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Bigger Is Not Always Better

MANAGED CARE October 1999. © MediMedia USA
HEALTH CARE MERGERS AND ACQUISITIONS

Bigger Is Not Always Better

People talk of mergers as if they were all done when the ink dries. But the real secret to a successful merger comes afterward.
Karen L. Trespacz
Contributing Editor
MANAGED CARE October 1999. ©1999 MediMedia USA
HEALTH CARE MERGERS AND ACQUISITIONS

People talk of mergers as if they were all done when the ink dries. But the real secret to a successful merger comes afterward.

Karen L. Trespacz

Contributing Editor

Everyone hears about the people who are thinking about putting a merger together, and they get all kinds of kudos when they sign the papers to conclude a deal. But not everything that goes together stays together. Columbia/HCA used to be one of the biggest buyers of hospitals, but recently it has been one of the biggest sellers. And as Richard L. Solit, M.D., associate at McKinsey & Co., a consulting organization, observes, figuring out on paper that the average reduction in head count is 15 percent and declaring a 15-percent cut "is the easy part." The hard part is deciding "who is the 15 percent who isn't going to have a job — and for what reason?" What can the company really do with fewer people? How can the company do it with fewer people? So the real — and largely unsung — heroes are not the folks who put deals together, they are the folks who get deals to work afterward.

Horizontal and vertical

The type of merger matters. Mergers between two companies in the same business are "horizontal" mergers, such as the combination of two hospitals. Horizontal mergers are more likely to raise antitrust concerns: If the merging companies were doing the same business in the same market, then it's a merger of competitors. Companies doing the same thing are also more likely to generate revenue through consolidating operations and purchasing.

"Vertical" mergers are between companies in different businesses, like hospitals buying physician practices. These are a lot harder to pull off: While it's difficult enough to manage a bigger entity doing what you already do, imagine how hard it is to manage a company doing a bunch of things you don't already do. As Michael Millenson, principal in the health care and group benefits practice of William M. Mercer, suggests, this kind of activity may be more an exercise in "colonization" rather than "consolidation." He points to Great Britain, which at one time owned a good part of the world. Millenson notes, "A lot of the colonies that were supposed to be feeding the mother country turned out, instead, to be draining a lot of money from the mother country."

Verticals may not even be a meaningful strategy. As Ken Abramowitz, M.B.A., a health care analyst with Sanford C. Bernstein & Co. notes, "Vertical integration is not so important anymore." Not that it's good or bad, it's just not necessary "because you can buy those capabilities from other companies."

Finally, Jeff Goldsmith, Ph.D., president of Health Futures, cautions that things we think of as consolidation — reduction of excess capacity and overhead costs, and elimination of duplicative programs — may merely be a matter of "concentration of ownership." He thinks we've seen a lot of concentration of ownership, but not a lot of "meaningful, measurable" consolidation.

"The purpose of concentrating ownership of health care assets was absolutely anticompetitive — to create bargaining leverage to extract higher payments from managed care plans without creating any additional value," says Goldsmith.

Why combine?

The classical economic reasons for consolidation are neatly expressed by Abramowitz. "The theory is that size gives the organization in question — whether an HMO, a medical group, or a hospital — lower cost, higher quality, higher profit margins, better negotiating power, and, if you're a public company, higher stock price."

Remember, though, that the first thing mergers are going to do is generate costs. Such as the expenditures involved in linking or replacing two information systems. (Given the mergers upon mergers that have been happening, if you're dealing with only two information systems, you're lucky!) The cost of severance. The real, even if largely hidden, cost of distraction from the ongoing demands of the business.

There is also some doubt about how much savings companies like health plans can expect to have. As Bernard T. Ferrari, M.D., J.D., and senior partner at McKinsey & Co. reminds us, the cost structure of managed care is roughly 85 percent medical and 15 percent overhead. "There's not a whole lot of 'scale' there," he says of the administrative slice of the pie.

Plus, Doug Sherlock, M.B.A., senior health care analyst with the Sherlock Co., adds that there are some functions that can't be centralized, and they're almost all in the provider area. "For instance, it's very hard to put a nurse on the road checking charts in local hospitals and ask her to call on hospitals in three states." Consequently, administrative savings can depend, in part, on whether the larger company is spread thinly across many markets or has achieved critical mass in its markets.

