The consolidation trend in hospital and health systems continues. To address perceived inefficiencies and quality of care issues, hospitals are attempting to form larger enterprises to create scale, expand geographically, manage risk, access capital, contend with the changing regulatory environment and more effectively manage the health of the populations they serve. This article is part one in a two-part series detailing key issues that should be addressed before a hospital or health system begins discussions with potential partners.

The consolidation trend in hospital and health systems continues. At this time, horizontal consolidation (hospital-to-hospital combinations) is keeping pace with vertical consolidation (hospital acquisitions of ancillary providers and physician groups). To address perceived inefficiencies and quality of care issues, hospitals are attempting to form larger enterprises to create scale, expand geographically, manage risk, access capital, contend with the changing regulatory environment and more effectively manage the health of the populations they serve. Despite the trend toward consolidation, completing hospital consolidation transactions is more challenging than ever, as demonstrated by an alarmingly high failure rate. Over the past several years, about 25 percent of announced partnerships have failed after the signing of a letter of intent and before close. A “busted deal” may cause economic harm and operating disruption to all involved.

One of the keys to ensuring that a hospital transaction can be successfully completed is advance preparation, which mitigates two significant risks. First, preparation mitigates risk of delayed closing or a sidetracked deal due to the discovery of a regulatory issue during due diligence. Second, preparation can help mitigate the risk of a “re-trade” on fundamental economic terms. Presenting potential issues (and their solutions) early helps to ensure that the terms of the transaction take into account all of the known risks associated with the operation of the hospital partners. Preparation can lead to a swift and more painless closure of hospital transactions at attractive valuations, thereby maximizing community benefit and creating a positive outcome for all stakeholders.

This is the first article in a two-part series detailing critical steps that should be taken before a hospital or health system begins discussions with potential partners.

1. Bond Issues

While hospital transactions sometimes are motivated by an actual or impending bond covenant default, bond covenants also often restrict the ability of health systems to enter into transactions with potential partners. In transactions in which a for-profit hospital management company acquires a nonprofit health system, tax-exempt bonds usually are fully discharged out of the transaction proceeds, making the bond covenants less relevant. However, in transactions between nonprofit health systems, it is common for tax-exempt bonds to remain in place for some period of time post-closing. If the bond trustee has a right to consent to the transaction, the parties must plan early to seek the consent. If the bond trustee withholds consent, the parties may need to refinance the debt contemporaneously with the closing of the hospital transaction, even where there otherwise might be financial reasons to wait.

Nonprofit health systems that are acquirers also can face bond covenant issues. In many cases, bond indentures require the maintenance of certain financial ratios that can be violated if the balance sheet of the acquired hospital is consolidated. Bond covenants also often restrict health systems from assuming additional debt (such as the bond debt of the acquired hospital). In cashless member substitution transactions between nonprofit health systems (i.e., transactions in which the parent of one health system becomes the corporate member of the other health system’s hospitals), the acquiring health system often makes commitments to fund routine or special capital projects on the acquired hospital’s campus. Before committing to make these capital expenditures, the acquirer should ensure that its own bond covenants do not place restrictions on the amount of capital that can be spent on projects outside of the acquirer’s bond obligated group.

Regardless of the transaction’s structure type, all parties to hospital transactions should be aware of the restrictions imposed by their bonds before they consider potential transactions with partners. In addition to ensuring that there are not delays associated with the unanticipated bond approvals, the parties can develop transaction structures that account for the restrictions or for the need to refinance.

2. Pension Plan Deficits

Underfunded pension plans present an issue when negotiating change-of-control transactions. Approximately 72 percent of the 460 not-for-profit hospitals that are rated by Moody’s Investors Service offer defined benefit plans to their employees (referred to herein as “pension plans”). According to Standard & Poor’s, the median funded status of defined benefit plans for hospitals was 69.4 percent in 2012, down from 72.6 percent in 2011. If a pension plan is significantly underfunded—i.e., the benefit obligations under the pension plan exceed the assets held in trust to settle the accrued benefits—the pension plan represents a concern from both a liability and a cash flow perspective. In many transactions, the affiliating party may adjust its financial commitment to reflect the negative credit impact of underfunded pension plans. In hospital transactions in which a hospital’s assets are sold to a buyer, the buyer likely will exclude the underfunded pension plan from the transaction so that the buyer is not legally obligated to maintain or fund the pension plan following the closing.

The seller may be required either to maintain the underfunded pension plan or to fully fund and terminate the underfunded pension plan (which can be expensive). From a buyer’s perspective, the termination of these pensions may pose employee relations issues or require a delicate negotiation with labor unions (potentially delaying the closing of the hospital transaction).

Prior to approaching buyers or partners, a selling hospital should have an actuarial study commissioned on the cost to fund-up or terminate the pension plan. A buyer must understand how pension liabilities will affect the preferred structure of a transaction and the operations of the acquired hospital post-closing.

3. Physician Referral Source Relationships

Large nonprofit systems and for-profit consolidators alike heavily scrutinize physician referral source relationships because the financial impact of non-compliance can be substantial. In many situations, an acquiring hospital or system will require the target hospital to self-disclose any inappropriate financial relationships with physician referral sources to regulators prior to closing. This has been demonstrated in a number of recently announced settlements that preceded transactions. For example, Condell Medical Center in Illinois paid a $36 million settlement for False Claims Act violations that emanated from alleged below-fair-market-value leases and other alleged improper financial relationships with physicians prior to Condell’s merger with Advocate Health Care.

In preparation for any transaction, hospitals should identify physician and institutional referral sources, consider whether a financial relationship exists, and assess whether the relationship is compliant with the anti-kickback statute and Stark law, as well as applicable state laws. Relationships that should be examined include physician employment agreements, leases, medical director agreements and supply agreements with physicians. Non-compliant relationships should be identified, corrected and, if necessary, self-disclosed to the appropriate regulator.

4. Errors and Omissions (Malpractice) Coverage and Tail Insurance

Most buyers of hospitals require that a target obtain an insurance policy (or an endorsement to an existing policy) that provides coverage for past known and unknown medical malpractice claims. This type of policy is commonly known as a “tail insurance” policy. The cost and structure of a tail insurance policy can vary widely. One of the key influencing factors on the cost of such a policy is the cost of malpractice insurance (also known as “errors and omissions coverage”) in the state in which the hospital operates. If the hospital’s malpractice coverage was expensive, the tail insurance policy likely will be costly also. If a hospital that is being acquired maintains its own captive malpractice insurance or is “self-insured,” that may complicate the approach to tail insurance, and there will be a need to purchase tail insurance for the captive’s re-insurer. Finally, different features of the tail insurance policy itself (such as whether the policy includes demand or incident triggers) can influence its cost. Hospital management that is preparing for a consolidation transaction should be aware of the structure of its coverage and options for obtaining tail insurance.

The second installment of this two-part series is forthcoming and will address additional preparatory considerations for hospital transactions, including licenses, permits and accreditations; program integrity contractor audits; commercial insurance relationships; compliance programs; HIPPAA and patient privacy; and real estate restrictions.