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Hospitals and health systems are on the frontlines fighting the COVID-19 pandemic. But, behind the scenes, they are grappling to sustain operations and finances significantly impacted by the state of the economy. In the latest version of our PointbyPoint podcast, Waller’s Ken Marlow and Eb LeMaster, managing director at Ponder, discuss the various factors impacting hospitals and health systems today. They share their insights based on decades of experience advising hospital leaders and look to the future of this healthcare sector.

Listen to podcast here.

Here is a transcript of the conversation:

Morgan Ribeiro 

In light of COVID-19 pandemic and the entire world economy shifting, seemingly overnight, many industries are having to rethink their businesses quickly. I think we can all agree that hospitals are dealing with more than most. Looking back to what feels like another era pre-Coronavirus, Eb, how would you characterize the hospital M&A market in 2019?

Eb LeMaster
You're right. It's almost impossible to remember 2019. It feels like it's years ago versus what we've been through here in recent months. I'm going to focus on hospital and health system transactions in these opening remarks. In this sector, volume was actually down just under 30%, year over year, from 2018 to 2019. From our count, 116 transactions in 2018, in number, to 85. And this was a significant dip from what we had seen going back three or four years ago, and from our perspective, there are three or four drivers to keep in mind that accounted for that in 2019.
First, we had a slowdown in for-profit divestitures. They continued, but not at the same pace, and others like Tenet slowed their selling, so some of the for-profit divestitures had slowed. We also didn't see as many what we refer to as mega-mergers, which are transactions that include systems north of a billion dollars. I think part of that was driven by a fair amount of digestion from recent years of big waves of mega-mergers, so there was integration work going on rather than looking for the next big mega-merger. We also had a pickup in failed deals for those that reached LOI but for different reasons didn't make it to a definitive agreement or closing, and we had some high profile, like Sanford and UnityPoint, Marshfield Clinic and Gundersen, and Baylor Scott & White and Memorial Hermann, those kind of transactions. And part of that we'll talk about later, healthy systems talking to healthy systems, was part of that. And then I think we're also seeing a dwindling pool of independent hospitals of significant size, and so they're less likely or just fewer targets out there. So that sounds negative overall, but what I would say though is the environment in 19, the level of dialogue, was as high as ever.

Morgan 
So fast forward now, and Q1 2020 has ended, how has the COVID-19 pandemic impacted hospitals and health systems?

Ken Marlow
First, I would say that it's sort of crazy when you think about it, who would have predicted this time last year that we would be facing a pandemic. Hospitals haven't seen this kind of national healthcare emergency really in modern history. I think forecasting precisely how the coronavirus is going to impact each community is really going to be impossible given the lack of data, the differences in demographics, as well as the varying level of protective measures put in place by the individual organizations. But I think than any of that you're going to see that the challenges include both a combination of the operational and the balance sheet impacts. And so I'd say first taking that operational impact, when you look at health systems, I think they're being pulled away from their normal course of business to focus on how do we prepare and deliver healthcare in the midst of this pandemic. Their focus, in many cases, is solely devoted to treatment of COVID patients. And they've put essentially a pause on a lot of their normal course of business. You've seen that the general hospital volumes have dropped dramatically in most facilities across the US. And then on top of that, you've also got this cessation or delay of elective procedures, which those procedures are huge revenue generators for hospitals, and then you got that coupled with significant declines in ER visits at hospitals as well. So I think when you look at these headwinds, plus a reduction in reimbursement driven by shifts from say surgical cases to more medical cases and increases in length of stay for COVID-19 patients, it really is a perfect storm. It's a very challenging environment for these systems. And at the same time, you've got these expenses that have skyrocketed as health systems are competing with one another in order to acquire PPE. So, I guess with all of us, I don't think that there's really any certainty and sight as to when hospitals are going to be in a position to resume their normal course of business with respect to their focus on patient care outside of COVID.

