In the five years leading up to 1998, executives and boards of US hospitals—convinced that if they grew larger they would be able to draw more patients, to leverage significant economies of scale, and to command higher prices from payors—consummated nearly 750 mergers and alliances.

(Terms printed in italics are defined in the glossary)

Yet second thoughts are now emerging. How much value has consolidation created? Are institutions really better off in local hospital networks and integrated health care systems than they were standing alone? Today, these are real questions.

Not long ago, we analyzed 300 transactions involving recently merged hospitals, comparing them with their independent counterparts in the same statistical market service areas. The study suggests that the economic advantages local hospital networks were expected to derive from con-solidation have largely eluded them. National for-profit hospital chains have certainly prospered through expansion. But they have benefited less from the structural advantages of combining assets than from the more exacting challenge of transferring, or "arbitraging," important skills from one facility to another.

As health care markets in the United States continue their journey into a turbulent and more fiercely competitive future, it is time for the country’s hospitals to start thinking more systematically about mergers and acquisitions. Hospitals do have many compelling reasons to unite in local or even regional or national networks. But these reasons must be examined strategically rather than opportunistically, and hospital executives must be careful to make sure that their expectations really match a prospective merger’s potential for creating value.

Conventional and unconventional wisdom

All hospital mergers consummated since 1993 can claim a certain degree of uniqueness. But most mergers have been propelled by three widespread and fundamental assumptions: that hospitals must join integrated health care systems or lose patients to larger rivals, that they can achieve major economies of scale by rationalizing capacity and amalgamating such functions as information technology and purchasing, and that they would somehow be better able to negotiate for the economic surplus with other players in the vertical chain (such as payors and physicians) if they could create scale-based structural advantages.

Think local

How have these assumptions stood up to reality? Not particularly well, in fact, because they overlook a basic truth: health care is primarily a local-market business, so any line of inquiry must focus primarily on local market conditions. The underlying market structures, the extent to which managed care has penetrated the market, the kind of managed care involved, and the degree of competitive rivalry in particular areas all respond to local, not national, market dynamics.

The three basic assumptions also ignore factors unique to any single transaction, for such factors too may give one hospital system advantages or disadvantages as compared with another, even when both compete in the same market. Such factors include the relative sizes of the hospitals, their geographic proximity, the underlying structure of governance, the strength of ties between individual hospitals and physicians, and the degree of unity in the leadership structures of the formerly separate institutions.

Focus on microeconomics

Six distinct levers influence the financial performance of hospitals. The levers on the income statement are price, volume, and the mix of patients (all three revenue-related), and operating expenses. On the balance sheet, the levers are physical plant and accounts receivable. To determine whether a particular merger or set of mergers has delivered value, four of these should be considered in detail: price, volume, operating expenses, and physical plant.

Price. A big part of the logic of hospital consolidation is the ability to influence price—that is, reimbursements from payors. The bigger the hospital system, or so the reasoning goes, the better its chances of negotiating away the econ-omic surplus from other part-icipants in the value chain.

Unfortunately, this argument has a significant flaw: no matter how big hospitals get, they can influence the price of only the 19 percent or so of their revenues derived from inpatient managed-care activity. For the remainder, prices are bound by the competitive dynamics of other, nonhospital suppliers of health care services; nonnegotiable; or not affected by structure (Exhibit 1).

Since local market power seems to be relevant for only 19 percent of total revenues, a 5 percent increase in reimbursements related to managed care represents an improved operating margin of slightly less than 1 percentage point. Even so, 19 percent is still a high enough proportion of revenues to be worth considering. Our research shows that merged hospital networks in narrowly defined geographic areas with few or no competitors have indeed succeeded in exerting a favorable influence on the price of the services that generate this part of the networks’ revenues. So too have hospitals in larger geographic areas if they have some kind of more natural monopoly—children’s hospitals, for example.

Volume. Integrated health care systems are conventionally said to attract a disproportionate share of managed-care patients by offering broad geographic coverage, a continuum of services, and a very practical way of accepting risk-bearing contracts from payors, such as reimbursement mechanisms providing for full capitation. This view has proved false: very often—and for a variety of competitive, emotional, and very practical reasons—merged systems fail to achieve the volume (and thus the market share) they had expected.

