Hospital mergers: Do your due diligence

In an earlier post, I looked at drivers of consolidation and the top eight reasons why a community hospital would consider joining with a larger hospital or system. Once a decision is made to move forward with some level of affiliation, the independent would need to find a suitable partner.

The first step is to determine the goals of the partnership and the desired characteristics of the larger hospital or health system. A chief consideration for any independent looking to partner with a larger hospital or health system is to achieve financial stability. Ideally, the potential partner should have a strong credit rating, a stable credit profile and a willingness to support and invest in the smaller facility.

The next step for the independent is to try to rectify any problems that would deter potential suitors regarding any financial (bond issuances, pension liabilities, capital leases, interest rate swaps and others) or regulatory liabilities. It also needs to provide a complete compliance plan, detailed histories of accreditation reviews, Medicare audits, environmental surveys and financial and billing audits.

The Financial Nitty-Gritty
While due diligence is being undertaken, a comprehensive balance sheet analysis along with an evaluation of the debt instruments of both entities needs to be completed. Special attention should be given to the documents of any existing financings that may be in place with either party. Some of the provisions that might need to be addressed include the following:

• Redemption or defeasance – Will the documents require that a current financing be either redeemed or advance refunded through a defeasance? If yes, how will this impact or hinder the transaction? Redemption is less costly; however, if there is a lock-out period on the bonds, then defeasance will be required.
• Membership substitution or asset transfer – Will a trust indenture allow a substitution in membership or transfer of assets? Leadership should know the requirements that need to be met in order to allow for this. 
• Transfer of assets out of the obligated group – How will the new parent be supported financially?
• Change in control – Although most debt structures have broad provisions for mergers and acquisitions, they often require prior approval from bondholders or lenders prior to the transaction.
• Approvals and consents – What parties are required to approve changes to these provisions? Typically the trustee, who serves on behalf of the bondholders and issuing authority, may be required to approve any changes. 
• Restrictions on admission into the obligated group – Bond documents address how an asset or entity may become a member of an obligated group. An obligated group allows organizations to combine assets or entities to create a single entity that becomes jointly and severally liable for debt.
• Interest-rate mitigation contracts – Swaps, caps or collars may impact the decision or timing of the transactions. 

Additionally, hospitals must also evaluate the impacts of a merger on their individual investment portfolios. The best way to protect investments is to have a highly liquid, well-diversified portfolio. The acquiring system also may choose to liquidate the investment portfolio to pay down existing debt, or if existing debt is not paid down, liquidated investments are re-invested by the acquiring institution.

In the case where a merger is between two smaller hospitals, the investment strategy should be reviewed before, during and after the merger. To stabilize, ensure liquidity and in anticipation of a very different debt structure of the resulting entity, they should introduce a new strategy for the risk profile as determined by the new entity’s financial strength and risk propensity of its board members.

No Easy Button Available
Hospital affiliations, particularly mergers, can be challenging. During the process it’s important to have a certain degree of alignment in terms of mission, strategies, services and culture plus a shared understanding of what party will assume the predominant role after the merger.

Deals often take time and are slow to coalesce. At the same time, market conditions can change rapidly, so hospitals looking to partner must be nimble and react quickly to new realities. Transparency, flexibility, attention to details and open communication with stakeholders will make the transition from being an independent to being a health system not exactly easy, but easier.