Divesting losers: chipping away at integrated delivery systems. (Management).

THE DAYS OF HEALTH system mergers and acquisitions may be fading fast as integrated delivery systems (IDSs) scramble to shed losers and ease serious financial pressures.

A large number of IDSs already divested unprofitable physician practices, provider-sponsored HMOs, long-term care facilities and mental health programs.

Although it represents approximately 30 percent of all deals, divestiture continues to lack a research identity that is distinct from other forms of corporate restructuring such as mergers and acquisitions. That's because one system's divestiture is another organization's acquisition. (1)

It may be tempting to conclude that divestiture is little more than a mirror image of a merger and deserves minimal attention But one thing is clear: we know a lot more about merging than we do about shedding our losses.

Management literature suggests that the decision to divest carries a higher risk than the decision to merge. Health executives often find it difficult to explain why it's necessary to sell a business unit that their IDS acquired at an earlier date. Managers are sometimes even inclined to escalate their commitment to a failing course of action to try to justify their original decision.

Bout (2) suggests that ineffective managers are not only less able to select worthwhile acquisitions, but are less willing to correct their mistakes by divesting.

Cutting your losses may be a more complicated strategy in the health field than simply admitting an erroneous management decision. There could be legal issues, a negative impact on market share and, worst of all, unremitting ill will from local physicians left out in the cold by an IDS.

Why do divestitures occur?

Poorly designed mergers and acquisitions often result in divestitures. Among the biggest barriers to successful integration are:

* Agreeing on a pattern of governance

* Sharing existing and projected capital and operating funds

* Figuring out how to best enhance the region's delivery of health services (3)

Other factors that contribute to divestitures include:

* Trouble negotiating an organizational-managerial fit

* Lack of geographic synergy

* Project alignment of resources between the main facility and the satellites

* Centralized versus decentralized decision making (4-8)

The recent collapse of a major physician group practice provides insight into the various dynamics of why so many IDSs are divesting physician practices. (9) The closing of the Nalle Clinic, a 140-physician, multispecialty clinic in Charlotte, N.C., was due to numerous factors including:

* Inability to adjust to a changing health care market

* A complicated billing process

* Decreasing reimbursement

* Increasing costs and high overhead

* Poorly managed accounts receivable

* Lagging profitability

* Inability to manage physician performance

* Physicians reluctant to change

Avoiding divestitures

If insightful health care executives reshape the delivery system to meet community health needs and evaluate the pros and cons of cuffing costs, they can reduce the number of divestitures.

Usually divestitures are avoided when cost reductions can be implemented by labor-saving technologies and when it is possible to centralize, integrate and coordinate clinical services without serious turf battles with physicians. (10)

Bottom-line savings are most readily achieved by merging two, medium-sized, high-case-mix, nonteaching, not-for-profit hospitals in the same service area, where both are experiencing low occupancy. (11-13) Such corporate consolidations offer the potential ability to shutter specific clinical services in one of the two facilities. This eliminates inter-institutional competition and controls the range of services offered in the community. As a result, prices can be raised for specific services in the marketplace.

Divestitures are more likely to arise when IDSs undertake an unrelated vertical rather than horizontal diversification (14) -- such as sponsoring a managed care plan (vertical) versus merging two hospitals (horizontal).

Integration that concentrates on the more acute care, hospital-related strategies--such as the ownership and operation of an ambulatory care facility, an ambulatory surgical center or a satellite radiation therapy unit - results in far improved short-term financial performance than a somewhat more disconnected or an unrelated post-hospital diversification like a nursing home or a wellness-rehabilitation center. (15,16)

Unrelated, vertically diversified acquisitions that so often fail fiscally are often a precursor to divestiture. There are several reasons for this:

1. Physicians, rather than those managing the IDSs, control the flow of patients to the various providers of health services.

2. Improving geographic distribution of primary care physicians into underserved rural and poor urban areas to enhance access is hard to achieve because most doctors grew up and were trained in metropolitan areas. Also, the traditional, publicly sponsored, community health center must serve a large number of uninsured patients.

3. Vertical integration usually requires significant capital investment that will only achieve long-term rewards.

4. Complicated organizational structures are often required. That makes it difficult to manage the chain of command, share risk and equitably distribute surpluses to shareholders.

5. Despite tighter integration and coordination of the region's health resources, there are no guarantees that vertical integration will improve fiscal or clinical outcomes. Operating losses from several of these vertical ventures may begin to pile up and an IDS eventually realizes that divesting some subsidiaries is the only viable economic alternative.

