A recent report from PwC finds that for-profit and nonprofit hospitals across the country continue to look at strategic affiliations and acquisitions with a large appetite.
The "bigger is better" mentality has led to a busy time for those who must valuate the deals. Frank Fehribach, director of real estate at VMG Health, discusses why he thinks hospital mergers have increased so much during the past half decade, what other real estate options hospitals are looking at and why the definition of "value" differs among the ranks of the C-suite.
Question: Hospital and health system mergers and acquisitions have undoubtedly been on the rise the past few years. In your mind, what are the most important issues executives need to focus on pre- and post-transaction?
Frank Fehribach: First, executives must be concerned with setting up transactions that do not lead to a violation of the Stark Law or Anti-Kickback Statute. Making sure all components of the transaction are set up under fair market value is critical to this. Typically a third-party valuation to support the FMV of the transaction's components will protect the health system. Since I deal with real estate, I typically estimate a fair market rent (FMV of the lease) for a transaction that will contain a lease between a hospital (or other provider) and physicians.
Second, a well-thought-out plan on how the acquisition fits into their system is important. The Patient Protection and Affordable Care Act has incentivized health systems to grow bigger. Conversely, a small hospital health system will find it difficult to survive in the new healthcare environment created by PPACA. Therefore, smaller hospital health systems need to merge or affiliate with a larger health system. There are numerous obstacles to these mergers/affiliations, such as legal, physical, religious and cultural, and all of these need to be thought through for a successful transaction. Recently, the courts have determined that the ProMedica-St. Luke's merger needs to be unwound because of antitrust reasons. This is an example of a legal obstacle that executives need to plan for.
Tangible assets (real and personal) make up the majority of the value of assets on a balance sheet. Many smaller health systems being acquired have a significant amount of deferred maintenance and need a large capital infusion to be successful. Executives need to proactively assess a hospital's physical condition before a transaction is complete. I would strongly recommend the engagement of an engineering firm to do a physical assessment of the real estate in a transaction.
Several health systems have religious affiliations. Executives must consider the implications of a merger to the religious order that the health system is affiliated and whether that will be a good fit for their health system. Finally, a health system has a culture, and the acquiring health system's executives have to consider the ability of the health system being acquired to fit into that new culture.
Post transaction, the acquisition/affiliation needs to be valued at its fair value for financial reporting. Therefore, all material assets need to be valued. Executives need to work with their outside audit firm and their third-party valuation firm to manage this activity. Early communication between the audit and valuation firms is essential to developing a reasonable scope of work that will satisfy the accounting requirements but not be too excessive. Additionally, the third-party valuation firm should have experience working on financial reporting engagements and have the capability of valuing all of the assets (real estate, fixed assets and intangibles) and not just one component. It is typically a mistake to hire multiple valuation firms to value the different assets.
Q: What do you think is causing the consolidation? Healthcare reform? The theory that America is "overbedded"? A need for capital requirements, like more expansions or electronic health record systems?
FF: Healthcare reform has created the greatest need to consolidate. The need for expansions and electronic records are just an offshoot of the PPACA. While in many areas hospitals are "overbedded," the PPACA exacerbates that problem. First, the bundling of reimbursement payments provides incentives for health systems to add physician practices and facilities so that they can maintain the majority of that bundled reimbursement and control the process. Then the changing reimbursement environment has created pressure to limit inpatient stays, which exacerbates the "overbedded" situation. Finally, additional requirements, such as electronic records and the changes made in disproportionate share hospital payments, create pressure through additional costs and lower revenue that small health systems are finding it difficult to maintain their independence. Many hospitals are finding that they need to go through an expensive process of repositioning themselves. Therefore, many small health system executives find it is preferable to merge/affiliate with a larger health system that has the resources to fund the repositioning.
Q: How do outpatient buildings fit into today's narrative? When it comes to medical office buildings and real estate investment trusts, what do you think are the most important trends?
FF: Many health systems are monetizing their medical office buildings or using developers and real estate investment trusts to add needed MOBs without having the costs associated with this construction. Once again, larger health systems seem to have a relationship with REITs while smaller health systems do not. MOBs are needed as physician groups are added to the staff of a healthcare system.
Many hospitals also need additional specialized healthcare facilities. A common arrangement for a health system that wants to add an MOB to its campus would be for the healthcare system to ground lease a land parcel to a developer. The ground lease is commonly used to protect the hospital as they will restrict the developer. As an example, you would not want the developer to lease a big section of the new MOB to the hospital's competitor. Once the developer stabilizes the new MOB in terms of leasing, the developer sells the MOB to a REIT. Alternatively, the hospital can have the developer build-to-suit the MOB, and then the hospital can sell the building (maintaining ownership of the land) to the REIT. The hospital would typically master lease the building and then sublease as they see fit.
Q: You mentioned the Stark Law and Anti-Kickback Statute earlier. How should hospitals and health systems factor those into their fair market valuations of real estate? What should executives consistently review?
FF: Hospitals and health systems should continuously monitor Stark and Anti-Kickback compliance through the use of FMV appraisals and the monitoring of their physician leases. Many health systems initiate their leases correctly only to fall out of compliance because they fail to renew them properly. Some examples of this would be not timely renewing the leases (allowing them to stay in a month-to-month status); not enforcing holdover clauses; and not adjusting the rent to a FMV level at renewal. Health system executives should support physician lease rates with third-party valuation opinions and put in place a monitoring system to avoid lapses when physician leases renew.
Q: You deal with pretty much everyone involved in a hospital transaction: the presidents, CFOs, controllers, board members and others. Do you find it interesting to see how everyone's viewpoint of "value" differs? How do their definitions of "value" differ?
FF: Truly, value is in the eye of the beholder. Some view it from the compliance aspect and are very concerned that FMV provides them cover for Stark and Anti-Kickback compliance. This is especially true in pre-transaction work. The pre-transaction work will involve the president, vice president of real estate, vice president of development and possibly CFO. The post-transaction work will deal with fair value (FASB standards) and mostly involves the controller and CFO. They will be more concerned with how the allocation between real estate, fixed assets and intangibles affects their depreciation, level of contribution and amount of goodwill.
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