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December 14, 2020

COVID-19 Will Have a Significant Impact on Hospital Financials, but Not on Antitrust Scrutiny of Hospital Transactions

This Briefing is brought to you by AHLA’s Antitrust Practice Group.
  • December 14, 2020
  • Lona Fowdur , Economists Incorporated

Health care providers have been operating on slim margins for a number of years. The large declines in health care utilization from the spring of 2020 abated somewhat over the summer, but utilization of hospital services remains below normal and is unlikely to fully recover until COVID-19 vaccines and treatments become widely available. The lost volume and corresponding declines in revenue have compounded the pressures on financially struggling hospitals. Congress has provided some relief in the form of grants and Medicare pre-payments, but this assistance represents only a portion of the financial shortfall that hospitals have already incurred, and it will not restore hospitals’ 2020 financials to pre-COVID-19 levels.

With or without additional government assistance, many hospitals will need to contemplate a variety of strategies to overcome financial challenges related to the pandemic and to withstand other crises in the future. Some embattled hospitals will undoubtedly seek alliances with stronger health care partners to stabilize their financial positions. Entities contemplating affiliations should be mindful, however, that antitrust regulators are unlikely to reduce their scrutiny of health care transactions, especially when transactions involve direct competitors. Indeed, “failing and flailing” firm defenses seldom provide regulators with a convincing justification for otherwise anticompetitive mergers. To the extent hospitals decide that an affiliation is an effective financial strategy for their future viability, they would be well served to look for partners that do not meaningfully compete with them. Alternatively, they will need to present convincing evidence that they will not have an ability to implement any pricing incentives that the transaction could confer.

Hospital Finances Leading up to the COVID-19 Crisis

Data from the California Office of Statewide Healthcare Planning and Development (OSHPD) provides an opportunity to study the finances of a large sample of hospitals operating in a state where reimbursements tend to be more generous than elsewhere in the nation. Limiting the analysis to hospitals not owned by the Kaiser system, OSHPD data indicate that collectively, the 249 general-acute-care hospitals operating in the state in 2019 realized an annual operating margin of only 5.3% in the preceding year, similar to the average margin that these hospitals earned over the prior five years.

There is significant variability around the average margin, however. In particular, 81 out of a total of the 249 hospitals operated at a loss in 2019, meaning that about one of every three hospitals (33%) incurred more operating costs than the patient revenues and other operating revenues that they received.[1] The hospitals operating at a loss generated about one quarter of the statewide patient revenues. Thus, loss-generating hospitals tend to be smaller on average, but they collectively account for a significant portion of patient care. Further, the financial losses in 2019 do not appear to be limited to that year. The percentage of California hospitals that operated at a loss between 2014 and 2018 are similar to 2019. Between 36% and 44% of hospitals incurred an operating loss in each of these five preceding years. Further, the same 40% of hospitals operated at a loss for at least three of the six years between 2014 and 2019 indicating that many hospitals have been struggling for multiple years.

Financially struggling hospitals are not confined to the state of California. A Fitch Ratings analysis of all nonprofit hospitals nationwide indicates that the median hospital realized operating margins of 2.3% in 2019, only marginally better than the 2017 and 2018 margins of 1.9% and 2.1%, respectively.[2] These low-single digit margins for the median hospital indicate that most hospitals have little cushion to withstand crises such as those brought on by the COVID-19 pandemic.

Volume and Margin Losses Related to the COVID-19 Pandemic

OHSPD data for the 249 general-acute-care hospitals in California indicate that, on average, these hospitals collectively performed about 3 million outpatient procedures and admitted about 190,000 patients in each month of 2019. After the shelter-in-place order took effect in March 2020, monthly hospital volume and corresponding revenues declined by an average of 37% between March and June 2020.[3] Data for the rest of 2020 are not yet comprehensively available, but the reduced utilization between March and June alone would be sufficient to cause at least a 10% reduction in hospital revenues on an annualized basis for all of 2020. Since California initiated a soft reopening of its economy in the second semester of 2020, utilization of hospital services improved, but did not fully recover. Factoring in further volume losses of elective and non-COVID services in the more recent months as more shutdowns went into effect, the annualized reduction in hospital revenues for 2020 will likely exceed 10%.

