When the planned tie-up between two US health management organizations—United Healthcare and Humana—collapsed last summer, some Wall Street analysts breathed a sigh of relief, glad that these two big health maintenance organizations (HMOs) would not have a chance to augment the already large catalog of failed mergers. PacifiCare’s troubled 1996 acquisition of FHP, for example, led to a 40 percent decline in operating margins. Aetna’s excessively expensive purchase of US Healthcare destroyed up to $500 million of market value within a month of the deal’s completion.
(Terms printed in italics are defined in the glossary)
Do such well-publicized difficulties mean that no HMO mergers make sense? Since 1993, 94 deals have taken place among US health care payors. The authors studied in detail 15 of these agreements, representing about 90 percent of the total transaction volume of $24 billion. We found that acquirers actually created significant value. In the short term, they increased their postacquisition market value by almost $6 billion and improved their operating margins through better selling, general, and administrative (SG&A) costs, as well as through medical-cost synergies. In the medium term, they increased returns to shareholders. Payors that failed to create value often fell short for one of two reasons: either they paid too much for their acquisition or did a poor job of integrating it.
It remains to be seen whether mergers and acquisitions will create value over the long term. But it is safe to say that they will continue to be important strategic levers during the next five years as payors try to raise their earnings by increasing the number of members under their care. Accordingly, we believe that payors will fall into two broad classes: the hunters and the hunted. The hunters will include such payors as United Healthcare, Aetna, and CIGNA, whose large market capitalizations give them the resources to make purchases. The hunted will probably include Foundation Health Systems, PacifiCare, Humana, and Oxford Health Plans, whose declining market-to-book value and declining market cost per covered member could make them bargains in an industry now depressed by rising costs and flat prices.
Forecast: More mergers ahead
Until recently, the pace of M&A activity had been slowing for a time as such leading payors as CIGNA and Aetna balanced their appetite for attractive targets against the need to digest recent acquisitions and to improve their overall financial position. But this temporary blip ended in December 1998 with the announcement of Aetna’s $1 billion acquisition of Prudential HealthCare and the completion of Aetna’s purchase of NYLife Care.
The need for growth
The long-term trend to consolidation has been driven partly by pressure from investors for membership growth and for attractive returns and partly by market forces, including the need to combat rising administrative and medical costs, the profit to be made by dominating market segments, and the growing expense of information technology. These forces have been at work in a number of deals, such as the PacifiCare-FHP merger, which gave PacifiCare almost 25 percent of what at the time of acquisition was an attractive and rapidly growing market segment: Medicare risk.1 (Today, of course, Medicare risk is an increasingly uncertain business, particularly in geographical areas where government reimbursement rates have become unattractive.)
There is not only much reason for further consolidation but also plenty of room. So far, the level of concentration among payors is pretty much what it was 15 years ago; the top ten received 44 percent of the premium dollars in 1983 and 41 percent in 1996. What has changed is the relative importance of the HMOs, which have become the dominant force in the payor industry, representing a larger proportion of the top ten players—six in 1996 as compared with one in 1983. In addition, HMOs have penetrated the market much more deeply, covering 77 million lives in 1997, as against 38 million in 1990. HMOs are more concentrated, as well: the top ten controlled 58 percent of HMO lives in 1997, up from 46 percent in 1990.2
California, which was among the first states to be heavily penetrated by HMOs and thus led the way to consolidation, shows how much scope there is for HMO-led mergers in the rest of the United States. By 1997, California’s top five payors, all operating HMOs or risk-bearing preferred-provider organizations (PPOs), controlled almost 80 percent of the state’s HMO market. About $40 billion in transactions would be required for the country as a whole to reach the same level of concentration.3
For the time being, the industry’s subdued state, as well as the need of certain organizations to digest their previous acquisitions, could inspire payors to focus more on internal operations than on M&A. But if they do so they might miss potential bargains—for instance, PacifiCare (whose market capitalization per member dropped to $980 in November 1998, from $1,310 in 1996) and Oxford (whose corresponding figure fell to $490, from $2,950, during the same period). Having lost more than 25 and 80 percent, respectively, of their market value per member in the past two years,4 these companies are potential takeover targets because recent history shows that payors with market capitalizations of less than $2 billion are vulnerable. Another group of payors, with market capitalizations of $2 billion to $5 billion, must expand aggressively or risk being taken over. Only organizations (such as CIGNA, Aetna, and United Healthcare) that are now capitalized at a level upward of $10 billion need not fear being acquired. Of course, they are likely to be the most active hunters (see Exhibit 1).
Hunt or be hunted
Payors have two possible ways of increasing their earnings and thus their market value: they can enlarge their membership through acquisitions or make their existing businesses more profitable. The first route is the more widely favored one (see boxed insert, "Payor M&A has its rewards"), which is why most payors would be wise to evaluate their strategic options and capabilities as hunters—or resign themselves to being hunted. The hunted can try to extract the best price when they are ultimately acquired by trying to dominate local markets or customer segments that are attractive to hunters. For hunters, the key to making effective acquisitions is the ability to pick the right target and to develop the right organizational capabilities and postmerger management techniques.
Pick the right target
Although it may seem obvious, to create sustainable value through M&A, buyers must first choose the right target—in other words, one that supports their overall strategy, offers short-term synergies, and has exploitable skills and capabilities. The second requirement is to pay the right price.
