The COVID-19 pandemic has severely strained the resources of the United States healthcare system. By July 1, the U.S. recorded more than 2.6 million confirmed cases and suffered more than 125,000 COVID-19-related deaths, taxing intensive care units and devastating the finances of health systems and physician practices alike. The financial fallout of the COVID-19 pandemic on hospitals and physicians will be extensive and is likely to result in the accelerated consolidation of these sectors.  

Impact of COVID-19 on Hospitals and Physician Practices 

In mid-March, the Centers for Medicare & Medicaid Services (CMS) recommended that all “elective surgeries, non-essential medical, surgical, and dental procedures” be delayed to preserve personal protective equipment (PPE) as well to free up hospital beds and healthcare workers to treat COVID-19 patients.  These actions resulted in sharp declines in hospital revenues as more profitable, elective procedures were cancelled so that hospital personnel could focus on treating COVID-19 patients. Hospitals also experienced sharp increases in labor costs during this time, resulting from rising overtime expenses, bonuses for frontline workers, and the need to supplement existing hospital staff with additional providers from staffing firms. Supply costs spiked due to shortages of PPE and other medical supplies. The American Hospital Association estimates that, as a result of the compounding effect of declining revenue and increased costs, hospitals and health systems will incur losses totaling $202.6 billion between March 1 and June 30.   

Physician practices similarly suffered from the postponement or cancelation of non-essential procedures. The Medical Group Management Association estimates that 97% of practices experienced a negative financial impact due to COVID-19, with revenue and patient volumes decreasing by an average of 55% and 60%, respectively.  Recent surveys performed by the American Medical Group Association and published in Modern Healthcare underscore the dire situation facing physician practices; 59.5% of practices expected that their cash reserves would run out in two months or less, and 23.8% indicated that their reserves would run out in one month or less.     

The Coronavirus Aid, Relief, and Economic Security (CARES) Act has provided aid to hospitals and physicians by expanding the pre-existing Medicare accelerated payments program, as well as through the Public Health and Social Services Fund, which allocated $100 billion of CARES funds to eligible healthcare providers to compensate for lost revenue and incremental expenses related to COVID-19. Organizations with fewer than 500 employees have also been able to pursue loans under the Paycheck Protection Program (PPP) of the CARES Act to cover eligible expenses. Many practices were able to take advantage of the PPP to retain staff during office closures. The CARES Act and PPP were enhanced through the subsequent passage of the Paycheck Protection Program and Health Care Enhancement Act, which provided an additional $484 billion to replenish CARES funds, including $75 billion in funding for healthcare providers to cover a portion of their expenses and lost revenue due to COVID-19. Further, CMS and legislators made telehealth services more widely available during the pandemic by loosening the restrictions on which patients could receive telehealth services and increasing Medicare reimbursement rates for telehealth visits to the same rate as in-office visits for all diagnoses, not just services related to COVID-19. 

These legislative efforts have been significant; however, they have only partially mitigated the COVID-19 pandemic’s disastrous impact on providers. The financial outlook for many hospitals and practices remains precarious. Although a number of states began allowing elective procedures and practice re-openings in May, safety concerns have lingered, and patient volumes will likely remain below pre-COVID levels for months. Record unemployment has led to significant loss of job-based health insurance, resulting in the further deferral of medical care as well as higher rates of uncompensated care for providers. Due to the financial challenges facing hospitals and the uncertain timing of an eventual recovery, Moody’s Investors Service is predicting an increase in “technical” defaults by hospitals resulting from the violation of bond covenants such as debt service coverage and days cash on hand.       

Current M&A Environment and Outlook

M&A Transaction Activity - Hospitals 

M&A Transaction Activity - Physician Medical Groups

The hospital industry is in the middle of a sustained period of consolidation propelled by new payment and care delivery models required by health reform and the need for significant capital to invest in aging facilities and costly electronic medical record (EMR) systems. In response to these forces, community hospitals often seek larger health system partners with the know-how to adapt to health reform and the ability to access capital markets. Additionally, larger health systems have more market power than community hospitals to negotiate higher reimbursement rates with payers and more favorable terms with suppliers. 

Physician practice acquisition activity has risen in recent years due to the challenges of health reform as well as the increasing preference of doctors to leave private practice for the relative security of employment with a health system or a physician practice management (PPM) platform. A practice sale provides the additional benefit of allowing doctors to focus exclusively on the practice of medicine while simultaneously taking some chips off the table. Competition among private equity (PE)-backed PPMs for practices and the resulting attractive purchase multiples have also contributed to the recent flurry of consolidation.    

In contrast to the trends of recent years, acquisitions slowed considerably in March as governors issued shelter-in-place orders and COVID-19 cases spiked. Prospective sellers in the early stages of preparing for a sell-side process were advised to delay going to market, while auctions that were already underway generally moved forward at a measured pace as buyers and sellers evaluated the economic impact of the pandemic. Transaction timelines stretched due to the complications of performing due diligence and site visits during a time when many employees were working remotely and significant travel restrictions were in place. As the economy reopens and elective procedures restart, acquisitions of hospitals and practices will gradually resume and then accelerate beginning in Q4 2020 or early 2021.

