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There is no question that the broader healthcare field and the hospital sector in particular are undergoing a period of major transformation. The domestic models of healthcare and insurance are being changed to improve quality, lower costs, and expand coverage, thanks to the Patient Protection and Affordable Care Act (ACA). The new laws will strive to create a system that focuses on managing peoples’ health, rather than the treatment of sick people.

The Numbers

Healthcare-related merger and acquisition (M&A) activity in the June quarter of 2013 was up 10% on a sequential basis, as 223 deals were reached in the period. More specifically, deals involving hospitals fell considerably in the second quarter of 2013, as just 15 deals closed compared to the 22 that were finalized in the first quarter. Volume was down even further compared to a year ago, when 26 transactions were completed. What is promising, however, was the significant step-up in dollars committed. The value of all healthcare-related deals transacted during the second quarter was an eye-opening $52.6 billion, up more than 250% from the $14.6 billion in deals that were inked in the first quarter of this year.

The Reasons

We believe that the hospital sector is due for an increase in M&A activity in both volume and value. Indeed, since 2007, only about 12% of U.S. hospital companies were involved in a merger or an acquisition, and the vast majority of the transactions involved financially struggling hospitals that were seeking to shore up their long-term viability. The ACA will likely serve as a catalyst for deals in a sector that was likely long overdue for some consolidation.

One major reason for the projected uptick in mergers and acquisitions is revenue pressure. Hospitals are already receiving lower Medicare payments from Uncle Sam, and the ACA may drive top lines even lower. Indeed, the new statutes will change the model for how some hospitals are paid from a fee-for-service model, where doctors and hospitals are paid for every procedure, to a system where hospitals are paid a certain amount per condition. This, theoretically, should provide doctors and hospitals lots of incentive to keep patients healthy and out of the hospital in the first place.

Other big reasons for consolidation include the new efficiencies mandated by the ACA, such as electronic record keeping, which tend to be very expensive for stand-alone facilities to implement. Hospitals will also face steep fines and financial hits if they run afoul of new patient-safety rules, admit too many patients, etc. By merging, hospitals can save millions on billing, purchasing, and other administrative costs. They can also share the brunt of the hit they’ll take updating their systems, and be able to shore up their finances. And with a scary number of hospitals already operating in the red (an estimated one-third of all U.S. hospitals), any opportunities to save money and share expenses would undoubtedly be welcome.

Finally, we think M&A activity will enable hospitals to expand services offered and drive up costs. Studies have shown that hospital consolidation generally results in higher prices, as facilities with a monopoly in a certain market can demand higher payments from insurers. These higher payments are ultimately passed along to the patients and consumers in terms of increased premiums, but patients would benefit from the likelihood of service expansions.

The Deals

The uncertainty surrounding the implementation of the statues has likely impacted both the volume and size of healthcare mergers and acquisitions, but we expect to see more transactions, big and small, in the coming six to 12 months.

One example of a large deal in the hospital sector was the announcement that Community Health Systems (CYH) agreed to acquire Health Management Associates (HMA) in a $3.9 billion deal. The combination would bring together two companies facing similar business and regulatory challenges, and together, the two would create the largest U.S. hospital by number of locations, with 206 stretching across much of the country. Expense reduction and geographical complements were cited as the main reasons for the deal.

Elsewhere, Tenet Healthcare (THC) agreed to buy Vanguard Health Systems for a total of $4.3 billion. Tenet’s management hopes the deal will cut down on redundant expenses, take the company into new geographic markets, expand service offerings, and diversify earnings sources.

More industry consolidation is likely to follow, as hospitals need to improve their economies of scale and leverage their market positions. Sure, there could also be an influx of newly insured patients, but we think more cutbacks as far as inpatient volume is a far more likely scenario. The only way for hospitals to make money in this new landscape will be to overhaul their systems, reduce their expenses, expand their high-margin offerings, and improve their finances, and the quickest way to accomplish many of these goals is through M&A activity.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.