Strategies for Creating Merger Value
The healthcare industry is experiencing an almost unprecedented period of consolidation. Many physicians are selling their practices outright to hospitals, integrated delivery systems or practice management companies. Others are merging their practices with those of colleagues, hoping to stay independent and gain sufficient size to effectively compete in a marketplace of giants. This article will explore some of the strategies for successful formation of a group practice.
One of the commonly cited synergies of a merger are cost reductions from economies of scale. The hoped for reductions are in areas such as the billing function and information systems costs. Often overlooked are the significant increases in costs resulting from the need for professional administration, a human resources department, and the cost of legal, accounting and benefit plan consultants necessary to accomplish the transaction. Significant commitment of time is always required from the physicians themselves as well. Many mergers simply result in a break-even scenario at best from a cost standpoint.
Mergers should not be undertaken unless there are significant revenue enhancement opportunities available from capitation, expansion of services or, at least, conservation of existing revenues. Ideally, mergers should be offensive, not defensive in nature.
Capitation is increasingly used in the market as a means for creating financial incentives to control utilization of expensive services, such as ancillary testing and referrals to specialists. Actuarial factors create a significant issue for group practices looking to accept capitation. The eventual likelihood of one or more catastrophic cases, even when stop loss insurance is in place, can have a severe adverse impact on the group's financial performance. Only if this risk is spread out among a large number of covered lives can the group have a reasonable expectation of successfully managing care. In a recent example, a client with approximately 1000 patients in a full risk commercial capitation contract had a catastrophic "out of area" case. The hospital did not have a contract with the insurer and as a result 100% of the hospital charges were paid, with no discount. The patient developed severe complications and spent several months in the hospital. Even with a $50,000 stop loss, this one case increased costs by more than $4.00 PMPM, in a total budget of under $100 PMPM. This was an example of poor contract structure by the network with which the practice was affiliated. At least 10,000 lives are probably necessary (in this instance) for a reasonable balancing of actuarial risk.
In another instance, a client with a panel of approximately 3,500 patients experienced six catastrophic cases in a single six month period, each with a $50,000 stop loss. The insurer paying the capitation also had a marketplace strategy which tended to attract unhealthy patients and was suffering ongoing losses. This $300,000 of cost increased costs by more than $7.00 PMPM in a budget of $110 PMPM. In addition, this practice was located in an area with extremely unfavorable socioeconomics, including a high incidence of substance abuse among the insured population and a generally older, unhealthy population.
These two examples are intended to illustrate the serious risk inherent in taking capitation for small panels. Reducing or spreading this risk over a large number of lives is one of the principal goals of practice mergers. The latter example also illustrates the potential for "arbitrage" profits in a market where the competing insurance companies do not have uniform distribution of health status among their insureds. Arguably, the best place to begin a capitation strategy is with an insurer with positive rather than adverse selection. (Arbitrage refers to the strategy of taking advantage of price differences in two different markets for the same thing. In the instant case, the insurer is presumed to set a price high enough to cover the costs (plus profit) of its insureds. Rates are typically only age/gender adjusted, not for severity of illness. A capitated group which succeeds in attracting healthy patients can obtain capitation rates based upon the higher costs of a sicker population.)
Although in mature capitation markets the premiums and therefore capitation rates will likely reflect health status differences in the underlying insured population, in early stage markets the insurers will compete for business based primarily on cost, not health status. Further influencing this process is the increasing presence of state laws preventing experience rating of (notably) the small employer and self-employed markets and requiring community ratting. These laws preclude insurers from increasing premiums to particular classes of insureds based upon prior claims experience. The ability of the insurer to selectively attract a healthier population through its marketing, advertising and sales efforts can create enormous differences in costs. Practices may similarly be able to attract healthier patients through their own characteristics, such as location, age of providers, presence of female physicians, inclusion of pediatricians and other factors.
A larger practice is more attractive to an insurer for negotiating purposes since a number of providers can be bound with a single contract, along with their underlying patient panels. Clinical protocols can be adopted more easily. Of course, the group obtains both efficiencies and leverage in its negotiations if it presents a plausible, integrated practice.
Many of the practice management companies have made substantial profits after acquiring physician practices by adding ancillary services. This strategy is particularly successful in markets with little or no capitation and much fee-for-service reimbursement. The strategy also has some potential to succeed even in those markets with significant capitation if certain factors are present.
The Stark laws are critical in evaluating and executing this strategy. Recall that the Stark laws generally prohibit anything amounting to a payment in exchange for referrals among medical providers. Specifically, physician group practices must meet a qualifying definition under Stark II in order to avoid liability for referrals among the members of the group. (A legal organization in which (a) each physician member provides the full range of services which the practice routinely provides through the joint use of space, equipment and personnel; (b) substantially all of the services are billed under a group billing number and are treated as receipts of the Group Practice; (c) overhead and income are distributed in accordance with an existing methodology; (d) members of the Group Practice personally conduct no less than 75 percent of the physician patient encounters of the Group Practice; and, (e) overall profits of the Group Practice, or a productivity bonus based on services personally performed or services incident to such personally performed services, are paid to the physicians, and the share or bonus is not determined in any manner which is directly related to the volume or the value of referrals made by the physician) This definition prevents independent practice units, or even those connected via contractual arrangements for common contracts or MSO services, from sharing common ancillary services. A true group on the other hand, can share such services. Herein lies the opportunity.
As an example, assume a group practice of 8 physicians includes the subspecialties of cardiology, invasive cardiology and hematology. As a result, they own cardiac stress testing equipment and an ultrasound unit as well as a full lab with blood chemistry capability. As managed care and capitation penetrate the market, maintaining specialty referrals from primary care physicians becomes increasingly difficult. Certain insurers no longer permit the practice to perform laboratory tests on their patients but require the tests to be done by an outside reference lab the insurer has contracted with. The practice will likely experience a steady decline in profitability.
This situation can be the foundation for a successful expansion of the group practice by adding primary care physicians and perhaps solo specialists who do not have the investment in equipment. A Stark qualifying group practice could provide laboratory and cardiac services to its new members patients, as well as lock up the referrals which might otherwise go to specialists outside the group. The net income from the ancillary services would have to be allocated among the physicians in a manner permitted by Stark II, basically one that does not reward a provider for the value or volume of referrals made. The simplest allocation would divide the ancillary profits up equally among the physician-owners of the group but other methodologies may be developed.
If the situation were different in that the group would have to go out and purchase the various equipment in order to provide cardiac testing and lab services, the likelihood of success would be different. The new equipment would have a significant cost outlay; staff would need to be trained, and even existing referral patterns would have to be altered. This would increase the risk associated with the strategy.
Note that the two revenue strategies reviewed - gaining actuarial stability and negotiating leverage for capitation, and expansion of ancillary services - are enhancement or offensive strategies, not defensive strategies. Successfully executing either strategy is difficult, but more value is placed on growth and expansion than on operating efficiency in a practice of a given size. An expanding revenue base usually offers growing profit opportunities to the hypothetical any willing buyer, where a fixed revenue base offers fixed profit once efficiencies are maximized. Revenue growth, in reality, does not always translate to profit growth due to poor management, but it remains the "Holy Grail" of value since normalized profit assumes competent management.