So moving to the second impact, which is the balance sheet impact, we've seen double-digit drops in hospital margin in March, and I think we are going to see that and continue to grow as health system AOR from pre-COVID days runs out and health systems really start to feel this brunt of lower volumes and this cessation of elective procedures. So, when you take all of this coupled with the increases in expenses, I think that the not-for-profits that have historically been skating on thin margins are now operating in the red, and I think that creates a really difficult environment for those not-for-profit hospitals. And I know that Ponder had done a white paper in the early stages of COVID, estimating the health systems' liquidity, i.e., cash days, cash on hand, would likely be hit by 30 to 50 days due to the one-two punch to the equity market drop, and then this significant near term cash flow losses. Now, some of this loss may be of a lower impact as a result of some of the government programs that we're seeing, and there is a market rebound that's occurring as well. But I don't think that there's any denying the impact is going to be significant and severe for most of the not-for-profit systems.

Morgan 
Ken mentioned the white paper that you all did, I'd love to get more input from your end, particularly as it relates to the investment portfolios and the impact of what happening in the markets right now on hospitals and health systems.

Eb 
Thanks, Morgan. You're right, we had put out a white paper early on during the pandemic, and it really is the one-two punch and fairly equally balanced in terms of the equity markets drop and its impact on liquidity in days cash on hand and then the operating cash flow losses. Some of that has rebounded as the equity markets have come back some, but at the end of the day, when you think about it, as Ken said a 30 to 50 days cash on hand effect, that means one thing if you have 300 days cash, but if you're a hospital or health system that doesn't have that type of liquidity, let's say less than 150 days cash, that's a major impact to any system but especially those with less liquidity and starts to move even towards some covenants in terms of days cash that need to be kept on hand. So it's a significant impact. I think Ken nailed it. I think our clients have not been focused on larger strategic issues in this near-term pandemic and effect that they've been focused on just how do they handle testing, how do they handle patients, and it really pulls them out of the normal part of their business and larger strategy.

From a capital advisory perspective, which our firm spends a lot of time on, the huge thrust has been making sure adequate lines of credit and liquidity are in place. And for those that are closer to covenants managing that, and we're going to see more of that because we really didn't test covenants completely in the first quarter because operating income was hit but not nearly to the degree it will be in the second quarter. So a lot of our clients are trying to either gain exceptions, using this as an extraordinary event and being able to normalize it, or asking banks for covenant waivers. I think that's a huge part of what we're as a firm dealing with and working with our clients on is during Q2 and will definitely extend into the third quarter. The other thing we've spent a ton of time on more recently with clients is modeling scenarios. I think what the ramp as Ken said will be no one knows, but I think our clients and the rating agencies are really bearing down and asking for much more detail than they typically do from our clients. They're asking for different scenarios, obviously, what COVID's impact will be, what will be long term. These are really difficult questions to answer for even the most sophisticated clients. So we have been spending time doing scenarios. If the ramp looks like this over the next six months. On a positive note, here's what it looks on a more positive note, if it's more challenging, it's why, and educating their finance committee and boards, but for our finance team clients that's been their world. Liquidity and outlook in the near term and explaining COVID's impact. Our higher rated credits have been able to get access to the markets in a limited way. It's been more challenging for those that are, for example, a triple B category or still investment grade but at the lower end, it's certainly been challenging. So I think one other thing that our clients we're starting to hear, what really will my mix look like coming out, payer mix. Because of unemployment, a massive spike in unemployment, what will that mean? What will that look like? And some clients will say we don't think volumes will return to their pre-pandemic levels, maybe 85 or 90%. Well, that's a dramatic position when you think about healthcare is, if healthcare is 20% of GDP, and you see a 15% decrease in usage, that's a 3% cut in GDP or something of that magnitude. That would be a major impact. So I think our clients are really trying the best they can to model out what this will look like by using scenarios because the reality is it's very difficult to predict.

Morgan
On the M&A side, how do you see this pandemic and the current crisis impacting hospital mergers and acquisitions?

