Merger and acquisition activity in the health care sector is on an upswing, as predicted in January by Moody’s Investors Service's 2010 Outlook. However, whether these acquisitions will realize their intended benefits may depend on how well the parties involved have considered, and executed, their key objectives.
Moody’s Outlook cited two primary deal motivators that are particularly acute for stand-alone nonprofit hospitals: limited access to capital at a time when capital needs are increasing, and a need for economies of scale. Nonprofit health care systems, like their for-profit counterparts, are seeing opportunities to acquire distressed facilities hard hit by the economic recession.
Many commentators also believe the recent federal health care reform legislation (the Patient Protection and Affordable Care Act) will encourage further consolidation within the industry, including among hospitals, as hospital providers seek expanded breadth of services and economies of scale in devising newly structured health care delivery ventures.
Certain success factors will help both nonprofit buyers and sellers achieve success, whether the transaction takes the form of a merger, affiliation, or other corporate combination. Seven of those factors are discussed in this advisory.
1. Know and remember your rationale
Whether buying or selling a hospital, the parties’ rationales for the transaction must be clearly articulated and understood. For buyers, this is particularly important, since the buyer’s board and management will need to keep this rationale front and center as they undertake negotiations and due diligence. Buyer rationales might include accessing a new market, or service line, obtaining greater market share, or expanding services to a greater segment of the population.
In today’s environment, most buyers also need to justify a return on investment, so a careful pro forma projection of income and expenses, with clearly stated and valid assumptions, will be key. The negotiators should have these assumptions in mind when negotiating some of the finer points of the transaction. These key assumptions will also inform the due diligence review and help establish materiality thresholds.
For sellers, the sale must be viewed in the context of the organization’s strategic initiatives—whether as basic as survival or, in the context of securing necessary resources or commitments, to guarantee future services or expansion.
A failure to focus early and often on the rationales may lead to a transaction that closes but fails to deliver.
2. Know your limits
Knowing your limits (or constraints) is as important as knowing the rationales. Hospital boards and management cannot afford to put time, energy, and resources into a transaction that fails because of a deal breaker that emerges late in the negotiations. Accordingly, hospitals should invest time at the outset internally investigating and clearly spelling out “deal breakers.” For sellers these might include requiring a certain dollar threshold to clear all existing financial obligations, certain post-closing commitments to maintain facilities or services, or prohibitions on religious control or use of the facilities. Similarly, if the prospective seller has requirements for potential buyers—access to capital, a strong seller balance sheet or credit rating, expertise in a particular service line, reputation for excellence in care, or presence in a useful geographic area—these should be understood.
For buyers, their requirements might include certain due diligence thresholds (e.g., no history of or ongoing investigations by the Office of Inspector General or the Internal Revenue Service), fully funded pension obligations, no services that contravene the strictures of faith-based organizations (e.g., euthanasia or abortions), no interference with the eligibility to continue to receive certain governmental funding (or no requirement that the entity would have to pay back such funding as a result of the transaction, such as with certain grants from the Federal Emergency Management Agency), or a pro forma financial projection that shows the requisite return on investment.
3. Know your hurdles
Apart from the parties’ negotiations, the major hurdles will be provisions in third-party contracts and charter documents, and certain regulatory approvals.
Some third-party contracts may include provisions allowing or requiring termination upon the change of control of the seller. If a key payor contract is terminable on a change of control, the parties should consider approaching the payor to explore its willingness to work with a new buyer. In addition, charter documents may contain religious operations issues or other requirements.
Regulatory hurdles principally surface in two areas: antitrust and so-called “conversion” statutes applicable to transactions involving the sale or change of control of a nonprofit hospital. A thorough analysis of the market and the potential effect of a transaction on pricing and competition should be evaluated before due diligence is commenced and significant resources or time are expended on a potential transaction.
If the parties anticipate that there may be antitrust resistance, then safeguards around the negotiations and due diligence must be put in place, in case there is a successful assault on the transaction or the transaction fails to close. Similarly, the requirements of the conversion statutes need to be evaluated to ensure that all requirements can and will be met. For instance, some conversion statutes in effect require a Request for Proposals (RFP) process so that the regulators (generally the attorney general for the state) can conclude that the price and terms reflect market value. In some states, an appraisal must be submitted, and, in others, conflicts of interest rules prohibit those who might accept employment with the buyer from participating in the negotiation. These requirements must be considered in advance. In addition, closing conditions should be negotiated to protect the buyer from undue governmental conditions or requirements.
