Taking the Temperature of Healthcare Lending
Date February, 2017
The state of the healthcare system has been a consistent topic of public debate and discourse, so much so that it is one of the most polarizing topics confronting the entire nation. Uncertainty surrounding the healthcare industry has never been greater.
ABL Advisor recently reached out to Gordon Brothers for the company’s insights into the major issues impacting this challenged and evolving sector – one that will surely have an impact on the asset-based lending industry.
In the following joint interview, Bob Maroney, President, Commercial and Industrial and Rick Schmitt, President, Valuations, share their collective insights.
ABL Advisor: The healthcare sector has experienced significant challenges over the past few years. Some industry analysts attribute these challenges to the impact of the Affordable Care Act (ACA), while others attribute them to changes in how healthcare services are provided today. From your perspective, what is/are the major underlying factor(s) causing this sector the greatest level of financial stress?
Bob Maroney & Rick Schmitt: It’s really a combination of everything you just mentioned. We’re seeing a confluence of significant financial challenges, most of which stem from reimbursement cuts, the shift from inpatient to outpatient services, and rising costs to maintain or update equipment and technology to meet industry standards.
Reduced reimbursement from health insurers, coupled with necessary investments in personnel, equipment and technology, as well as the overall rising cost of care, have led to significant margin compression in the traditional hospital setting. And the increasing challenges associated with complying with HIPAA and the HITECH Act – especially in today’s digital world of electronic medical records – have created complex, expensive financial stressors. Providers in general face high costs in compliance as well with a range of federal laws, including anti-kickback and general medical malpractice rules.
There is also a shift in payments – one of the ACA’s primary objectives was to change healthcare incentives, rewarding quality of care rather than quantity of care – which has adversely impacted hospitals serving Medicare patients the most. Those providers with high Medicaid/Medicare patient populations will need to adapt in order to survive in a world with lower reimbursements.
Further complicating matters are changes in consumer behavior, driven largely by the increase in high-deductible plans. Patients are no longer necessarily looking for the most convenient place for services; they are now considering their out-of-pocket cost, an approach that has driven many consumers to seek care outside of traditional hospitals. Finally, a challenge facing some rural hospitals is a scarcity of medical talent, particularly in primary care and in highly specialized areas such as cardiology and oncology. This problem is another reason contributing to consolidation.
ABL Advisor: What are some of the implications of these pressures and challenges?
Maroney & Schmitt: What our team has seen is that these financial challenges have led to a steady increase of healthcare bankruptcies and consolidation over the last three years, a trend that began in Q4 2014 and has continued as hospitals merge or become part of larger health systems. In fact, the number of distressed M&A deals involving healthcare providers in the U.S. swelled from 13 transactions during 2013 and 2014 to 94 transactions during 2015 and 2016, according to data compiled from CapitalIQ.
It’s a particularly tough environment for hospitals in rural America right now. Over 60 hospitals in rural areas have closed since 2010 (North Carolina Rural Health Research Program). We see this trend continuing, especially since the reduction in Medicaid/Medicare reimbursements and the increasing availability of alternative healthcare solutions directly impacts hospitals in rural areas. Another reason these hospitals will have an increasingly difficult time staying relevant and profitable is that the increase in outpatient providers will reduce the need for beds in a hospital setting. The fact that some states have failed to expand Medicaid or opted out of Medicaid makes the problem even worse.
In addition, independently employed physicians are aligning themselves with hospitals or healthcare systems to relieve their own financial burdens and take advantage of the technology, equipment and economies of scale that a larger entity provides. Increasing regulatory and administrative requirements favor larger providers with dedicated staff relative to small, independent practices.
ABL Advisor: You mentioned specialized outpatient solutions, which are now available from a myriad of healthcare providers (orthopedic clinics, urgent care clinics and the like). What impact will the growth of these specialty providers have on the already struggling hospitals? Is further hospital consolidation a truly-effective “survival strategy” for hospitals?
Maroney & Schmitt: As mentioned before, the increase in outpatient services is lessening demand for traditional hospital beds. We’re seeing more satellite locations, bigger hospitals getting bigger, and smaller hospitals getting smaller. And, just like hospitals in rural areas, smaller hospitals will be forced to close or consolidate with larger healthcare systems, strengthening the probability of larger hospital survival.
That said, specialty providers offer a more consumer-friendly option, as they provide speed, availability and affordability. And consumers are responding to lower prices and more streamlined approaches offered by outpatient and urgent care clinics. This has bifurcated revenue away from hospitals, causing another layer of stress.
Hospitals should also consider expanding service line offerings and specialty programs related to oncology and rehabilitation services, especially since treating cancer and other serious illness or injury typically requires extended outpatient care in a hospital setting. These are two very lucrative service areas that should help preserve patient loyalty and retention, as well as generate long-term revenue streams that could help support the hospital for many years to come.
