Spurred on by growing economic challenges, many remaining independent community hospitals are currently considering some degree of affiliation with a larger health care system. This is not surprising as hospital mergers and acquisitions have steadily been increasing since the recession of 2007-2009.

According to Irving Levin Associates, there were 51 merger or acquisition deals in 2009, 75 in 2010 and 86 in 2011?the highest number in the past decade. Moody’s Investors Service reported in March 2012 that this consolidation trend is expected to continue.

Drivers of Hospital Consolidation

There are several factors driving the pace of mergers and acquisitions for independents: volume growth constraints; struggling local job economy; continuing cuts to Medicaid and Medicare reimbursements—two major payer sources; rapidly changing technologies; other hospital consolidations in the regional market; limited geographical growth opportunities; poor payer mix; and difficulty in accessing capital to make needed improvements. Any one of these market forces would put enough pressure on a hospital’s revenue base to push it toward affiliating with a bigger, more financially stable hospital or hospital system.

Furthermore, the Patient Protection and Affordable Care Act?ACA for short?is expected to push independents to strongly consider an affiliation with other hospitals as health care reform is phased in. Its implementation for hospitals is projected to raise the costs of doing business (increased compliance) and to reduce revenues (reimbursement cuts), making it more difficult for smaller hospitals to remain autonomous. Additionally, by mandating new delivery models to reduce health care costs and improve quality, the ACA will encourage hospital consolidation by rewarding integrated health care systems that can achieve these goals.1

The Need To Affiliate

While the economic pressures cited above are external drivers, there are several internal indications that may signal when an independent hospital should consider aligning itself with another hospital or hospital system. When conducting an assessment of a stand-alone hospital’s ability to remain independent, leadership should focus on some of these key indicators:

• Ongoing financial problems, including a strained balance sheet and an unfavorable cost position hindering the ability to reduce expenses to stay competitive
• Limited debt capacity to meet current or long-term capital needs
• Inability to attract and retain physicians, in both primary care and key specialties
• Reduction in total market share and a lack of profitable service lines
• Poor clinical performance
• Deteriorating utilization and financial performance trends
• Weakened position in negotiating rates with insurers
• Ability and willingness to pursue new opportunities.

Once the assessment has been made and leadership believes the hospital can no longer remain independent, it is not always a “merge or perish” situation. There is a range of affiliations that a hospital’s leadership can consider from a fairly simple cooperation agreement between hospitals for some mutual benefit, such as group purchasing, to an acquisition of one facility by the other in which all control is surrendered to the acquiring facility. In between are management agreements, clinical affiliations and lease transactions?each one a formal partnership with legal and financial commitments by each party.

It is important that board members and senior management understand what is involved with each type of affiliation?the resulting legal, governance and financial aspects of the transaction structure under consideration. While the idea of partnering may seem to be the obvious decision, the benefits of any type of affiliation must be weighed against the loss of independence, local control and flexibility.

Types of Affiliation

• Affiliation or cooperation agreement: Smaller hospital can benefit from purchasing power of a larger health care provider for vendor contracts.
• Management agreement: Larger hospital or health care system will agree to manage operations of a community hospital. Board governance is still maintained at the local level.
• Clinical affiliation: Partnership with larger hospital where defined referral relationship is agreed to formally.
• Lease transaction: An acquiring partner may agree to lease facilities and/or operations from a community hospital.
• Acquisition: Outright purchase of a hospital by a larger provider. Local control and governance is lost in this type of transaction.

Do Your Due Diligence

Once a decision is made to move forward with some level of affiliation, the community hospital needs to find a suitable partner. The first step is to determine the goals of the partnership and the desired characteristics of the larger hospital or health system. A chief consideration for any independent looking to partner with a larger hospital or health system is to achieve financial stability. Ideally, the potential partner should have a strong credit rating, a stable credit profile and a willingness to support and invest in the smaller facility.

The next step for the independent is to try to rectify any problems that would deter potential suitors regarding any financial (bond issuances, pension liabilities, capital leases, interest rate swaps and other debt) or regulatory liabilities. It also needs to provide a complete compliance plan, detailed histories of accreditation reviews, Medicare audits, environmental surveys and financial and billing audits.2

Financial Considerations

While due diligence is being undertaken, a comprehensive balance sheet analysis along with an evaluation of the debt instruments of both entities needs to be completed. Special attention should be given to the documents of any existing financings that may be in place with either party. Some of the provisions that might need to be addressed include the following:

• Redemption or defeasance?Will the documents require that a current financing be either redeemed or advance refunded through a defeasance? If yes, how will this impact or hinder the transaction? Redemption is less costly; however, if there is a lock-out period on the bonds, then defeasance will be required.
• Membership substitution or asset transfer?Will a trust indenture allow a substitution in membership or transfer of assets? Leadership should know the requirements that need to be met in order to allow for this.
• Transfer of assets out of the obligated group?How will the new parent be supported financially?
• Change in control: Although most debt structures have broad provisions for mergers and acquisitions, they often require prior approval from bondholders or lenders prior to the transaction. How does a change of control affect the hospital being acquired?
• Approvals and consents?What parties are required to approve changes to these provisions? Typically the trustee, who serves on behalf of the bondholders and issuing authority, may be required to approve any changes.
• Restrictions on admission into the obligated group?Bond documents address how an asset or entity may become a member of an obligated group. An obligated group allows organizations to combine assets or entities to create a single entity that becomes jointly and severally liable for debt.
• Interest-rate mitigation contracts?Swaps, caps or collars may impact the decision or timing of the transactions.

Additionally, hospitals must also evaluate the impacts of a merger on their individual investment portfolios. The best way to protect investments is to have a highly liquid, well-diversified portfolio. The acquiring system also may choose to liquidate the investment portfolio to pay down existing debt, or if existing debt is not paid down, liquidated investments are re-invested by the acquiring institution. In the case where a merger is between two smaller hospitals, the investment strategy should be reviewed before, during and after the merger. To stabilize, ensure liquidity and in anticipation of a very different debt structure of the resulting entity, they should introduce a new strategy for the risk profile as determined by the new entity’s financial strength and risk propensity of its board members.

Here’s the Thing

Hospital affiliations, particularly mergers, can be challenging. During the process it’s important to have a certain degree of alignment in terms of mission, strategies, services and culture plus a shared understanding of what facility will assume the predominant role after the merger.
Deals often take time and are slow to coalesce. At the same time, market conditions can change rapidly, so hospitals looking to partner must be nimble and react quickly to new realities. Transparency, flexibility, attention to details and open communications with stakeholders will make the transition from being an independent to being a health system…not exactly easy, but easier.

John Randolph is a vice president with Lancaster Pollard in Atlanta. He may be reached at jrandolph@lancasterpollard.com.

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