Editor’s Note: The healthcare M&A market continues to be among the most active sectors. In a recent webinar, Manatt examined how the policies and goals of the new administration are likely to impact healthcare M&A trends…how changes in the regulatory landscape are likely to affect M&A across all healthcare segments…and what to expect in terms of antitrust regulation and enforcement. The article below summarizes key points from the program’s M&A market overview. To view the full webinar free on demand, click here. To download a free copy of the webinar presentation, click here.

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Healthcare M&A Transactions—Deal Volume and Value

Healthcare M&A deal volume has been robust over the past five years and shows few signs of slowing down. Activity peaked in 2015—the year of the megadeal, particularly in the managed care and pharmaceutical arenas—with almost 1,100 deals approaching $100 billion in aggregate value.

In 2016, there remained a healthy level of activity with 939 healthcare industry deals valued at an aggregate of $71.7 billion. The most active sectors in 2016 included long-term care, hospitals, physician practices, healthcare IT, labs and other outpatient services (such as dialysis). Activity also increased in the rehabilitation, home healthcare and behavioral care segments. In contrast, activity levels declined in the managed care segment, in part because most of the major participants, including Aetna, Humana, Anthem and Cigna, were working through their then-pending deals that had been announced in the previous years. Sector transaction multiples declined slightly, with skilled nursing, assisted living and other facilities feeling reimbursement rate pressures seeing the most significant drops.

In Q1 2017, there were 239 announced deals in the healthcare industry, on par with the 240 deals that were announced in Q1 2016. The trends for 2017 year-to-date are similar to those seen in 2016. Long-term care, healthcare IT, physician practices and hospitals are comprising the bulk of activity thus far, while activity in the managed care and pharmaceutical spaces is more modest—although that could change quickly as the market begins to react to the recent terminations of the Anthem/Cigna and Aetna/Humana deals.

Drivers of the Robust Healthcare M&A Market

There are a number of drivers behind the robust healthcare M&A market, including macroeconomic factors such as a reviving economy, relatively low interest rates (at least for now), and available cash reserves for strategics, private equity and other potential buyers. In addition, the following trends stemming from the Affordable Care Act (ACA), repeal and replace efforts, and other market dynamics continue to influence the pace of healthcare M&A activity:

  • Coverage expansion, leading to the potential for providers and managed care organizations to increase revenues and cash flows, as well as the need for providers to develop additional capacity and capabilities to handle the influx.
  • Continued consolidation, resulting in increased negotiating leverage between payers and providers to achieve cost savings.
  • The shift from the fee-for-service model to population health management, driving novel strategic relationships, new business models and an increased emphasis on consumerism.

Other key drivers in the current marketplace include:

  • Hospitals and health systems seeking to build or expand integrated delivery systems with enhanced technology, clinical protocols and contracting leverage.
  • Investment in innovation and technology becoming increasingly critical to functioning effectively in the new healthcare delivery model.
  • Pharmaceutical companies shifting from in-house R&D to M&A strategies.
  • Private equity (PE) activity in the healthcare space continuing to increase, particularly in healthcare services (i.e., long-term care, rehabilitation and behavioral health), digital health, and medical devices and pharma.

Healthcare Antitrust Enforcement in a New Administration

There were very few pre-election positions taken on healthcare antitrust enforcement—and since the election, there haven’t been many clues about how important antitrust enforcement, let alone healthcare antitrust enforcement, is to this administration. The new administration has been slow to appoint agency leadership. Makan Delrahim, nominated to be the “top cop” for antitrust at the Department of Justice (DOJ), had his confirmation hearing postponed due to a paperwork snafu. Therefore, for now, the DOJ Antitrust Division is operating without permanent leadership. The Federal Trade Commission (FTC) also has not seen much appointment activity. The Commission is now operating with only two out of five commissioners.

In spite of the lag in appointments, healthcare antitrust enforcement is likely to continue in force. There has been a history of bipartisan support for strong antitrust enforcement in healthcare, and the agencies over the last eight years have established a strong track record in prosecuting anticompetitive conduct in healthcare.

In addition, there’s a large and growing body of economic analysis raising concerns about consolidation and its effect on pricing, quality and other metrics. Most studies indicate that the growth of market power in various segments of the healthcare economy is not helping to keep costs down, which is ultimately what everybody wants. The administration continues to be concerned with healthcare cost issues, and acting FTC Chair Maureen Ohlhausen already has said that healthcare and pharma will remain strong focus areas.

