Lisa Goldstein

New drivers, players, and models define the latest wave of consolidations involving hospitals.

At a Glance   

  • Reimbursement challenges, spiraling healthcare costs, and a slow economic recovery are driving the latest wave of hospital consolidation.    
  • Health insurance companies and provider systems are forming partnerships in the consolidation field with the goal of reducing healthcare costs and improving quality.    
  • The "cost" of the acquisition may include debt and other obligations of the acquired hospital, such as pension liabilities, along with a multiyear capital commitment.    

The growing trend toward not-for-profit hospital consolidation is positive for the financial health of many, but not all, hospitals. Consolidation offers the promise of greater operating efficiency and risk diversification across larger organizations, likely leading to stronger and more stable bond ratings for affected hospitals. However, given current looming headwinds confronting the sector, those hospitals left out of consolidations, especially smaller stand-alone hospitals that cannot match the financial, managerial, or market access capabilities of larger multihospital systems, will face greater negative rating pressure going forward (U.S. Not-For-Profit Healthcare Outlook Remains Negative for 2012, Moody's Investor Services, January 2012). For bondholders or lenders, consolidation can also provide an exit strategy if bonds or loans are fully redeemed or assumed by the consolidator.

Much like the last pronounced wave of hospital consolidation in the late 1990s to mid-2000s, the forces behind current consolidations are numerous, with both similarities and differences. Payment challenges, spiraling healthcare costs, and a slow economic recovery are some market forces that have ignited the national explosion of consolidation, much like in the past. Driven by healthcare reform and an unsustainable payment system, the deep and impactful financial changes that are undoubtedly coming have led many hospitals to seek long-term partnerships. The current consolidation participants vary greatly and consolidation models are different, each with unique credit risks.

Hospital mergers and acquisitions have been the primary means to consolidate, with goals to increase market share and negotiate leverage with commercial payers. Gaining size and scale remains a key reason to consolidate. Because the opportunities to gain leverage and higher rates from commercial payers are quickly dissipating, size and scale are now a more important means to gaining greater efficiencies and driving waste and costs out of the delivery system. The ability to demonstrate lower costs while providing high-quality care will be the key driver in governmental and commercial reimbursement going forward. Physician alignment, another form of consolidation that many are pursuing, is another strategy to control costs and drive improved quality by adopting evidence-based medicine.

The Drivers: Weak Economy, Spiraling Healthcare Costs, and Payment Changes

Many of the forces behind today's consolidation are similar to those in the past. However, this cycle's deeper and more prolonged economic downturn is the key backdrop driving the recent wave of consolidations. Data from Moody's FY10 medians showed a 0.4 percent decline in hospital admissions from FY09, the first time we have observed such a decline, even during other economic downturns. Inpatient volumes are down for many hospitals, while uncompensated care has increased, creating greater financial challenges and contributing to many recent downgrades. Access to the capital markets has become more difficult for smaller and lower-rated hospitals, driving the need for many to seek a partner.

Spiraling healthcare costs and the insurmountable federal deficit necessitate reducing waste and gaining efficiencies through consolidation. Medicare reductions, such as those legislated by the Balanced Budget Act of 1997, drove much of the consolidation in the late 1990s. And Medicare reductions continue to loom. The Centers for Medicare & Medicaid Services (CMS) reports 2010 national healthcare expenditures represented 17.9 percent of GDP. Meanwhile, the Affordable Care Act is focused on reducing Medicare costs. Annual reductions to Medicare inpatient hospital payment rates are now hardwired into the Medicare payment formula.

Hospitals are also facing lower Medicare payment related to bundled payment programs, readmissions, and continued recovery audit contractor (RAC) reviews that seek to recoup overpayments made to hospitals. Bundled payment programs in particular will pay hospitals a flat amount that must cover hospital, physician, and postacute care costs, driving the need for greater efficiencies.

During the last consolidation wave in the late 1990s to mid-2000s, hospitals generally received favorable annual increases from commercial payers that subsidized losses with governmental payers. Commercial payers are now implementing significant payment changes that will force hospitals to change how they operate. Most hospitals now report moderate to low single-digit rate increases after years of double-digit increases as a result of leverage gained from consolidation. Some large hospital systems have proactively negotiated global cost and quality contracts that include a reduction in payment rates and that shift much of the financial risk to the hospital. This new payment platform requires hospitals to achieve greater cost reductions and efficiencies to manage this risk, much as capitation did in the 1990s.

