7 Common Reasons for Hospital Transactions

We have observed an increase in the number of transactions between hospitals over the past three years. This increase is driven by a host of factors — most notably the Patient Protection and Affordable Care Act of 2010. Observed transactions include outright acquisitions of one hospital by another, as well as joint operating agreements or joint venture structures between previously independent hospitals. Through our direct experience with these transactions and supplemental research, we have compiled the following list of the seven most common drivers of hospital transactions.

1. Financial condition
While demand for healthcare services continues to rise and healthcare constitutes an ever greater portion of the United States Gross Domestic Product, not all hospitals are experiencing robust financial performance. In many markets, hospitals are feeling strained by the increased competition of market consolidation and the pinch of crushing levels of debt and high fixed operating costs.  In some instances, this results in a violation of bond covenants, a reduction in bond ratings, or worse, bankruptcy. As a result, struggling hospitals have chosen to align themselves with a more financially secure health system, either as a proactive approach to remaining viable as a going concern, or as a last resort through the bankruptcy process. A recent case in point is a health system which experienced a credit rating downgrade from "CCC" to "C" in the beginning of this year. A suitor is currently in negotiations to acquire the health system and restructure its liabilities in an effort to save the troubled system from insolvency (names intentionally omitted).

The high and relatively inflexible fixed cost structure of hospitals necessitates growth in size to achieve the economies of scale to remain both viable and competitive. The larger a health system, the better off it is in negotiating payor contracts, contracting for medical supplies and the more it can leverage the costly implementation of information technology systems such as electronic health records. This all comes at a time when hospitals must continue to do more with less. Revenue sources for hospitals are continually under pressure, with the recent sequestration in Washington, D.C. the latest in a string of cost cutting measures impacting the industry. As part of the sequestration, there will be a two percent decrease in Medicare payments to hospitals beginning April 1, 2013.  The pressure on revenues is not unique to government payors, and commercial payors are also taking actions to control cost that impact reimbursement. As such, hospitals must seek to find ways to maintain or increase revenues through additional services or increased volumes, or continually cut expenses in order to stay profitable and maintain the capital needed to stay competitive.

2. Access to capital
The rapidly changing landscape of healthcare has taken the need for capital to new levels. As electronic health records replace paper charts, health systems have been required to invest millions in the software, hardware and staff training necessary to implement EHRs throughout their systems. Additionally, advances in medical technology have led to continuing increases in costs associated with the latest technologies available in medical treatment. Case in point would be proton therapy for cancer radiation, as a proton facility can cost in excess of $100 million to construct. Expansion of facilities to include new service lines or centers of excellence can be costly, though necessary, to stay competitive. Even routine maintenance capital outlays, such as building renovations or outdated equipment replacement, can prove costly given the highly capital intensive nature of health systems.

Consolidation in local healthcare markets has been occurring rapidly in recent years, as health systems have purchased freestanding imaging centers, ambulatory surgery centers, physician practices and other outpatient ancillary businesses. Without adequate access to capital, a health system may find itself unable to participate in this consolidation activity and ultimately lose key services and market share to its competitors. An example of this includes formerly independent physician practices, who may have previously serviced multiple hospitals in a given market, but after being acquired they now only utilize the hospital where the physicians are employed. This may force the now weaker health system to seek a sale of itself to a larger health system, as it loses market share and has a harder time finding the providers necessary to provide adequate care to the system's patients (Note: the volume and value of physician referrals may not be taken into consideration when determining the fair market value purchase price of a physician practice, regardless of any potential impact on health system).

3. Declining and/or changing census
Population changes to a specific region have led to increased consolidation among hospitals as well. Certain hospitals have observed shrinking populations in their service area, which may not have been projected when a facility was built or expanded years prior. This is especially true in rural markets and in the Midwest, where several manufacturing plants have closed or been outsourced. By merging with another health system in the local market, a hospital struggling with revenue associated with its low patient census may be able to realize overhead expense synergies and relieve margin pressures. 

Another population trend relates to a shift of patients to more high-deductible plans with health savings accounts. Health systems generally have a harder time collecting fee-for-service payments from their patients as opposed to payments remitted from commercial payors. As a result, a shift toward more private payors will put pressure on revenue, and in turn, profit margins.

4. Pricing power
Commercial payor consolidation has been increasing in recent decades. According to IBIS World, in the five years ended 2012, the number of health insurance companies decreased by approximately 1.8 percent annually due to consolidation, and consolidation is expected to continue at a 0.3 percent annual rate through 2017. According to the Department of Justice and Federal Trade Commission, an industry is highly concentrated if the Herfindahl-Hirschman Index is greater than 2,500. Based on this standard and based on research conducted by The American Medical Association, 70 percent of the United States' 385 metropolitan areas are highly concentrated for insurers, while in 38 percent of areas one insurer had a share of at least 50 percent. This consolidation in the managed care industry has led to payors having more clout in regards to contract negotiations with regional and community health systems.  As a result, health systems have consolidated themselves as a way to increase their size, and in turn increase their own negotiating clout with managed care companies. 