Provider Merger Antitrust Enforcement

Hospital mergers are the province of the FTC, which has achieved nine straight wins since 2008. Two recent appellate decisions have confirmed the FTC’s approach to market definition, including the presumption of anticompetitive harm at high levels of concentration. In addition, the courts have remained skeptical of efficiency justifications, not accepting claims that hospitals and physician groups need consolidations to develop the scale to invest or create a continuum of care. There also are concerns that any savings won’t be passed on to insurers.

The states often play a supporting role in provider merger antitrust enforcement. Examples include Idaho in St. Luke’s, Pennsylvania in Hershey/Pinnacle and Illinois in Advocate/North Shore. States generally are supportive of the FTC and hostile to concentration.

Where is provider merger antitrust enforcement going? There certainly continue to be big deals in the provider segment, such as the recent announcements of transactions between the University of Pittsburg Medical Center and Pinnacle Health and Partners and Care New England. In addition, there is the potential for the FTC to focus on other types of provider mergers, such as cross-market mergers across different provider types or adjacent geographies.

There is economic evidence suggesting that these types of mergers can lead to upward pressure on reimbursement rates due to greater provider bargaining leverage and, therefore, that they are anticompetitive. To go after this kind of case would push the envelope for the FTC—but the agency could decide to act on the basis of sound economic theory. At the end of the day, it’s more likely that the FTC is going to take a relatively conservative approach and stick to cases that are in line with the enforcement proceedings it has brought in the past.

Using COPAs to Avoid Federal Enforcement

As federal enforcement has become tighter, some states have turned to state Certificate of Public Advantage (COPA) laws, which entitle the state Department of Health to grant a certificate that immunizes the transaction from federal antitrust oversight. There have been several recent examples of state action protection being tested. For example, in Cabell/St. Mary’s, West Virginia introduced a COPA law under which it would allow the merger to go ahead after the FTC had decided to challenge the transaction in court. The FTC was subsequently forced to withdraw its challenge because under the COPA law, the transaction was immune from federal antitrust enforcement.

The FTC is hostile to these kinds of mechanisms to exempt transactions from the federal antitrust laws. The jury’s still out, however, on how effective they are—and whether their impact on competition has had any adverse effects on the market.

Insurance M&A Under the New Administration

There are a lot of lessons to be learned from the unsuccessful Aetna/Humana and Anthem/Cigna deals. The biggest learning from the Anthem/Cigna deal is that culture remains the most underdiligenced enemy of M&A transactions. Anthem and Cigna hit some cultural shoals during their engagement. It’s a cautionary note that when considering a merger, efforts should be made to ensure there is a cultural match.

It’s important to note that Aetna, Humana, Cigna and Anthem—as well as many others—are still looking for partners, particularly in the Medicare and Medicaid space. They must acquire to grow, and they all have a lot of cash to deploy.

Where are we likely to see growth? The employer market is the largest and most stable, so it probably will not see much movement. Some of the smaller players will certainly be picked up and traded—but even if the employer mandate is repealed, nothing’s likely to change. It’s likely payers that have achieved success in the employer market will realize that they’re over-concentrated there and seek to expand their product lines, particularly into the faster-growing government sectors, such as Medicare Advantage(MA).

Medicare is the third rail of American politics. Even though some more extreme members might like to, the GOP-controlled Congress can’t get rid of Medicare—but it can support efforts to push Medicare members into private MA plans. Therefore, MA is an important sector to watch in today’s political reality. About 25% of the MA market share is outside of the “big seven” payers, leaving a lot of opportunity for transactions and growth.

Medicaid is another area that probably will see a lot of activity. What does that mean in terms of the M&A market? The prevailing sentiment is uncertainty. ACA repeal-replace is in flux, but the direction is clear. The goal of the Trump administration and the GOP Congress is to convert existing entitlement programs to block grants/per capita allotments, which could be a disaster for states, bringing cuts to funding and increases in uninsured rates.

In terms of M&A, however, block grants—which mean greater flexibility for states—present an opportunity for commercial players and payers. Some states already are speaking about potential commercial partnerships with private managed care organizations. The current political climate is likely to accelerate the march toward a public/private benefits administration paradigm, bringing an increased role for commercial players.