Managing and absorbing the costs of increased regulation is another reason to consolidate. Already subject to close regulatory scrutiny, hospitals face even tighter regulations stemming from healthcare reform. CMS more closely scrutinizes hospital admissions, readmissions, and in-hospital patient safety violations, for example.

Largely absent in the last consolidation wave, significant pension liabilities for hospitals with defined benefit plans are new issues in consolidation discussions. Falling discount rates, lackluster long-term investment returns, and federal requirements to be 80 percent funded have created overwhelming pension obligations relative to unrestricted resources that many hospitals cannot afford, driving the need for a capital partner.

Exhibit 1


The Consolidators: New Players Join Traditional Participants

In this cycle, there is a noticeable difference in the type of participants involved in consolidations. In addition to the traditional market consolidators, such as large not-for-profit or established for-profit hospital companies, new players have entered the hospital industry.

One of the more interesting developments is the expansion of health insurance companies into healthcare services. Since the passage of healthcare reform, there have been several mergers, acquisitions, and partnerships of insurers and provider systems with the goal of reducing healthcare costs and improving quality. The proposed affiliation between Highmark, Inc., in western Pennsylvania and West Penn Allegheny Health System is one of the largest movements of a payer into the hospital industry (see "Affiliation with Highmark Would Be Credit Positive for West Penn Allegheny Health System," Sector Comment, Moody's Investors Services, July 5, 2011). Other recent examples include Humana's December 2010 acquisition of Concentra, which provides physical therapy, urgent care, and occupational medicine, and WellPoint's August 2011 acquisition of CareMore Health Plan, a Medicare Advantage plan and clinic network.

Hospitals and payers are affiliating to form new coordinated global healthcare insurance plans, such as Banner Health Network and Aetna in Arizona. Steward Health Care and Tufts Health Plan, both in Boston, have also created a narrow network to provide healthcare services at a lower cost. We expect payer and provider affiliations to become more common as additional aspects of healthcare reform are defined and implemented and the demand for low-cost, high-quality healthcare escalates.

Private equity is not new to the hospital industry, as many private equity funds have long backed some of the largest for-profit hospital companies, including HCA and Vanguard. However, two new private equity firms recently entered the hospital ownership model. In 2010, Cerberus acquired six-hospital system Caritas Christi Health System in Boston, now called Steward Health Care, and continues to pursue a growth strategy through the acquisition of other not-for-profit hospitals. In 2011, Oak Hill Capital Partners established a joint venture with Ascension Health, the largest faith-based hospital system in the country, to acquire distressed Catholic hospitals. If these ventures prove to be successful, we anticipate more private equity firms may enter the hospital industry through acquisition.

The Models: Credit Risks Differ Among New Models

We expect that full-asset mergers or acquisitions will be the most common form of consolidation strategy over the near term, although some new models are evolving, each with different credit risks and implications for bond ratings.

In acquisition strategies, the "cost" of the acquisition may include debt and other obligations of the acquired hospital, such as pension liabilities, along with a multiyear capital commitment. When a for-profit hospital acquires a not-for-profit hospital, the debt is redeemed and the rating is withdrawn upon receipt and review of bond documents.

In many not-for-profit merger strategies, the debt of both organizations is refinanced by debt of the newly combined organization, or the higher-rated entity may guarantee or assume the debt of the lower-rated provider. In other cases, each hospital may join each other's obligated group, effectively creating one new credit group. We will assess the impact of the guaranty on the higher-rated credit or the creditworthiness of the combined organization. Sometimes the different debt securities of the merging hospitals are not changed, warranting a determination of the near-term and long-term impact on each borrower's rating.

Joint ventures between not-for-profit and for-profit healthcare systems are emerging across the country. The percentage of each party's ownership interest in the operations usually determines a hospital's tax status. In most joint ventures, the for-profit company usually has majority ownership, which leads to redemption of all debt and an exit strategy for bondholders. Health Management Associates, LHP Hospital Group, and Lifepoint have engaged in this strategy with mainly rural not-for-profit community hospitals, and we expect this trend to continue.

Joint operating companies (JOCs) or joint operating agreements (JOAs) between not-for-profit hospitals largely function like a full asset merger. Our assessments mostly weigh the strength of security on the bonds and which joint operating partner assumes the debt obligation. Accordingly, we evaluate the creditworthiness of a JOC or JOA if it provides security for the debt. As we have seen in the past, disruptions may occur if management and governance roles are complex or not clearly defined, such as requiring multiple approvals from multiple boards. In one instance, management at the JOA had to seek approvals from three different boards for capital spending, budgets, and strategies, creating an onerous process and ambiguity as to which board had final authority.