From a competitive standpoint, payors began to work against integrated health care systems soon after they became popular. Evidently, the payors realized that formally acknowledging the value of integrated systems by granting them selective or exclusive contracts would reinforce the perception among nonparticipating hospitals that remaining outside the systems was disadvantageous. Such "legitimation" would only encourage more mergers among independent hospitals and reduce the payors’ structural leverage.

As for emotional factors, physicians who practice at the acquired hospital may question their ability to influence decision making in what is often a larger, more bureaucratic, and more distant administrative hierarchy. Another problem is both economic and emotional: if the acquiring institution is an academic medical center with physician practice plans, community physicians could feel that they are in effect subsidizing their research-oriented counter-parts, whose practices may cost more to conduct. In some cases, such con-siderations have led physicians to stop sending patients to the acquired hospital and to open up shop, patients in tow, at a competing one.

Another emotional factor mostly affects patients. For the past several years, nationwide enrollment has declined in tightly managed, "pure" health maintenance organizations (HMOs), which give patients little choice in the physicians they see. At the same time, enrollment has grown rapidly in more loosely managed point-of-service products, which provide access to many parts of the health care system without referrals from physicians responsible for primary care but usually require a higher level of co-payment. (In some of these products, for example, patients have a greater selection of physicians than they would in a pure HMO.) Patients are voting with their feet in favor of health plans that offer convenience and broad choice, and most integrated health care systems come up short on both counts. After assuming complete financial risk for 200,000 lives, for instance, one such system lost 10 percent of its subscriber base in the first year because its narrow provider network gave patients little choice in the physicians who treated them.

The practical factors constraining the ability of a health care system to shift the flow of patients in its favor may be the most com-pelling of all. One health system’s out-of-network medical expenses for a group of capitated lives approached 75 percent of all medical expenses. Upon being interviewed, many of the physicians employed by the system—both at the primary- and the specialty-care level—mentioned a number of significant problems that discouraged the use of in-network providers and facilities.

These physicians complained, for example, of severe capacity constraints in the areas of surgery, cardiac catheterization, and even such less-invasive procedures as the insertion of ear tubes. Patients disliked having to drive more than 15 to 20 minutes for routine procedures if competing community hospitals were much closer. Primary-care physicians feared that in-network specialists would take their patients after referrals, and primary-care physicians who had worked for years with people who were now out-of-network specialists felt loyal to their old colleagues.

That wasn’t all. Within the network, the degree of coordination among such participants in the vertical chain as hospitals, specialists, primary-care physicians, and outpatient centers was relatively low, so overall transaction costs were high. Patients and physicians alike wondered about the quality of the nursing and support staffs at some of the newly integrated hospitals. Finally, physicians worried that their incomes, their lifestyles, or both would suffer if the use of a hospital in the network forced them to travel farther than they had in the past.

Patients want choice and convenience. Physicians want better incomes and lifestyles. Put it all together, and you understand why neither the policies of the payors nor the best efforts of the integrated hospital networks themselves have succeeded in bringing them as many patients as they had first expected.

Operating expenses. Even a casual look at a hospital’s cost structure suggests that the potential for cutting expenses after a merger is significant (Exhibit 2). A bit more than one-third of all costs are indirect. Another third consists of the hospital’s spending on purchased goods and services. Yet for several reasons, most hospital mergers do not reduce costs to anything like the fullest possible extent.

For one thing, either independent structures of governance remain intact, or the board of the combined entity is stacked with members of legacy boards who cannot agree about which facility should bear the greatest burden of cost reductions. Leadership structures, performance evaluations, and incentives remain geared to improving the operation of each individual facility, not the system as a whole; physicians, in particular, resist the idea of eliminating or relocating almost any clinical support service. Moreover, performance imperatives—especially in nonprofit settings not subject to capital market disciplines—are often limited, and many doctors and hospital administrators are reluctant to capture economic value beyond what is needed to fund the entity’s ongoing operations if this means laying off employees or withdrawing business from local suppliers. Finally, separate IT systems can take years to replace and often impede the integration of many functions.