Avoiding divestiture most often depends on the management skills of the IDS leaders and the amount of competition the health network experiences from physicians, hospitals and other providers located nearby. (17)

Variables tied to divestiture

Consider what happened in a several specific cases:

In 2000, Optima Health in Manchester, N.H. and Baptist St. Vincent's in Jacksonville, Fla. were in the midst of a corporate divestiture.

At first glance it appeared that the split was due to cultural issues-- problems blending Catholic and non-Catholic values. But the real difficulties apparently involved various vested interests that made it virtually impossible for the system's leadership to implement projected savings.

Similar conclusions were reached in the attempted merger of the University of California-San Francisco and Stanford Health Care system, where the major teaching hospitals for the UCSF and Stanford Medical Center were divested. (18)

The merger of the Milton S. Hershey Medical Center of Pennsylvania State University, an academic health center, with the Geisinger Medical Center and its large physician group practice, was a precarious marriage from the start.

It attempted to wed two dissimilar physician cultures: a faculty primarily interested in teaching and research with doctors in a large multispecialty group practice focusing on quality patient care.

In all of these cases, projected financial savings never materialized.

The most publicized divestiture and recent debacle in the health field was the attempted integration of Allegheny Health Education and Research Foundation with major teaching hospitals both in Philadelphia and Pittsburgh.

Tenet, the nation's second largest investor-owned hospital group, purchased a majority of Allegheny's assets in Philadelphia. And Pittsburgh's Allegheny General Hospital merged with the Western Pennsylvania Hospital, forming the West Penn Allegheny Health System.

In hindsight, one question to consider is whether there could be some discernable operating or fiscal characteristics that might be identified as a risk variable for divestitures.

To make such a possible assessment, Tables 1 and 2 summarize institutions' recent Medicare cost reports, including their percentage change in revenues from an earlier year, operating margin, total margin, debt to equity ratio, current ratio and days of cash on hand.

To assess any detectable operational differences between the two partners within an alliance that potentially caused the divestiture, Table 2 looks at the number of full-time equivalent manpower hours per adjusted discharge, the adjusted operating expense per discharge and the adjusted net revenue per fulltime equivalent employee.

These analyses find no overt operating risk variable for divestiture, so the break up of these IDSs was most likely related to the inability of the two partners to agree on how to downsize.

Although there is some variation in the fiscal performance between some partners, there is more overall consistency than expected, suggesting these were 50/50 marriages dissolved with an expensive divorce.

Implications of divestitures

The idealistic view of divestitures is that IDSs:

* Eliminate redundant services

* Embrace improved access, social equity and higher quality of care

* Eventually reduce costs

The obvious concern is that these health networks are almost always shedding their fiscal losers--programs and services often critical to a community's broad social-medical needs, but a drag on the bottom line.

The closings often include mental health services such as substance abuse, inpatient rehabilitation, long-term care and home health care.

What should be worrisome to the public concerning these divestitures is when some IDSs acquire their competitor's programs, services and facilities and move to shutter them, with the IDS ultimately positioning itself as an oligopoly.

Once there are no qualified competitors in the area, HMOs have virtually no other alternative than to negotiate reimbursement rates with the remaining provider. IDSs in highly concentrated areas tend to restrict the range of services offered, increase prices and are not overly sensitive to reducing costs. (11)

The idea that IDS divestitures can in some way be controlled by stringent regulatory measures seems foreign. Neither the Department of Justice nor the Federal Trade Commission have been particularly successful in the courts when they argue that proposed mergers are clearly in conflict with well-tested antitrust statutes and rulings. (19)

Furthermore, the government's experience with other regulatory measures such as price controls, (20) certificates of need (21) and rate-setting (22) suggest that IDSs can divest their losers without any significant federal or state review.

Politics of divestiture

Divestiture can carry heavy political baggage.

How does a network's management team explain to its community, trustees, medical staffs, and particularly the organization it plans to shed, that it is in the IDS' best interest to divest? How do IDS leaders rationalize a large financial loss that can impact the bottom line for a year or more?

Most politically sensitive is criticism of the IDS trustees who approved the earlier acquisition and share some blame its failure. However, they often hold the management team solely responsible.

The medical staffs and doctors who are caught up in the divestiture will likely feel disenchanted, disenfranchised, displaced. Some will opt to start practicing elsewhere. These spin-offs usually become contentious due to third-party contract issues and the nature of the IDS' warranties and representations.

Consummating effective mergers is a task more complex than generally perceived by most health leaders. Shedding losers, a topic rarely studied to date, may have more political, legal and economic overtones for even the most well managed IDS.

Chipping away continues

The obstacles to integrating and coordinating health care services aren't new. They were discussed over a half century ago in 1932 as part of the final report of the Commission on the Cost of Medical Care (CCMC). (23)

And divestitures likely won't end any time soon.