4. Control your message
The parties will undoubtedly enter into nondisclosure agreements which will prohibit each party from sharing confidential information with third parties and generally require that any public comments about the transaction be approved in advance by both parties. Early on in the process, the seller will want to communicate with its employees, medical staff, and constituents to keep them apprised of the status of the deal and give, if possible, assurances around services to be continued and the status of employees vis-à-vis the buyer. Additionally, both parties should be able to express a common vision for the future after the transaction closes.
The parties’ messages should be accurate and consistent, use a similar vocabulary, and be organized and complementary. Governmental agencies monitor press releases, sometimes attend town hall meetings or forums convened by the parties, and rely on or replicate the disseminated information during the course of their investigations and approvals. Most conversion statutes also require the seller to convene a public hearing on the transaction, and it is again important that the testimony be consistent with the parties’ messages. A communications consultant can be helpful.
5. Follow an orderly board process
Board members have fiduciary duties of care and loyalty. The duty of care requires the board to engage in a thoughtful and thorough review of options and proposals. In some instances, because of the inevitable governmental investigations, a heightened sensitivity to the duty of care of the seller’s board may be required. The duty of loyalty requires confidentiality and the absence of conflicting interests on the part of board members and management involved in the decision-making and/or negotiations.
To effectively fulfill these duties, the seller’s board could:
- Hire a consultant to work with the board and management to evaluate the options available to the hospital—these options could be changing service lines, joint venturing, affiliation, or sale.
- If a sale or joint venture is suggested, conduct an evaluation to determine the fair market value of the hospital.
- Clearly articulate the rationale for the transaction, any hurdles, and any deal breakers.
- Conduct an RFP or approach the likely buyer candidates to explore their respective interest in engaging in the contemplated transaction.
- Require any board members (or executive officers) with financial or other relationships with any of the potential buyers to disclose such relationships in writing. The executive committee (or other appropriate committee) can determine appropriate conflict of interest procedures with the assistance of counsel. Often these disclosures are made in response to a questionnaire prepared for this purpose.
- Evaluate in comparative terms the proposals received. Investment bankers generally help with this process and often each governing board member is asked to rate each proposal based on a number of predetermined criteria. If only one potential buyer emerges, the proposal must be evaluated in the context of the previously established rationale, desired benefits, and rationale for the deal.
- Move to confidential discussions with one or more of the potential buyers.
- Conduct some preliminary due diligence on the preferred potential buyers.
- Agree upon a letter of intent with the selected potential buyer following board evaluation and approval.
Although not generally subject to the same review by governmental agencies, a process for the buyer’s board might proceed as follows:
- If a sale or joint venture is suggested, conduct an evaluation to determine the fair market value of the hospital to be acquired as well as the strategic value to this particular buyer.
- Clearly articulate the rationale for the transaction, any hurdles, and any deal breakers (including due diligence thresholds).
- Require any board members (or executive officers) with financial or other relationships with any of the sellers to disclose such relationships in writing. The executive committee (or other appropriate committee) can determine appropriate conflict of interest procedures with the assistance of counsel.
- Conduct some preliminary due diligence on the seller around material items (generally around those items that directly impact value—material contracts, for instance).
- Agree upon a letter of intent with the selected potential buyer following board evaluation and approval.
6. Do not neglect a well-developed letter of intent
Some parties overlook the importance of the letter of intent. Before time and money is devoted to moving a deal forward, carefully consider whether there is enough “common ground” on key terms to make the deal work.
Whether a Memorandum of Understanding (MOU), a term sheet, or a letter of intent is used, a signed, written agreement should be prepared reflecting the basic business terms, including purchase price; the CEO to serve post-closing; what commitments, if any, are made with respect to the continuation of services or facilities; commitments made with respect to capital expenditures; other financial commitments; and commitments with respect to governance or management.
7. Move quickly to close
Once the deal is agreed upon, move as quickly as possible to closure—understanding that there is generally little an entity can do to speed up the governmental reviews that might be required. The deal will be a large distraction to management, employees, and the medical staff. After a certain period, people get “tired” of the deal and may change their minds or raise new issues or objections. Provided an entity has completed due diligence and obtained all necessary third-party and governmental approvals, expediting closure is in both parties’ interests.