The margin loss that corresponds to a 10% reduction in hospital revenues can be estimated for each hospital in California based on an assumption that half of the costs a hospital incurs is fixed and the other half is variable.[4] Since hospitals tend to operate with high fixed costs, this assumption likely understates the reduction in margin that a 10% loss in revenue will generate. With a 50/50 fixed and variable cost breakdown and a 10% decline in patient revenues in 2020 relative to 2019, the 5.3% average margin that the group of 249 comparable hospitals in California generated in 2019 will decline to roughly 0.3% in 2020. Thus, a mere 10% reduction in patient revenues is sufficient to create a margin shortfall approximately equal to the annual margin that the hospitals have averaged collectively over the past six years. With an annualized reduction in patient revenues that exceeds 10% or a fixed to variable cost ratio higher than 50%, the corresponding operating margin shortfall created by the pandemic naturally will be higher than a one-year equivalent.

As hospitals prepared for and responded to the influx of COVID-19 patients, an increase in operating costs due to higher expenditures on more expensive personal protective equipment (PPE), the acquisition of ICU equipment such as ventilators, and increased staffing costs further stretched hospital finances in 2020. Such increases in operating costs will depress hospital margins beyond the reduction caused by the decline in volume.

Yet another source of strain on hospital finances is a change in payer mix. With higher unemployment and a looming recession, patients’ insurance status will tend to shift from commercial to uninsured or Medicaid coverage. Uninsured patients can ill-afford to pay their hospital bills and tend to generate the lowest reimbursement rates for hospitals. Medicaid reimburses at significantly lower rates than commercial payers. A recent study by economists affiliated with the California Health Care Foundation finds that hospital net revenues could fall by an additional 2% as patients’ insurance status shifts from commercial designations to Medicaid and uninsured.[5]

Based on their pre-existing financial difficulties, many hospitals may not be capable of withstanding the additional financial shock brought about by the COVID-19 pandemic.

CARES Act and Other Relief Provided to Hospitals Partly Only Offset Hospitals’ Revenue and Margin Losses

In March 2020, Congress passed the Coronavirus, Aid, Relief, and Economic Security Act, also known as the CARES Act, which included provisions for grant funding and advance Medicare payments to compensate hospitals and other health care providers for COVID-19-related financial shortfalls.[6] According to the American Hospital Association, about $70 billion in relief grants had been awarded to hospitals by October 2020, but the projected losses for the year exceed $320 billion.[7] Thus, the grant assistance that hospitals have received represents less than a quarter of the projected revenue losses for the year. An additional $20 billion in grant assistance is scheduled to be disbursed, but even factoring that in, a significant loss in revenues will remain.

In addition to grant funding, many hospitals have received advance payments from Medicare, which will help alleviate present cash flow constraints. However, hospitals will need to repay these balances eventually and will not be able to use the advance payments to reverse the revenue and margin shortfalls experienced in 2020.

Hospitals Seeking Affiliations Should Not Expect Lessened Regulatory Scrutiny Due to the Pandemic

As hospitals contemplate the path to financial recovery in a post-pandemic world, affiliations with stronger financial partners will likely emerge as a preferred strategy for some entities. Antitrust regulators have already noted, however, that they do not plan to change, let alone lessen their regulatory scrutiny of transactions, whether in the health care industry or elsewhere, simply because companies are experiencing pandemic-related financial challenges.[8] In the case of health care transactions in particular, Federal Trade Commission (FTC) regulators have commented that in cases where merging parties present deal rationales centered on COVID-19-induced financial challenges, the FTC will undertake its review based on the stringent failing- or flailing-firm criteria established in the merger guidelines and case law.[9]

Regulators place a high bar on merging parties claiming a failing or flailing firm defense to a transaction that is otherwise likely to enhance market power. The merger guidelines stipulate strict criteria for such defenses to be valid. First, the parties need to prove that the failing or flailing firm would be unlikely to meet its financial obligations in the near future; second, that the firm is unable to reorganize under bankruptcy; and third, that the firm made good faith but unsuccessful attempts to affiliate with a different merging partner with which it does not have as much competitive overlap. If these circumstances are met, regulators can be more likely to overlook traditional indicators of competitive harm from a transaction—such as high shares, HHIs, and pricing indexes—and to view the transaction as competitively benign. The reason is that the acquired firm would likely no longer exist in the near term but-for the affiliation, and hence the transaction is unlikely to create competitive concerns.

