Hospital M&A deals continue at a rapid pace. Evaluating a prospective deal requires a more detailed process of transaction due diligence than ever before, as tightening reimbursement and pressures to lower costs mean decreasing margins for error in decision making.
The due diligence process should include not only a rigorous analysis of the target organization’s financial performance and position “as-is,” but also a thorough assessment of the operational, strategic, and financial “deal value” that would be created by the proposed transaction, and determination of the impact the transaction would have on the target organization, the acquiring organization, and the combined system. This comprehensive picture of prospective financials will inform the decision on whether to move forward, and help shape or reshape proposed deal terms.
To create this comprehensive financial picture, the due diligence process needs to address each of the components discussed below.
The Foundation: Volumes and Services
Develop a full understanding of the target hospital’s service area, volume trends, market share, and physician network. This will help in identifying opportunities to bolster and expand key service lines and improve access to physicians and services. It will also provide a basis for identifying low volume, unprofitable, or other potential candidates for service consolidation or redistribution among system sites.
If the acquirer and the target facilities are in close geographic proximity, it’s likely that some volume will shift from the system’s current facilities to the acquired hospital, and vice versa. Take this into account in projecting shifts of market share to avoid counting this natural cannibalization as net volume gained or lost to the system.
Properly considering population demographics and growth estimates, as well as expected changes in utilization rates and payer mix is essential to the blocking and tackling of developing a robust financial model. In some markets, these can have a substantial impact on future volume and revenue trends. Since competitors are likely to implement whatever strategies are in their power to mitigate the impact on their patient volumes, be sure that projections account for competitor response to the transaction; this will provide a reality check for anticipated volume increases.
Synergies: Proceed with Caution
While potential economies of scale are a key driver of M&A activity, the magnitude and pace of realization of anticipated synergies is typically overstated. A Bain & Company executive survey and analysis of deal data and company financial performance in various industries found that an estimated 70 percent of merging companies overestimated synergies, and that those overestimations were the second most common reason for disappointing deal outcomes.i Recent research on hospital mergers by Deloitte and HFMA found that while some expense reductions were achieved, the revenue of the target hospital also generally declined;ii overall, acquired hospitals did not improve their financial and operational performance in the first two years post-transaction.
Being realistic about what can actually be achieved will ensure financial benefits are not overstated. Rather than using a top-down approach to expense reductions and applying a savings percentage (e.g. 3% or 5%), use a thoughtful bottom-up approach that identifies and quantifies specific areas where economies can be achieved. Assessing these opportunities as part of the due diligence process, with input from subject matter experts at both the acquiring and target organization, will foster alignment between counterparts and identify specific areas of opportunity.
Think carefully about the effort and elapsed time that will be needed to achieve the identified synergies, especially in light of the flurry of integration efforts that will be taking place once a deal closes. Give priority to a short list of low-hanging fruit that can be implemented within the first three- to six-months. Much of the timeframe and urgency for expense reduction efforts will be dictated by the target’s current operational and financial performance.
Capital Commitments: Stress Test
Access to capital and investment in facilities and infrastructure are key drivers for community hospitals seeking to partner. But allocation of capital dollars to the target must be carefully vetted given an environment of thin margins and scarce capital resources.
Due to deal pressure and timing constraints, the capital commitments agreed to in the LOI are typically not assessed with great rigor before the LOI is signed. Start by assessing the magnitude of proposed capital commitments and whether the target and system can absorb the potential strain they will place on the income statement and balance sheets. Then assess ROI for strategic capital investments in new facilities, services, or programs and in physician network growth, to ensure the investments make sound business sense. Consider the acquirer’s broader strategic vision: Are there other areas for program development, or expansion opportunities with higher potential ROI, which require reallocating capital commitment dollars?
Debt and Capital Capacity: Big Picture Impact
The transaction’s probable effect on the combined organization’s underlying debt, capital structure, and balance sheet is a critical component in assessing overall viability. Analyze existing debt covenants and the transaction’s potential impact on applicable financial ratios, funding of capital commitments and other planned capital projects, the transaction’s impact on credit ratings (especially if the target is in dire financial straits and requires a turnaround), and opportunities to improve the debt structure and cash flow by consolidating, restructuring, or refinancing debt post-transaction.
Extending Population Health, Value-Based Payment, and Other Initiatives and Payer Programs
Formation of a broader network that can better manage population health and performance under value-based payment arrangements is often a key driver for the transaction. Where this is the case, a thorough understanding of the target’s related current resources and performance, as well as the impact of extending system programs and strategies to the target, should be an important aspect of the prospective financials.
These analyses could include the effect of extending system ACO or CIN participation and contracts, developing narrow network products with commercial payers, or extending bundled payment programs to the target. In determining the impact of these initiatives, account for changes in utilization and reimbursement, as well as incremental resources and expenses needed to support value-based payment efforts including data analytics and care management activities. Carefully assess the quality performance of the target organization, considering readmission rates, HCAHPS scores, and other metrics that will have an increasing impact on reimbursement as value-based arrangements are rolled out.
Threats to Deal Value: Impact of Risks
Due diligence efforts will assess all facets of the target organization and determine key areas that pose risks for the acquirer. Typically, there are a handful of risks that may have a material impact on future operations and should be incorporated into the forward looking financial picture, particularly those that will have an ongoing impact or that may compound over time. Determine which potential risks pose the biggest threat to realizing deal value and assess the ability to mitigate or eliminate each risk, to estimate the prospective financial impact accordingly.
Walk Away or Move Forward?
While walking away from a deal can protect the organization from risks or the headaches of acquiring a troubled hospital, it can also have negative impacts. Several different scenarios may need to be analyzed to understand the effect of not completing an acquisition, depending on the proximity of other potential suitors and their presence in the service area of the potential acquiring and target organizations. Develop contingency plans for addressing these possible impacts.
For example, consider a target community hospital that transfers complex cases primarily to two comprehensive regional hospitals that compete with each other, one of which is the potential acquiring organization. If the deal does not go through and the target is acquired by the other hospital, the majority of transfers could shift to that hospital, causing a significant negative impact on the original prospective acquiring hospital.
If none of the risks are deal-breakers, and attention has been given to lesser risks that can be addressed during or after the transaction, the deal can proceed. Be certain that the components discussed above, as well as other relevant transaction-specific impact factors, are used to inform decision-making about the overall viability of the deal and specific deal terms before a definitive agreement is signed. Understanding the likely post-transaction financial picture and the range of possibilities through scenario and sensitivity analyses will allow the leadership team to move forward with a solid foundation of understanding for the work they have cut out for them in the coming years.
Significant time and effort is required to thoroughly assess the financial impact of an acquisition, but it will provide a roadmap for post-transaction financial planning and will greatly increase the likelihood that deal value will be realized.
i Bain & Company, “Why Some Merging Companies Become Synergy Overachievers”, August 2014.
ii The Deloitte Center for Health Solutions and the Healthcare Financial Management Association, “Hospital M&A: When done well, M&A can achieve valuable outcomes”, October 2017.
Sean Looby, MHA, Manager
Sean has worked with academic medical centers, community hospitals, health systems, post-acute care providers, and health plans. He assists health care organizations with strategic, financial, and business planning, as well as with valuation analyses, physician compensation planning, and clinically integrated network development.
The views, opinions and positions expressed within these guest posts are those of the author alone and do not represent those of Becker's Hospital Review/Becker's Healthcare. The accuracy, completeness and validity of any statements made within this article are not guaranteed. We accept no liability for any errors, omissions or representations. The copyright of this content belongs to the author and any liability with regards to infringement of intellectual property rights remains with them.