Eb 
We definitely are seeing a slowdown in activity in this. We saw it at the tail end of the first quarter and into the second quarter. There are transactions getting done, but I think the volume we'll see is down. I think another thing we're seeing is a lot of high profile deals put on hold. Just in recent months, Beaumont was going to move geographically out of its footprint and merge with Summa, Jefferson Health was going to by Fox Chase, St. Luke's was going to do a transaction with Easton Hospital in Pennsylvania. So I think we're going to certainly see a decline in Q1. We saw it in Q2; we'll see it further. And so the question becomes, you're hearing more and more a predictive big spike in M&A post-pandemic. And I think there will be an increase, but I am cautious because you also not only a driver is a need to affiliate but you also have partners who are in a position and willing to take the risk and take on a different additional investments like this that are many cases very significant.

From our work, we're really seeing from ongoing projects. We're seeing really three things. One, those that are in the early stages, they are continuing for the most part, from our perspective and what we see, to move on, to plow on through the process, even though it's challenging remotely, but to the extent they can advance their process. There's not a decision or a vote in the near term, but they feel like they can continue to advance the ball, so there's that group. There are those who were, I'll call it the seventh inning and nearing, for example, board presentations, finalist presentations; we're finding those kind of transactions are delayed two to four months to wait until people really can get together in person. So I think for those opportunities that were strategic to both parties, the interest is still there, but there's a kind of pause. And then we had a few deals, and one we're involved with Ken, that was right up on the goal line, and votes were held off at the very last second on the definitive agreement. And I think those are more day to day, when does the environment open back up? When can I get the right people together to make a big decision like that? So I think those are some of the factors we're seeing. The other thing I'll say is I think there's going to be a theme of haves and have nots. So those opportunities or targets, I'll call them, that are very strategic, that are in good demographic areas, growth, that have more than one system that are interested, I think the interest will continue to be there. They'll continue to be able to move processes. The challenge is on the other end of the spectrum where those who don't have the same kind of dynamics in their market or with their health system or growth rates, or are in states that are more challenged, I think that's going to be the difficult part of advancing those projects. So again, if you think about the larger systems that are still very interested in those strategic transactions, those are likely to continue. Those that are more difficult or marginal opportunities for those systems, they have greater risk of being delayed or abandoned. So that's what we're seeing for the short term. One final thing we may talk about is on closures. I think we've already seen a pickup in especially in the small rural market. I think that will continue. I do think there's some larger hospitals that we've begun to see, one of the Catholic systems just closed a hospital in Kentucky with north of 200 million in revenue. It's not a small rural hospital. I think larger systems may have some more leeway in this environment to make difficult decisions, and not that communities will embrace that, but there's more understanding amidst a pandemic and all the pressures.

Ken 
I would say that's virtually identical to what I'm seeing. I think that those transactions that have a strong strategic basis are ones that will get done whether or not they're on a temporary pause or they push through the process. I think those that were marginal with respect to the strategic basis, you'll see are delayed and in some cases just terminated. I think that given this environment, it's more important to have certainty with respect to a strong strategic basis and execution. And so it's not a time to put liquidity and resources at risk for something that may be of marginal importance. I'd say that another thing that we're going to see is this tension between health systems wanting to be optimistic and get assets at a really good value, but also cognizant at the same time that the limited power they have available to acquire the assets. So back to what Eb said, I couldn't agree more, I think that every transaction will require an undeniably strong strategic reason for the transaction. And those are the ones that are going to get done.

Morgan 
Ken, what are you seeing with the investor-owned hospital systems right now, particularly as a result of COVID-19?

Ken 
Well, I think you know, many of the larger investor-owned systems over the last few years have divested from their portfolios and some of their non-core markets. And so I think that what we're going to see is perhaps another stronger wave of portfolio rationalization to divest the hospitals that aren't strategically important to the organization. And while I think companies have done a good job eliminating the non-core assets, I do think there's still this next tier, where there are some that they've held on, and I think given this environment and the need to have liquidity, I think that they're going to look at taking another shot at potential divestitures. And part of that will obviously be dependent upon the asset itself and how marketable it is and what value they're going to get for it. I think it really brings into view the fact that you're going to want to make sure that you have buyers and those buyers are going to purchase at the price that's acceptable to you, or in some cases, there just may be assets where you just want them off your books. We have seen some of that as well. I think despite the shake up in the capital markets, the healthy for-profit systems are going to continue their strategic growth initiatives. I know in talking with clients that have large development departments, they have the resources to be analyzing and identifying the right targets, and I think that we're going to see those strongest investor-owned systems seizing the opportunity to acquire hospitals and health systems where honestly, they may have had difficulty getting those potential partners to the table pre-COVID. And in some cases, it may be about re-establishing and reengaging with partners where they've either had an affiliation and they're wanting to do something more significant but seeing now may be the time for those systems to partner with one another.