Large health systems and small community hospitals alike felt the economic pressure that resulted from the COVID-19 pandemic. While hospitals are now able to begin to resume full operations, volumes may remain below historic levels in the near term as patients delay healthcare visits due to safety and personal financial concerns. Hospitals that burned through their cash reserves in recent months will aggressively pursue strategic acquirers over the next 12 months to ensure survival. For-profit hospital operators and large, non-profit systems with strong balance sheets and the ability to raise new capital will be well-positioned to selectively take advantage of these distressed opportunities. Even community hospitals and regional health systems with the financial wherewithal to survive the initial fallout will be forced to reevaluate their strategies to remain independent.  

Practice consolidation will accelerate over the next two years due to the financial stress experienced by physician owners during the pandemic. Practices with only a few physicians may elect to pursue employment opportunities or negotiate modest asset sales to larger practices. Many medium and large-sized practices will pursue sales to health systems and PE firms. Health systems are expected to be active acquirers of practices, as the COVID-19 pandemic has underscored the drawbacks of owning large and costly inpatient facilities which were underutilized during the partial shutdown. Practice acquisitions will provide health systems with a more attractive and less costly growth strategy than hospital acquisitions. 
PE firms will continue to roll up their practices through their PPM platforms. PE funds raised a record level of capital in 2019 ($474.1 billion) following a strong year in 2018; thus, there is ample “dry powder” to be deployed over the next several years.  

Valuation Outlook and Related Considerations

Due to the slowdown of transactions during the pandemic, there is currently limited data measuring the impact of COVID-19 on M&A valuations. However, an analysis of public market multiples provides some evidence of recent valuation trends for hospitals and practices.

Public Company Multiples Analysis (EV / LTM EBITDA)

To analyze the impact of the pandemic on M&A valuations, we calculated the enterprise value (EV) to the latest 12-month earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples for five publicly traded acute care hospital operators and three publicly traded physician services companies as of the end of each quarter from March 2019 through June 2020. Next, we compared the post-COVID multiples of the public companies as of March 31, 2020, and June 30, 2020, to the multiples for the quarter that ended December 31, 2019, as well to the average of the 2019 quarterly multiples. 

As demonstrated in the adjacent chart, the COVID-19 pandemic had a clear impact on valuations. Multiples for the eight public companies declined by approximately 20% on average between December 31, 2019, and March 31, 2020. Hospital multiples declined by an average of 17%, while multiples for companies providing physician services declined by 24%, on average. Declines in multiples were similar as of June 30, 2020. When measured against the average 2019 quarterly multiples, the declines in physician multiples were lower at 17% and 20% as of March and June, respectively.

While the decline in public company multiples provides some indication of the impact on post-COVID deal pricing, valuation is always fact- and circumstance-specific. The hospitals and practices that were hardest hit by the shutdown will actively seek stronger strategic or financial partners, while buyers can be expected to be more cautious and selective in pursuing acquisition targets. As market forces shift from a seller’s market to a buyer’s market, multiples will likely remain below pre-COVID levels for the remainder of 2020 and the first half of 2021. 

After the initial shakeout, valuations should begin to return to pre-COVID levels as strategic buyers continue pursuing their growth plans and PE deploys capital. As the economy reopens, market participants will have increasingly divergent valuation expectations due to the uncertain near-term outlook. Deferred and contingent consideration will be used to help bridge these valuation gaps. For example, some buyers and sellers are currently negotiating a deal price based on a multiple of current (lower) earnings, with an agreement to “true up” the purchase price at a later date when earnings return to a normal level. Additionally, rollover equity may represent a larger portion of purchase consideration as buyers seek to minimize cash outlays and allocate more risk to sellers. Rollover equity is common in physician practice transactions involving a PE-backed buyer. In these deals, the seller agrees to receive a portion (often between 10 and 30%) of the purchase consideration in the form of the buyer’s equity. In these instances, it will be incumbent on sellers and their financial advisors to ensure that the valuation of the buyer’s equity is well-reasoned and reflects the impacts of COVID-19. 

Navigating M&A markets in the aftermath of COVID-19 will be challenging. Having an experienced and qualified financial advisor to provide valuation guidance during the deal process is crucial. Seller boards will be under increased pressure to demonstrate to shareholders and stakeholders that they have achieved a fair price. Likewise, as distressed M&A and bankruptcies surge, buyers and sellers may find themselves defending against claims that a deal represented a constructively fraudulent transfer, which, if upheld, could result in a voiding of the transaction by a bankruptcy court. A contemporaneously prepared valuation or fairness opinion would help transacting parties demonstrate that the deal price represented fair market value or reasonable equivalent value.