The M&A market also is focusing increasingly on joint venturing and cross-platform investing. More and more insurers are deploying capital to build service units or make other alternative investments. In addition, insurers are building joint ventures with other players in different segments, such as hospital systems, pharmacy benefit managers and ambulatory care providers. This allows insurers both to diversify their revenue streams and to position themselves defensively against their competitors.

The new environment brings regulatory concerns. The Centers for Medicare and Medicaid Services (CMS)always will be an issue for companies with significant Medicare revenues. It’s possible that a Trump administration could loosen regulatory constraints.

State regulators also can present issues and increase costs. For example, Centene won approval to purchase Health Net in California only after agreeing to keep its headquarters in the state and spend $350 million on community health measures.

Health Insurer Antitrust Enforcement

Before Aetna/Humana and Anthem/Cigna, the DOJ had reviewed several other health insurer mergers, and obtained consent decrees requiring divestitures to address potential competitive concerns in five of them. After several of these deals, there were economic studies looking at the impact of transferring MA lives to see whether competition had been maintained in relevant markets. The results showed that divestitures had not been successful in containing pricing. The recent megamergers were an opportunity for the DOJ to test its theories of competitive harm in court, using this evidence.

What are the main takeaways from the Aetna/Humana and Anthem/Cigna decisions? Both courts accepted the DOJ’s position on narrow market definitions. In Aetna/Humana, the judge agreed with the DOJ that Medicare Advantage was a separate market from traditional Medicare. Once that decision was made, there were 364 counties where both Aetna and Humana offered MA plans, which the court found could result in a monopoly.

Anthem/Cigna presented a different issue. In that case, the focus was on the provision of an administrative services only (ASO) contract to large national accounts, which the court defined as companies with more than 5,000 employees spread over at least two states. Looking only at that customer segment, the court found that there are just four insurance companies capable of offering national services, and the merger would reduce that number to three, making the transaction anticompetitive.

These cases illustrate that agencies and courts will look critically at any potential divestitures. Although Aetna spun off certain MA plans representing 290,000 members in 437 counties to Molina, the court was skeptical of Molina’s ability to take on the MA business—a concern echoed in documents authored by Molina’s executives. That development is a cautionary tale about how things beyond a company’s control can make the process more difficult.

There are other key health insurer antitrust cases underway. For example, there is an in re Blue Cross Blue Shield class action litigation going on which could be a market disrupter. There were two class actions, consolidated in Alabama, that allege the Blues’ system of dividing states between themselves and putting limitations on Blues companies’ ability to have non-Blues’ business is effectively a market restraint. The outcome of this case has the potential to shake things up in the insurance market and open up opportunities for deal making.

Overall, the DOJ is in a relatively strong position. Deals among the five largest insurers are likely to face significant antitrust headwinds; but, the devil is in the details. It is important to identify specific business overlaps to uncover possible issues.

Conclusion: Trends to Watch and Considerations for Deal Execution

To summarize the current trends in the healthcare M&A market:

  • Consolidation across most segments is expected to continue—at least until the “irresistible M&A force” runs into the “immovable antitrust object”;
  • Wellness, population health management and digital health technologies are likely to continue to be high-growth areas, with the managed care space likely to remain active following the termination of the recent Anthem/Cigna and Aetna/Humana transactions;
  • Novel and creative strategic relationships will continue to develop among industry participants to adapt to the dynamics of the marketplace; and
  • As an outgrowth of these new relationships, there should be expansion in the number and type of potential investors and funding sources, including through private equity.

In terms of transaction execution, there are several areas that are commanding increased attention and resources:

