Lower margins, softer liquidity sets the stage for hospital dealmaking in 2023

2023 will likely be a year of upheaval and market transformation for hospitals bouncing back from a financially distressing 2022 amid several post-pandemic headwinds, analysts said in recent reports.

With costs up, liquidity down and bond covenants potentially in jeopardy, the industry should expect upticks in merger and acquisition activity, “non-traditional partnerships,” further divergence between value-based care and fee-for-service entities and plenty of public health emergency administrative headaches on the horizon for health systems, analysts said.

“Historically viewed as recession-proof, 2023 is expected to be a challenging year for the healthcare industry as macroeconomic factors—inflation, high labor expenses, volatile markets, supply chain snarls and other issues—exert their influence in ways not previously seen,” partners at McDermott Will & Emery wrote in a recent report.

The early numbers on health systems’ 2022 financial performance are not encouraging.

In a Thursday note focused on rated nonprofit hospitals that report their full-year earnings halfway through the calendar year, Fitch Ratings highlighted “barely breakeven” median margins due in part to an 11.1% increase in labor costs.

On the liquidity side, systems saw a median 7% decline across their investments and a year-over-year decline of 45 days of cash on hand—though here Fitch analysts acknowledged that most organizations had accumulated a sizable war chest coming out of previous years’ savings and pandemic pauses to capital expenditure. Cash to adjusted debt fell from a high of 190.3% to “a still robust” 157.6%, Fitch analysts wrote, while median debt-to-EBITDA ratio rose from 2.5x to 3.9x, “reflecting the combination of increased debt and lighter cash flow generation.”

Fitch analysts wrote that they expect operating struggles “to be even more pronounced” when reports for all hospitals with fiscal years ending Dec. 31 become available. Early full-year readings from consultancy firm Kaufman Hall and big health system names like Cleveland Clinic, Mayo Clinic and Kaiser Permanente seem to be pointing the industry in that direction as well.

“Fitch does not expect a rapid financial recovery for most providers,” analysts wrote. “Margins are not expected to return to pre-pandemic levels for quite some time.”

These hamstrung operations plus other external pressures will likely see major systems and financially weaker organizations alike making moves to grow or save, respectively, their businesses, the McDermott partners said in their 2023 market outlook report.

Those in the worst positions will be proactive in reallocating resources, eliminating underperforming service lines, outsourcing certain functions and, in some cases, weighing a sale to health systems or third parties outside of the traditional healthcare ecosystem, the firm’s partners said.

“Large healthcare retailers, technology and private equity investors are all venturing further into the healthcare space, and these companies may offer attractive deal terms for distressed organizations,” they wrote.

More megamergers could also be in the cards as large, generally stable systems look to offset financial headwinds by leveraging greater scale. The firm’s partners specifically highlighted cross-market mergers—such as those recently announced by Sanford Health and Fairview Health Services or UnityPoint Health and Presbyterian Healthcare Services—as a potentially popular avenue for systems due to little interference, to date, from federal regulators. Still, researchers have noted these deals could still bring anti-competitive power in circumstances where the merging entities deal with the same payer, which could give the Federal Trade Commission ammunition in its efforts against provider consolidation.

The potential for partnerships in 2023 extends beyond merger and acquisition agreements. McDermott partners said that cost pressures will likely push health systems toward partnerships with technology firms to cut down workflows while improving outcomes.

They also expect providers to bolster their supply chains through alternatives to traditional group purchasing organizations such as joint ventures with other health systems or deals on nonmedical supplies with major retailers, collaborations with payers to address social determinants of health and deals to build or jointly operate risk-bearing physician networks to meet growing demand for value-based care strategies.

Despite the difficulties, both McDermott and Fitch suggested hospitals and health systems will forge ahead with capital investments, which could help the organizations address inefficiencies in their care models and could yield new streams of revenue. Fitch also noted that many hospitals had pumped the brakes on capital expenditures during the earlier parts of the pandemic and may still be playing catch-up.

“Given sector pressures, Fitch expects investments of capital assets to continue at a modest pace, near depreciation, with a focus on outpatient and technology investments that drive profitability improvements and cost-efficient growth,” the ratings agency wrote.

All of these strategic decisions will land as the nation unwinds itself from a lengthy public health emergency that’s slated to end May 11.

Though certain pandemic flexibilities have been extended, McDermott partners said the process is likely to be difficult for hospitals and health systems that have become reliant on waivers. Some facilities may not have adequately tracked their use of waivers and may need to devote substantial effort to understand the transition, let alone pull it off.

“Some facilities may need to undertake internal audits or other actions to root out and resolve any remaining practices that will no longer be permissible once the waivers have terminated,” they warned in the report. “Certain flexibilities, such as those related to aspects of telehealth and continuation of acute care hospital-at-home programs, were already extended via legislation into 2023–2024, although in some cases related provisions were not continued and could complicate ongoing compliance if further action is not taken.”