Chris Myers
Jason Lineen
Consolidation activity is expected to increase as hospitals position themselves for survival in the current economic environment.
At a Glance
- The rapid hospital consolidation activity of the late 1990s has tapered off, but it’s expected to pick up again.
- The reasons for hospital consolidation have shifted from gaining leverage with payers to achieving cost savings and operating efficiencies to survive in the market.
- The hospital industry can expect to undergo more profound structural and organizational changes in the decade ahead than it did in the past decade.
Most major service industries in the United States have experienced considerable transformation, consolidation, and reorganization over the past 25 years. Unlike the banking, airline, hotel, telecommunications, media, and other industries, however, hospitals remain predominantly local businesses. Consider how many times the name of your bank and telephone company have changed since the 1980s. During the same period, the name of your local hospital likely has not changed. In fact, many tax-exempt hospitals continue to behave more like school districts than traditional businesses and have not expanded much beyond their original and contiguous boundaries.
Relatively few truly national health systems exist, and some of the best known “brand name” organizations are available in a limited number of markets (e.g., the Mayo Clinic, headquartered in Rochester, Minn., operates in four states; Johns Hopkins Health System, Baltimore, in one). In fact, the largest U.S. operator of hospitals—HCA, based in Nashville, Tenn.—has only 3 percent market share nationally (about 160 hospitals out of roughly 4,900 nonfederal, short-term general community hospitals). The top 10 systems in the United States together have less than 15 percent market share. On the other hand, payers are highly concentrated, with the government insuring approximately 26 percent of the total population (through Medicare, Medicaid, and other public programs) and the 10 largest managed care companies collectively accounting for more than 70 percent of the estimated 170 million privately insured lives in the nation.
With the exception of the for-profit chains and the large faith-based systems, most hospitals have consolidated on a local basis. Although the pace of change in health care has been glacial, the growing pressure on hospital bottom lines, coupled with a growing mandate to meet national quality and cost benchmarks, could drive increased consolidation among hospitals over the long term into regional or national super systems.
A Look Back
The era of most rapid consolidation activity occurred between 1995 and 2000, when 550 hospitals became part of systems and the overall percentage of hospitals in systems increased dramatically from 38.3 percent to 51.7 percent (see exhibit). Since then, the pace of consolidation has slowed, as hospitals benefited from increased operating income and investment income between 2001 and 2007. This phenomenon is reflected in a slowdown in the number of hospital merger and acquisition (M&A) transactions since 2001 (see exhibit) . In 2007, 2,730 hospitals were part of a system, representing 55.7 percent of total U.S. community hospitals.
Much of the system formation activity occurred in response to the rapid consolidation of commercial payers. To further study this relationship, we analyzed commercial payer and health system concentration in the 85 largest U.S. Metropolitan Statistical Areas (MSAs) as measured by the Herfindahl-Hirschman Index (HHI). Our analysis found that commercial payers are concentrated in a remarkable 91 percent of the 85 largest markets, whereas health systems are concentrated in only 66 percent of the largest markets (see exhibit) .
The analysis disclosed that hospitals located in highly concentrated commercial payer markets (e.g., Austin, Texas, and Charlotte, N.C.) have more aggressively pursued consolidation activities than hospitals in moderately concentrated commercial payer markets (e.g., Miami and New York). Also, hospital sectors in smaller markets (, 1 million in population) tend to have higher concentration levels than larger markets, and none of the top largest markets are concentrated with regard to health systems. Only a handful of markets have a greater concentration among health systems than among commercial payers (e.g., Albuquerque, N.M.; Buffalo, N.Y.; Cape Coral, Fla.; Charlotte, N.C.; Colorado Springs, Colo.; Fresno, Calif.; Jacksonville, Fla.; Norfolk, Va.; Orlando, Fla.; Portland, Ore.; Salt Lake City; Springfield, Mass.; West Palm Beach, Fla.; Wilmington, N.C.; and Worcester, Mass.).
Lessons Learned
The analysis of health system and payer concentration brings to mind the pragmatic difficulties in achieving material market concentration among hospitals in large cities. Simply put, two mergers may accomplish in a small market what may require up to 10 mergers in a large market. Furthermore, the exercise yielded the following broad observations.
Driven as a response to commercial payer concentration, most M&A activity among tax-exempt hospitals predictably occurred between organizations in the same market. In addition to improving leverage with managed care plans, local consolidation enabled modest administrative economies of scale, shared branding, improved access to capital, avoidance of duplicative capital, and limited consolidation of clinical programs.Few systems to date have strayed beyond their original and contiguous borders and have linked with hospitals in nearby metropolitan areas (with notable exceptions being MedStar Health in Baltimore and Washington, D.C., and Novant Health in Charlotte and Winston-Salem, N.C., as well as other nearby areas.
Excluding activity by the for-profit chains, the key exception among tax-exempt hospitals has been the formation and growth activity of the faith-based national systems, driven primarily by the reconfiguration of Catholic congregations. Between 1990 and 2003, the growth of cosponsored Catholic systems proliferated from two to 17 systems with multiple sponsors. Although much of this consolidation activity has enabled these systems to achieve significant economies of scale through the integration of administrative functions such as finance, supply chain, IT, and others, it has done little to drive greater penetration in local markets. One notable exception is Ascension Health’s expansion in Michigan over the past 10 years, which now includes 14 affiliated general acute care hospitals across the state.
