Making the Right Decisions in a Consolidating Market

Kenneth Kaufman
Mark E. Grube

A troubled economy is often a harbinger of increased merger and acquisition activity. Healthcare executives should recognize the opportunities while also understanding the challenges and risks involved.

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At a Glance

• Market forces may lead to increased consolidation in the healthcare industry, creating both opportunities and challenges.
• Opportunities for small hospitals and health systems include partnering with stronger organizations, while for larger organizations, acquiring potentially undervalued hospitals can yield the benefits associated with increased size and scale.
• Potential barriers to success arise in three areas—strategy, finance, and operations. Healthcare executives must understand and be willing to fully address these challenges.

Numerous forces and factors are creating an environment ripe for healthcare consolidation. Volumes are declining for some of the most profitable lines of business—elective and semielective ancillary services and surgical procedures. Payer mix has already deteriorated in many geographic areas as a result of employer decisions to eliminate health benefits and/or lay off staff. A January 2009 survey indicates this trend is likely to worsen; nearly 20 percent of employers plan to drop employee health benefits over the next three to five years (Hewitt Associates, March 4, 2009).

The combined impact of volume declines and payer-mix deterioration puts substantial pressure on operating margins. Hospitals and health systems have also realized a significant degradation of liquidity as a result of the steep stock market drop. Capital requirements for new or updated facilities, physician strategies (particularly physician employment), IT, and service-line growth may now be far beyond what can be afforded by some organizations. All of these forces are converging to drive providers to consolidate to improve market influence and essentiality, realize operating efficiencies, and deploy scarce capital more effectively.

Challenges and Opportunities
Dislocations of the healthcare market create challenges, but they also create opportunities for both small and large organizations. Hospitals and small health systems that are unable to access capital may be able to partner with stronger organizations that can support the continued provision of services in their communities. Stronger organizations may be able to use the market downturn to acquire potentially undervalued hospitals and achieve the benefits associated with increased size and scale. (Read Corporate Mergers and Acquisitions During Recessionary Periods at www.hfma.org/hfm.)

Hospital M&A trends. The data on merger and acquisition (M&A) activity since 2000 indicate that the number of annual hospital transactions each year has remained under 60 for the past seven years, and the number of hospitals involved in each transaction has varied widely, with marked increases in some years. These data suggest that health systems have increased acquisition activity, acquiring multiple entities with each deal. The exhibit shows the number of hospital M&A deals and hospitals involved in such deals from 2000 to 2008.

The big-picture goal. The goal of consolidation, whether by M&A or affiliation and partnership, is for organizations to achieve mutual benefits through synergies of mission, strategies, operations, and ultimately competitive and financial position. Mergers require a significant commitment on the part of leadership to understanding and addressing the challenges and potential risks inherent in such an undertaking—to both the acquiring entity and acquired/partner-seeking organization. At the most fundamental level, a partnership with the “wrong” provider limits or eliminates future opportunities, so choosing the right partner is critical.

Essential Groundwork
Healthcare leaders should take every step necessary to increase the likelihood of success in a consolidating market. As a starting point, four tasks will lay the groundwork for best-fit partnerships:

• Accurately assess the organization’s strategic and financial position. (Read Elements of a Baseline Position Analysis at www.hfma.org/hfm).
• Determine the appropriate level of risk that can be taken based on the organization’s credit and capital position.
• Identify strategic partnership options and evaluate the opportunities and risk associated with each.
• Decide which option(s) would best enable the organization to fulfill its objectives while maintaining an acceptable level of risk and purposefully pursue this option.

The exhibit provides more details.

Organizational self-assessment. Whether leading an acquiring organization or an organization looking for a strategic partner, executives begin by evaluating their organization’s own strengths and vulnerabilities. The goal is to objectively define what the organization brings to the partnership table—its value proposition. These characteristics are likely to have a material impact on likelihood of success for the mergers or partnerships. Differentiating characteristics might include:

• A strong credit rating and access to capital
• Strong payer relationships that can be extended to other providers
• A track record of patient care excellence and clinical innovation
• A solid physician strategy, including physician practice management and recruitment expertise, and a well-developed medical group infrastructure
• Unique programs and services with best practices that could be exported to another organization
• Significant investment in IT systems, which could be used in another organization
• Sophisticated quality improvement and management capabilities
• Operations management expertise, with successful approaches to enhancing profitability and creating capital capacity

Matching needs with competencies. Best-fit strategic partnerships are those that match the key development needs of the acquiree with the differentiated strengths of an acquirer. Essentially, the acquiree should carefully define what it needs to succeed in the market and look for partners that can effectively address those needs. When the acquirer’s core competencies are applied to the acquiree’s needs, improved performance and value are created, thereby justifying the investment and risk associated with the acquisition. Conversely, over-reaching to acquire an organization whose key strategic needs cannot be filled by the acquirer will undoubtedly result in a poor-performing combination that fails to meet the objectives of either party. Poor-fit acquisitions can threaten the viability of merging organizations.