  • Regulatory Compliance. Parties are devoting significant resources for confirming Stark and Anti-Kickback Statute compliance—not just in terms of historical compliance (with billing and coding audits, contract reviews, etc.), but also in terms of the quality and scope of the target’s policies and procedures to ensure that an ongoing “culture of compliance” exists. If and when issues are uncovered, there are frequently discussions between buyers and sellers as to whether the matter is of a nature that should require self-reporting (and if so, who bears the economic and operating risks that might result from the self-report).
  • Privacy and Data Security. While privacy and data security are increasingly relevant to all business enterprises, the healthcare industry presents some unique risks and challenges, given that protected health information (PHI) and other sensitive information are central to the services provided and the industry’s processes generally. As providers, systems, payers and other participants become even more interconnected through technology and integrated delivery systems, the potential for security breaches—and the resulting implications—are likely to increase exponentially. Therefore, deal participants are spending significant time and resources to scrub current IT and related systems, identify any known breaches and assess any vulnerabilities (and the costs to address them). Privacy and data security, along with regulatory compliance, are also key focus points when it comes to negotiating representations and warranties and related indemnity provisions. In some instances, the parties end up negotiating separate parameters around these subjects in terms of baskets, caps and survival periods. There is also increased interest in considering representation and warranty insurance or other insurance coverage to manage these risks.
  • Valuation Reports and Analyses. In the area of diligence, valuation analyses and reports are commonplace in many transactions to support the parties’ determinations as to fair market value and commercial reasonability (i.e., under Stark and Anti-Kickback regulations). Among other things, it is important to address the scope and methodology of any such report early in the deal process, and with appropriate input from legal counsel.
  • Antitrust. It’s obviously important at the outset of transaction discussions to conduct a realistic assessment of antitrust risks and concerns presented by the proposed transaction. There needs to be candid and informed discussions of how the market is likely to be defined in each instance, where the overlapping operations are and what the options are for addressing these matters with the appropriate regulators, whether at the federal or state level. Parties should also anticipate a candid discussion and negotiation of which side bears the risk of a failure to gain antitrust approval. In addition, both teams need to be thoughtful in preparing board books, management presentations and other internal communications (i.e., so-called 4(c) documents for purposes of Hart-Scott-Rodino (HSR) filings), with an eye toward the likelihood that these will be produced to antitrust regulators and will factor into their analyses. There is a tension here, in that internal communications often seek to support the transaction by showing the positive impacts that the transaction will have on such things as market share, pricing power, ability to compete more effectively with others, etc. The fact is, however, that these statements will be viewed in a much different light by the antitrust regulators. Accordingly, communications need to be crafted thoughtfully and strategically (and hopefully, with the benefit of legal input) to avoid potential pitfalls down the road. Finally, to the extent that the diligence process will include a review of payer contracts or other sensitive pricing information, parties should be very thoughtful about the manner and timing for this specific process. There are a number of approaches that can work, but they generally involve providing only high-level, “bundled” or de-identified data at the early stages to help inform a go/no-go or pricing decision, with a follow-on process that may involve a review conducted by a third party who will once again report only limited data to the other side. The goal is not only to preserve the integrity of the deal from the standpoint of antitrust review, but also to avoid potential antitrust issues down the road should the parties not proceed with a transaction and remain competitors in the marketplace.
  • State and Local Government Approvals. Many transactions—particularly hospital and payer combinations—will typically require some level of state or local government approvals. The parties should, of course, identify the applicable approvals up front, and develop a strategy and game plan for advancing the transaction with the appropriate agencies. In doing so, it is important to identify at the outset individuals or groups who may be opposed to the transaction based on their own agendas—e.g., other competitors, labor unions or other issue advocacy groups—and then develop a strategy for responding to these groups’ arguments. A question that is also likely to come up in the negotiations is the extent to which one or the other parties to the transaction must agree to make financial commitments or other commitments pertaining to its business operations if required as a condition of obtaining these approvals.
  • Closing Conditions. With regard to closing conditions, parties are carefully evaluating any kind of material adverse change (MAC) condition in the context of the current political climate and resulting market uncertainty. Unlike many closing conditions that have become somewhat standardized, the MAC condition can take on added significance in negotiations, given the prospect for actions to repeal and replace Obamacare, reduce federal funding for Medicaid, etc. One can guard against these risks by framing the condition to exclude changes or effects on the industry generally, but the parties may want to anticipate possible changes that could have a disproportionate impact on the target, and then allocate the risk between them accordingly.
  • Post-transaction Considerations. It’s never too early to focus on postdeal integration planning from operations, governance and other relevant perspectives. In addition, communication plans are essential, from the initial announcement through the closing and beyond. The plan should encompass both internal and external communications and, if applicable, factor in compliance with relevant securities laws. Finally, with novel deal structures being presented, lawyers are spending increased amounts of time working with clients on post-transaction governance and related structures. In instances in which a party is being acquired in total, there may not be much mystery, but in the context of affiliations, joint ventures and other forms of strategic relationships, governance structures and associated decision matrices can often take a fair amount of creativity and, ultimately, time to negotiate and document.