I think another point worth mentioning is, unlike some of the independent health systems that really don't have the time to focus on anything but COVID, I think these investor-owned systems with their development teams are really busy right now scoping out the opportunities that are out there. They may not be actively acting on them, but I do think that they are reaching out. They're spending the investment time to say, in many cases, how can we be helpful to your system, and it may start with dialogue from how they can be helpful to that system to something much more significant in terms of integration. I think that we'll also see investor-owned hospitals aggressive in building out other service lines. So there's no doubt in this environment telehealth has been a huge winner. I think behavioral health, as everyone has seen, has become even more important than ever, and also in the post-acute space, I would see a lot of potential development, whether it be through acquisition or joint venture or affiliations, building out that larger service platform.

Eb 
One of the development people on the for-profits side said, when asked, are you going to sell more, they said, well, first, am I going to have buyers? I'm still not confident there may be buyers, especially for some of my more challenging situations. An two, what run rate are they going to use when they offer me a price. And I think that's a pretty good perspective.

Morgan 
One of you mentioned earlier the amount of government funding that is being funneled towards hospitals and health systems right now and really providers in general. Eb, how is that impacting what you're seeing with hospitals and health systems, particularly thoughts on M&A activity?

Eb 
I think the government funding has definitely been a source of partial relief. The degree and extent to which it can fill holes, though, is is limited at some point. I think it's been interesting. We've been trying to forecast for clients, they've looked at their portfolio hits, they've looked at their operating cash flow, and we'll have a call in the next week, they said, we've received $12 million or whatever the number is from different from different government programs. So it's challenging, frankly, to figure out exactly how much can be helped through those programs. I think it will relieve some of the pain, but I don't think it's a solution long-term. I think the other thing and we're just starting to see stories on this at a state level, I think we're going to have some significant pressure as state budgets are highly affected by the pandemic. There's even recent articles of a number of states looking at cutting Medicaid rates in the near term. So we think about the federal government, and at this point, the federal government's had the ability to do what it's going to do, and the markets not punished, you know, long term Treasury rates or whatever. They've been able to affect these programs. But I think the state can be particularly problematic as they turn to look at their own full operating budgets and try to find where they're going to get that additional savings. So the government programs we've seen are definitely a help to our clients, we have to model that into the scenarios we've talked about, but especially if the links of ramp is longer than we think back to more normal levels, the less influence those programs have.

Ken 
I guess the only other thing that I would add just in talking to some of our large not-for-profit hospital clients. I think one significant factor is going to be the unemployment rate and the impact that it has. Back to what Eb mentioned, I think that part of the issue will be when will they be able to resume more of their normal business. And I think another part of this is when will we see employment rise again, because right now, if you look at the forecasting, and what's anticipated by the end of this year, that will increase the number of uninsured and under-insured. So I think at the same time, you'll have a significant impact to bad debt, which will be very challenging for these systems, regardless of this funding that they receive. So I think when you take all of these headwinds, there's there's certainly help that can be provided to the hospital systems, but I don't think that you can save the hospital systems.

Morgan 
As we touched on earlier, there's just macro-level issues that are happening here that are impacting hospitals and have been for even prior to the pandemic. And my next question is really around, there's a number of hospitals that have been operating on really thin margins pre-pandemic, then you add in the pandemic, and that definitely worsens the situation for some of these hospitals. Do you imagine that will force closures in a number of areas, and ultimately that that will impact the number of independent hospitals that we see across the country?