There has been only one notable example of a tax-exempt health system that has significantly migrated markets. Since its formation about 15 years ago, Banner Health has shed assets in slow-growth markets (such as North Dakota) to generate capital to invest heavily in the high-growth Phoenix market.
More recently, there has been an increase in the number of partnership conversations and transactions between “full” academic medical center hospitals and community hospitals with available capacity to provide a more efficient venue of care for lower acuity patients (e.g., Loyola University Medical Center purchased Gottlieb Memorial Hospital in 2007, with plans to relocate its low-risk obstetrics and orthopedics programs).
A Look Forward
In the coming decade, the hospital industry will undergo more profound structural and organizational changes than it did in the last. Although the last big wave of hospital consolidation was largely driven by accelerating managed care consolidation, the next wave is being jolted into action by the current economic and political tsunami. Facing the perfect storm of decreasing demand, tightening payment, rising bad debt, escalating fixed costs, and investment income losses, U.S. hospitals are once again turning to mergers, affiliations, and partnership strategies to remain viable.
For example, in the Chicago MSA, where only one health system has double-digit market share (Advocate Health Care, based in Oak Brook, Ill., with 12 percent) and where health systems are not concentrated (unlike commercial payers), M&A activity historically has been limited. This began to change in 2007 when Loyola University Health System, Maywood, Ill., acquired Gottlieb Memorial Hospital, Melrose Park, Ill., and MSMC Investors LLC, a group of investors, acquired St. Francis Hospital and Health Center, Blue Island, Ill., and in 2008, when NorthShore University HealthSystem, based in Evanston, Ill., acquired Rush North Shore Medical Center, Skokie, Ill., and Advocate acquired Condell Medical Center, Libertyville, Ill.
In the current economic environment, health systems using the old playbook seeking scale to gain leverage with payers is an increasingly short-sighted strategy, as community officials, employers, and hospital board members alike are weary of annual double-digit medical inflation increases, particularly while all other sectors of the global economy are retracting. Therefore, the rationale for hospital mergers needs to be much broader than simply the ability to negotiate better managed care rates.
So in these uncertain times, what is the emerging mandate driving the next wave of hospital consolidation in the new economy? First and foremost, the most vulnerable organizations are driven by sheer survival. Health systems that have heavily relied upon investment income to bolster operating revenue are now forced to confront the stark reality of expenses accelerating faster than revenue. Further, some organizations experiencing a dramatic drop in days cash on hand due to investment losses are, at best, indefinitely freezing capital spending and, at worst, in danger of breaching debt covenants.
In the new economy, the case for hospital consolidation has shifted from the revenue side of the equation to improved efficiency and expense reduction. Employers can no longer afford double-digit premium increases that allow providers to subsidize rising shortfalls from government payers. Further, the recent era of historically low interest rates and cheap capital has not produced the most efficient infrastructure for care delivery in many communities. For example, do MSAs the size of Kalamazoo, Mich., and Rockford, Ill., really need multiple Level I trauma centers? Are private rooms with flat screen HDTVs the best value for a community’s healthcare dollar? The credit crisis has rapidly reintroduced the cost of capital concept that will temper the medical arms races for duplicative services going forward. However, expansion projects already completed and approved on the premise of growing volumes and strong payer mix are facing serious challenges. Whether driven by visionary collaboration efforts or survival strategies, the new economy will force a rationalization of hospital services through clinical affiliations, joint ventures, mergers, acquisitions, divestitures, and bankruptcies.
Acknowledging the new revenue realities and constrained access to capital, providers that were once staunchly independent are beginning to explore their partnership options. Economies of scale and other partnership advantages that come at the expense of local control are hard to ignore in the current economic environment. As a result, board members of independent hospitals are beginning to ask the tough question, “Is it better to have a viable organization or local control of a declining asset?” To prepare for any potential M&A conversations, it is prudent for hospitals to undertake the following activities in advance:
- Gain an understanding of the entire M&A life cycle, including definition of common terms, typical phases, activities, and key decision points
- Think through the likelihood of M&A activity in your market and consider the range of potential partners for your hospital and the pros and cons associated with each potential combination
- Get agreement among key leaders on the organization’s preferred position on all critical deal terms, such as organization mission and name, governance, leadership, organizational chart, job losses if any, change in scope of clinical services if any, and future capital commitments
Despite the rise of a handful of health systems with a presence in several parts of the country, health care remains a highly fragmented cottage industry. History tells us that external shocks (e.g., managed care consolidation, Balanced Budget Act of 1997) are required to stimulate hospital M&A activity. As one would expect, there will be winners and losers in the next round of consolidation. Hospitals and health systems evaluating their partnership options before a declining financial position pins them in a corner will be best positioned for success.
Chris Myers is a director, healthcare provider strategy practice, Navigant Consulting, Inc., Chicago (cmyers@navigantconsulting.com).
Jason Lineen is an associate director, healthcare provider strategy practice, Navigant Consulting, Inc., Chicago, and a member of HFMA’s First Illinois Chapter (jlineen@navigantconsulting.com).