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Required Capital Ratio Part 2: How Finances Are Affecting the Boston Merger Market

To read Part 1 about required capital ratio, what it is and what it means, click here.

In February, Cooley Dickinson Hospital in Northampton, Mass., announced it would merge with Massachusetts General Hospital, the Boston-based teaching hospital of Harvard Medical School and part of Partners HealthCare. Terms of the deal were not disclosed, and the transaction is expected to be finalized in the next six to seven months, pending regulatory review.

Cooley Dickinson trustees had several willing buyers to choose from, but they eventually whittled down the competition to Massachusetts General and Baystate Health in Springfield, Mass. Vice President of Principle Valuation Adam Lynch says between those two health systems, Massachusetts General was destined to win out — but not for the obvious reasons.

Previously, Mr. Lynch presented his theory and study of hospital "required capital ratio." A hospital's RCR essentially explains how much it will cost for a hospital to maintain its current operations. RCR is calculated by taking the hospital's unrestricted net assets and dividing them by the contingent capital asset costs (which are the current costs it would take to replace buildings and equipment). In addition, RCR only applies to non-profit hospitals due to their balance sheet structures.

Mr. Lynch says RCR could influence the hospital and health system merger and acquisition market because an organization's RCR denotes its need to update pertinent resources and whether it has sufficient balance sheet capacity to pull it off.

So how did the Cooley Dickinson-Mass General transaction play out? Mr. Lynch believes RCR had a potential role.

The Cooley Dickinson scenario
In 2008, Cooley Dickinson sought out different partners to help with overhead costs, new sources of revenue and expansion of programs. The board of trustees did not think the hospital could remain independent and consequently became a strategic seller.

Cooley Dickinson officials eventually narrowed the field to Massachusetts General and Baystate Health. Massachusetts General is a behemoth in the Boston market, as it is part of Partners HealthCare and is widely regarded as one of the most renowned hospitals in the country. Baystate Health, another large health system with several high-performing hospitals, recently opened its $300 million "Hospital of the Future" at its Baystate Medical Center campus.

Although Cooley Dickinson choose to affiliate with Massachusetts General, Mr. Lynch does not think the decision was necessarily based on Massachusetts General's stronger name recognition — Massachusetts General, and its parent Partners, simply had more balance sheet capacity and the highest RCR, he says.

Out of all the Boston-area health systems with more than $500 million in net revenue, Partners was the only "Tier 1" health system and had an RCR of 127 percent. Mr. Lynch defines a Tier 1 system as an organization that has an RCR of more than 125 percent — indicating it has more than enough resources to replace buildings and equipment with no major problems and is also a very motivated buyer.

Baystate Health, on the other hand, had an RCR of 57 percent, making it a Tier 3 health system. Tier 3 organizations, those with RCRs lower than 70 percent by Mr. Lynch's calculations, do not have all the means necessary to keep up their current operations and replace all future assets and usually are motivated to sell. (Tier 2 organizations have RCRs between 70 and 125 percent and have some leverage in the market. They also have, or are close to having, sufficient balance sheet capacity to replace their buildings and equipment. However, Tier 2 hospitals could become strategic sellers if the market begins to consolidate around them.)

Although Mr. Lynch calculated that Baystate Health could replace all future assets in roughly three-plus years (he divided its shortfall by the increase in net assets), Partners had far more balance sheet capacity for Cooley Dickinson's current needs and future plans, he says.

The Boston merger market
Mr. Lynch admits the RCR is still just one of many tools to explain the hospital and health system M&A market, but in the Cooley Dickinson case, he says it was apparent Partners offered a more financially reasonable opportunity for Cooley Dickinson to maintain its current operations while replacing necessary assets.

Required capital ratio of large Boston-area hospitals and health systems

Mr. Lynch looked at the RCRs of other Boston-area hospitals and health systems (using the most recent financial data of each organization), and compared with Chicago — his first RCR analysis — Boston and the surrounding communities are primed for much heavier doses of consolidation.

Partners was the only Tier 1 health system with more than $500 million in revenue, and there were only two health systems in that revenue category that were in Tier 2 — Providence, R.I.-based Lifespan and New Bedford, Mass.-based Southcoast Health System. Mr. Lynch found several large Tier 3 hospitals and health systems with limited balance sheet capacity, including Boston Medical Center, Tufts Medical Center and Beth Israel Deaconess Medical Center.

A similar picture was painted for the RCRs of hospitals and health systems with less than $500 million in net revenue. Exeter (N.H.) Hospital had an RCR of 214 percent and was the only Tier 1 hospital in that revenue category, indicating it has enough resources to remain independent and financially sound. There were only four Tier 2 hospitals with less than $500 million in net revenue, including Rochester, N.H.-based Frisbie Memorial Hospital (RCR of 106 percent) and Dover, N.H.-based Wentworth-Douglass Hospital (RCR of 89 percent). Mr. Lynch found more than a dozen hospitals in Tier 3 that are in straits when it comes to their balance sheet capacity and ability to replace assets.

Required capital ratio of small and medium Boston-area hospitals and health systems

In the end, every hospital board of directors has several factors to weigh before an affiliation, merger or acquisition is completed. In an era where having solid assets and buildings gives hospitals a competitive edge, RCR could give some insight into what hospital boards are thinking — and in Boston, that may mean even more M&A activity. "What we're seeing in Boston is that we have a lot of Tier 3 hospitals, and that means there's a rush to consolidation," Mr. Lynch says. "The analysis is indicating the Boston hospitals are going to require significant capital improvements, and this need will cause hospital boards to re-think their independence."

More Articles on Hospital Finance and Acquisitions:

Moody's Uses New Scorecard for Non-Profit Hospital Credit Ratings

Moody's: New Forces Drive Non-Profit Hospital Consolidation

Hospital M&A Up 12% During 2011

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