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A look at the financial, branding and cultural considerations when deciding to acquire or merge with another hospital.

Mergers and acquisitions are common occurrences in healthcare. The impetus behind consolidation can range from shifting patient demographics to new and disruptive technologies, but financial concerns are almost always at the root — which means the acquiring entities always assume some modicum of risk when pulling the trigger on these deals.

Oftentimes, the acquirer will subsume members, who then become part of the larger system. This brings risk if the hospital being acquired is distressed. These hospitals either don’t have the in-house expertise or aren’t willing to hire outside expertise, or they take shortcuts with physicians and kickbacks, according to Roger Strode, a partner with Foley and Lardner, who said he has seen it time and time again.

“They tend to be so cash-strapped, and they’re in such dire need, that they’ll take risks that other systems won’t take,” said Strode. “You might not have a pool of indemnification, so it takes a lot to get these deals done. The other risk is that they’ve brought on a base of employees so you’ve got cultural risk.”

Cash-strapped hospitals, for instance, are likely to operate under a different culture than organizations that have the financial means to pay for strong leadership. And then there’s the risk of how the healthcare provider is going to be perceived in the community. Will they be looked at as the hero swooping in to rescue the struggling hospital, and keep its promises, like maintaining services in the community? There’s risk if the acquirer hasn’t done its due diligence and realizes only after the fact they they can’t keep all the services it said they would. The health of a company’s branding is on the hook.

There’s a tremendous amount of diligence to keep in mind when making these deals, said Strode. There are lawyers and outside accountants to hire. There’s understanding the material contracts. And there’s hashing out what the five-to-10-year financial plan is going to be.

“There’s a certain amount of mission-driven thinking that goes into this,” said Strode. “If you’ve seen one of these deals, you’ve seen one of these deals. Healthcare is local, markets are different, so every deal is a little bit different. Some feel that if they don’t grab it now, their competitors will grab it, so they’ll fix the problems after they get it. Sometimes there’s a concern they’ll go to bankruptcy, and then it’s really difficult to acquire them.”

Rob Fraiman, president of Cain Brothers, sees most merger and acquisition activity taking place among nonprofit entities, more so than in the investor-owned world. There’s certainly some of the latter — Tenet and Universal Health come to mind — but they’re generally the exception, and structurally, most of these nonprofit transactions are outright sales of a hospital. They’re essentially mergers with a membership substitution, so a tax exempt entity merges with another tax-exempt entity and substitutes the tax-exempt member of the company with the new business.

“They don’t pay any cash, typically,” said Fraiman. “And the acquirer essentially picks up all the liabilities as well as all of the assets of the system. As far as risks, they’re merging with an enterprise that may have financial stress, which may be what’s leading the board to choose to do a transaction. Those financials don’t go away just because a transaction happens. It happens if the acquiring entity can go in and make some significant changes.”

There are also elements related to what kind of payer contracts the entity has. When two systems join together, replacing the contracts the acquirer has with the payer is not a quick, snap-of-the-finger type of move. It happens over time. Initially, the buyer is stepping into the shoes of whatever the seller has in place. Those contracts are a part of the reason there’s stress on the part of the target entity, so the acquirer is assuming that risk, though it tends to be short-term risk.

Capital is what drives a lot of those transactions, said Fraiman. Ultimately, the hospital industry is very capital intensive. In many of these instances, the target hospital or health system looks at the three-to-five-year time horizon and concludes they don’t have enough capital to invest in their business, and they need some deeper pockets. It’s not about price. It’s about terms, and how much capital they’re prepared to commit.

“There’s a huge risk the buyer is taking to assess whether the amount of capital they’re willing to commit over five or eight years is in fact going to be a good investment,” said Fraiman. “And if it’s not, that’s a huge risk, obviously, for the acquirer. At that point they’re really committed to it.”

There’s a view in the healthcare industry that scale is critically important, said Fraiman. Large corporate players are transforming how they’re operating in the healthcare economy.

“You’ve got some very, very large transactions that are happening in other parts of the healthcare economy, typically in the payer world, and that has a huge impact on hospitals,” he said. “In a given market or state, there’s a handful of insurance companies, and if a couple of them combine, that can have a real impact on the hospital system. Similarly, physician groups are going through a massive consolidation. All of that has a direct or indirect impact on health systems.”

Strode said that risk is slowly shifting away from insurance companies, and that this has had a catalytic effect on the ways mergers and acquisitions have played out in healthcare over the past several years.

“Insurance companies used to handle all the risk,” said Strode. “Now when they’re pushing that risk on hospitals and health systems, they have to spread that risk over larger and larger populations of people. They need more people to spread that risk. They need more doctors to spread that risk. The system needs to be bigger. You’re looking to be bigger because bigger geography gets the attention of payers. Smaller hospitals and community health systems can’t keep up. They can’t negotiate the same deals. They’d rather join them than fight them.”

Strode said that, despite the decreased number of independent facilities due to consolidation, the trend is still good in terms of market competition — at least for now — because it tends to drive down prices. He sees continued consolidation in the coming years, partly because there are still a lot of fragmented markets throughout the country. There are also a lot of academic medical centers that are expanding their sphere of influence by swallowing up some of the smaller hospitals around them.

Fraiman said the key to these deals is to be as prepared as possible.

“Like any business, it’s all about management,” said Fraiman. “Do they have the management capability to actually implement what they say they’re going to implement? That’s really hard. The implementation is harder than the deal. The deal might takes six months or a year, but you’ve got to live with it forever.”