E-Briefings V7N3 May 2010

Moody’s Investors Service, Special Comment

The recent announcement of two transactions involving the purchase of sizeable not-for-profit healthcare systems by for-profit entities signals a significant shift underway in the hospital sector toward increased competition and consolidation in various markets in the U.S. This trend will place additional pressure on the remaining not-for-profits in affected markets to operate more efficiently, but also offers a potential new source of capital for not-for-profits considering a merger or sale. It could also provide unexpected exit strategies for investors holding the debt of low-rated, not-for-profit hospitals.

Major developments in the healthcare sector over the last several years have helped create an environment that has made consolidation more attractive to both potential acquirers and possible targets. While the acquisition of not-for-profit hospitals by other not-for-profit systems continues at a measured pace, the proposed acquisition of Detroit Medical Center (rated Ba3) by for-profit Vanguard Health System, and the purchase of Caritas Christi Health Care (rated Baa2) by the investment firm Cerberus Capital Management, signal an increased appetite for challenged credits by for-profit investors.

From the perspective of not-for-profit hospitals, this development creates conflicting possibilities. The for-profits represent potential new partners capable of injecting much needed capital for modernization and expansion. However, only those capable of attracting for-profit partners will benefit—the remaining independent not-for-profits may face operating challenges and increased competition from their newly capitalized competitors. The net effect is likely to be an increased rate of mergers of not-for-profits with other not-for-profits as well as for-profit firms.

For-Profits Make Inroads into Not-for-Profit Strongholds

In late March, two transactions were announced involving the acquisition of prominent not-for-profit healthcare systems by for-profit enterprises new to the respective markets. A shared aspect of the two proposed transactions is that they involve healthcare markets that have traditionally been overwhelmingly dominated by not-for-profit institutions. The introduction of for-profit operators to these not-for-profit market places could impact other entities within these service areas.

The first of these was Detroit Medical Center (DMC) (rated Ba3), which on March 19 announced its intention to join Vanguard Health System (rated B2), a for-profit health system currently with $3.4 billion in revenues, and, prior to this transaction, active in four other urban markets, including Chicago and San Antonio. DMC carries a payer-mix that is not typical of Vanguard’s other markets, with a high concentration in Medicaid and self-pay patients. In exchange for DMC’s eight facilities representing 75,000 admissions, Vanguard will assume DMC’s debt, invest $850 million over five years in major capital projects, and take responsibility for DMC’s sizable unfunded pension liability, which presently stands at approximately $184 million. The hospitals will continue to operate under the DMC brand and Vanguard commits to keeping the hospitals open for ten years and retaining their charity care policy.

On March 25, Caritas Christi Health Care (CCH) (rated Baa2), a six-hospital system headquartered in Boston, announced that it has signed a letter of intent to be acquired by Cerberus Capital Management, a private equity investment firm. Under the terms of the agreement Cerberus will assume CCH’s debt, invest $400 million in future projects, and keep all hospitals open for at least three years. Also, current management will stay in place, as will the current Catholic operating provisions.

Both Massachusetts and Michigan have historically been healthcare markets overwhelmingly dominated by not-for-profit operators. Both transactions are subject to numerous approvals and further negotiation, but if completed they will materially alter the competitive landscape of these markets. As illustrated in Figure 1, for-profits differ appreciably from not-for-profits in many respects, and will provide these markets with new operating practices and fresh access to very significant resources. Furthermore, disclosure practices of the hospitals under the ownership of large for-profit entities may become less detailed, providing their not-for-profit competitors with a disadvantage with respect to access to information.

Access to Capital Tops List of Incentives

Since the credit crisis began, a number of new risks have intensified that are pushing the hospital industry toward greater consolidation (see Figure 2). Reduced access to capital markets and deferral of needed investment top the list of new risks. Healthcare continues to be a highly capital intensive industry, and while the cost of new construction has fallen somewhat in the last year, the cost of medical equipment has not. Furthermore, the cost of information technology (IT) systems continues to climb, and with the passage of healthcare reform, the need for state-of-the-art systems has increased. Many organizations deferred projects following the credit crisis in late 2008, and many low rated credits continue to accumulate deferred maintenance. We believe there is significant demand for new capital investment within the industry.

While access to capital has improved over the last year, it remains more limited compared to historical measures. Before 2008, many not-for-profit organizations had relatively easy and inexpensive access to capital due to very narrow credit spreads, strong investor appetite, and cheap access to bank capital. While market access is improving for many, credit spreads remain wide and structuring enhancements – such as debt service reserve funds – remain required for lower rated credits. This, along with other developments, such as the recent withdrawal of the property tax exemption for Downstate Provena Covenant Medical Center in Illinois, diminishes the relative benefit of tax exemption, and makes funding on a taxable basis relatively more attractive.

There are a number of other factors that we believe may make consolidation more likely. These include: increased reimbursement pressures across all payers; the greater need for cost controls and access to economies of scale; increased competition for physicians, suppliers, and patients; the prospective cost of compliance with new reporting requirements; and the increase in unfunded pension liability. We believe that it is not only the small independent hospital that constitutes a potential target, but as was seen with the two recent transactions, also the more lowly rated system.

From the perspective of the acquiring entity, we believe there have been a number of developments that have increased the attractiveness of these transactions. With the passage of healthcare reform, the importance of payer mix has possibly diminished, making systems in more demographically challenged markets possibly of greater value than currently appreciated in the market. Also, with healthcare reform, there will possibly be a greater benefit to being a low cost provider, and to having comprehensive data reporting systems. This possibly increases the value of the benefit that a larger, integrated, sophisticated system brings.

Conclusion

The expansion of for-profit operators and investors into markets previously dominated by not-for-profits will likely increase competitive pressures in the not-for-profit hospital industry. This will, in turn, be a force for further consolidation among all types of hospitals seeking larger economies of scale and better capital access. For investors holding debt of acquired hospitals, this may result in an increase in the credit quality of their bonds. Many individual operators could become further stressed, creating an even greater need for sound management and capital strategies to compete in markets favoring larger hospital systems and chains.

Moody’s Related Research

Outlook:

Annual Sector Outlook for Not-For-Profit Healthcare for 2010: Negative Outlook Continues Due to Sluggish Economy and Government Budget Deficits, January 2010 (122650)

Special Comments:

Preliminary Medians for Not-for-Profit Hospitals Show Stabilization in Operating Ratios, But Continued Weakening of Balance Sheet Metrics, April 2010 (124111)

Long-term Credit Challenges of Healthcare Reform Outweigh Benefits for Not-for-Profit Hospitals (124233)

To access any of these reports, visit www.moodys.com. Note that these references are current as of the date of publication of this report and that more recent reports may be available.

The Governance Institute thanks Moody’s Investors Service for contributing this article. This Special Comment was published by Moody’s on April 29, 2010. Reprinted with permission.