The potential for savings can also depend on lines of business. The administrative cost structure for the Medicaid managed care business, for example, is different from the administrative expenses for large-group commercial business, which in turn is different from small-group commercial business.

Sherlock should know. His company puts out the Peer Administrative Expense Benchmarking Study, a composite analysis of the administrative expenses of five large, publicly traded managed care companies broken down into expense categories within product lines — 75 expense categories in all. Without benchmarking, all a manager can do is look at her company's own experience and guess where to trim the sails. With benchmarking, she can discover whether her company is out of line in some categories and take a whole different tack.

Meanwhile, what about the 85 percent that's medical cost? Here is where the increase in market size is supposed to garner better prices from providers. Ferrari sounds a note of caution about this, too. While you can use market share to get some volume discounts from suppliers — in this case, providers, "Once you get past about 20 percent of any supplier's business you proceed at your own peril beating them up on unit price, because you bankrupt them." Bankrupting a supplier becomes equivalent to shooting yourself in both feet: in the financial foot, a la health plans that have had to pay twice for the same health services (once to the provider organization, and again to participating physicians when the provider organization went bankrupt); and then in the community-relations foot, because it is the provider that had the relationship with the community.

"But," Ferrari suggests, "there is another kind of scale that can be quite powerful, and that is intellectual scale." Intellectual scale comes from "knowing how to do it better" against a bigger book of business.

Seller's reasons

"In some cases a plan is just not doing very well," says Walter Zelman, Ph.D., president and CEO of the California Association of Health Plans. "Its leadership looks around and may conclude, 'Maybe it's time for us to have an exit strategy.'" Merging becomes the exit strategy.

Take, for example, the merger between Aetna and Prudential. "I think one reason for that merger was Prudential's realization that, 'We're not doing very well in this business.' Now, should we tell Prudential, 'No, you can't merge? You must stay in this business?'" The same questions can be asked about some physician-owned plans, which have experienced significant difficulties.

No wonder. As Sherlock points out, managed care isn't like other health care businesses that can have a 10- or 17-percent profit margin; managed care "is a 1- or 2-percent profit-margin business." When you're skating that close to the edge, management missteps have impact, and the question of survival — not raking in huge profits, but survival — looms large.

"Consolidation is good for everybody," Abramowitz asserts. "It's good for the organizations. It's good for the patients. It's good for the corporate customer. Everyone wins."

How is it good for patients? Aren't they little guys in the face of all this, too? It's good for patients, Abramowitz explains, because "Patients get higher quality and lower cost." Overall lower cost — not just a lower copayment schedule — matters to patients because, as Abramowitz points out, patients are really paying for the whole thing. "The employer is just taking the money out of our collective salaries" to buy health coverage.

That's the economic view. What about quality of care? "I know of instances," Millenson reports, "where larger and more affluent hospitals have taken over less affluent hospitals and have improved quality." That's partly because, often, "Better-financed institutions are more willing to be proactive about quality improvement, and can raise standards. When an institution is seeking to keep its head above water, things other than continuous quality improvement or benchmarking can take priority."

This effect is not generally talked about, Millenson notes. The industry is always claiming that quality is about to suffer unless it gets more money, "so we become desensitized to it.

Consolidation holds even broader promise for improving quality, says Millenson, because it is "all about creating a brand name, and the essence of a brand name is consistency of product." When a company focuses on consistency of product it wades into measurement and management of performance, and quality improvement often follows. That's because "Consistency, and looking at what you're doing, are things that have never been valued in the health care field," Millenson explains. "We presume that if we hire good people and we give them a good place to practice, they'll produce good results. And they will, but they simply won't produce consistently excellent results."

Larger size also helps because "You can start to have a statistically significant number of clinical cases that you can start to monitor." But, as Millenson cautions, "Consolidation by itself is simply not good enough." You have to ask whether the larger organization with more money, better information systems, and more data is actually devoting them to improving quality. More, "You have to ask with all these organizations whether what is created at a national level is used at a local level." Because, of course, it is at the local level where patients receive care.