ABL Advisor: Traditionally, general practitioners served common patient needs. Today, these needs are being met by Retail Clinics (CVS, Rite Aid, etc.). Are you seeing (or expecting to see) financial stress among larger independent physician practices resulting from the growth of these Retail Clinics? What do you foresee occurring in this portion of the healthcare sector?
Maroney & Schmitt: The growth of these retail clinics is another reason why independently employed physicians continue to align themselves and their practices with hospitals and health systems. It is increasingly difficult to remain profitable when patients have the ability to seek common care at the pharmacy around the corner.
By 2018 it is anticipated that there will be more than 2,800 retail clinics around the country (Accenture). This is because retail clinics are more accessible and offer a greater financial incentive compared to care provided in a traditional hospital setting. The rise of high-deductible plans has driven consumers to seek lower cost, flat rate care from clinic settings. These alternatives are often closer geographically, have extended hours, and may even be staffed by the same personnel that a patient would see at a doctor’s office.
Many traditional clinics now offer alternatives, sometimes via telemedicine in an effort to compete. However, structural challenges will make it difficult for most traditional service providers to deliver care as conveniently as retail clinics.
While the retail clinic certainly puts pressure on the traditional healthcare system, it can’t replace the offerings from a legacy provider such as a hospital. We expect clinic offerings to continue to expand and for legacy hospitals to create clinics and/or partner with retail clinics as an extension of healthcare delivery, interconnected with hospital data and e-records.
ABL Advisor: With a clean sweep in Washington D.C. by the Republican Party, there is talk of either repealing or significantly changing many provisions of the ACA. Do you see this uncertainty creating additional stress within the sector over the next 12-18 months? Please explain.
Maroney & Schmitt: Uncertainty will continue to have an impact on the industry, especially since many healthcare providers had already delayed investments and capital expenditures in the 12 months leading up to the election. This delay will likely continue at least until the industry sees what changes will be made to insurance coverage and Medicaid/Medicare reimbursements.
Questions about reimbursements, incentives, and the insured pool will likely continue to suppress investment in complex equipment and facilities. This flies in the face of an industry that demands innovation to improve the standard of care.
Take investments in medical equipment, for example. The average life of medical equipment is relatively short, approximately five to seven years. This lifespan has lengthened in recent years as providers have delayed purchasing decisions to stretch equipment further, especially since deinstallation and removal of existing equipment and installation of new equipment is so costly. Although values have been holding steady, this reduction in transactional activity may signal a decline in future equipment values.
In addition, consumer reactions to high-deductible plans are creating further uncertainty for hospitals in projecting patient volume and revenue.
Our view is that a complete overhaul of the ACA is unlikely. The ACA is a primary reason why hospitals have been seeing higher volumes of insured patients. If the law is repealed or replaced, those volumes would drop significantly and adversely impact payments. The impact on providers would be significant, to say the least.
Regardless of the direction from Washington D.C., health providers will continue to face pressure resulting from continued consolidation. The need for creative solutions to ensure survival will remain.
ABL Advisor: What alternatives should healthcare providers consider to help survive the uncertainty?
Maroney & Schmitt: The first thing we would tell providers to do is take a step back. Is their business plan clear? Are their core services supported? Does their business model support growth and sustainable margins? If the answer to any of these questions is no, providers should consider paring back on non-core assets. They should take a long, hard look at facilities and equipment and consider whether there is an opportunity to dispose of investments, non-strategic facilities and expansions that don’t support or further their cause.
Providers might also consider taking advantage of an asset-based lending facility, particularly given the fact that hospitals are asset intensive and typically have major investments in machinery and equipment. The number of financial institutions that have opened or expanded healthcare lending practices is one indicator of where the industry may be headed.
ABL Advisor: What major financial stress indicators should lenders be monitoring from Gordon Brothers’ perspective when lending within the healthcare sector?
Maroney & Schmitt: Lenders should examine the composition and trends associated with the institution’s reimbursement streams, as well as the nature of its “bad debt”—uncollected revenue (e.g., uncollectable pledges from donors) and if its levels of “uncompensated care” exceed or are beginning to exceed state regulations.
Lenders should also pay attention to the number of industry bankruptcies (as well as the cause of distress), reported cash flows from major hospitals and clinics, reports from major manufacturers and industry associations on reinvestments in equipment, as well as hospital facility expansion.
Of course, lenders will be closely watching the new administration’s approach to policy-making and regulatory matters, such as price controls. For example, over the past few years the prices on generic pharmaceuticals has decreased – as have the margins for several companies we appraise. This may be driven in part by the increased negative publicity on the price of drugs, as well as fear from the industry that the government will mandate price controls.
Our team expects 2017 will bring an increase in lending against unique use and esoteric healthcare collateral, including specialized real estate, specialized equipment, and fluid and solid state inventories that are used in surgery or treatment.