Eb 
Yeah, when you look back in 2009, about 45% of hospitals were not part of systems. And even as recently as the end of '17, you were down to 33%. I think that trend is going to continue. I think the pressures that they were feeling are only magnified by one balance sheet impact. I think even during the pandemic, the resources you need to mobilize the additional staff, you have to think through all the gyrations, it's even more pressure on an independent system who doesn't have that kind of system resource behind them. So I think this will definitely continue to accelerate things. I think we spent a lot of time in '19 with independent hospitals, I'll say in the $300 to $600 million range, who hadn't had to choose a partner who had, frankly, strong positions, either from a financial perspective or market position. But I think this is another factor as they look at what they face or what their challenges are, it's yet another kind of strike that may get them to think even further about, should I be thinking about this differently? Probably the biggest thing we've seen since the pandemic in terms of inbound is more independent hospitals saying, I want to be more thoughtful about my options. And maybe I'm not ready to do something today. I'm still focused on my own internal reactions to the pandemic, but I want to be ready and thoughtful about option B, at a minimum, have re-educated or educated my board and management team and have them ready. So I think to answer your question is yes, I think we'll continue to see the number decline. And I think one of the immediate kind of ramifications is more clients want to be thoughtful and ready with an alternative option.

Morgan 
What about valuations? I've read a number of articles recently generally about healthcare M&A, but particularly around hospitals. And you mentioned earlier even a number of hospitals that may have been looking at a transaction prior to the pandemic, maybe press pause. I would imagine that valuations are looking very different now than they did even just a few months ago, and what are those based upon right now, because things are such in flux?

Eb 
I'll be honest in saying it's almost untested at this point. I think it's so early and difficult to tell. You have the publicly traded hospital companies have dropped by north of 30%, on average. So you would immediately think, wow, that's got to translate to lower valuations. I think it will translate in a way that I mentioned really twofold. One, what they're applying multiples to is going to be more depressed. And then I think for the near term, at least, those multiples will be impacted. There's just no way they aren't. But I think it does come back to the have and have nots. Again, we have several situations across the country where clients are, again, very attractive markets, good growth rates. And this is an asset, let's say, two or three or four systems have been waiting on for years to have a dialogue with them, and now they're willing to. So I don't think they'll try to be overly aggressive about valuation cuts, if it's extremely strategic to them. This is their opportunity to pick up a key market, adjacent market, for example. So I think valuation will be hit. I think it's too early to tell. We did visit with one of the investor-owned hospitals who said interestingly, putting aside purchase price and talking about capital commitments, that their appetite in dollar amounts that they typically have done or done in years past, that part they likely will be more conservative about. Now that's just one data point, but basically saying, in today's environment of unknowns, I am not willing to, let's say, do a linear capital investment of x hundreds of millions that I would have five or 10 years ago. So I think it's gonna have an impact on purchase price, but also on capital commitments, we'll be tested there. But at the end of the day for somebody to say multiples have dropped by 27.3%. I think it's too early to tell exactly what it's going to be.

Morgan 
Ken, what about deal structures? Are there certain deal structures that may be more attractive in this post-pandemic world?

Ken 
I think from the standpoint of whether or not COVID is going to change what particular structure is chosen, I don't think we're going to see a huge change in that. I think that membership substitutions are going to continue to be the top structure utilized in change of control transactions, especially as non-upfront payments are preferred by acquirers in this environment. I think that what you will probably see even more of are some of the alternative structures such as joint ventures and minority equity investment transactions, and I think those will continue to grow. As I mentioned before, I think there will also be a significant examination of the clinical affiliations, clinical integration, the clinically integrated networks. So I think that there will be an analysis of what works best in this particular situation. On the one hand, I think if you're looking at sort of the independence, they may fiercely want to remain independent. And so the clinical affiliation may be better for them from the integration standpoint. But the reality is that from a liquidity standpoint, they may have no other choice but to undergo a change of control transaction. I think part of this is really about the system being honest and understanding where it sits from a financial perspective when it's making that decision. I think we'll still largely be driven and the same structures we've looked at before, but I think it'll really depend on that system as to how realistic they are in terms of positioning themselves best for the future.