Not everyone views consolidation with that much optimism, starting with physicians. As AMA President Thomas R. Reardon, M.D., explains, the vote by the AMA House of Delegates to establish a national negotiating organization was "a reflection of the frustration and sort of helplessness" that physicians feel in the face of consolidation among health plans.

The name given to this organization, "Physicians for Responsible Negotiations," signals the way the AMA sees the process playing out. "We would encourage physicians to solve differences with plans in the traditional way, by approaching them to sit down and try to have a dialog to resolve differences,"says Reardon. If that doesn't work, the PRN would act as a catalyst to help the local physicians organize a bargaining unit.

This organization isn't the only major reaction that Reardon sees. "I think that the battle for the Patients Bill of Rights in Congress has clearly been a result of the integration and consolidation on the payer side."

Zelman, in California, is also concerned that the negative image that many consumers have of managed care companies "is fueled by the notion that they are getting bigger." Given that American sympathies run to the little guy, the larger managed care plans are starting to bump up against an entrenched cultural notion that big corporations are bad corporations. Add to that a public image that managed care companies, says Zelman, are "all powerful, push the physicians around, are responsible only to Wall Street profit mongers" and the thought of them getting bigger "raises deep concerns with the general public."

In a market-based system, the beam of light that checks the bloodthirsty ravages of corporate vampires is competition. As Zelman notes, you don't need a lot of companies in order to have competition. Take California, with five or six dominant health plans. "You could say that that's a lot of concentration," says Zelman. "I don't know whether it is or not, but we have one of the most competitive marketplaces in America. Consumers are getting enormous benefits from this competition."

Antitrust issues

One can't talk about consolidation for long without talking about antitrust. A way to begin thinking about antitrust, explains Phillip A. Proger, J.D., an antitrust lawyer with Jones, Day, Reavis, & Pogue in Washington, D.C., is that "Like a football game or sporting event, the game of competition has to have certain rules, and antitrust is kind of the rules of the game of competition." What antitrust legislation seeks to do is "preserve a free marketplace where everyone has the right and ability to compete and succeed based on how good he is."

How good, and from whose point of view?

The consumer. In a free marketplace, "Consumers get to vote hundreds of times a day by their purchasing," says Proger, making a critical point. "Antitrust laws are consumer laws," intended to protect the consumer, "not to protect individual competitors."

"There is nothing in antitrust that says it's bad to be big," says Proger. If you have 80 percent of the market because 80 percent of the consumers want your product, there's nothing wrong with that. If you get a sizable market share because you have a better mousetrap, that's fine. "The law encourages people to have a better mousetrap." For example, in the not-too-distant past, Blue Cross/ Blue Shield plans had market shares that today's plans can only dream about.

But, as Proger points out, "We have a specific statute that says you can't get too much market power by merger." That's because gaining market share by merger expresses the will of the governing board; it doesn't necessarily express the will of the consumer. So mergers over a certain size must be submitted to federal regulators for approval. Federal regulators may or may not give the green light, depending on how the merger might affect marketplace competition for the consumer.

Consequently, the critical factor is market power, not size. "The mere size of an entity doesn't tell you anything about its competitive viability or vitality," Proger explains. What's more important is what market share that entity has. So, as Proger continues, "People in this industry talk about 'level playing field' and what they usually picture is a David and Goliath snapshot" with the insurance company cast as Goliath and David played by the small provider organization. But because small providers can have huge clout in their own markets, "That is a false picture. If there is a Goliath in the industry, it's the federal government," which — between Medicare, Medicaid, and other programs — spends nearly half of the nation's health care dollars.

A Goliath like that points to the next uncertainty. Getting bigger is fine if the climate stays the same. That's what the dinosaurs did. But what happens if the climate changes suddenly?

Stephen Monroe, partner in Irving Levin Associates, says that much of the downturn in health care mergers and acquisitions can be traced to the Balanced Budget Act of 1997 and its new Medicare-payment rules.

Ferrari, at McKinsey & Co., agrees, putting it this way: "If you are aggregating or consolidating to play an old game, and the game changes to where the aggregation has no value, you've just spent a lot of money for nothing."

