The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
The economic downturn and resulting restricted access to capital have caused many hospitals to consider a partner or other affiliation strategy. Declining volumes and the deteriorating payer mix, a result of high unemployment rates, are further forcing these discussions — as are the seemingly countless opportunities for capital rich hospitals to acquire struggling, undervalued hospitals.
Recent healthcare reforms signed into law may have a further impact on hospital affiliation. In fact, a recent Moody’s report predicts that “as governmental auditing and oversight of revenue are tightened, hospitals will be pressured to operate more efficiently, forcing spending cuts and mergers among smaller hospitals after 2014.” In layman’s terms: as reform legislation reduces Medicare reimbursement and disproportionate share funding, and with higher costs, less efficient hospitals could see further Medicare reductions under the law’s efficiency provisions.
Affiliating or acquiring may be the right thing to do, but before taking such a step, there are some considerations for both parties. From the perspective of the facility that needs a partner to survive in the long term, the executive team and board of directors need to carefully consider the type of affiliation needed (i.e. what objectives need to be achieved through the affiliation) and the type of partner needed.
From the perspective of the hospital needing a partner, there is a continuum of control that the board wants to consider (i.e., How much control and independence do they want or have the ability to retain?). At one end of the spectrum is an affiliation arrangement that simply calls for cooperation between the hospitals for some mutual benefit and virtually all control is maintained. At the other end of the spectrum is an acquisition of one facility by the other and all control is surrendered to the acquiring facility. In between are management agreements, clinical affiliations, lease transactions, and more formal partnerships with legal and financial commitments by each party.
Consideration should also be given to the benefits provided by the other party. For example:
Another consideration is whether the acquiring hospital or system has had experience with successfully acquiring other facilities. The merging of two cultures and achieving the synergies planned are not always easy or successful. Those facilities with a successful track record of achieving these objectives are more likely to be successful again. Does the acquiring facility have the management staff depth to assume the assimilation of another hospital into the organization’s structure?
Does the acquiring facility have the ability to recruit physicians in a different way? If so, they may be able to bring physicians who can facilitate strategic growth initiatives.
Achieving synergies through elimination of duplicate services and departments seems rather simple on paper, but are often met with failure due to poor execution or cultural conflicts. Do not underestimate the cultural differences between two organizations that come together.
And what are the capital needs of the acquiring facility? Are they capital starved? If so, they won’t have the capital to fund your capital needs either.
Debt Factors
Most debt structures have broad provisions for mergers and acquisitions, and they often require bondholder or lender approval prior to such a transaction. Reviewing the debt documentation is a key first step in proceeding with any affiliation/merger discussion.
Hospitals must understand what corporate entity is obligated in the outstanding debt of the hospital being brought in, usually known as the Obligated Group. For example, a debt obligation may be supported by both a hospital and its physician practice group – two separate entities. The merger/affiliation, however, may be desired with the hospital only. Understanding the assets or collateral the hospital owns and the debt it can support without the physician practice group is important to knowing how it might be able to refinance or restructure existing debt. In addition, the acquiring hospital/system may have limitations on its ability to restructure its Obligated Group and must understand current refinancing limitations on its own debt before proceeding with the merger/affiliation.
My Debt is Your Debt
A hospital with outstanding letter-of-credit-enhanced debt may see its debt structure improved by affiliating with a partner that brings a stronger financial position or banking relationship to the table. The LOC may be able to remain in place, saving both hospitals the time and cost of refinancing. Further benefits can be realized if the acquirer has a significant banking relationship with the letter of credit provider, which may prove cost beneficial.
HUD/FHA Section 242 mortgage-insured loans are assumable by acquiring hospitals, with approval from FHA, and they remain non-recourse to the affiliation/acquiring hospital. It is important to understand the limitations of transfers among affiliated entities when assuming such a financing structure, but the current limitations on transfers are not overly burdensome and should not be viewed as a deterrent to the affiliation/merger. FHA-insured loans can be assumed by either nonprofit or for-profit hospitals.
USDA direct loans may be assumable depending on the acquirer or affiliation partner. USDA financing is limited to nonprofit hospitals that are rural and that cannot access other means of capital. If an affiliation changes any of these features, then the USDA financing would most likely have to be refinanced. If the partner is a similar-sized rural nonprofit, then assuming the debt may be negotiable.
If a hospital is considering a new debt instrument and is also considering a future affiliation/merger, it should proactively consider future flexibility in creating its financing documents. Potential negative implications of a merger/affiliation can be minimized or eliminated through active management of debt covenants and prepayment requirements within the financing documentation.
Lastly, as organizations consider a merger/affiliation, they need to evaluate the impacts of such a transaction on the investment portfolios of each as well as any interest rate mitigation contracts such as swaps, caps or collars on the new combined entities. Often these contracts will also include provisions related to mergers/affiliations, which may impact the ultimate decision and/or timing of the transaction. A comprehensive balance sheet analysis needs to occur along with the evaluation of the debt instruments of both parties.
Mike Johns is vice president, Finance Practice, at Quorum Health Resources. For additional information on QHR’s consulting solutions, contact vice president Susan Hassell at (866) 371-4669. Tanya K. Hahn is senior vice president at Lancaster Pollard. She can be reached at (614) 224-8800 or thahn@lancasterpollard.com.
