As healthcare organizations explore opportunities for mergers or collaborations, their very first step with any prospective transaction should be to undertake a structured process to assess the transaction’s true viability.


The recent surge in merger-and-acquisition activity in health care has gone beyond the boundary of such activity as seen in the past. Healthcare organizations today are pursuing a wide variety of transactions in the form of mergers, affiliations, and partnerships that tend to be much more complex than traditional combinations from previous decades. In the past, the main goals of a merger were to achieve economies of scale and improve market position and leverage. Today, most healthcare organizations see such transactions as strategic platforms for achieving economies of scope, scale, and skill and delivering value-based care.

Given the increased complexity of today’s transactions, ensuring their success also requires, much more than in the past, a highly sophisticated planning process. And a key step all too often overlooked in the process is to perform at the earliest stages—even before due diligence—a well-structured and in-depth analysis of the transaction’s financial impacts and viability, including potential benefits and pitfalls.

We call this analysis a pre-transaction stress test, because it involves running the potential deal through a series of financial and strategic scenarios that gauge its ability to withstand stresses under various possible or likely circumstances. The process is built around the following 10 key questions.

1. What Are the Expected Financial Benefits, and Are They Achievable?

All healthcare mergers and partnerships aim in some way at financial benefit. Typically, however, the financial benefit is poorly defined at the early stages. As a result, healthcare leaders may be tempted to commit to a transaction before having fully examined and established the financial case. To circumvent this risk, leaders must establish in early discussions the exact means by which the transaction will generate financial benefits.

This effort begins with identifying the specific mechanisms expected to generate revenue in the combined organization. For example, if the two organizations’ leaders believe a merger will facilitate growth, they should specify the services that will drive this new volume, starting with the following fundamental considerations.

If the expected benefit is inpatient growth, which service lines will drive the increase. Points to consider here include whether the focus should be on strengthening existing services or adding new service lines, and the extent to which each partner brings centers of excellence that the other partner does not offer.

If outpatient growth is expected, how that growth will be accomplished. For example, the strategy for expanding outpatient services might include adding ambulatory care sites or seeking to improve access for specific populations. Mapping these outpatient sites and understanding proximity and patient travel times to pre- and post-acute facilities can be helpful.

If the vision includes growth in physician practice revenue, how that growth will be achieved. Possible strategies include increasing the number of primary care physician practices to provide stronger referral volume for employed specialists and implementing quality-incentive payments, made possible by vertical integration. It also is important to ask whether the physician financial and operational infrastructure is prepared for this growth.

Next, the leaders should develop realistic estimates. All too often, executives focus exclusively on easily quantifiable dollars tied to patient volumes and supply chain savings. Not enough attention is given to potential financial benefits from improved productivity, which are harder to quantify but can have significant impact on the performance of a combined organization. Many entities seek economies of skill that can translate into enhanced capabilities and, in turn, create improved performance and productivity.

The third step in assessing financial benefits is to establish a time frame for financial milestones that is acceptable to both the governing board and executive leaders. Organizations typically want to realize most of the economic benefits of a transaction within the first three to five years. Whether this time frame is realistic will depend on current performance. If the combining organizations are struggling financially, there tends to be an opportunity for more rapid change and faster realization of financial benefits. Conversely, if the combining organizations are strong, an “if it ain’t broke, don’t fix it” mindset may prevail, which can help facilitate a stable transition but also can delay the realization of anticipated synergies.

2. What Efficiencies Can Be Realized Only Through the Transaction?

Operational efficiencies are a type of financial benefit of mergers, affiliations, and partnerships, so planners should subject potential efficiencies to the same questions outlined above. However, this analysis requires special attention to regulatory questions.

Regulatory authorities often feel compelled to strongly question the potential efficiencies that are a rationale for a healthcare merger. To pass muster, an efficiency must be “transaction-specific,” meaning it can be achieved only through the proposed union. Supply chain efficiencies typically meet this standard. Regulators may sometimes accept the assertion that a merger will enable volume-driven cost reductions. Labor cost savings are a tougher sell. Two organizations might argue that a merger will enable them to reduce nursing staff by 50 FTEs. The likely regulatory response: Why not remain separate and each cut 25 nurses?

The same problem applies to many administrative and infrastructure efficiencies. In response to the assertion that the transaction will enable the organizations to improve revenue cycle performance or avoid capital expenses, the question from reviewing agencies, again, is likely to be, Why can’t you achieve this efficiency without combining?

The transfer of capabilities is one justifiable means for improving efficiency via a combination. If, for example, one of the combining organizations has been able to consistently deliver high-quality nursing care more efficiently, the merger could be seen as a way to transfer nursing expertise in one organization to the other, resulting in a transaction-specific efficiency.