Sudden federal moves aren't the only harbingers of changes in the health care environment. Another is consumer empowerment. If consumer empowerment is met by better information on care outcomes, and consumers "can trade off price and productivity, then you've got a very different system developing," says Ferrari. Whether the big aggregator will have an advantage in the different system is an open question, which is why, he adds somewhat sympathetically, executives' jobs are so hard.

"They've got to fight today's battle but they also have to figure out what tomorrow's battle is." They can't put a chip on all of the numbers and all of the colors, nor can they put all of their chips on one color number, he says, "So they have to know how to place some bets."

Difficult task

Probably the most vivid picture of how difficult a consolidation can be was the picture the Wall Street Journal painted of the Aetna-U.S. Healthcare merger. Many experienced people left to be replaced by newcomers "who at times seemed overwhelmed, rude, or simply clueless." Greenhorn claims processors could handle only one third to one fourth of the number of claims as the people they replaced. Aetna took a $160 million charge in 1997 for unanticipated medical costs because it had lost so many people it lost track of what it was spending. Customers left.

That merger wasn't the only one plagued with difficulties. "PacifiCare," Health Futures' Goldsmith observes, was also "damaged by its merger with FHP."

Solit observes that "Most companies underperform their group following a merger." So, for example, if it's a pharmaceutical company, "They will do worse than the pharmaceutical average in the two years following the merger." Now, that could be because they were having problems in the first place. It's also possible that they underperformed because they were so distracted by the merger they couldn't focus on business. Because post-merger, "You spend a lot of time in merger-related issues."

Generic issues

If you get them right, it will help a lot in achieving success.

Move quickly to keep the best people. As Solit observes, once a merger is announced, headhunters swarm around the merging companies. Amid the inevitable talk of staffing cuts, company loyalty is at a low ebb. Unfortunately, the most talented have the most opportunities to leave. Note, too, from the report of Aetna's claims experience, it's important to keep the most talented people at all levels of the organization.

Move quickly to clarify who is going to be making decisions. An organization that can't make decisions, or is dizzy from conflicting decisions, is in a "headlock." When choosing executives, the tensions are particularly high. A 10-percent cutback in the back office is hard enough, but at the top, you're taking a much bigger slice (only 1 of 2 can stay) out of much bigger corporate muscle.

Clarify the vision of the new company — what value it adds, what brand it's going to use. Not doing this can lead to situations like the old joke about two guys straining to move a piano. "Gosh, this piano is hard to move in!" one guy finally says. "In?" the other guy says, "I thought we were trying to move it out!"

Although most descriptions of mergers use numbers, culture is actually a very critical part of the merger process. Solving the culture problem can make a difference whether both sides feel a part of the team or not. Solving the culture problem can also minimize roadblock. As Solit notes, some organizations operate leaner than others and they'll say it's more cost-effective. Others will say, "Yours may cost less, but ours is ultimately more effective. We're able to generate more revenues; we have higher quality." Because there is often no objective way to show which one is right — especially in the time available for a decision -- "People get pushed into trying to show that one's better than the other, which delays the time that it takes to actually do a consolidation."

There's also a risk of having an internally inconsistent organization. When people from different companies get senior roles, "One part of the company under the first individual is like his old company" while "The other part of the company under the second individual is like her old company."

Goldsmith says continuous clinical quality improvement can help an organization heal. When concern for patient care and objective measurement are combined, CQI unites practitioners and managers in a common effort to improve results, reduce suffering, and eliminate needless cost.

Such long-term strategies aside, there are some basic things that can and should be tended to. Go after the savings that are nondisruptive to the core business. "Purchasing and supply management are usually very high on the list," Ferrari notes.

Figure out what your information system strategies are going to be and implement them in a careful, deliberate way.

"It's not that fast is bad," says Ferrari. "It's just that fast for the sake of being fast is probably bad. The speed has to be determined by a well-thought-out plan of integration, "rather than somebody at the top yelling 'I want these systems to be one in six months.'" As you proceed, recognize that you are going to be faced with making important investment decisions.

The investor-owned physician management company consolidations gave us a rather spectacular lesson that buying up little things to make one big thing, by itself, doesn't guarantee success. The actions and the leadership of the executives — those folks who are darkly suspected of gathering dust and large salaries — make a tremendous difference.