The big squeeze

Coming on the heels of the recent Tenet-Vanguard merger, last week's proposed $3.9 billion tie-up between Community Health Systems and Health Management Associates demonstrates the rise of the hospital mega-system as a response to declining inpatient volumes and payment rates. It would create the largest hospital chain in the country by hospital count.

The deals, if consummated, would reduce the number of large, publicly traded hospital companies from seven to five. They also come as not-for-profit systems—such as Catholic Health East and Trinity Health, whose May deal creates a system with $12.8 billion in operating revenue—are similarly consolidating and rolling up independent hospitals across the country.

As the big get very big in the investor-owned and not-for-profit hospital worlds, the stakes are being raised across the country for smaller, independent, not-for-profit facilities that increasingly are being driven toward alliances, formal and informal, to achieve the same purchasing and hiring power and economies of scale.

A report last month from Moody's Investors Service—issued in response to Tenet Healthcare Corp.'s acquisition of Vanguard Health Systems—said blockbuster tie-ups among for-profit providers put pressure on smaller, stand-alone facilities. For instance, a large hospital system is in a better position to recruit physicians, giving it more leverage with payers and offering a diversity of services that draw patients into its network. Smaller hospitals, particularly in rural areas and smaller cities such as those owned by Community and HMA, often have a hard time recruiting top-notch physician groups.

“We're seeing an increased awareness and even a sense of urgency from not-for-profit systems to band together to match the for-profits,” said David Cyganowski, managing director at consulting firm Kaufman Hall. “These two deals are leading indicators that size and scale matter.”

In an interview, Community Chairman, President and CEO Wayne Smith said the proposed deal allows his Franklin, Tenn.-based system to develop its physician and outpatient-care networks, adding not only 71 hospitals, but 472 clinics and 1,000 physician offices. Building those networks increases the entry points through which patients access the system—a key benefit at a time of falling patient volumes, particularly on the inpatient side.

Community and HMA operate primarily in nonurban areas, and both systems have reported declining admissions numbers in their past two quarterly earnings reports.

“The volumes are a little more critical in nonurban hospitals than urban hospitals,” Smith said. Over the short term, the deal would allow Community to diversify and find synergies where it can cut expenses. “As 2014 gets here and we start enrolling people (in health insurance exchanges), then the revenue will start to grow,” he predicted.

The deal will give Community at least 10 hospitals in eight of its 29 states, Smith said, adding that it also allows the system to pursue additional contracts with payers.

Community and Tenet have both highlighted the opportunities to cut costs and achieve operational efficiencies through the mergers. The deals also allow the systems to increase their clout in states where they already have strength.

Community's proposed deal with HMA would bring together 206 hospitals in 29 states, according to the companies. Community would acquire all of HMA's outstanding shares with a mix of cash and stock. Including the assumption of HMA's debt, the companies valued the deal at $7.6 billion.

Tenet last week received antitrust approval for its $1.8 billion acquisition of Vanguard, which Tenet says will create a system with 77 hospitals in 30 markets, with a largely urban focus.

One notable difference between the Tenet and Community deals is the focus on new payment and delivery models. While Tenet emphasized the value of Vanguard's experiments with these new models, including accountable care organizations, Smith said Community remains skeptical about ACOs. Nevertheless, he said his company is preparing for “whatever comes in the next five years,” including population health management and the increasing strategic importance of outpatient care.

There are some concerns about overlap in the markets where Community and HMA both have hospitals. Even if they don't reach the level of giving the new merged company market power that would prompt action by antitrust regulators, the added market power may put pressure on stand-alone hospitals in those states.

Community has a hospital presence in each of the 15 states where HMA hospitals operate. In at least three states—Alabama, Florida and Oklahoma—the systems own hospitals within 20 miles of each other.

Smith acknowledged that the systems share some territory and that Community would agree to divestitures if necessary. “We'll have to work our way through that,” he said. “It won't be anything that would derail the deal.”

George Paul, a healthcare antitrust attorney at White & Case, agreed. He said he doesn't expect regulators to find substantial overlaps on the “highly localized” level on which regulators are likely to evaluate the deal.

Van Conway, CEO of Conway MacKenzie, a restructuring and financial advisory firm, said the costs of operating a free-standing, full-service hospital are unsustainable in the long-term, especially as reimbursements are cut and patients travel to larger facilities for higher-acuity conditions. He said they are facing powerful pressures to sell or face closure. “The big guys want to buy them for the referral business,” he said.

Martin Gaynor, a professor of economics and health policy at Carnegie Mellon University, cautioned that there is strong evidence that hospital consolidation raises prices, particularly when the number of competitors is reduced in a given market. In one study in the Bay Area of California, that price increase was as much as 20% to 40%.

Yet even when the number of competitors doesn't change, there's evidence that having a multistate system in a market puts the stand-alone at a competitive disadvantage, and may even raise prices.

Large chains have the advantage of being able to leverage their scale in negotiations with payers, said William Vogt, associate professor of economics at the University of Georgia's Terry College of Business. “You're a less valuable contracting partner if you only bring one hospital to the table,” he said.

Suzanne Delbanco, executive director of Catalyst for Payment Reform, similarly noted that multistate chains often try to establish a single rate across the system that may be “way higher than (local) competitive payment rates.”

“They try to put into place an all-or-nothing approach,” she said.

However, Gaynor said the for-profit consolidation is rippling over to the not-for-profit space. “Firms feel in essence that they're engaged in a game of musical chairs,” he said. “No one wants to be left standing when the music stops.”

Yet many stand-alone hospitals remain “fiercely independent” and are finding other ways to compete with mega-systems, Cyganowski said. They are doing so through looser alliances such as Stratus Healthcare, which brought together 23 hospitals in Georgia, and the BJC Collaborative, a four-hospital partnership in Missouri and Illinois. Novant Health, a 12-hospital system in Winston-Salem, N.C., has made a business out of nonownership deals through its shared savings division.

Still, those alliances are barred from negotiating jointly with payers without a legal change in ownership.

Connecticut, once a state with three large health systems and a multitude of independent hospitals, has seen for-profit systems buy up stand-alone facilities, with Vanguard leading the way.

Vincent Capece, president and CEO of Middlesex Hospital in Middletown, Conn., has watched the for-profit interest heat up in the state. He acknowledged that large systems can take advantage of economies of scale and raise money more cheaply from the bond market. However, he said mergers can also create “dis-economies of scale”—more layers of management, more time to make decisions and issues with melding cultures.

“The biggest strategic threat is reduced government reimbursement, which we all rely on,” he said. “One of the fundamental factors that will drive performance is getting your operating costs in line with your revenue stream.”

The 211-bed Middlesex Hospital undertook an evaluation several years ago and decided against linking up with a larger partner, and it's sticking with that decision for now.

“I don't know how much longer that will be viable,” Capece said. “I personally believe that healthcare is still a local business. I still believe there are still markets where individual hospitals will survive.”

Follow Beth Kutscher on Twitter: @MHbkutscher