replace buildings and equipment. Mr. Lynch says he focused on those two aspects — building and equipment replacement costs — because they are cornerstones of any hospital transaction. "If you're a hospital trying to merge, the primary motivation is the need to access capital to replace buildings and equipment," he says.

Required capital ratio brings everything together. RCR is the hospital's unrestricted net assets (which are similar to retained earnings for a for-profit entity) divided by the contingent capital asset costs. RCR, more or less, explains how much it will cost for a hospital to maintain its current operations.

Hospital tiers of required capital ratioMr. Lynch says RCR is significant for a hospital or health system because it is a more accurate gauge of an organization's need to update its resources and whether it has sufficient balance sheet capacity compared with accumulated depreciation. For example, if a hospital building cost $100 million and the building has a useful life of 20 years, it will depreciate in value by one twentieth every year. So after one year, the accumulated depreciation of that building would be $5 million. However, that is not a sufficient measurement of the hospital's replacement costs because it does not take inflation and other factors into mind, Mr. Lynch says.

RCR compares replacement costs and unrestricted net assets. An RCR at 100 percent is considered to be "parity," or a relatively normal state. Anything above 100 percent is excess capacity, while anything below 100 percent is a capacity shortfall.

A hospital's situation becomes more telling — and more interesting — when it is placed into one of three tiers based on its RCR, Mr. Lynch says:

•    Tier 1: In this tier, hospitals and health systems have an RCR of usually more than 125 percent, indicating they have sufficient balance sheet capacity and the ability to replace their buildings and equipment with no major problems. Large health systems in Tier 1 are motivated buyers, and small hospitals and health systems in Tier 1 have the capacity to remain independent.

•    Tier 2: In Tier 2, hospitals and health systems have an RCR ranging from 70 percent to 125 percent. Large health systems are strategic buyers while small hospitals and health systems are strategic sellers — in others words, these organizations have some leverage in the market and have, or are close to having, sufficient balance sheet capacity to replace their buildings and equipment. However, if the market began to consolidate around them, those hospitals may be compelled to act and would become strategic buyers or sellers.

•    Tier 3: Tier 3 hospitals and health systems — RCRs below 70 percent — are motivated to merge or sell because they simply do not have the means to keep up their current operations and replace all future assets.

Mr. Lynch says this tier system — based on a hospital or health system's RCR — explains a lot behind the current M&A market. For example, let's say a Tier 1 health system is a large and financially strong institution with an RCR of 135 percent. A community-based hospital may have an RCR of 75 percent, making it a more "strategic seller." Because the Tier 1 health system has its building and equipment replacement costs well in-check and has sufficient balance sheet capacity, it is a motivated buyer to expand its market share, while the community-based hospital is in a position where a merger with a bigger system could help maintain its current operations when assets need to be replaced.

Provena and Resurrection's merger is one deal that could also be explained by the RCR. At first glance, many wondered why Provena and Resurrection — two very large Catholic health systems — merged. After looking at their RCRs (Provena at 28 percent and Resurrection at 19 percent), it became clear that both needed financial help and balance sheet capacity in the near future to stay afloat, leading to their eventual merger.

One of the major trends Mr. Lynch has seen from this analysis is the fact that Tier 2 hospitals and health systems are the catalysts of many M&A deals. These hospitals and health systems have to consider their financial stability today with the future costs of tomorrow. "To me, Tier 2 is the most interesting," Mr. Lynch says. "These are the hospitals that will make their decisions very strategically. They don't have to do anything today, but they don't have the excess capacity to say, 'We can be immune to whatever is around us.'"

A factor that could enhance a hospital or health system's RCR is if they have built replacement hospitals. For example, Elmhurst (Ill.) Memorial Hospital and Sherman Hospital in Elgin, Ill., both built replacement hospitals, but they still have their other property on their balance sheet. Selling the old lot could wipe a large chunk of depreciated assets off the books. "If those hospitals sell their old property, the accumulated depreciation could go down pretty significantly," Mr. Lynch says. "The required capital ratio could also go up substantially."

Overall, Mr. Lynch says the RCR could help explain the hospital M&A market but emphasizes that there are still other non-financial reasons behind hospital mergers. The key thing to keep in mind with many of these deals is how strong the hospitals' balance sheets are and how asset costs, specifically for buildings and equipment, will be handled. "It's about understanding where you are — what tier you're in — and how that affects your strategy," Mr. Lynch says. "Unless a hospital changes its strategy, those assets will be replaced. It's an inherent cost to maintain operations in the future."

Related Articles on Hospital Finance and Acquisitions:

Healthcare Consolidation: Key Concepts for Hospitals Seeking Partners

6 Challenging Components of Managing a Hospital's Finances

8 Issues for Hospitals to Consider Before an Integration or Sale

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