Healthcare M&A reshaped by COVID-19

The COVID-19 pandemic is threatening to postpone, derail or force a restructuring of hospital deals in the works, but an unusual four-hospital, two-system deal is still intact.

Advocate Aurora Health’s Advocate Trinity Hospital, Trinity Health’s Mercy Hospital & Medical Center, South Shore Hospital and St. Bernard Hospital would join forces to downsize aging, underutilized facilities and create a new hospital and several community centers. It would require a $1.1 billion infusion of capital from the hospitals and their parent companies, private donations and the government.

Hospital executives say the merger is still on track, but declined to elaborate if or how COVID-19 has changed timing or strategy.

Initial plans didn’t call for any facilities to close until new ones were opened, but the COVID-19 pandemic may accelerate that, said Michael Buchanio, a principal in West Monroe Partners’ healthcare practice.

“This may expedite closures, especially of hospitals that relied on outpatient elective procedures,” he said, adding that could dent revenue by 40% to 60%. “The CARES Act and short-term relief would likely not be enough to offset that.”

Prior to the onslaught of an unprecedented pandemic that spiked labor and supply costs, the deal was already complicated. It calls for Advocate Trinity and Mercy Hospital to be divested by their respective parent companies and St. Bernard to separate from its sponsor, Catholic Health International, as the institutions look to blend cultures, reposition, revamp decades-old facilities and turn around years of operating losses.

The four not-for-profit South Side Chicago hospitals are within a 20-minute drive of each other, predominantly serving Medicaid beneficiaries, many of whom are battling chronic illnesses. They recorded a collective $84.3 million operating loss in 2018 as they have struggled to maintain hospitals that are too old and too big, executives said.

“Developing a transition plan to carve out three hospitals from their parents and sponsors is complex and requires significant time and resources,” Buchanio said.

Typically, these divestitures include temporary service agreements, which grant access to the parent company’s infrastructure as the new entity gets its footing.

The hospitals’ average inpatient occupancy levels are 45%, and none are leading their respective service areas in market share, according to HMP Metrics data compiled from Medicare cost reports.

“If a larger system’s smaller hospitals don’t support its referral network and fit well, they are taking a more critical look at them,” said Gregory Eli, shareholder at consultancy LBMC. “I don’t know how you sustain the number of hospitals and beds in this country at these census levels.”

Oftentimes, the emotion and optics of maintaining a small community hospital can trump business and financial aspects, he added.

Tentatively, a new 500-bed hospital or two 250-bed hospitals are planned to take the place of the four hospitals’ nearly 800 combined beds. They had planned to sign a definitive agreement and announce a CEO and leadership team by midyear.

The hospitals could aggregate their data to identify future care sites and service lines, like violence recovery, executives said. The community centers would offer urgent care, ambulatory surgery, infusion therapy, mental health services, diagnostics and imaging as well as specialty care.

Similar moves are being made throughout the country, Buchanio said, noting that Chicago’s South Side has changed a lot since the 1950s.

“It’s hard to adapt unless hospitals merge and attack regional patient demographics in a different way,” he said.

Changes to reimbursement, including efforts to spur new models of care, are leading to consolidation and specialization, said Mark Armstrong, a shareholder at LBMC.

“Smaller markets have been encouraged to be more general, but then they have to adapt when they realize they shouldn’t be all things to all people,” he said.

Illinois officials are seemingly supporting this deal because of the treatment barriers that low-income communities face, said Jennifer Perry, managing principal at consultancy FMG Leading.

The hospitals predominantly serve a South Side community that has significantly lower life expectancy than downtown Chicago, the result of food deserts, violence and substandard housing, among other issues.

“Competition isn’t serving all of them or the community that well,” said Perry, adding that several of the hospitals’ faith-based missions may have led to a partnership. “They may have tried to be involved in other transactions that may have not been attractive because of their performance.”

While the new entity will not be a Catholic system, discussions about the church’s Ethical and Religious Directives that ban abortions, gender reassignment surgeries and other procedures are ongoing, executives said.

Catholic and secular hospitals will often set up separate subsidiaries to ensure patients have access to all treatments, but they aren’t performed through the faith-based division, Perry said.

Meanwhile, it’s uncertain whether the funding commitment from local and state agencies and philanthropists was guaranteed.

“The money may be going toward more immediate needs,” Buchanio said. If that’s the case, it may push back a lot of that funding, he said.

Thus, it’s imperative hospital leaders make a compelling case, experts said. The executives must clearly explain the rationale of closures and operations adjustments to the community, Buchanio said.

“An inability to do so erodes trust and can negate or dampen the momentum behind the investment,” he said.

“Given the complexity of the deal, they have to spend time upfront clarifying their shared purpose and manage expectations,” Perry said.