Strategy-Related Considerations
Mission, market, and clinical synergies, or lack thereof, can reduce or intensify strategy-related challenges for merging or partnering organizations.

Mission and cultural synergy. For ongoing overall success, merging or partnering organizations must have congruent missions. Although many mission and vision statements sound alike, how organizations operationalize their missions and their culture can vary significantly. Talking with stakeholders of all types—including physicians, nurses, patients, and local community leaders—is essential due diligence work for all organizations considering a partnership.

Small organizations seeking a partner should investigate a potential partner’s track record as a partnering organization. Although the premerger period with a potential acquirer may be promising, the partner-seeking organization cannot risk a deterioration of the relationship following the merger. Site visits to, and executive-level meeting with, other organizations that are affiliated with the acquirer are appropriate and recommended. These activities will allow the board and management team the opportunity to assess whether the acquirer has a solid track record in broadening the success of acquired organizations. The activities also establish the degree of compatibility and cultural fit between the organizations.

Governance issues. The ability to retain local control over important decisions should be considered by both acquiring and acquired organizations. What governance structure is proposed? To minimize the risk of diminished service to its community, most partner-seeking organizations look for meaningful commitments and local influence related to the capital plans and the allocation of capital, operating budgets, facility staffing, service offerings, and clinical care, but some give and take may be needed with selected issues.

Market and clinical synergies. The key market-related question all organizations should ask is, Will a partnership strengthen our position in our current market and/or allow us to develop a position in new markets? Continued strategic growth to meet community needs is often critical to partner-seeking organizations. Is the acquiring organization strong enough to compete and achieve growth into the future? A complete market assessment, which includes an estimate of demand changes with and without a partnering organization, is required due-diligence work.

To minimize the risk of diminished service to its community, partner-seeking organizations should also ensure that the acquiring organization has a plan that will enable continued strategic success and support for program and service growth. That plan should outline specific goals, time frames, and success indicators. Acquiring organizations should be able to offer evidence of a strong track record in successfully developing programs that are supported by communities.

Brand. Another important question is, Does the acquirer offer a strong brand and reputation, and will those attributes be recognized by the patients and physicians in the community served by the partner-seeking organization? From the acquirer’s perspective, the question is, Will this hospital contribute to brand and identity strength, or do we run the risk of diluting our brand? The preservation of local identity may be critically important to the partner-seeking organization, in which case, a local board should be involved in decisions related to its name and other identifying characteristics.

Physicians. Local access to primary care and specialty physicians is an ongoing concern nationwide. Both acquired and acquiring organizations must be assured of strong physician involvement and presence into the future. Referral patterns can be disrupted or enhanced when organizations merge, so mitigating the risk of physician disenfranchisement is critical. Partner-seeking organizations should be looking at the success, or not, of a potential partner’s initiatives in recruiting and supporting physicians across specialties and markets. Through medical staff satisfaction and quality-of-care survey results, executives should be able to document specific hospital-physician models that work.

Financial and Operational Considerations

Given the economic downturn, hospital executives are doing everything they can to preserve and improve their organization’s operating and financial positions. Continued balance sheet stress is making it very difficult for many organizations to meet their day-to-day operating cash needs as well as their capital requirements for the future. Financial and operating challenges abound for organizations considering strategic partnerships. In evaluating, selecting, and implementing a partnership arrangement, organizations should address specific issues, including capital requirements, financial performance, operating performance, and partnership execution.

Capital requirements and structure. As mentioned earlier, the need for capital is motivating much of the current consolidation activity. Leaders of any organization with known capital constraints that will limit the organization’s ability to provide needed services in its community should be assessing partnering options now. Critical concerns for such organizations are whether prospective partners offer the needed capital support and whether the selected partner will honor the capital commitments into the future. Through the transaction structuring, there are numerous ways to help ensure that these needs are met, and financial and legal advisers can provide guidance. However, leaders of capital-constrained organizations need to conduct their own due diligence about the potential partner’s financial capability to implement the agreed-upon transaction.

Executives of organizations capable of acquiring other organizations should understand what capital will need to be deployed to achieve long-term partnership success and then evaluate if this is the best use of available capital. An assessment of the partnership’s impact on core profitability measures (operating margin, EBIDA margin), liquidity measures (days cash on hand, cash-to-debt ratio, cushion ratio), and debt indicators (debt service coverage ratio, debt-to-capitalization ratio) is critical. Liabilities assumed by the acquirer, such as underfunded pension plans, should be quantified to the greatest possible degree. Transaction agreements can address potential liabilities that are not identified during the due diligence process.

