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Deals involving financially distressed health-care facilities are making up a large—and growing—part of the health-care industry’s mergers and acquisitions landscape.
There are many good deals to be had, as distressed entities are seeking cash infusions from investors or selling to more well-heeled buyers, rather than closing and possibly leaving a community without a facility.
Potential buyers and investors, however, face unique challenges when contemplating transactions involving distressed facilities, two attorneys who counsel industry players in connection with these deals told Bloomberg BNA.
The considerations vary depending on the target facility’s status and the depth of its difficulties. Typically, the distressed entity is contemplating bankruptcy, which can be a complication or a boon for the potential buyer.
An increasing number of financially distressed health-care entities are filing for bankruptcy. Filings have increased by more than 20 percent since 2010, according to the Polsinelli/TrollerBK Distress Index, Polsinelli partner Jeremy R. Johnson, in New York, told Bloomberg BNA.
The health-care industry consolidation trend, ironically, is at least partially to blame, Johnson said.
Hospitals that tried to buck the trend and remain independent found it nearly impossible to compete against larger systems, while some entities caught up in the craze simply over-extended, he said.
Capital expenditures required to remain competitive or in compliance with state and federal regulations, as well as shrinking payer reimbursements, have added to the difficulty, Thomas H. Hawk III, of King & Spalding in Atlanta, told Bloomberg BNA.
Johnson doesn’t see transactions in the distressed hospital space slowing. The adoption of the American Health Care Act and repeal of the Affordable Care Act won’t change that, he said.
All types of hospitals—from acute care to highly specialized—are experiencing financial challenges. The current environment has been especially difficult for rural hospitals, both Johnson and Hawk said.
The aging of Americans means fewer private-pay patients, Hawk said. Thus, many hospitals survive mostly on the lower payments they receive from Medicare and Medicaid. Sometimes reimbursements from public payers aren’t enough.
But the level of distress varies, and it may not be one that would lead outside observers to believe a facility was in imminent danger of closure. The primary issue for a distressed hospital often is its inability to meet its contractual obligations with creditors, Johnson said.
Nonprofit hospitals, for example, may be financed through tax-free bond debt or borrow from private lenders. Regardless, they agree with their creditors to abide by certain covenants or indentures, which measure a hospital’s financial health.
Typically, these covenants require hospitals to meet financial benchmarks every quarter, like a requirement to have enough cash on hand to meet expenses for a designated time period. If the facility doesn’t meet that benchmark, it technically is in breach of the covenant.
Facilities should start thinking about finding a buyer or investor before their distress actually sets in, Johnson said. Normally, however, they don’t start looking until “there is no way to make the numbers add up,” Hawk said.
Johnson told Bloomberg BNA there are rolling tests designed to catch serious breaches. Bondholders may not object if a hospital breaches a single covenant in one quarter, but if it fails to meet obligations over successive quarters, the facility may be in danger.
The system is designed to catch big problems, not “blips,” Johnson said. A facility’s financial health can tip temporarily for a variety of reasons, included a delayed Medicare reimbursement.
A single breach probably won’t lead a hospital’s governing board or its financial consultants to recommend a sale. Consultants instead look for patterns that raise alarms, Johnson said.
If a facility’s debt level is too high, and the facility still is operational, it could amend the covenants, restructure the debt and remain in business, Johnson said. Alternatively, a facility could raise the needed funds through private investment. The final option is liquidation and sale.
The decision to sell is “a numbers issue in many cases,” Hawk said. A need for major capital improvements, a high level of outstanding debt, and low cash reserves might prompt the governing board, with the advice of senior management, to recommend a sale. One especially expensive endeavor for hospitals, Hawk said, is installing and updating electronic health records systems required by government regulations.
The transaction could be “a fire sale,” if the hospital is in imminent danger of closing and needs to find a buyer quickly, but more often the board or its consultant has time to hire investment bankers to discretely “shop” the facility.
Hawk said hospitals typically hire investment bankers who specialize in health-care industry transactions and who are able to understand a facility’s particular needs. For example, the board of a nonprofit hospital run by a religious organization may entertain only buyers who have the same religious affiliation. Such a hospital would want a banker familiar with the needs of religious-based entities.
Once identified, potential buyers are invited to review confidential memoranda. Those who show interest will be invited to visit the facility and be given a chance to review more confidential information in a process known as “data room access,” Johnson said.
Maintaining confidentiality during this stage is important, Johnson said. Potential buyers must sign nondisclosure agreements.
This process is intended to winnow the pool of potential buyers down to two or three and allow the board to choose the best offer, Hawk said.
