Howard J. Peterson

The prospect of a merger can be disconcerting for community hospital leaders, but today's economic conditions have many feeling that they have no other choice. Success can depend on how well they apply the lessons learned from hospitals that have traveled this path before.


At a Glance   

  • Today, more than ever, the nation's independent community hospitals are facing the critical decision of whether to remain independent or to align with a strategic partner.    
  • Hospital leaders should keep in mind that successful consolidations require a common vision and shared values, and that the most competitive parties within a market are often the best partners for alignment.    
  • They should not allow competing interests of independent physicians to influence the outcome of such transactions.    
  • The senior finance leader's goal, in particular, should be to uncover potential issues early to avoid surprises surfacing during the due diligence process.    

"Remain independent, or align?" Leaders of independent community hospitals who must contemplate a change in the control of their organizations may never encounter a more significant and difficult challenge. At one time, this challenge rarely intruded upon the boards and senior executives of independent community hospitals. Today, however, increased financial pressures and changes to the way care is delivered, largely under the influence of healthcare reform, are driving board members and senior leaders of hospitals nationwide to consider alternate futures.

For many reasons, both need-based and strategic, many healthcare organizations are seeking opportunities to align. American Hospital Association Annual Survey data indicate the number of independent community hospitals fell by 345 from 1999 through 2009 (from 2,432 to 2,087), and more drastic decreases are predicted as merger and acquisition activity heats up. Data from Norwalk, Conn.-based Irving Levin Associates indicate that the pace of hospital mergers and acquisitions accelerated 33 percent in 2010 relative to 2009, and experts believe that many of the factors responsible for this increase will likely continue through 2011 and beyond.

As hospital mergers and sales become more commonplace, a growing number of hospital boards, CEOs, and CFOs are treading into uncharted territory. The prospect of alignment through consolidation with another not-for-profit hospital or system, or with a for-profit hospital corporation, is likely to be foreign, and the right process for approaching the subject, uncertain. For most independent community hospital leaders, this type of strategic transaction is a once-in-a-lifetime event, and managing through the complexity of this critical decision is not business as usual.

These leaders can benefit from the experience of others on the front lines.

5 Tips for Successful Consolidations

There are five lessons learned that can help guide a successful consolidation, build the right governance structure for alignment, and better protect the interests of independent community hospitals.

Alignment is predominantly strategic. Successful consolidations are built on a common vision and shared values. They are about ensuring a "goodness of fit" between the parties and melding their missions and cultures to produce a stronger, more stable combined entity. Financial considerations are, of course, important. No merger will take place if it does not make good economic sense. A merger must yield integration benefits and escalate access to capital.

However, financial analysis should occupy its proper place in the decision to align. That place is to test for feasibility of the merger, and to ensure against alignment simply for an immediate financial solution whose benefit may be short-lived. The financial benefits afforded by a potential partner are not reason enough to close a deal.

A decision to align that is founded solely on financial considerations can yield results far below expectations, if not outright failure. Yet this point is not to diminish financial considerations or the need for a partner with a strong balance sheet and existing lines of credit. Independent hospitals seeking alignment often have balance sheet problems in the form of underfunded pension programs and difficulty accessing capital needed for strategic initiatives or necessary facility upgrades and renovations. A merger that does not, at least, bring the balance sheet to normative parameters is one to be avoided.

Nonetheless, in the search for a financially sound partnership, it is also important not to overlook important strategic considerations. Consider the case of one independent community hospital in the Northwest that was compelled by financial circumstances to align itself with one of two health systems. One was a dominant system that would provide virtual assurance of financial stability, but also would significantly reduce the hospital's local autonomy. The health system also had a hierarchical management structure that was inflexible, and its culture was profoundly different from that of the hospital. The alternative was a system that lacked the former system's financial strength, but seemed to be a better strategic fit. This system was generally more compatible and more malleable with respect to governance, and it offered the hospital a greater opportunity to influence the overall organization's long-term development and direction.

The hospital decided that the right choice, despite the somewhat greater risk, was to align with this more compatible system. In the end, the choice was not all about the money. It was largely strategic and focused on identifying the best opportunity to preserve the community hospital's mission of care to patients and communities it served.

