Providers jeopardize deals as they rush into M&A talks

Healthcare executives often point to a persistent financial pressure that has accelerated strategies to cut costs, grow revenue or potentially scale up. That pressure may be causing providers to hastily enter mergers or acquisitions without the proper due diligence, some M&A experts say. 

Hospitals, particularly of the not-for-profit ilk, have struggled to boost revenue enough to keep up with rising labor, technology, supply and compliance costs. They are also closely eying threats to their business models as new competitors take shape. Outside investors are behind the scenes of many healthcare deals, scanning for new opportunities.

In some cases, hospital and health system executives are prematurely signing a letter of intent to get under the hood and take a look rather than diligently forming a detailed offer, said Angela Humphreys, head of the healthcare practice at Bass, Berry & Sims.

“This is putting the cart before the horse,” Humphreys said, adding that outside of the hospital sector, most deals aren’t announced until the definitive agreement is signed. “You open yourself to a lot of scrutiny and criticism if you haven’t brought in your stakeholders. In some cases, it can make a deal dead on arrival.” 

A letter of intent, which typically includes exclusivity provisions, confidentiality mandates and sometimes deadlines, once represented a firm handshake—a good faith commitment, said Joe Lupica, chairman of Newpoint Healthcare Advisors. 

“Now some think that it is more exploratory. A letter of intent is signed to do due diligence; that is disappointing,” Lupica said. “People are under pressure to get into the game and get quickly to an LOI.”

More private equity money is flowing into the industry as healthcare deals have yielded more than a two-times return, a recent report from Bain & Co. found. Global private equity deal value surged almost 50% to $63.1 billion in 2018, up from $42.6 billion, according to Bain. 

The number of healthcare deals involving private equity firms is estimated to reach nearly 750 in 2019, up from 229 a decade prior, according to PricewaterhouseCoopers. Total assets under private equity management have increased by $600 billion since 2006, up to $1.35 trillion in 2017, PwC’s data show. 

Private equity investment coupled with some of the big tie-ups like CVS and Aetna are causing providers to think about how primary and long-term care are shifting, and may be accelerating merger talks, said Gurpreet Singh, a partner at PwC and its health services sector leader.

“The threat of a lower-cost or value play occurring in the provider space is putting pressure on about 70% of their revenue, which is why we are seeing more conversations,” he said. 

The number of failed deals hasn’t increased significantly, said Robert Creighton, managing partner at Farrell Fritz who focuses on mergers and acquisitions. About a quarter of announced deals don’t come to fruition, a ratio that has stayed relatively constant, he said.  

Baylor Scott & White Health and Memorial Hermann Health System called off their merger in February, about five months after the Texas-based health systems signed a letter of intent. 

Atrium Health (formerly Carolinas HealthCare System) and UNC Health Care scuttled their deal last year, about six months after the letter of intent was signed. Just this month, Atrium entered into another agreement to merge, this time with Wake Forest Baptist Health and Wake Forest University.

Cone Health and Randolph Health, also based in North Carolina, called off their deal in May 2018 after more than a year of talks as Cone Health was unwilling to “scale back projects or put them on hold,” Cone Health executives said.

“More often than not it’s related to a mismatch of expectations or a clash of culture,” Creighton said.

There needs to be buy-in from leadership, physicians and the community, experts said. Frank discussions about culture and objectives are needed. Leadership teams should be mapped out as well as defined-benefit pension plans.

Pensions, especially legacy pensions, can often be the elephant in the room during large corporate mergers, said John Lowell, Atlanta-based partner and actuary at October Three, an actuarial firm specializing in retirement plans. It is often challenging for hospital executives to quantify the expense, particularly when forecasting combined balance sheets, he said.

“It is a dance and there has to be trust built, a lot of which has to do with the expectations built up informally through a series of nonbinding arrangements,” Lupica said. “It is not all science; some of it is art.”

Sanford Health has completed four significant mergers over the past decade, most recently consummating its merger with Good Samaritan. But the deals it has walked away from may be more telling. 

It has yet to have a transaction stall between the letter of intent and definitive agreement. It could be a byproduct of the amount of the time and effort that goes in before the letter of intent as Sanford meticulously reviews strategic alignment, potential structural remedies, financial performance and cultures, said Micah Aberson, executive vice president at the Sioux Falls, S.D.-based health system.

“It may be a Midwestern thing where you give a handshake, say you will do the deal and stay true to your word,” he said. 

But when the fit isn’t right, one can sense it, Aberson said. The deals that don’t get done lack transparency and open communication, he said. 

“It’s hard to quantify the ‘it factor,’ but you know when it exists,” Aberson said. “You have the same camaraderie and spirit and see the world in the same way. It starts with the culture and leadership.”

Governance and control can often be a deal-breaker, said Neil Olderman, a partner in Drinker Biddle & Reath’s healthcare practice. Hospitals are sizable employers, and it’s hard to rationalize huge cuts without adequate protections. Egos can clash. Compliance issues can also arise, especially with lower-performing hospitals, he said. 

Regulatory and antitrust issues rarely thwart a transaction, Bass, Berry and Sims’ Humphreys said. “It’s typically more around other issues related to expected synergies and a gap in valuation,” she said. 

Healthcare industry mergers and acquisitions continue at a fast clip—setting a record at 1,882 deals in 2018, up more than 14.4% from 2017, according to PwC. There were 79 hospital transactions in 2018, marking a slight decline from the prior year.

Consolidation will likely continue as care shifts to outpatient facilities, a change that requires significant investments. Access to capital and improved negotiating leverage are also big draws, experts said. A driving force behind M&A has been private equity investment, said Ryan Binkley, CEO of M&A advisory firm Generational Equity.

But the dip in hospital deals in 2018 and relatively quiet first quarter of 2019 may signal a slower M&A pace, Olderman said. Hospital M&A volume reached its lowest mark in the first quarter in nearly a decade, which may indicate a more deliberate approach to dealmaking, according to a new white paper by Ponder & Co. “A little bit of the air has come out on the super aggressive ‘if you are not partnering you are dying’ model,” Olderman said. 

There are certain service line and one-off deals that may happen with greater frequency, but the unproven strategy of large asset sales, mergers or member substitutions that typically require ceding some control is losing steam, he said. “Deals will be more of a rifle shot and less of a shotgun approach,” Olderman said. 

Scale isn’t necessarily a panacea, research shows. A related Navigant study dismissed a link between higher revenue and improved operating margins. Some have been deterred by buyers that bit off more than they could chew, Olderman said.

“As they contemplate building beds and adding new towers, folks are asking if an arms race is really the solution. Or, should they be looking at more outpatient, telehealth and other consumer-driven options,” Olderman said, adding that joint ventures and less-formal affiliations are becoming more popular.

Successful health systems often do well because they remain true to their mission; they won’t sacrifice that just to grow, experts said. 

No one goes into a deal with the expectation that it is going to fail, but it’s important for the board to consider how to present the failure to the public.

It may be bad optics if providers call off a transaction early in the process. Potential partners may be turned off after a deal collapses. But certainly, no deal is better than a bad deal, Humphreys said.

“There is nothing worse than doing a bad deal,” she said.