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HealthCare Appraisers - Redeening Healthcare Valuation Since 2000 30 Executive Briefing: Hospital & Health System Transactions Sponsored by: 7 Common Reasons for Hospital Transactions www.HealthCareAppraisers.com | info@hcfmv.com | (561) 330-3488 DELRAY BEACH | DENVER | DALLAS | CHICAGO | PHILADELPHIA By Nicholas J. Janiga, Manager and Matthew J. Muller, Senior Associate, HealthCare Appraisers W e have observed an increase in the number of transactions between hospitals over the past three years. This increase is driven by a host of factors — most notably the Patient Protection and Affordable Care Act of 2010. Observed transactions include outright acquisitions of one hospital by another, as well as joint operating agreements or joint venture structures between previously independent hospitals. Through our direct experience with these transactions and supplemental research, we have compiled the following list of the seven most common drivers of hospital transactions. 1. Financial condition While demand for healthcare services continues to rise and healthcare constitutes an ever greater portion of the United States Gross Domestic Product, not all hospitals are experiencing robust financial performance. In many markets, hospitals are feeling strained by the increased competition of market consolidation and the pinch of crushing levels of debt and high fixed operating costs. In some instances, this results in a violation of bond covenants, a reduction in bond ratings, or worse, bankruptcy. As a result, struggling hospitals have chosen to align themselves with a more financially secure health system, either as a proactive approach to remaining viable or as a last resort through the bankruptcy process. A recent case in point is a health system which experienced a credit rating downgrade from "CCC" to "C" in the beginning of this year. A suitor is currently in negotiations to acquire the health system and restructure its liabilities in an effort to save the troubled system from insolvency (names intentionally omitted). The high and relatively inflexible fixed cost structure of hospitals necessitates growth in size to achieve the economies of scale to remain both viable and competitive. The larger a health system, the better off it is in negotiating payer contracts, contracting for medical supplies and the more it can leverage the costly implementation of information technology systems such as electronic health records. This all comes at a time when hospitals must continue to do more with less. Revenue sources for hospitals are continually under pressure, with the recent sequestration in Washington, D.C. the latest in a string of cost cutting measures impacting the industry. As part of the sequestration, there will be a two percent decrease in Medicare payments to hospitals beginning April 1, 2013. The pressure on revenues is not unique to government payers, and commercial payers are also taking actions to control cost that impact reimbursement. As such, hospitals must seek to find ways to maintain or increase revenues through additional services or increased volumes, or continually cut expenses in order to stay profitable and maintain the capital needed to stay competitive. 2. Access to capital The rapidly changing landscape of healthcare has taken the need for capital to new levels. As electronic health records replace paper charts, health systems have been required to invest millions in the software, hardware and staff training necessary to implement EHRs throughout their systems. Additionally, advances in medical technology have led to continuing increases in costs associated with the latest technologies available in medical treatment. Case in point would be proton therapy for cancer radiation, as a proton facility can cost in excess of $100 million to construct. Expansion of facilities to include new service lines or centers of excellence can be costly, though necessary, to stay competitive. Even routine maintenance capital outlays, such as building renovations or outdated equipment replacement, can prove costly given the highly capital intensive nature of health systems. Consolidation in local healthcare markets has been occurring rapidly in recent years, as health systems have purchased freestanding imaging centers, ambulatory sur- gery centers, physician practices and other outpatient ancillary businesses. Without adequate access to capital, a health system may find itself unable to participate in this consolidation activity and ultimately lose key services and market share to its competitors. An example of this includes formerly independent physician practices, who may have previously serviced multiple hospitals in a given market, but after being acquired they now only utilize the hospital where the physicians are employed. This may force the now weaker health system to seek a sale of itself to a larger health system, as it loses market share and has a harder time finding the providers necessary to provide adequate care to the system's patients (Note: the volume and value of physician referrals may not be taken into consideration when determining the fair market value purchase price of a physician practice, regardless of any potential impact on health system). 3. Declining and/or changing census Population changes to a specific region have led to increased consolidation among hospitals as well. Certain hospitals have observed shrinking populations in their service area, which may not have been projected when a facility was built or expanded years prior. This is especially true in rural markets and in the Midwest, where several manufacturing plants have closed or been outsourced. By merging with another health system in the local market, a hospital struggling with revenue associated with its low patient census may be able to realize overhead expense synergies and relieve margin pressures. Another population trend relates to a shift of patients to more high-deductible plans with health savings accounts. Health systems generally have a harder time collecting feefor-service payments from their patients as opposed to payments remitted from commercial payers. As a result, a shift toward more private payers will put pressure on revenue, and in turn, profit margins.