In seeking a partner, a competitive dynamic is critical. Too often, independent hospital executive leaders and boards instinctively limit their consolidation discussions to just one potential partner. They allow their decision to be influenced by preferences, a sense of history, previously established relationships, or an internal assessment of which prospective partner is likely to be best. Although their analysis is often analytically correct regarding what is known, it also often assumes that the factors analyzed are sufficient to drive a final choice.

Organizations that limit consolidation discussions to a single party often exclude from consideration organizations with which they have had negative history, usually for competitive reasons. This can be a mistake. In many cases, the most competitive-even hostile-parties within a market are in reality the best partners for alignment. By excluding them, a hospital may overlook opportunities to optimize its future performance.

Choosing to negotiate only with a single party also carries significant risk. Negotiations may start on positive footing, but they invariably become unbalanced as the independent hospital becomes more invested in the process and dependent on the outcome. Eventually, the larger organization, with better finances or a stronger strategic position, can be expected to assert the authority it derives from its stronger position. For the independent hospital, the result all too often is less favorable terms for the alignment, particularly with respect to governance, and few protections or commitments for the future.

A competitive process with two or more responding parties is a better path for independent hospitals to reach the best outcome. Presuming the hospital has a "value proposition," much of which may be derived from nonfinancial attributes, it can be assured that a sufficient number of prospective partners will answer its request for proposals. Knowing that others are also submitting bids, these competing parties will be strongly motivated to put their best offer forward. Thus, a competitive process will often prompt a prospective partner to offer governance, capital, or other tangible benefits that it might never offer if it knew that it was the sole candidate.

Exhibit 1

f_peterson_exh1

The governance structure of an alignment should not be a formula. There is a natural inclination to believe that governance of consolidated hospitals should reflect the relative contributions of each organization. In fact, the primary objective for some financial advisers to such transactions is first to create a proof of a financial benefit from the merger, and then to calculate the value of contributed assets to provide a basis for a governance formula. To a limited extent, this approach has merits: Representative governance may be appropriate in the earliest stages to facilitate a gradual, thoughtful transition to a single governance structure.

It is important, however, for the merged entity to shift to conventional board elections after a reasonable period. Sustaining a representative governance structure creates barriers to integrated thinking. It introduces a long-term imbalance into a relationship between the merged parties and sets the stage for decision making fraught with opposing ideas from two sides, where winning becomes the focus rather than developing solutions that are in the best interest of the organization overall. The nation's healthcare environment is strewn with unsuccessful mergers that were predicated on proportionate representation from each party. This "we-they" orientation is the most common reason mergers fail.

System governance should be constructed on the premise that the transaction will culminate in a single organization. Practically speaking, a merger of a health system with an independent hospital should result in governance that extends pre-existing attributes of the system to the merged independent hospital, while retaining for the hospital appropriate and reasonable local control.

Hospital interests are similar to, but not the same as, those of independent physicians. Economic pressures are also driving closer relationships between hospitals and physicians, including increasing employment of physicians. Physicians employed by hospitals or health systems share many common interests with those organizations, including strong interest in long-term economic success and viability. However, independent community physicians (even those with seats on hospital boards) often also have their own for-profit businesses, creating self-interests and economic agendas that may conflict with selfless allegiance to the hospital. A hospital's merger discussions with another hospital or health system may elicit a number of conclusions that physicians may find objectionable, particularly with regard to four concerns:

  • The competitive effect of the integration
  • Compensation and benefit differences resulting from the new partnership
  • Effect on commercial insurance rates
  • Changes implied for IT platforms

Although the patronage of independent physicians is critically important to a hospital's viability, a hospital that is undertaking a merger should ensure that-given the magnitude of what is at stake-physicians' competing interests don't influence the outcome.