When evaluating opportunities for such a capabilities transfer, planners could benefit from discussing which areas or components of each hospital may be integrated in the first 12 months and which hospital may lead that integrated service. Performance benchmarking can help in determining the higher-performing partner in particular support areas.

3. How Would Health Plan Contracting Be Affected?

Organizations that are contemplating a merger, affiliation, or partnership sometimes count on improvements in contractual rates, so it is critical to test this assumption well in advance.

Executives should initiate discussions with third-party insurers to find out how they view the potential combination. Leaders might assume that the favorable rates enjoyed by one organization will be extended to the other. But it is important to verify that health insurers would do so. A key question is whether insurers will even view the combined organization as a single entity for contracting purposes or will insist on maintaining separate arrangements and rates. Even if both entities will be moving to a single Medicare provider number, the answer is not cut and dried.

It is especially important to have these discussions with commercial insurers. To prepare for a thorough conversation about the proposed combination, health system leaders should bring to the meeting a comprehensive list of all existing contracts and subcontractors. If the leaders do not initiate this conversation, they will likely find the insurers unwilling to work with the combined entity on its own terms.

It also is important to understand the view of regulatory authorities such as the Federal Trade Commission (FTC), state attorneys general, health departments, and authorities overseeing processes for certificates of need and determinations of need. Points that should be considered include the regulatory bodies’ conditions of approval and how these conditions might restrict the combined organization’s ability to optimize contracting. Questions regarding these points could bring the discussion back to third-party insurers, because reviewing agencies often regard insurers as the proxy-holding representatives of the public at large.

The opinions of large, influential employers in the marketplace also should be considered. These employers also may have surprising perspectives regarding a proposed transaction.

4. What Transaction-Related Costs Would Be Incurred?

Healthcare leaders commonly underestimate the costs that will be necessary simply to complete the merger, affiliation, or partnership. Three broad categories should be considered.

Costs of planning and managing the transaction. The first category is the cost of the expertise required to plan and manage the transaction. Most leaders understand that bringing about a merger, affiliation, or partnership will generate significant consulting, legal, and accounting costs. In general, the harder the approval process, the higher these costs will run. In addition, the deal may require further expertise in facilities planning, IT integration, clinical process redesign, change management, business strategy, organizational transition, and integration.

Costs created by the transaction. This category includes all the new costs that will be incurred by the joined organizations. The underlying issue is that when two health systems combine, instead of melding their two existing leadership structures, they tend to create a new leadership architecture over the combined entity. This outcome is especially common when two strong organizations come together. As a result, instead of gaining efficiencies, the union creates additional administrative costs.

IT can be subject to a similar effect. Once two systems have merged or affiliated, people begin to argue (often logically) for the value of a single IT platform, which can lead to huge post-transaction costs.

Cost of developing the necessary internal expertise. This cost should not be underestimated. The wear and tear on employees who are expected to perform their “day jobs” while taking on additional responsibilities related to the transaction can lead to compromised morale and productivity, representing a significant soft-dollar cost. Attention to cultivating strong, committed internal expertise is necessary to avoid the risk of falling short in areas such as due diligence, post-merger integration, and the ordinary course of operations. Meanwhile, board and executive leaders run the risk of becoming fully consumed with the transaction and losing sight of market forces, competition, and other issues that may be quietly upending the industry status quo. The consequences of ignoring, disregarding, or just not being aware of other smaller actions that could be taken to maintain or improve market share, for example, represent a clear “opportunity cost” to the system.

5. How Would Current and Future Debt Be Affected?

A healthcare merger, partnership, or affiliation can have a profound effect on the underlying debt infrastructure of the combining organizations. To assess the impact, planners first should understand how current lenders might view the transaction. They should start by evaluating each organization’s existing debt covenants, determining which financial ratios must be maintained by the parties, and ascertaining how these requirements will affect the prospects of the combined entity. Other considerations include how lenders are likely to view the status of the combined organization and, most important, whether they will expect defeasance of debt as a condition of the transaction.

It also is important to understand the potential reaction of bond rating agencies, and whether the agencies agree that the combination will result in an overall stronger financial position that merits the same or better lending rates. To secure a favorable answer, it is important to be able to project five-year growth in revenue, operating cash flow, and other financial measures. On a practical level, the planners should consider how future borrowing will be accomplished, including whether debt will be assumed by a jointly obligated group or some other mechanism.