As third-party reimbursement pressures increase, the American public should expect that IDSs will divest more of their losers, eventually forming regionally-oriented hospital systems as advocated in the 1970s and 1980s. (24)

These hospital systems will primarily consist of acute care inpatient and ambulatory care facilities with a few profitable diversified subsidiaries that offer geographic and clinical synergy.

As IDSs divest physician practices, more doctors can be expected to be organized as freestanding, single or multispecialty groups continuing to compete with hospitals for ambulatory care revenues across a broad spectrum of services.

IDSs will also continue to spin off long-term facilities, often to investor-owned groups, most of the large chains already having filed for bankruptcy protection because of over-capitalization and low reimbursement.

Quality mental health services will continue to be rationed by family income with an increasing number of Americans being cared for by Medicaid. Some will end up homeless or committed to a correctional facility.

As a result, the public will experience a far less integrated and coordinated delivery of health services with referrals among providers becoming less seamless.

Since it is unlikely that the financing of health care and the level of reimbursement will be modified more than at the edges during the next few years, chipping away at the IDS concept is predictable simply because it is fiscally expedient to shed losers.

This trend is expected to continue in spite of the fact that some of these services divested are critical in providing needed health services in their community.

Here's a checklist to objectively evaluate a possible divestiture.

Integrated delivery system

                                                          Retain  Divest

Is the subsidiary's role consistent with the               Yes      No
IDS' mission, vision and strategic plan?

Do business failure risks significantly                     No     Yes
outweigh the divestiture risks?

Are the subsidiary's activities creating a                  No     Yes
negative effect on the IDS' image?

Is it difficult to recruit and maintain                     No     Yes
adequate management and professional staff
to deliver high quality care?

Is the subsidiary likely to remain viable with             Yes      No
the public, the physicians and with others who
have a vested interested in its continuation?

Market

Does the community and the IDS' medical staff              Yes      No
feel that this subsidiary provides an important
healthcare function and that a divestiture
would not be in the public interest?

Do market projections indicate reasonable                  Yes      No
long-term demand?

Is the market now actually smaller than earlier             No     Yes
projected?

Can the subsidiary obtain sufficient volume to             Yes      No
achieve reasonable economies of scale?

Has the subsidiary matured on the product life              No     Yes
cycle?

Are reimbursement or scientific changes                     No     Yes
occurring faster than the subsidiary can
respond to them?

Do the clinical services provided by the                   Yes      No
subsidiary differentiate the IDS or add a
distinctive competency?

Social and legal issues

Is the business structure or referral                      Yes      No
patterns consistent with state and federal
rules and regulations?

Is the subsidiary's role consistent with                   Yes      No
societal values?

Financial issues

Has the subsidiary met return on investment                Yes      No
targets for the past five years?

Is the subsidiary's projected return on                    Yes      No
investment acceptable?

Has the subsidiary met key financial indicators?           Yes      No

Will divestiture significantly reduce the IDS'              No     Yes
fixed costs?

Can the subsidiary survive significant forthcoming         Yes      No
changes in third-party reimbursement?

Are funds available to support its future capital          Yes      No
and operating requirements?

Does the subsidiary generate economic benefits?            Yes      No

Is the subsidiary creating operating losses?                No     Yes

Will the divestiture result in unaffordable forfeitures,   Yes      No
penalties or liabilities?

Sources: Spallina, J.M. "Analysis Weighs Issues in Divestiture
Decisions."

Financial Management 1990, 44(7): pp. 44,46-48 and revised by Spallina
and Well, January 2001.
Table 1

Selected Financial Data of Divested Hospitals, 2000

Hospital            Latest Year's   % Change from  Operating
                    Revenue(Mill.)  Earlier Year   Margin

Hahnemann           $144.5          -83.3%         -27.7%
University
Hospital, Pa.

Medical             263.5           -52.1%         -54.4%
College of
Pennsylvania
Hospital, Pa.

Allegheny           1,074.8         -1.0%          -13.0%
General
Hospital, Pa.

Western             587.2           N/A            -1.1%
Pennsylvania
Hospital, Pa.

M.S. Hershey        469.7           N/A            -7.9%
Medical
Center, Pa.

Geisinger           437.0           +4.6%          -9.1%
Medical
Center, Pa.

Stanford            1,147.1         +3.3%(2)       -5.3%(2)
Medical Center,
Calif.

UCSF Medical        989.6           +26.1%(2)      +18.4%(2)
Center, Calif.

Baptist Medical     498.1           +5.7%          +0.3%
Center,
Jacksonville, Fla.

St. Vincent's       541.1           +9.8%          +13.2%
Medical Center,
Jacksonville, Fla.