While much of the consolidation happened in the mid-1990s through the early 2000s, recently we have observed mergers of several of the big commercial payors. In 2012 alone, the industry experienced Aetna's $5.6 billion merger with Coventry Health Care, WellPoint's $4.9 billion acquisition of Amerigroup, and Cigna's $3.8 billion acquisition of HealthSpring. These large industry consolidations are possible due to the decades old antitrust exemption for the health insurance industry contained in the McCarran-Ferguson Act of 1945. There has been effort in recent years to amend this piece of legislation through the Health Insurance Industry Fair Competition Act, which requires that the health insurance industry be held to similar antitrust standards as other industries. While in 2010 the bill passed on a 406 to 19 majority vote in the United States House of Representatives, the bill did not make it to a vote in the Senate before the Congressional recess of the 111th Congress. The bill was reintroduced to the House Judiciary committee by sponsors Rep. Peter DeFazio (D-Ore.) and Louise Slaughter (D-N.Y.) in February of 2012. The legislative attention the industry has received in recent years has likely helped spurn the recent wave of consolidation.

5. Management

Frequently large health systems have more experienced leadership and greater breadth and depth of management. The benefits of having an experienced and proven leadership team in place for a health system can be easily overlooked given the multitude of seemingly macro-level pressures. While many of these industry pressures are universally shared, a savvy leadership team can navigate these turbulent industry conditions with a greater likelihood of success. Frequently, smaller hospitals do not have the manpower or depth and breadth of management experience to steer through the many nuances of PPACA and/or prepare for the outcomes the new law will create.  Smaller hospitals may also have difficulty with succession planning, particularly as seasoned management teams opt for retirement instead of retooling for the forthcoming industry transformations. Without resources it can be very difficult to train and groom a new set of executive leaders, and it may be more effective to simply tap into an already proven executive team at a different health system.

6. Lack of name recognition

A number of transactions have involved the use of a more recognized name, in the hopes of shoring-up or expanding the existing services offered to patients. Hospitals may look for the use of a more recognized name in order to stop patient leakage from primary and even secondary markets. Health systems such as the Mayo Clinic, Cleveland Clinic and Johns Hopkins Hospital are internationally known for their reputation of quality and innovative patient care. On a more regional level, many areas throughout the country contain a health system whose reputation, though not national, is recognized as providing the highest quality of patient care for their local or regional market. For a lesser known hospital, an alignment strategy that permits re-branding with the trade name of a better known system may prove beneficial in boosting a declining or stagnant patient base. A transaction such as a joint venture or similarly structured alignment between hospitals allows a lesser known hospital to not only utilize the brand name of a better known competitor, but may also improve access to care. This is particularly true when the alignment partner has specific expertise, including centers for excellence in oncology, orthopedics, and cardiology.

7. Increased patient base
The quickly changing, and often ambiguous, landscape in healthcare has required health systems to become more dynamic and nimble to remain profitable, avoid regulatory violations and to provide the care their patients have come to expect. Recent developments include the emergence of accountable care organizations, which are expected to replace traditional fee-for-service payment models. This has resulted in health systems acquiring a variety of healthcare entities from physician practices to hospitals as they seek to increase their ability to provide adequate healthcare at all phases of the care process as efficiently as possible. The continued rollout of PPACA will also lead to a larger amount of the population seeking healthcare, which has led health systems to acquire other health systems as they seek to prepare for the increase in demand for their services. The Congressional Budget Office projects the number of people gaining insurance coverage the newly developing exchanges will rise from 7 million in 2014 to 24 million in 2016, while the number gaining coverage through Medicaid will rise from 8 million in 2014 to 11 million in 2016.  Given the high fixed costs associated with running a health system, a failure to increase its patient base as a result of the aforementioned increase in demand may result in a health system finding itself at a disadvantage to its competitors.

Conclusion
There are numerous factors driving the increased number of hospital transactions in recent years. Regardless of the driving force behind the transaction, it is more important than ever to understand the opportunities and risks that may present.  Whether looking to acquire a hospital or enter into a joint venture or other alignment, hospital management must be prudent in selecting advisors who are well versed in the various structural, legal, and valuation issues manifest in these deals.

Contact the authors at (303) 688-0700 or njaniga@hcfmv.com. Learn more about HealthCare Appraisers, Inc. at www.hcfmv.com.

More Articles on Hospital Transaction:

Developing a Regional Hospital Strategy: Key Lessons and Takeaways
More Than Money: The Changing Landscape of Hospital Consolidation, Affiliation

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