Is Bigger Better?

The basis of hospital mergers has historically been argued as a net benefit to patients because of diversification and scaling resources while consolidating negotiating power with health plans. Does this bear out from what you’ve seen?

First and foremost the thing to remember is, in order to heal patients in the most appropriate environments, hospitals are incredibly capital intensive. And the amount of dollars that it takes to be competitive in the inpatient business and the fact that we’re such a workforce-dependent industry, the perception might not always meet reality when it comes to hospital consolidation.

When hospitals get together, it is most of the time driven by the fact that we need bigger and bigger balance sheets to support the ongoing investment in technology and age of plant to make us competitive with consumers and the clinicians we must recruit to provide care. And then the other piece is that hospitals—the inpatient business—are not very profitable. People see these big buildings and a lot of capital being spent, but most hospitals have a low-single-digit margin for their hospital beds. So the only way sometimes to grow is by merging or looking for merger partners of some kind. Some health systems, like UK HealthCare, have pursued a model of collaborating on service lines across broad geographies—such as cardiovascular care or oncology—which is a less capital-intensive model.

There has been a tremendous amount of research done that has looked at whether you can find scale or if scale helps drive down cost. While the evidence is a little bit mixed, I think there are really good peer-reviewed articles out there that say if hospitals merge you can find synergies in cost. You could also rationalize healthcare services a little bit so you don’t have duplication of very high-cost inpatient services. That is where good public policy matches good strategy. Then the question is, what is the effect of consolidation on price? Think about who our biggest payer is. Our biggest payer is Medicare, now, I think almost everywhere, followed by Medicaid. And there’s very little price variability in Medicare. There’s geographic variability, but Medicare is going to, in general, pay at the same rate regardless of if you’re consolidated or not.

So it does then come down to the commercial insurance space or the self-funded space. And there’s no doubt we need a lot more research to happen right there about the effect of consolidation, specifically on self-insured and fully commercially insured contracts. I used to talk about how the fact that, because we’re so heavily regulated, maybe the markets don’t work perfectly and it’s hard to disrupt healthcare. There’s no doubt that there’s more disruption than ever and the traditional margin making activities at hospital systems are being encroached upon by disruptors.

Like who?

In primary care, there’s finally some uptick in patients using apps on their phones and iPads to interact with primary care physicians and pediatricians. And those companies that are doing that are managing a greater number of scripts that are being written and then dispensed. And so I think at the consumer-to-physician level there is finally some disruption happening. There is also disruption from the standpoint that these large national healthcare systems are starting to make inroads in direct-to-employer contracts so that traditional referral patterns of high-cost cases get disrupted and moved out of a traditional referral region and to a national health system of some kind. The ancillary space—imaging, ambulatory surgery centers, outpatient surgery—as the certificate-of-need laws change, private practice physician groups and private equity groups are starting to play a bigger and bigger role in that space. Private equity is starting to deploy capital directly in the physician space and in the healthcare ancillary space. There’s all these threads in the healthcare industry where 10 years ago we talked about technology being a disruptor. But it never really showed up, so people stopped believing in it. Then it started to show up…and it’s all being driven by the fact that consumers are directly paying for a greater portion of the healthcare cost than ever before.

Is the effect on hospitals that they are losing some of the market?

If you talk about small, rural hospitals, they are going to continue to struggle and will depend on—in states like Kentucky—Medicaid expansion in order to sustain a margin of some kind. That means they must operate at a low cost. Small, rural hospitals will continue to look for ways to access capital for primary and secondary care because of the workforce and the cost to do it, again driving consolidation. So that is a world where the use of telemedicine for emergency medicine, primary care and psychiatry can work and help hospitals survive and continue to be an important economic driver in their local community. In large urban areas, these factors of disruption on the outpatient side are driving consolidation to try to protect margin and to have income to reinvest in the system. They will also continue to drive large health systems to be more specialty oriented or geographically oriented in order to build the infrastructure necessary to take care of the patients who need hospitalization. And there will always be a population—I think as long as we’re alive—that will need hospitalization of some kind with a lot of support and services.

What do you believe are the most important factors and determinants related to a hospital transaction?