6. How Would Income Statements and Balance Sheets Be Affected?

Beyond the issue of borrowing, healthcare leaders also should evaluate how the transaction might affect assets and revenues. Addressing this question is largely a matter of understanding the trade-offs. For example, a merger may result in a dilution of equity on the balance sheet, yet this effect might be balanced out by stronger earnings before interest, taxes, depreciation, and amortization. Key ratios to examine include total debt to cash flow, unrestricted days cash on hand, unrestricted cash to total debt, and maximum annual debt service coverage.

7. How Would Capital Budgeting Be Performed?

Capital budgeting may appear to be a straightforward issue, but in the context of today’s mergers, affiliations, and partnerships, it is important to think through the following high-level questions in advance:
  • At what level in the combined organization will capital budging take place?
  • Will the individual entities continue to establish their own capital budgets, or will this function now occur at a systemwide level?
  • Alternatively, will routine capital be handled at the business-unit level, while strategic capital is budgeted at the system level?

These questions can be highly important in an acquisition that includes a capital commitment in lieu of cash. Such a commitment could create unforeseen complications down the road if the decision-making process is not clearly stipulated. Leaders should reach at least conceptual agreement on how capital budgeting will be managed and how funding priorities will be established.

8. How Would Overhead Costs Be Managed?

Similar issues arise with management of overhead costs. During negotiations, one party may focus on all the services it will receive but not pay much attention to the related overhead allocations.

Key points to consider here include whether the combining organizations intend to establish a centralized “corporate services” department that charges costs back to the individual entities, and whether corporate services should be housed within a separate holding company that serves as a management services organization. If this approach is to be adopted, it is important to clarify early how it will work—including which services are to be centralized and which are not.

It also is important to agree in principle on how overhead costs will be allocated to the individual entities. Three possible options are a 50-50 split, a proportional allocation tied to revenue, and an “a la carte” system in which each entity pays for the services it uses.

9. Would Performance Under Value-Based Payment Be Enhanced, and if So, How?

Virtually all healthcare mergers, affiliations, and partnerships today are based on the premise that forming a larger combined entity will enable better performance under value-based payment models. Going forward, it will be critical for financial leaders to develop solid projections around this expectation.

For this purpose, finance leaders require a deep understanding of the strategic context of value-based care. The finance leader also must understand the combined organization’s capabilities regarding population health, and whether it truly can position itself for at-risk contracting. Again, it is important to identify specific drivers of the transaction, including whether the transaction is being pursued to create a more vertically integrated care organization, thereby enabling the combining entities to better manage patients within new care models. No matter what the conclusions are, finance leaders should understand that gains related to value-based care have a longer time frame than other financial benefits, because the specific capabilities required to be successful under value-based care are much more highly evolved than the current capabilities of many health systems, which tend to be highly variable and are generally in rudimentary stages.

One caution: Based on repeated pronouncements, the FTC does not appear to accept the argument that the only way to create a functional value-based organization is through the formation of a large integrated enterprise. As noted above, if gains in value-based care are part of the rationale for a potential merger or partnership, leaders will need to work hard to demonstrate that those gains are transaction-specific.

10. Which Metrics Would Be Used for Assessing Financial Performance?

When two or more healthcare organizations with distinct organizational cultures come together, they require a common understanding of success. Leaders therefore must agree on the key measures that will be used to evaluate performance.

A “less is more” approach tends to be most effective, where one metric is selected to represent each broad dimension of financial performance. The exhibit on page 55 lists several indicators that can be used to monitor top-line growth, bottom-line profitability, and other performance areas. Leadership teams should focus on the handful of metrics that best represent their goals for the combination or partnership.

Final Step: Document the Findings

Once all 10 questions in the pre-transaction planning process have been addressed, the essential next step is to document the answers to the questions. This final stress-test document provides the starting point for a post-transaction road map that leaders can use to track performance and hold individuals accountable for realizing the transaction’s intended benefits. The road map also provides an important basis for creating a detailed action plan that specifies initiatives, responsibilities, and a pathway to achieving specific financial and operating targets.

An additional benefit of a pre-transaction stress test is that it allows healthcare organizations to assess a deal without moving prematurely into due diligence. Healthcare leaders gain a full picture of the potential combination and how to structure it to ensure it does not run afoul of regulators.

Although addressing the stress test’s 10 questions in detail may seem like a daunting task, the process is invaluable in that it provides a strong framework for assessing the expected benefits and potential pitfalls of a transaction. The process invariably will prove enormously helpful to any organization considering a merger, affiliation, or partnership by helping the organization establish the viability of the transaction before committing time and resources to it.


Stephen Gelineau is principal, Eastern Health Care Advisors, Boston, and a member of HFMA’s Massachusetts-Rhode Island Chapter.

Robert Green is senior vice president, GE Healthcare Partners, Chicago, and a member of HFMA’s First Illinois Chapter.

Publication Date: Friday, December 01, 2017