Catholic Medical    184.7           -5.0%           -6.2%
Center,
Manchester, N.H.

Elliott Hospital,   172.0           +3.1%           -5.5%
Manchester, N.H.

Hospital            %             Debt to
                    Total Margin  Equity Ratio

Hahnemann           -24.6%        -7.52(1)
University
Hospital, Pa.

Medical             -44.9%        -2.13(1)
College of
Pennsylvania
Hospital, Pa.

Allegheny           -4.4%         -4.64(1)
General
Hospital, Pa.

Western             +4.6%         N/A
Pennsylvania
Hospital, Pa.

M.S. Hershey        0.0%          8.04
Medical
Center, Pa.

Geisinger           -0.6%         0.37
Medical
Center, Pa.

Stanford            +2.2%(2)      0.47
Medical Center,
Calif.

UCSF Medical        +15.6%        0.47
Center, Calif.

Baptist Medical     +8.2%         1.99
Center,
Jacksonville, Fla.

St. Vincent's       +12.0%        0.74
Medical Center,
Jacksonville, Fla.

Catholic Medical     +0.2%        0.63
Center,
Manchester, N.H.

Elliott Hospital,    +1.3%        0.36
Manchester, N.H.

NA = Not available

(1) Negative fund balances

(2) Data from year earlier.

Source: Pearl, GM. Financial Statements for U.S. Hospitals: 2001
Edition. (Compiled from 1998-99 Medicare cost reports). Cottage Grove,
Minn. Rate Control Publications, LLC., April 10, 2001.
Table 2

Financial Comparisons of Divested Hospitals, 2000

Hospitals                 CurrentRatio  Days Cash  FTE Man-hours/
                                        on Hand    Discharge Adj.
                                                   by CMI(1)



Hahnemann                 0.7           142.0      819.0
University
Hospital, Pa.

Medical College           0.4           65.9       1,190.3
of Pennsylvania
Hospital, Pa.

Allegheny                 0.9           64.9       150.8
General
Hospital, Pa.

Western                   N/A           N/A        N/A
Pennsylvania
Hospital, Pa.

M.S. Hershey              3.5           107.4      173.8
Medical
Center, Pa.

Geisinger                 2.2           121.5      148.0
Medical
Center, Pa.

Stanford                  1.9           181.6(4)   271.8
Hospital, Calif.

UCSF, Calif.              1.9           95.3(4)    269.4

Medical Center,           2.1           96.4       140.4
Jacksonville, Fla.

St. Vincent's             1.3           79.1       137.4
Medical Center,
Jacksonville, Fla.

Catholic Medical Center,  2.3           107.7      156.5
Manchester, N.H.

Elliott Hospital,         1.3            75.0      206.9
Manchester, N.H.

Hospitals                 Operating     Revenue/
                          Expense/      FTE Adj.
                          Discharge     by CMI
                          Adj. by       & MWI(3)
                          CMI & MWI(2)

Hahnemann                 $5,367.8      $11,009.8
University
Hospital, Pa.

Medical College           8,696.1       9,991.9
of Pennsylvania
Hospital, Pa.

Allegheny                 1,585.8       39,545.9
General
Hospital, Pa.

Western                   N/A           N/A
Pennsylvania
Hospital, Pa.

M.S. Hershey              1,921.7       48,813.3
Medical
Center, Pa.

Geisinger                 1,381.6       52,965.9
Medical
Center, Pa.

Stanford                  4,413         107,343
Hospital, Calif.

UCSF, Calif.              2,961         121,624

Medical Center,           1,091.5       48,193.1
Jacksonville, Fla.

St. Vincent's             1,122.1       49,409.7
Medical Center,
Jacksonville, Fla.

Catholic Medical Center,  1,361.5       38,572.5
Manchester, N.H.

Elliott Hospital,         1,972.2       58,371.8
Manchester, N.H.

NA = Not Available

(1) Full-time equivalent man-hours per discharge adjusted by Medicare
case mix intensity.

(2) Operating expenses per discharge adjusted by Medicare case mix
intensity and Medicare wage index.

(3) Net revenue per full-time equivalent employee adjusted by Medicare
case mix index and Medicare wage index.

(4) Data from a year earlier.

Source: Pearl, GM. Financial States for U.S. Hospitals: 2001 Edition
(Complied from 1998-99 Medicare cost reports). Cottage Grove, Minn. Rate
Control Publication, LLC, April 10, 2001.

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Thomas P. Weil, PhD is a hospital and health services consultant residing in Asheville, N.C. He is the author of Health Networks: Can They Be the Solution? published jointly by The University of Michigan Press and the American College of Physician Executives. Well can be reached by phone at 828/252-1616 or by e-mail at [e-mail].