Key tips for a successful hospital merger or acquisition

The only constant in life is change. This axiom has as much application in business, as it does in life. And no industry has experienced more change and upheaval in recent years than the healthcare industry.

Independent hospitals, in particular, have been caught up in a sweeping national trend of consolidation, a trend that shows little sign of abating. The forces driving change are varied, as are the approaches hospitals are taking to adapt. One of the clearest consequences of change is the recent surge in merger and acquisition activity. Hospital M&A is booming.

There has been much debate about whether consolidation in the healthcare sector will help or hurt patients, with many arguing that fewer hospitals will result in higher prices and inferior care. Others argue the exact opposite. What can't be argued is that consolidation is happening at a rapid pace in communities across the country. For example, the Detroit News recently reported that metro Detroit will soon be down to its last independent hospital. A similar story is playing out in other cities and states across the country.

So what are the catalysts driving hospital consolidation activity, and what issues should buyers or sellers of hospitals consider when pursuing a deal?

Issues Driving Hospital Consolidation

Access to Capital

At the same time that independent hospitals need more access to capital to address aging infrastructure, equipment and information technology, cash flow is stagnating and the ability to tap outside financing is diminishing. Moody's Investors Service issued a negative 2015 outlook for not-for-profit hospitals (which make up more than half of all U.S. community hospitals according to the American Hospital Association), projecting that the financial and business fundamentals of this sector will be weak over the next 12 to 18 months.

Moody's cited three main factors likely to impact financial performance in 2015. First, little to no cash flow growth, with operating cash flow growth ranging from negative 0.5% to positive 1.5%. Second, weaker operating margins due to spending on needed capital investments. Third, low revenue growth.

With margins razor thin, hospitals are increasingly looking to transactions to achieve economies of scale and boost profitability.

Regulatory Requirements

Hospitals are operating in an increasingly burdensome and expensive regulatory environment, and are looking to M&A to better - and more affordably - overcome regulatory challenges.

The healthcare regulatory framework is complex and far reaching. The Health Information Technology for Economic and Clinical Health Act (HITECH) requires implementation of both electronic health records (EHR) and the Centers for Medicare & Medicaid Services' (CMS) meaningful use (MU) rule. The MU rule requires providers to demonstrate that they are making "meaningful use" of certified EHR technology. These requirements are leading hospitals to increase their IT know-how and equipment capabilities through mergers and acquisitions.

The Affordable Care Act (ACA) and the Health Insurance Portability and Accountability Act (HIPAA) also add significant new regulatory burdens, and are driving consolidation among hospitals. The ACA is adding more patients into the system and HIPAA adds to the costs of treating those patients. For example, HIPAA requires hospitals to provide patients with electronic copies of their medical records.

While regulatory requirements are leading to more consolidation in the industry, in some instances regulators are standing in the way of transactions. The surge in mergers has led to greater scrutiny from the federal government, which has challenged a number of transactions on antitrust grounds.

Buyers in a healthcare transaction should be aware that most, if not all, deals carry some compliance risks. If an organization has sound strategic and or financial reasons to pursue a transaction, it should not necessarily be deterred by compliance risks alone. Rather, buyers should evaluate compliance risks in the context of the entire transaction, and be prepared to mitigate them through compliance remediation plans, and require representations and warranties that address the other party’s compliance with relevant laws and regulations.

A Changing Model of Reimbursement

The federal government has been actively trying to change the way doctors and hospitals get paid, focusing more on quality of care over quantity of care. The ACA expanded payment models that reward healthcare providers based on the value of the care they provide, as opposed to the amount of care they provide. And the Obama administration recently announced big changes to the way Medicare payments will be made, setting a goal to have half of all Medicare payments be based on qualitative measures by 2018.

A shift to value based payments has been taking place in the private sector as well. The Washington Post recently reported that approximately 20 percent of provider payments by Blue Cross entities "are through contracts that try to prioritize quality over quantity," and that 28 percent of Aetna's reimbursements are in value based contracts - which is expected to jump to 75 percent by 2020.

Because fees and payments are being tied more closely to value, healthcare providers are seeking better ways to integrate the care they provide, and more ways to improve the value they provide. Consolidation can help hospitals and medical staff work more closely together and coordinate care for better patient outcomes.

In addition to these main drivers, there are other considerations including expanding market share for urban based providers including targeting neighboring rural areas to secure patient flow, particularly for more complex procedures. Whatever the market or industry reason for hospital consolidation, it is well underway and buyers and sellers need to have the requisite tools to ensure a successful transaction.