We expect to see some of the larger systems create separate obligated groups, particularly those that have a faith-based mission but want to merge with secular hospitals. Other not-for-profit systems have created joint ventures with for-profit companies to assist distressed hospitals with their financial and capital needs. Finally, some not-for-profit systems have different obligated groups largely because of state regulatory issues. Catholic Health East, for example, is the sole corporate member of St. Peter's Health Partners in Albany, N.Y. New York regulation currently prohibits hospitals from being obligated on the debt of a corporate parent that is located outside of the state. Nonetheless, the Baa2 rating assigned to St. Peter's debt reflects the shared benefits of being part of a national system while Catholic Health East's A2 rating reflects its strong geographic diversity.

Our ratings reflect the creditworthiness of the security pledged to the bondholders, which includes the impact of nonobligated entities on the obligated group, requiring an analysis of the entire enterprise to understand the management, governance, strategic, and financial relationships among the various entities (see Moody's Rating Methodology: Not-for-Profit Hospitals and Health Systems, Moody's Investors Service, January 2008).

Irrespective of the model used, management teams should be able to engage in much better financial planning due to better technology to assess the short-term and long-term financial risks. These tools include much more sophisticated software tools to assess costs and clinical outcomes, and to produce more detailed financial data.

Exhibit 2


Consolidation and Bond Rating Factors

For all types of consolidation models, our analysis incorporates the five key rating factors in our general rating methodology for not-for-profit hospitals:

  • Governance and management
  • Market position
  • Operating performance
  • Balance sheet and capital plan
  • Debt structure and legal covenants

Key areas Moody's assesses within these broad rating factors are listed in the sidebar below.

We expect consolidation to be a major strategy for not-for-hospitals in the next two to three years as hospitals face pronounced payment pressures and the economy continues its slow recovery. Undoubtedly, the long-term benefits of consolidation will result in greater operating efficiencies and an ability to spread risk across a larger organization, leading to stronger and more stable bond ratings.

Lisa Goldstein is an associate managing director, Moody's Investors Service, New York, and a member of HFMA's Metropolitan New York Chapter ( Goldstein was an HFMA national director from 2006 to 2009.



Key Areas Moody's Assesses Within 5 Broad Rating Factors  

1. Governance and Management  

  • Clarity of roles for senior management team, including the CEO, CFO, and medical staff and nursing leadership
  • Composition of parent and subsidiary boards and clearly defined reserve powers
  • Extent of centralized functions, coordination and control over system entities
  • Likelihood of successfully forming a cohesive governance structure that provides unified direction and avoids conflict caused by historical allegiances
  • Board's ability to execute strategies and respond to unforeseen challenges quickly
  • Adequacy of disclosure practices to all stakeholders, including bondholders

2. Market Position  

  • Integration of physician leadership to support the consolidation and goals to engage physicians in the planning and execution stages
  • Plans to engage and align with community and teaching medical staff, employed and independent physicians, and small- and large-group practices
  • Strategies to address merger of unionized and nonunionized hospitals
  • Goals to achieve market-share growth, increase covered lives 

3. Operating Performance  

  • Integrated operating, financial, and capital plans that outline the short-term risks as well as the expected long-term benefits of the consolidation, including service and facility consolidation or coordination, IT interoperability, and medical staff compatibility
  • Multiyear projections based on conservative assumptions of reimbursement, volumes and expense reductions
  • Scenario planning in the event of an economic downturn or unforeseen challenge and strategies to respond to these events
  • Thorough review by management of methodologies between the hospitals to assess accounting differences in areas such as charity care policies, provision for bad debt, discount policies, and contractual allowances
  • Plans to address inequities in salary and benefits, including pension plans
  • Approach to commercial payer contracting (centralized or local; payment methodologies, unified terms)

4. Balance Sheet and Capital Plan  

  • Assessment of current and future capital needs and funding sources, including IT, inpatient, and ambulatory needs and pension requirements
  • Decisions on asset allocation and investment strategies, along with the use of consultants and investment managers

5. Debt Structure and Legal Covenants  

  • Assessment of outstanding debt and lease obligations, including covenants and exposure to third parties such as banks and swap counterparties
  • Decisions around debt obligations and changes to security packages
  • Receipt of all regulatory and bond approvals, including church approval, university approval, and municipal parent approval, if needed

Publication Date: Monday, April 02, 2012

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