The economic downturn and resulting restricted access to capital have caused many hospitals to consider a partner or other affiliation strategy. Declining volumes and the deteriorating payer mix, a result of high unemployment rates, are further forcing these discussions — as are the seemingly countless opportunities for capital rich hospitals to acquire struggling, undervalued hospitals.
Recent healthcare reforms signed into law may have a further impact on hospital affiliation. In fact, a recent Moody’s report predicts that “as governmental auditing and oversight of revenue are tightened, hospitals will be pressured to operate more efficiently, forcing spending cuts and mergers among smaller hospitals after 2014.” In layman’s terms: as reform legislation reduces Medicare reimbursement and disproportionate share funding, and with higher costs, less efficient hospitals could see further Medicare reductions under the law’s efficiency provisions.
Affiliating or acquiring may be the right thing to do, but before taking such a step, there are some considerations for both parties. From the perspective of the facility that needs a partner to survive in the long term, the executive team and board of directors need to carefully consider the type of affiliation needed (i.e. what objectives need to be achieved through the affiliation) and the type of partner needed.
From the perspective of the hospital needing a partner, there is a continuum of control that the board wants to consider (i.e., How much control and independence do they want or have the ability to retain?). At one end of the spectrum is an affiliation arrangement that simply calls for cooperation between the hospitals for some mutual benefit and virtually all control is maintained. At the other end of the spectrum is an acquisition of one facility by the other and all control is surrendered to the acquiring facility. In between are management agreements, clinical affiliations, lease transactions, and more formal partnerships with legal and financial commitments by each party.
Consideration should also be given to the benefits provided by the other party. For example:
- If capital needs are driving the decision, then the strength of the balance sheet of the acquiring facility should be evaluated. Will they be able to provide the capital needed for the coming years?
- If expanding the hospital’s market is the objective, will the partner provide the complementary service lines, the brand name and reputation that will enhance the ability to increase market share?
Another consideration is whether the acquiring hospital or system has had experience with successfully acquiring other facilities. The merging of two cultures and achieving the synergies planned are not always easy or successful. Those facilities with a successful track record of achieving these objectives are more likely to be successful again. Does the acquiring facility have the management staff depth to assume the assimilation of another hospital into the organization’s structure?
Does the acquiring facility have the ability to recruit physicians in a different way? If so, they may be able to bring physicians who can facilitate strategic growth initiatives.
Achieving synergies through elimination of duplicate services and departments seems rather simple on paper, but are often met with failure due to poor execution or cultural conflicts. Do not underestimate the cultural differences between two organizations that come together.
And what are the capital needs of the acquiring facility? Are they capital starved? If so, they won’t have the capital to fund your capital needs either.
Debt Factors
Most debt structures have broad provisions for mergers and acquisitions, and they often require bondholder or lender approval prior to such a transaction. Reviewing the debt documentation is a key first step in proceeding with any affiliation/merger discussion.
Hospitals must understand what corporate entity is obligated in the outstanding debt of the hospital being brought in, usually known as the Obligated Group. For example, a debt obligation may be supported by both a hospital and its physician practice group – two separate entities. The merger/affiliation, however, may be desired with the hospital only. Understanding the assets or collateral the hospital owns and the debt it can support without the physician practice group is important to knowing how it might be able to refinance or restructure existing debt. In addition, the acquiring hospital/system may have limitations on its ability to restructure its Obligated Group and must understand current refinancing limitations on its own debt before proceeding with the merger/affiliation.
My Debt is Your Debt
A hospital with outstanding letter-of-credit-enhanced debt may see its debt structure improved by affiliating with a partner that brings a stronger financial position or banking relationship to the table. The LOC may be able to remain in place, saving both hospitals the time and cost of refinancing. Further benefits can be realized if the acquirer has a significant banking relationship with the letter of credit provider, which may prove cost beneficial.
HUD/FHA Section 242 mortgage-insured loans are assumable by acquiring hospitals, with approval from FHA, and they remain non-recourse to the affiliation/acquiring hospital. It is important to understand the limitations of transfers among affiliated entities when assuming such a financing structure, but the current limitations on transfers are not overly burdensome and should not be viewed as a deterrent to the affiliation/merger. FHA-insured loans can be assumed by either nonprofit or for-profit hospitals.
USDA direct loans may be assumable depending on the acquirer or affiliation partner. USDA financing is limited to nonprofit hospitals that are rural and that cannot access other means of capital. If an affiliation changes any of these features, then the USDA financing would most likely have to be refinanced. If the partner is a similar-sized rural nonprofit, then assuming the debt may be negotiable.
If a hospital is considering a new debt instrument and is also considering a future affiliation/merger, it should proactively consider future flexibility in creating its financing documents. Potential negative implications of a merger/affiliation can be minimized or eliminated through active management of debt covenants and prepayment requirements within the financing documentation.
Lastly, as organizations consider a merger/affiliation, they need to evaluate the impacts of such a transaction on the investment portfolios of each as well as any interest rate mitigation contracts such as swaps, caps or collars on the new combined entities. Often these contracts will also include provisions related to mergers/affiliations, which may impact the ultimate decision and/or timing of the transaction. A comprehensive balance sheet analysis needs to occur along with the evaluation of the debt instruments of both parties.
Mike Johns is vice president, Finance Practice, at Quorum Health Resources. For additional information on QHR’s consulting solutions, contact vice president Susan Hassell at (866) 371-4669. Tanya K. Hahn is senior vice president at Lancaster Pollard. She can be reached at (614) 224-8800 or thahn@lancasterpollard.com.