Despite these problems, some integrated hospital systems do manage to cut costs significantly. The key to success appears to be a strong orientation to performance, as well as standardizing and integrating work processes, functions, suppliers, and investments—but not necessarily centralizing them, since that often makes them more complex.

Physical plant. One of the more significant oddities of today’s US health care market is the fact that hospitals using only 50 to 60 percent of their capacity continue to add new physical plant. There are a number of very important practical and competitive reasons for this kind of apparent underutilization, and the merger of hospital assets fails to address most of them.

First and foremost, not all hospital capacity is alike; indeed, using bed occupancy levels as a measure of utilization is plain misleading. We studied an integrated hospital system where the average rate of bed occupancy was around 60 percent. But the utilization rate of the operating room approached 85 percent and was even higher from 8:00 in the morning to 12:00 noon on weekdays. A children’s hospital had a utilization rate of almost 95 percent in February and March but only about 40 percent in June and July.

What constitutes a fungible unit of hospital capacity? What does capacity utilization really mean at a granular level? These are difficult questions to answer in any general way. After all, a private room differs from a semiprivate room, a bed in a pediatric ward from a bed in a labor and delivery suite, a bone marrow unit from a critical-care unit, an operating room at midnight from an operating room at 10:00 in the morning, and a private room in the suburbs from a private room downtown.

Those who plan hospital mergers must first determine the extent to which specific units of capacity are truly fungible. In doing so, the planners confront several market realities. First, practicing at a number of facilities or at an entirely new one will probably have an adverse impact on the economic interests and lifestyles of physicians, since travel time means lost income, and they will be more distant from their offices. Patients, as we have seen, dislike the idea of traveling long distances for care, particularly if a competitive alternative remains in an area after a hospital system attempts to ration-alize capacity. Moreover, some em-ployees and communities actively resist such efforts.

For these reasons, the reduction in the capacity of hospitals (that is, in the number of beds they contain) has lagged behind the reduction in the number of days an average patient spends in a hospital (Exhibit 3). Even so, when conditions are right, the rationalization of capacity can lever-age the high fixed costs of operating hospitals into significant economic gains. The necessary conditions include very close geographic proximity among hospitals, a high degree of overlap among physicians working at them, and some degree of competitive isolation.

The two dimensions of success

Deals giving hospitals increased market power, better leverage on prices, and a good chance of reducing operating expenses are possible. But each of these deals must be evaluated on its own and not by the lights of the conventional wisdom that has vitiated so many transactions. To assess the logic of a potential merger, examine its structural attractiveness and the degree of organizational resistance that must be overcome to make it work.

Structural attractiveness

A transaction’s structural attractiveness depends on a number of factors reflecting either fundamental market conditions or the size or location of the merging institutions. The three most important structural factors are the geographic proximity of the merging hospitals, their size as measured by discharges each year or staffed beds, and the level of enrollment in pure managed-care plans in the local market.

Geographic proximity—always, of course, a relative measure—is often defined by the alternatives facing patients and physicians. In a rural setting, for instance, two institutions located 30 miles apart may be considered "adjacent," particularly if there are no other hospitals between them. In urban areas, two hospitals that are three miles apart may serve fundamentally different populations.

As for relative size, hospitals stand to derive no benefit from growth unless they are too small without it. Indeed, if they have already achieved optimal size they can actually create diseconomies of scale by merging with other institutions. Economies of scale are generally thought to be optimized as hospitals approach the level of 300-400 beds, or 15,000-20,000 discharges a year.

The level of pure managed care, the third important factor, suggests the degree to which health plans can succeed in guiding patients into narrow networks of providers. In this context, "pure" means either a group-model HMO or a staff-model HMO. Neither provides real point-of-service options. Payors regard integrated health care systems anchored by merged hospitals of this kind as attractive partners, and as a result the existence of such in-stitutions significantly increases the probability that patients will be "steered" into the network. But patients, of course, dislike being steered in this way.