The experience of an independent hospital in the Southeast reinforces this point. The hospital had disproportionate physician representation on its board committee charged with evaluating alignment options. Despite the fiduciary duty of these members to advocate for the choice that would best position the hospital to continue to fulfill its mission of service to the community, they allowed themselves to be influenced by their personal agendas. As a result, despite a strong not-for-profit alternative, the hospital opted to align with a proprietary hospital company to serve the proprietary, economic interests of the physicians, at the expense of the hospital's local control and long-standing charitable mission.

Exhibit 2

f_peterson_exh2

In general, such an outcome runs counter to an independent community hospital's reason for existence. The fundamental fiduciary question should be, "Which future course will ensure that my hospital is best positioned to fulfill its service to the community?"

The hospital should understand its own finances thoroughly before entering into merger discussions. In entering alignment discussions with another hospital or health system, the community hospital should expect that its prospective partner will critically examine its finances. The greatest areas of concern in due diligence are finance and liability: Findings in these two areas are likely to determine the direction of negotiations and the final terms of the transaction or affiliation, if one is pursued.

Therefore, to prepare for partnership discussions and sharing of financial information, the independent hospital's senior finance leader should carefully scrutinize the hospital's income statements, financial projections, and balance sheet, testing them against commonly known parameters and proactively preparing answers to questions that potential partners will ask, including how the hospital reached its current state of performance.

A common misstep among financial leaders is to focus only on the current year's run rate as a measure of the hospital's financial health and basis for partnership discussions. This approach fails to consider the variable nature of key underlying drivers, such as payment, labor costs, insurance costs, and investment returns. Changes to these drivers, which are especially likely to occur in the current environment, can significantly affect the hospital's financial position over the next three to five years. To account for such critical considerations, the finance leader should develop and test pro forma financial analyses under a range of likely scenarios to gain a thorough understanding of the hospital's financial condition and ascertain whether potential problems exist or improvements are required to ensure that the hospital can meet its annual targets.

Exhibit 3

f_peterson_exh3

The goal is to uncover potential problems early and avoid surprises surfacing during the due-diligence process. Particular attention should be paid to cash, funding of liabilities, and age of plant. The finance leader should be equipped to anticipate a prospective partner's concerns and possess either a plan for improving positions perceived as unfavorable or an explicit case for how the partnership can benefit both parties. Positioning the issues before a partner raises them can help the hospital retain value and close successfully on favorable terms.

Let Experience Be the Guide

For an independent community hospital, the processes of deciding whether to remain independent or align and finding and joining with the right partner are no simple matter. Risks are inherent at every step, failures are all too common, and there's no instruction manual for success. The best guide is the experience of those that have gone before-distilled from past consolidation successes and failures into the five key lessons described here. By keeping these lessons in mind, hospital leaders who are just beginning to confront the challenges of consolidation can avoid common pitfalls, negotiate favorable terms for partnerships, and achieve the best possible outcome for their organizations and the communities they serve.


Howard J. Peterson is managing partner, TRG Healthcare, LLC, Philadelphia (hpeterson@trghealthcare.com).


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Summary of 5 Key Lessons  

1. Alignment is predominantly strategic. The most successful consolidations are values-driven, focused on mission and a common vision rather than financial considerations.

2. A competitive dynamic is critical. It is best to establish a competitive dynamic with more than one suitor, regardless of preferences for an outcome. Without this dynamic, a hospital loses negotiating leverage and jeopardizes its ability to close under its terms.

3. The governance structure of an alignment should not be a formula. Governance should not be based on the relative value of each entity's contributed assets. Rather, it should be an amalgamation of the two that extends preexisting attributes of the system to the merged independent hospital while retaining for the hospital an appropriate and reasonable level of local control.

4. Hospital interests are similar to but not the same as those of independent physicians. Economic interests of independent physicians should not be allowed to influence alignment decisions. The board has a fiduciary responsibility to make choices that best serve the long-term interests of the hospital and its community.

5. The hospital should understand its own finances thoroughly before any merger discussions. The senior finance leader should scrutinize the hospital's income statements, financial projections, and balance sheet and conduct pro forma analyses under various scenarios to fully understand the hospital's financial condition and prepare answers to questions likely to arise during due diligence.

 

Publication Date: Tuesday, November 01, 2011

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