Aside from their applicability to failing/flailing firm defenses, the pandemic-related financial challenges have little bearing on the traditional tools that regulators use to evaluate the competitive effects of health care transactions. These traditional tools focus heavily on the calibration of post-merger pricing incentives that depend on the degree to which patients and health plans view the merging parties as substitutes to one another for the same health care services. Since the pandemic-related financial losses are unlikely to affect the degree of substitutability between competing health care providers, they do not enter the regulators’ typical analysis of pricing incentives and do not impact the conclusions that can be drawn from those analyses. As a result, regulators will likely discount deal rationales centering on pandemic-related financial challenges, except in situations where merging firms can demonstrate the existence of a failing or flailing firm.

An implicit assumption underlying the validity of the competitive inferences that can be drawn from the regulators’ traditional merger-analysis tools is that current market conditions accurately predict future market conditions. The market-wide upheaval created by the pandemic could upend that assumption, however. For instance, changes in supply and demand conditions could affect the set of competitive responses available to patients, health plans, and the merging parties’ competitors subsequent to merger-related price increase. These market-wide changes could be as diverse as a greater acceptance of telemedicine as an alternative modality of care, greater adoption of high-deductible health plans that would make patients more sensitive to the pricing of health care services, greater integration of supply chains between hospitals and input suppliers to minimize the risk of disruption to care due to equipment and personnel shortages, and the retooling of hospital wards to enable prompt expansion of inpatient capacity when needed. While these changes may not impact the traditional analysis of merger incentives that regulators routinely rely on, they nevertheless call for an examination of the extent to which merging parties will be able to convert those incentives into actual price changes post-merger.

Dr. Lona Fowdur is a Principle and economist with Economists Incorporated in Washington, DC. The views in this article are her own and do not necessarily represent the views of her clients or of others at Economists Incorporated.

 

[1] The Kaiser system does not report detailed financials for its individual Kaiser hospitals to OSHPD. The analysis excludes non-comparable hospitals providing specialized services such as psychiatric care, long term care, children’s services, and specialized surgical services.

[2] Fitch Wire, Not-for-Profit Hospital Medians Improved Prior to Coronavirus, July 16, 2020, https://www.fitchratings.com/research/us-public-finance/not-for-profit-hospital-medians-improved-prior-to-coronavirus-16-07-2020.

[3] Glenn Melnick and Susan Maerki, The Financial Impact of COVID-19 on California Hospitals, California Health Care Foundation Report, p. 3 and Exhibit 6 (June 2020), https://www.chcf.org/wp-content/uploads/2020/06/FinancialImpactCOVID19CAHospitals.pdf.

[4] Based on the author’s experience, a 50/50 split in fixed and variable costs is a conservative assumption. For volume changes around 10%, the variable costs that can be saved by providing less services are likely lower than 50% of total costs. A 50/50 split will therefore understate the reduction in margin.

[5] Id., p. 10 and Exhibit 9.

[8] Ian Conner, Fed. Trade Comm’n Bureau of Competition Blog, On Failing Firms—and Miraculous Recoveries (May 27, 2020), https://www.ftc.gov/news-events/blogs/competition-matters/2020/05/failing-firms-miraculous-recoveries.

[9] Jeff Overley, Law360 (May 22, 2020), “FTC Attys Talk COVID-19’s Impact on Hospital M&A Oversight.” Available from https://www.law360.com/articles/1275378/ftc-attys-talk-covid-19-s-impact-on-hospital-m-a-oversight.

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