Due diligence can get complicated for the chosen buyer, but it should proceed in the same fashion as it does in any other transaction, Hawk said.
Regulatory issues should be one of the first areas of inquiry, and a review of “the hospital’s compliance program, its contracts with referral sources, licensure issues, and billing and coding” is essential, he said in a paper accompanying a presentation at the American Health Lawyers Association’s annual health-care transaction’s law conference in April in Nashville.
The buyer should recognize that “management turnover is a common problem of distressed hospitals,” and that can complicate due diligence, Hawk wrote. Years of “institutional knowledge” may have been lost as a result.
Compliance programs can be hit hard if management focused too keenly on “short-term survival,” Hawk said. He advised buyers to closely review contracts with referral sources to look for potential Stark law and anti-kickback statute risks. Third-party payer contracts also should be reviewed carefully, he said.
After the potential buyer is identified, but before the sale is closed, distressed facilities often file for bankruptcy under Bankruptcy Code Chapter 11. However, Johnson told Bloomberg BNA that isn’t inevitable.
If the existing secured creditors are “of a manageable size,” say two or three that hold 100 percent of the debt, it might be possible to get them to agree to a change in ownership and avoid putting the facility through bankruptcy.
Bankruptcy, however, is a more favorable avenue if the facility has high debt and the potential for a large amount of other liability.
In most deals, the parties can include in the contract a provision, called an indemnification clause, in which the seller agrees to reimburse the buyer for any liabilities incurred prior to closing. This includes items like personal injury and other tort damages.
A distressed facility likely won’t have any assets to put toward indemnification, so the provision usually is worthless in a deal involving this type of seller, Hawk told Bloomberg BNA.
Liability issues go away in bankruptcy because the court can discharge the distressed facility’s debts. Bankruptcy, however, puts “operational pressure” on distressed facilities, Johnson said. Bankruptcy also is expensive and can be time-consuming.
Also, the filing lets the cat out of the bag, so both consumers and hospital employees know—if the signs weren’t already there—that the facility is in difficulty.
The buyer identified prior to the bankruptcy petition filing is known as the “stalking horse bidder,” according to Hawk. Generally, the stalking horse already will have signed a letter of intent and an asset purchase agreement.
The bankruptcy court holds an auction of the facility’s assets, known as a Bankruptcy Code Section 363 auction. The stalking horse sets the floor, or minimum, bid, Johnson said.
New bidders can “throw everything off,” Hawk said. Hospital deals, however, “are so heavily shopped before they get to this point” that it’s unlikely the stalking horse will be outbid, he said.
The process moves pretty quickly after the auction begins, Johnson said. The Section 363 sale can be completed within two to three months.
Acquirers can take over the facility free and clear of any successor liability or unfavorable contracts and liens. A bankruptcy court’s order “is a very powerful tool,” Johnson said.
Buyers of distressed facilities face challenges even after closing, Johnson said. Medicare overpayments, for example, can come back to haunt them. The Centers for Medicare and Medicaid Services can seek reimbursement, and bankruptcy won’t eliminate the liability.
The acquisition of a new certificate of need or a transfer of an existing CON may be required by state law, Johnson said. The buyer also will have to acquire a new Medicare provider number unless it was able to assume the prior entity’s status.
Workplace unions also can complicate a transaction, though buyers can agree as part of the sale to recognize or disavow an existing collective bargaining agreement.
In addition, pre-closing distress may have an impact on post-closing employee morale. Employees may have jumped ship, doctors may have moved their practices to other hospitals, and the remaining staff members could be nervous about how they will be treated by the new management regime.
The buyer will have to rebuild the employees’ confidence, as well as make sure it has the medical personnel in place to help the facility become successful.
If the distress was well known outside the entity—and it will have become public knowledge upon the filing of a bankruptcy petition—the buyer will have to work to restore the hospital’s reputation, even if the quality of its operation wasn’t affected by its financial distress.
Hawk recommended the acquirer undertake a public relations campaign aimed at employees, the medical staff, and the community that makes clear the facility is under new management. Make a “bright-line demarcation” between the old ownership and the new, Hawk said.
New owners can accomplish some “quick wins,” he said, by making capital expenditures to upgrade existing facilities. Showing stability through continuity or improvement of patient satisfaction and care quality is important.
One important goal of every transaction in the distressed hospital space is to “right the ship in terms of finances,” Hawk said. The resulting entity needn't be debt free, but shouldn't have too much debt, Johnson said.
Failure to accomplish that goal could lead to a “Chapter 22” bankruptcy—meaning a Chapter 11 bankruptcy petition filing by the acquirer.
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The Polsinelli/TrollerBK Distress Index is at https://www.distressindex.com.
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