Tools to Ensure a Successful Transaction

There are many steps to be taken, and challenges to overcome, to complete a successful healthcare transaction. A few of the most important issues to think about include deal structure, due diligence, contractual protections and integration strategy.

Choosing the Right Deal Model

Hospital transactions come in many varieties. An asset purchase involves a purchaser acquiring the assets of a seller. In an asset deal, the risk of successor liability is low, because a buyer typically only assumes certain liabilities that are identified in the purchase agreement. However, in the context of a hospital transaction, there is a risk – one that should be analyzed during due diligence – that a buyer will assume Medicare liabilities of the seller.
Another common deal model is a joint venture. Join ventures can be structured as a “buyer joint venture,” “seller joint venture,” or “multi-party joint venture,” all of which involve two or more entities joining forces and owning and operating a new entity.
Other alternative models – which fall short of a merger, asset purchase or joint venture – are also used to realize the benefits of a transaction without a change in ownership or corporate structure. An example is a management services agreement pursuant to which a health system manages an independently owned hospital for a fee.

Choosing the right structure, which is dependent on the facts and circumstances of a particular situation, can significantly impact the success of a hospital transaction.

Thorough Due Diligence to Uncover Risks and Unlock Synergies

Regardless of the nature of the deal or the buyer, thorough financial and operational due diligence is critical to identify obstacles as well as opportunities that may impact the success of a healthcare transaction. Indeed, due diligence is key to either confirm or rule out the business and economic rationale for a transaction.

It is through due diligence that buyers – whether strategic or financial – can uncover the cost savings and synergies that can be achieved through consolidation. For example, back-office administrative functions can be combined and redundant positions eliminated. Purchasing and negotiating power with vendors (including GPOs) and suppliers can be increased. Economies of scale can be achieved, and duplications of effort can be identified, related to the costs
of compliance with federal regulations related to electronic health records and IT protocols. Assumptions about these and other benefits are often made by parties when entering into a transaction, but due diligence gives the parties the opportunity to test these assumptions.

Due diligence is also the tool that allows parties to test assumptions and representations related to revenue. Integrity of revenue is a key issue in every hospital transaction, as different entities have different processes for documentation, coding and billing for private insurance, Medicare and Medicaid claims. Due diligence helps uncover issues with coding and billing that affect revenue integrity, including upcoding, unbundling, duplicate billing and lack of documentation.
Finally, hospitals have myriad agreements in place – many of them complex – with third party entities that should subject to careful review in a thorough due diligence process. For example, physician agreements may be undocumented or not properly documented, and could give rise to Stark and Anti-Kickback issues for the hospital. These potential landmines need to be identified so they can be addressed as part of the transaction.

Contractual Protections and Insurance

Because of the healthcare industry’s complex regulatory framework, the potential for fines and penalties related to regulatory violations, and active governmental enforcement divisions giving special scrutiny to healthcare transactions, representations, warranties and indemnification clauses related to regulatory compliance are important. For example requiring thorough representations and warranties related to regulatory compliance often forces a seller to conduct its own internal due diligence, which may unearth problems that a buyer may not have found on its own. And if problems do arise, indemnification obligations can help mitigate financial risks.

But as important as these contractual provisions are from a legal and financial standpoint, the protection they provide is limited, particularly if the seller is distressed and thus unable to fulfill its indemnification obligations to the buyer.

More parties in hospital transactions are turning to M&A insurance to transfer risk to insurers related to regulatory compliance, as well as other contingent liabilities, such as tax, litigation, and environmental risks. Insurance can provide an important protection against inaccurate financial statement representations as well.

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These policies are also useful in determining pricing strategy, as hospital buyers can quantify the dollar value of the risks they face once the fixed fee of the policy is determined. Buyers, therefore, can offer a seller smaller indemnity caps and/or escrows while shifting the cost of the insurance during transaction price negotiations.

Integration Strategy

Once the financial rationale deal is confirmed, due diligence is performed, and negotiations and documentation are complete, the success or failure of a transaction hinges upon the parties’ ability to implement an integration strategy – ideally one that was developed from the outset of merger discussions – that leads to success over the long-term. A successful integration plan will help to merge the cultures and future goals and visions of the entities.

Conclusion

There are many variables and catalysts influencing the systemic change that is underway in the hospital sector. Given the need for capital, heavy regulatory burdens, and changing models of reimbursement, independent hospitals are increasingly turning to mergers and acquisitions as a means to address the business and financial challenges they face. Through careful planning, thorough due diligence, and strategic integration post-transaction, hospitals can join forces to meet the challenges they face and succeed in today’s ever-changing healthcare marketplace.

Peter J. Smidt is a managing director and Practice Group Leader, Transaction Services, at Conway MacKenzie Inc.

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