I think this is true for all the industries you’re looking at, but culture fit and leadership. If you don’t know those two things are solid, you’re not going to have a good transaction. Every industry is littered with examples of where the cultures didn’t fit or there wasn’t true leadership on both sides through the transactions and integration of the transaction. I think you have to have a tremendous amount of due diligence in our business because of how much money is at stake and the balance sheet effects of the transaction. You really have to have a two-way due diligence process, because both sides—even if you have a hospital that’s struggling going into a strong hospital—have to really come together to ensure that, from a strategy perspective, there’s a fit. From an employee culture and benefits standpoint, there’s a fit. From a physician medical group standpoint, there’s a fit. We track about 18 different work streams that we do due diligence on. But it works best when it’s a bidirectional due diligence process. Because both sides are setting expectations along the way of how implementation will go and what the long-term fit is. Implementation takes a while, integration takes a while, so you can limp along for, say, the first three years of a transaction. But if you don’t have that true fit and expectation setting and communication up front, you can get sideways pretty easily in these kinds of big megadeals.

Do you believe the calculus for hospital M&A has shifted in recent years, and do you believe it will shift in the coming years?

My short answer is no. I think those data show there was a lot of consolidation the several years following the ACA. I think true value-based contracting between hospitals and payers of any kind has been slow to move, but frankly that may be different based on what part of the country the hospital is in. So this idea that we need to have huge IT systems in place and clinically integrated networks in order to manage a population of 8 to 10 million people, it just hasn’t played out like that. And so I don’t think that transactions are being driven by value-based medicine. I think they’re still being driven by the need for access to capital and the opportunity to reduce costs and rationalize expensive healthcare services. There are opinions out there that say the idea of more value-based payment models, more risk-taking payment models, is driving healthcare payers to want to control more of that risk/reward factor. Do you think that falls along the same lines of just not really bearing out yet?

If you look at the transactions that have been happening on the payer side, it has really shifted from trying to increase your risk pool so you have less risk and you’re able to reinsure it better—those types of mergers from an account standpoint have decreased. But the way PBMs and insurers and frontline healthcare providers have merged with payers, I think, is much more indicative of how we might create new ways or reuse old ideas regarding managing the cost equation a little bit better if payers have the ability to directly manage care at the consumer level. When you look at these huge national pharmacy companies all looking at deals with the payers, that’s mutually a benefit. We get so much scale on the PBM side, but we also, from the payers’ perspective, have feet on the front line that we can direct our consumers to in pharmacies for very low-cost care.

Do you believe regulators have built the right rationale in both improving and challenging hospital mergers?

I think that there’s plenty of regulatory protection out there for consumers and payers and everyone in the healthcare industry. I don’t think the answer is more regulation. But every time the executive branch turns over, there’s probably a little bit different perspective on antitrust, in general. And I think we’re still trying to argue about what is truly monopolistic behavior, anymore, when there are disruptors and when geography doesn’t matter as much as it used to matter.

What do you think the trend will be in terms of vertical integration through payers’ acquiring providers and providers’ developing health plans? How does this change the strategic nature of hospital-centered M&A?

I really think the hospital industry has proven over and over again that having hospital- based health plans is not a successful strategy for hospital systems. And we can now point to some really big-time failures in provider-based plans as qualitative feedback that hospitals can’t build up a risk pool big enough to really compete against the Anthems or Uniteds of the world.

Now, on the other hand, United, Humana, Anthem are all starting to make acquisitions that help them be more vertically integrated, and I think, if you approach that from the standpoint of trying to reduce your risk of urgent-care costs and ancillary costs like imaging, outpatient surgical costs, it’s actually a pretty smart approach if you’ve got the population base in the same geography that matches up.

Do you believe we will get to some kind of end state here, and what would that look like?

I don’t think we will. I think we’re so subject to changes in the regulatory environment that it is a constant state of change with one asterisk: hospitals are extremely capital intensive and for now extremely workforce dependent. Because of that, a lot of disruptors will be scared off from getting into the hospital inpatient business. And the purpose that a lot of the larger tertiary, quaternary hospitals provide, this very high-acuity ICU care, where we have programs like pediatric solid organ transplantation, bone marrow transplant, ECMO [extracorporeal membrane oxygenation] programs, clinical trials in oncology, you need huge scale to be able to deploy those types of resources. I think that space will be very difficult to disrupt. While there’ll be some consolidation there, at some point your ability to grow scale is not as helpful from a margin-making standpoint as the first couple of those are. That’s really for the kind of classic, large, urban teaching or semi-teaching hospitals.

I think the community hospital space, where there are national players and for-profit players, will continue to grow and the disruption will be people exchanging hospital portfolios just like other industries, including insurance, do. Then the small, rural hospitals are going to be the place where, if want to protect them, we have to have true regulatory protection in place to keep them going. But I think it will continue to unfold as an interesting space to watch from an M&A standpoint. All it takes is a small regulatory change at the federal level or a small regulatory change at the state level to completely reshape the traditional hospital industry, because our margins are so small and we’re so sensitive to changes with the government payers.