Organizational resistance

To assess the second dimension for evaluating prospective mergers—the degree of organizational resistance both in the target and the acquiring hospital—three primary factors must be considered: relationships between physicians and hospitals; the assets, governance, and leadership of the hospitals; and drivers of performance.

Strong objections from physicians have undermined many mergers

Physician relations. Perhaps the most important of the three is the quality of the relationships of the merging institutions with their respective physicians. Strong objections from physicians have undermined many mergers before they went into execution. Even when physicians support a merger, such issues as the rationalization of capacity, the standardization of products, and adherence to new clinical protocols often generate strong misgivings. Reconciling the interests of different physicians and aligning their interests with those of the merging institutions early in the process can help significantly.

Integration of assets and leadership. The second important factor affecting organizational resistance to hospital mergers—the extent to which the assets, the governance, and the management of the merging institutions can be integrated—typically depends on the type of transaction consummated between the hospitals. The full consolidation of assets into a single balance sheet, by itself, will not always lead to the creation of a single, unified board and an integrated leadership team with one responsible head. These issues must be addressed separately and explicitly.

Unified governance does not mean simply that members of the previous boards now sit on a single system board. The point is rather that the single board for the whole system must consist of people whose interests and fiduciary responsibilities are clearly those of the system as a whole and not of each constituent institution. Very often, achieving this kind of unity requires replacing standing board members with new ones who had no relationship with the constituent institutions in the past. The unified board must focus its efforts on system-wide initiatives like strategy and planning, integrated financial performance, and evaluating its own performance.

Integrated management generally requires, at the very least, the appointment of a single chief executive officer, to whom all system functions and entities report directly or indirectly.

Imperatives to improve performance. Finally, the level of organizational resistance depends on the presence of two kinds of performance drivers. First, there are the capital market disciplines that typically impel for-profit entities, since economically oriented metrics determine the variable compensation of their executives. The second is the extent to which nonprofit hospitals must struggle to achieve minimum levels of sustainable profitability, defined as revenues that are 2–4 percent higher than expenses. For when nonprofits experience a significant degree of economic distress, they start cutting their costs and rationalizing their assets much more aggressively than they had previously—and in ways similar to the behavior of institutions guided by capital markets. This suggests that, all other things being equal, mergers led by for-profit institutions or involving struggling nonprofits will suffer less organizational resistance to change than other mergers do and can thus capture more economic value in the aftermath of the merger.

Gauging the opportunity

The next step is to evaluate the opportunity to capture value. A value creation matrix makes it possible to classify mergers into four quadrants, depending on where they lie along the two dimensions just discussed: the structural attractiveness of a transaction and the degree of organizational resistance to it (Exhibit 4).

Good neighbors

Two or more geographically close institutions that come together less to cut costs than to protect themselves from predatory payors, physicians, or new for-profit competitors enter into "good-neighbor" transactions. The conditions for them generally include not only a reasonably high degree of structural attractiveness but also significant organizational resistance.

Often, these transactions create affiliations of some sort rather than mergers of assets. The contracting institutions hope that by uniting to control hospital capacity in a relatively small geographic area they can put upward pressure on reimbursement levels and, perhaps, invest jointly in technology and equipment, such as a helicopter for emergency transport or a medical school facility shared by adult and children’s hospitals. The value cap-tured in these cases rarely exceeds 3 percent or so, but feelings of in-creased market security tend to satisfy the participants.

Option takers

A still looser alliance of "option takers" includes hospitals that are located in the same market service areas but not very close together. These institutions do not integrate their assets in such a transaction, but they often agree to fund system-level functions needed to accept risk-bearing managed-care contracts and to establish an organizational entity that can react quickly to rapid market transformations, such as a decision by large employers to reduce their health care expenses significantly. Such transactions typically capture very little value at first—perhaps 1 or 2 percent; in fact, the expenses of the institutions may even rise somewhat. Whatever value is captured comes typically from joint investments in branding or information technology. Nonetheless, the participants get the option value of the ability to respond effectively to changed market forces.