Many hospital deals lead to aggregation rather than integration, warned Gay Casey, a managing director at Berkeley Research Group. Economists have pointed to a number of studies that have shown prices typically rise after hospitals merge while expected savings often fall short.

“They cannot afford to have duplication of administration function,” she said. “They have to optimize resources and sites of service and figure out how to best deliver care for people in those communities. If they try to continue operations status quo, then I would venture to say the outlook is not great.”

Casey remembers one deal where a health system divested a hospital, and they had to set up everything from scratch.

“It took a small army and relentless focus to get that done,” she said.

Each of the four of the hospitals is operating in the red, with 2018 net losses ranging from $1.3 million at South Shore to nearly $70 million at Mercy Hospital, according to HMP Metrics data.

“Working individually, our hospitals will not be able to provide sustained, quality care on the South Side,” Charles Holland, CEO of St. Bernard Hospital, said in prepared remarks.

Mercy Hospital amassed more than $250 million in operating losses from 2014 through 2018. Advocate Trinity Hospital recorded around $30 million in operating losses over that span, much like St. Bernard’s results.

While its finances have been improving, South Shore racked up nearly $7 million in operating losses from 2014 to 2018, HMP data show.

“The financial implications may have forced their hand, creating an opportunity to form a unique approach,” Perry said. “Otherwise, the community faces a loss of income and access to care.”

They can position themselves as a growth opportunity centering around a new hospital and community clinics with a shared purpose, Perry said.

“It is good news for the South Side of Chicago, but there is a lot of work in human capital let alone structural and governance issues to make this deal happen,” she said.

Some of the hospitals involved only have a week or two of cash on hand, Casey said.

“If they are putting in new revenue-cycle processes and IT systems, it could have a major impact on cash flow,” she said. “If they are starting to build new facilities, it is a very scary time.”

Many health systems are laying off primary-care physicians and other staff members deemed “nonessential” to the COVID-19 response. Cash flow issues are paramount, said Christopher Kerns, vice president of executive insights at Advisory Board.

If overall cash levels drop significantly, that can trigger a material adverse change clause. Bondholders can rescind a bond or increase borrowing rates, Kerns said.

“A lot of those bonds are backed by a union fund and university endowments,” he said. “If they get skittish about cash flow, that can trigger material adverse changes resulting in a technical default or rate increases.”

The federal stimulus packages have largely been aimed at supporting cash flow and helping hospitals make payroll.

If hospitals lay off or furlough more than 10% of their workforce, they would have to pay back more of their Small Business Administration loans. There are also limits to executive compensation.

“Before hospitals make big moves like furloughing or firing employees, they should question how those decisions will affect funding,” Buchanio said.

Distressed markets typically create a lot of M&A activity and we are starting to see the beginning of it, he added.

“This is forcing companies to get creative, and they have to look at all their options,” he said. “I don’t think that we will see a downturn in activity. We may see an uptick because of companies that need additional funding or to expand their service offerings so they are not siloed in one market.”

COVID-19 has had a varied impact on hospital transactions, M&A experts said.

No transaction in the first quarter involved a seller with more than $1 billion in annual revenue, according to Kaufman Hall data.

Deals that offer a broader solution to combat the pandemic will likely expedite some transactions in the works. Financial headwinds will also force some administrators’ hands, said Anu Singh, head of the M&A practice at Kaufman Hall. Other hospitals and health systems will aim to get to a key milestone and then pause, he said.

“We believe the stronger the strategic rationale there was to pursue the transaction, the more likely these will continue—understanding the reality that COVID-19 will influence pace and process,” Singh said. “Larger systems with broader and deeper teams often have additional human capital and resources to continue certain strategic initiatives, such as transactions and partnerships—particularly as compared to smaller-scaled service providers where fewer total resources are available.”

The delay of elective surgeries could dent revenue by 40% to 60%, analysts said.

“I believe these pressures will accelerate the need for vulnerable hospitals to merge or be acquired to stay afloat, and fully expect that new models of care will emerge that will likely impact future growth plans, resource allocation and strategic relationships for all hospitals,” Perry said.

Many of the deals that hinged on ambulatory services certainly halted, Casey said.

“For the organization being acquired, it can change the entire structure of the deal and make the acquiring organization rethink what they are actually purchasing,” she said. “With hospitals, it’s a little less clear, but the activity around the deals has come to a halt just due to resources being immersed in caring for the patients or preparing to care for you.”

The priority for all hospitals right now is understanding how much support they will get from the stimulus bills, Casey said.

“They need to figure out what to track, how to qualify and what they are applying for,” she said.

Crain’s Chicago Business’ Stephanie Goldberg contributed to this report.

By the Numbers: Hospital merger and acquisition activity, Q1 2020