Even if capital is not committed through the transaction agreement, the acquirer will likely be assuming some or all of the acquired organization’s debt. This will change the acquirer’s capital structure; the organization will frequently be more heavily leveraged and its debt capacity reduced.

Financial performance. The overall financial question is, To what extent will the acquisition dilute or strengthen our balance sheet and financial position in the short term and going forward? This issue is important for both the acquirer and acquiree. Except in certain circumstances where one strong organization buys another equally strong organization that wants to partner for long-term growth, acquisitions almost always dilute the acquirer’s balance sheet in the near term.

As a result, the acquirer must be confident that it maintains the capability to improve the acquiree’s performance or derives other benefits, such as increased referral flow to its core operations. If such referral flow strengthens the acquirer’s own performance, the acquisition benefits both organizations. Enhanced near-term and long-term financial performance should be objectively quantified and performance indicators that will be used to monitor financial performance should be identified.

Operational impact and execution issues. As in other industries, the potential to achieve economies of scale is a major motivator of consolidation. Partnerships and acquisitions can offer the benefits of increased scale in such areas as managed care contracting, enhanced executive/medical and other clinical staff expertise, shared corporate services, IT/IS efficiencies and enhancements, and supply chain efficiencies. Benefits of scope can also be achieved, such as the cross-pollination of clinical and operational best practices, dedicated research and development initiatives, increased availability of clinical data, and quality and safety improvement through collaborative initiatives. Regional systems can also derive scale benefits through systemwide service line planning efforts that optimize capital and operating resources and avoid unnecessary service
redundancies.

However, the acquirer must take the actions required to achieve economies of scale; failing to do so could present significant operational and execution risk. More mature systems, which have successfully executed a number of mergers over the past decades, will bring helpful experience to the table. If the organization has no partnering experience, a learning curve can be expected.

Both acquirer and acquired organizations must have the “bandwidth” required for the work involved in consolidating two organizations. Complex issues that often prove problematic include:

• Ensuring compatibility of IT systems
• Staffing and employee considerations, such as employment policies, benefit plans, and reporting relationships
• Physician strategies, such as physician practice management infrastructure, recruitment plans and resources, and specialty coverage

To achieve successful integration, merging organizations should set priorities and establish a structure of accountability for specific post-merger goals. The exhibit illustrates the structure established by MultiCare Health System and Good Samaritan Community Healthcare with their 2006 merger.

Making It Work

Pursuit of strategic partnership options in the current economy requires commitment by healthcare leadership teams to in-depth strategic and financial analyses along all the dimensions illustrated in the exhibit and regular revisiting of such analyses. Executives should clearly specify the goals to be accomplished and the metrics used to assess whether goals are being achieved.

Executives of organizations that are in a position to acquire other organizations should think through their acquisition strategy, understand their current situation—what they have, or do not have, to work with—and determine whether they are willing to assume the challenges of a more aggressive growth posture. Based on this fact-based analysis, executives can make a decision about whether to be proactive. Growth through successful acquisitions is the quickest way to increase size and scale of operations; organic growth generally requires much more time.

In the final analysis, the key elements for ensuring good-fit partnerships or acquisitions are:

• Competitive position. The consolidated organization must be able to solidify market position.
• Operations. The partnering organizations must accurately estimate the investment of time and money required to implement change.
• Execution and implementation. The partnering organizations must make the staffing and/or service line changes required to achieve the financial projections used in the transaction evaluation. The organizations must also ensure cultural compatibility; the importance of cultural fit cannot be overemphasized.
• Financial performance. The acquirer must accurately estimate the financial synergies the acquired organization can bring in the near and  long term and then achieve and maintain such financial performance.

The healthcare industry has started to experience a musical-chairs situation. When the music stops, certain hospitals are going to find themselves without a chair. If weaker organizations wait too long, partnership opportunities may be eliminated because best-fit organizations already have committed to other acquisitions. If stronger organizations acquire the wrong organizations, they may not be able to regain lost competitive and financial ground. Uncertainty and change in the healthcare environment are a given for the foreseeable future. Executives should commit to the effective management of strategic, operational, and financial challenges and opportunities in a consolidating market.

Kenneth Kaufman is managing partner, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA’s First Illinois Chapter
(kkaufman@kaufmanhall.com).

Mark E. Grube is partner, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA’s First Illinois Chapter (mgrube@kaufman
hall.com).