Arbitrageurs of skills

Some mergers help hospitals benefit from one another’s individual strengths

Some transactions, involving the arbitrage of skills, help the merging organizations benefit from one another’s individual strengths by applying them across the board. In most communities, the practices and performance of hospitals vary. One might have accounts receivable of 52 days, another of 72 days. Costs per adjusted discharge for similar acute interventions could diverge by up to 20 to 40 percent. The ability to control the proliferation of vendors for supplies (such as implantable devices) that are in high demand among physicians may differ a good deal, and so can "turnover" times in operating rooms. Such differences represent an opportunity to exchange best practices and thus arbitrage the comparative strengths of each institution.

In addition, altogether new capabilities can be introduced more effectively in environments that increase their leverage. Some would call this an advantage of scale, but it must be used selectively to focus on the most important areas: purchasing and the management of supplies, the management of affiliated physicians, negotiations with payors, and market and business development. Economies of scale derive not from the centralization of functions in itself but from standardizing and integrating them, as well as encouraging each institution in the network to specialize in the things it does best.

Integrated hospital systems have a wonderful opportunity to restructure their core clinical programs around tightly managed, operation-ally integrated product lines focused on the market. In the area of organi-zational design, the arbitrage of skills calls for abandoning the old model of facility-based organizations and a clear management hierarchy in favor of product-based organizations with much more fluid, matrix-like structures. Product-line managers should "own" responsibility for developing product and market strategies, for relationships with physicians, for procuring supplies and services specific to particular product lines, and for managing the level of utilization. They should be monitored with P/L-like accountability and required to pay for shared services from other parts of the network.

Organizational redesign should also embrace governance. Boards must be properly integrated. They should have a fluid committee structure built around important strategic goals—for instance, cost management and the development of talent and new business. The heart of this strategy is specialization, focus, and the transfer of skills. All of these can be derived from scale and translated into higher market share, lower expenses, and even some rationalization of capacity. In many cases, the value thus created approaches 10–12 percent. Although the proper integration of such transactions minimizes the level of organizational resistance, they rely very little on structural attractiveness.

Consolidators

Sometimes the structural attractiveness of a proposed transaction is very great, and the parties to it are willing to make whatever changes may be necessary to achieve success. The "consolidators" in this very high-impact model—nearby institutions that have not achieved optimal scale as separate entities—choose to enter into a full asset merger with a unified board and integrated management. Although the parties to such a transaction may lack the sharp edge of networks that arbitrage skills, consolidators are much more likely to influence market prices and to rationalize large chunks of capacity; indeed, these hospitals have an opportunity to create value exceeding 25 percent overall. Such transactions are very common in smaller metropolitan areas that have, say, only two acute-care institutions.

Controlling expectations

Understanding whether or not the merger of particular hospitals makes sense requires an examination of structural and organizational factors at a granular level. Each of the four kinds of mergers just described can create a range of value. Any of them might make sense for a particular transaction if the partners are realistic.

Hospitals that arbitrage skills seem to be the best at matching performance with expectations—probably because the success of these institutions comes mostly from organizational design and the transfer of capabilities; structural factors that may be less under the hospitals’ control and vary greatly from one transaction to the next are less important. In addition, the option takers, whose relationships generate relatively low immediate expectations, are rarely disappointed in them.

Hospital capacity is tremendously inelastic

Unsuccessful transactions are most common when the merging parties have expectations like those of consolidators but lack the underlying structural and organizational strengths required to play the part. The need to manage capacity, which is tremendously inelastic even in the face of falling demand for hospital beds, requires the merging institutions to be very close geographi-cally. Hospitals gain leverage over the price of their services chiefly at the "micromarket" level. Cutting costs requires tightly integrated management and governance structures. Absent these conditions, it is difficult to capture value along the lines of the consolidators.

Opportunities to enhance the economic value of hospitals by structurally aggregating their assets remain limited because patients and physicians still largely determine what kinds of procedures will be performed where and by whom. Meanwhile, merged hospitals relying on the conventional wisdom that size and scale alone create market power, and thus the possibility of economic gain, may actually find themselves destroying value and wondering why they were so eager to collaborate in the first place.