Eb 
One thing I might add to that, I think Ken's right on. I think we're going to see, we've already seen it with a couple of clients, is keeping their options open on structure later and later in the process. Because what's the size, for example of my capital need? Well, if my projection on the pandemic looks like this, it's x. And if it goes a different direction, it can be y. So we have a couple of situations where clients, we're used to them keeping their options open, but later in later in the process to see really what the impact ultimately is, and how big is the need based on that outcome?

Morgan 
Eb, I know you're advising a number of hospitals right now, and of course there's a lot of questions on the minds of administrators and board members. What advice do you have for them right now, particularly as they kind of consider their options for the future?

Eb 
I think number one, and virtually our clients are doing this, is just really to understand the scenarios from a financial perspective. No one has a crystal ball to tell you which one it's going to be but, for simplicity's sake, a worst, middle and best case and what that means to the institution. And so I think that's number one. And I think most are doing that. Number two, and I maybe alluded to this, is more than ever, being educated about your options is our advice. And that doesn't mean go, you know, run out to the market in this kind of environment. And but it does mean being aware what this dynamic means. What are other systems in my area doing? I think it's either be educated or reeducated on what the latest developments are, so that if this the effect of the pandemic is worse than you thought or less than expected, you're ready either way. So I think having the options refreshed and ready is our advice.

Ken 
I think for a lot of systems, it would be important for them to be realistic in the assessment of where they sit from a financial position, and that their board is adequately apprised of where they sit from a financial perspective. While it is virtually impossible to escape the fact that COVID will be front and center for purposes of their priorities right now, I think that they need to continue to have a focus on what the future looks like from a strategic standpoint, and going ahead and identifying what those goals are and how to best position themselves in order to execute those goals will be important. So I think it's very important for boards and administrators to be continuing those conversations and examining the opportunities and really re-establishing relationships with potential partners because I think if there's ever been a time to make sure that you're positioning yourselves in order to be successful for the future, this is now.

Morgan 
Is there anything you can see coming from this that's sort of a positive for the hospital and health system industry right now?

Ken 
I would say that one of the questions that's long been asked is can acute care hospitals change and progress forward in the way in which other industries do, and I think that what we will see is that this is a huge catalyst towards a real change in how care is delivered. I think this will catapult us in terms of the delivery of telemedicine and hopefully exact change through legislatures in order to allow for a more robust telehealth system. And I think that the public is ready for that and wants that, and I think it'll also be an opportunity to see advancements in different aspects of healthcare. I think behavioral health will be big. I think that we'll see continued advancements but at a much more rapid pace. And I think it has turned out to be a way to really make all healthcare providers look at issues together and really use their resources collectively to fund advancements in the delivery of healthcare. And I think that's a huge win in all of this.

Eb 
I think it does show, this type of environment, shows a need to be ready for the unknown and how to react in making hospitals and health systems even more agile, whether it's in their physician arrangements, or their facility strategy or telehealth, or whatever it is, I think it's all the more reason and maybe as we come out of this a willingness for health systems to take on risk at a different level. I don't mean payment risk, I mean, new strategies, new approaches, as Ken was alluding to, that may make the industry adapt. The one thing I'll say, and this is a positive and a negative, Ken talked about how there's the threat of unemployment. And I think they will have real payer mix change. But the thing we have to remember is the payment methodology overall in this country has not changed during the pandemic. We still have on the commercial side, just on that side, we still have the same monthly premium, the same deductible the same incentives for behavior. So this is a little outside of your question, but one of our CFOs kind of made that point to me. And I think my hope from a positive perspective, at least from a volume standpoint, as we come out we have the same payment structure and the same incentives to use healthcare. Now, one may argue we need to change those incentives, but my hope is in terms of the ramp, there's a positive in that we are already motivated the same way we were pre-pandemic. But I think, aside from that, is there a willingness to look at the business differently to develop new approaches and take risk on different strategies in a new way. My hope is that there is.