What increased M&A activity might mean for Houstonians

Wealthy investors involved in private equity are pouring funds into health care opportunities, and nowhere is it more evident than in Houston, Texas, one of the most economically thriving cities in the country.

For example, Memorial Hermann Healthcare System, Houston’s largest health care institution, appears hungry for growth. In April, it announced plans for a $650 million renovation to its flagship hospital.

Chief Executive Officer Dan Wolterman told the Houston Chronicle that the decision to expand was made defensively, in response to an expected drop in Medicare and Medicaid funding. He felt that if the hospital doesn’t grow now, it may lose the ability to do so later.

That juxtaposition of aggressive spending and anxiety may seem odd, but it seems to prevail among health care institutions. Providers have felt pinched since before the recession: For the 10th consecutive year in 2013, hospital CEOs named financial challenges as their top concern, according to a report from the American College of Healthcare Executives.

So even as Houston’s economy is thriving – it leads the nation in job creation, according to a March report from Gallup Inc. and leads major metro areas in post-recession job recovery, according to the Bureau of Labor Statistics – health care executives like Wolterman are anxious. They’re still uncertain about the ramifications of the Affordable Care Act. which is significantly affecting the industry. In addition, cutbacks to Medicare funding will cost Texas hospitals $2.5 billion by 2023, according to the Texas Hospital Association .

That cautious climate has sparked the interest of high-net-worth investors who see health systems ripe for modernization and consolidation. Private-equity firms specialize in providing major cash infusions to companies that need to spend big in order to succeed.

“There’s a lot of dry powder – capital ready to be invested – in the private-equity industry right now, and interest rates are still near or at all-time lows. That makes the financial arbitrage in these sorts of investments very attractive for the wealthy investor,” says Michael McDuffie. senior investment officer in Northern Trust’s Houston region.

Private Equity Allows for Technology Upgrades

A decade of constant financial pressure has led to underinvestment in emerging technological systems such as those devoted to electronic medical records and other administrative tasks. “Aging technological infrastructure is one of the biggest things” driving M&A interest in health care, says Mick Coady. a Houston-based partner in the health industries practice of PricewaterhouseCoopers LLC. “There has been essentially no investment for many years.” By growing or merging with another institution, hospital systems stand to benefit by consolidating back-end systems and other duplicative functions.

“There’s a large potential upside to health care system expansion and consolidation that is going to come in the form of economies of scale and increased value and efficiency, not to mention increased patient population and a larger geographic reach,” McDuffie says.

That logic seems to be resonating, as health care mergers and acquisitions are booming worldwide. During the first half of 2014, the sector accounted for 18% of all deals and already had topped its previous full-year record of $274.8 billion, set in 2007, according to Thomson Reuters Corp. PwC research shows the value of U.S.-based health care deals in the first quarter increased 152% over the year prior.

When Hospital Mergers and Acquisitions Collide

Two recent deals took place in Houston: First, in 2013 Denver-based hospital chain Catholic Health Initiatives (CHI) bought Houston’s St. Luke’s Episcopal Health System for $2 billion. In April, Camp Hill, Pennsylvania-based Rite Aid Corp. announced it was buying Houston-based RediClinic, a 30-location retail clinic, for an undisclosed sum.

The deals were unique because in each case, a national company used the transaction to buy its way into Houston. “Houston has been very parochial,” Coady says. “There haven’t been a lot of outside, bigger players coming in. And now we’re starting to see some interesting activity regarding these conglomerates.”

The St. Luke’s deal is an example of the sort of consolidation-friendly transaction that investors are eyeing. CHI gets to enter a thriving regional market previously dominated by four entrenched hospital systems, and St. Luke’s gets to incorporate some of the administrative and scale-related advantages of a larger system.

Coady cautions that the expense of combining two hospital systems isn’t limited to the purchase price. “People forget that integration in itself is costly and time-consuming,” he says, a point underscored by a Deloitte study showing that less than half of health care mergers and acquisitions resulted in long-term improvements in market value.

“You have to understand the risks,” says McDuffie. “An M&A deal is always a big step, and it’s imperative that you succeed in integrating both the technology and the culture.”

Yet the risk often is worthwhile. Coady and McDuffie agree that for the institutions able to successfully integrate, the benefits often are real and substantial.

Future of Health Care Investment

Could one of Houston’s hospital systems be subject to further consolidation? Maybe, Coady says, primarily because larger corporations will be drawn to Houston. “We’re continuously growing here, so if somebody is looking at managed health and looking to make an acquisition, this wouldn’t be a bad place to do it,” he says.

But health care M&A activity isn’t limited to large hospital systems. The Rite Aid/RediClinic deal provides a clue about the direction of future investment, McDuffie says. He believes that despite the prominence of Houston’s Texas Medical Center, the world’s largest such facility with 106,000 employees and 7.2 million annual patient visits, the industry’s future is in smaller clinics located close to patients.

“I believe the next wave of acquisition activity of health systems will involve the integration of specialty physician groups,” he says. “We’re also looking at a decentralization of health care delivery, with smaller hospital facilities built in suburban areas, along with the advent and influx of urgent-care centers.”