A merger that supports the overall strategy of the acquirer strengthens its product portfolio, helps it establish local market power, and builds up its dominance in strategic market segments. Health care remains a local business, so to judge a merger’s ability to create value it is necessary to make an accurate assessment of the merged entity’s ability to contract profitably with local hospitals and physicians and to attract employees and consumers in individual markets. It is also critically important to understand which components of an acquisition will be valuable, which should be divested, and who might be likely to buy them.
Acquisitions that make a good strategic fit also create the possibility of short-term synergies, economies of scale in SG&A, good provider relationships in overlapping markets, and opportunities to cross-sell products. Early gains for shareholders often depend on the ease and speed with which savings can be made in purchasing and on the sharing of administrative functions. (In this respect, understanding the extent to which IT systems are compatible or transferable is extremely important.) Finally, buyers ought to look for capabilities and expertise they can build on, such as superior medical management systems or risk management skills.
Hunters should also realize that as M&A gathers force over the next decade and opportunities to improve an institution’s SG&A become more elusive, profitable growth will depend more and more upon finding innovative ways to cut the cost of delivering care. To this end, payors must work with providers—for instance, by developing information systems that collect data on every aspect of patient care. Such systems could be used to minimize costly variations in practice patterns, particularly in the expensive treatment of chronic diseases. United Healthcare is already using its computerized medical-billing and pharmacy records to evaluate the practices of thousands of physicians in its nationwide network.
Carrying out a project of this sort requires not only sophisticated systems but also massive scale. Indeed, the Wall Street Journal reported that a central goal of United Healthcare’s decision to acquire Humana was the desire "to achieve efficiencies that would enable United to build better computer systems to analyze the medical success rates of doctors and hospitals."5
Integrate the acquisition
Picking the right target is not enough; a merger’s potential value can be realized only through effective management after the deal is completed. Best practice in postmerger management is a broad subject.6 Thus we will merely outline the areas that are particularly important in health care—areas frequently overlooked by managers consumed with the demands of building a new organization and clarifying their positions within it.
Exploiting opportunities for short-term value typically depends on the ability to keep internal operations running efficiently during the merger’s consummation, when managers may be too distracted to respond to rapidly rising medical costs. It is wise to agree on the direction and design of the health care delivery system before cutting back on administrative functions that might be needed to implement that direction and design. Some HMOs, for example, have a high level of capitation and therefore of risk. They require relatively more people to manage risk and contracts as opposed, say, to managing utilization. Moreover, any changes to IT systems must be carefully considered and executed to avoid disrupting daily operations.
As a rule, nondisruptive synergies should be tackled first in hopes of giving shareholders a quick return. Purchasing and supply-chain management costs, for instance, can often be cut simply as a result of the additional purchasing power the merger creates.
Another key to success is assessing and forming the combined entity’s brand position. Managers who attempt to clarify the identity of a merged entity sometimes forget the power of brands to convey value propositions to customers. Buyers should thus conduct market research into local perceptions of each brand to find out which is stronger, market by market, and then move to shape those perceptions. At least from the outside looking in, FHP’s acquisition of TakeCare in 1994 (before FHP was itself taken over by PacifiCare) seems to illustrate the cost of failing to get brands right: FHP replaced the strong local brand of TakeCare with what appeared to be the weaker FHP name. It lost members as a result.
Finally, it is essential for merged institutions to address straightaway any differences in contracts with physicians and models of governance. If the differences are significant, contracts must be renegotiated immediately to ensure that they accurately reflect the risks posed by the patient population, the productivity of physicians, and any central monitoring that may be required. If the autonomy of physicians accustomed to having a good deal of it must be curbed, effective contracting early on may decide a merger’s ultimate success or failure.
Two acquisitions
Our outsiders’ examination of two recent mergers—between United Healthcare and MetraHealth, on the one hand, and PacifiCare and FHP, on the other—shows that they both made strategic sense at the outset. But whereas the first deal seemed to fulfill its objectives and created value for shareholders, the second destroyed it.
The 1995 acquisition of MetraHealth by United Healthcare supported its strat-egy of diversification by creating a broader portfolio of products, including HMO, point-of-service, PPO, and administrative service organizations (ASO). This deal also expanded the scale and scope of United Healthcare by streng-thening its clout in local markets and adding ten million lives to its membership.
United Healthcare realized the strategic promise of its acquisition because it carried out careful due diligence in critical areas. Before buying MetraHealth, United Healthcare built up its target selection and postmerger management capabilities through a sequence of smaller acquisitions. Within a year of the MetraHealth purchase, United Healthcare thus managed to achieve $282 million in SG&A savings through consolidated claims processing and higher indemnity premiums. It also steered indemnity members to what were prob-ably more profitable managed-care offerings and took advantage of the oppor-tunity to cross-sell its specialty programs to the members of MetraHealth.
Moreover, the later purchases of PHP and Healthwise of America made it possible for United Healthcare to give its MetraHealth members access to managed-care facilities outside its own areas of geographical coverage. United Healthcare swiftly went on to establish common business performance indicators, such as average time to pay claims and average time to deliver bills, and used these metrics to monitor its performance during the conversion of the IT systems. Through all of these means, the company kept the damage to its financial performance to a minimum.
PacifiCare’s acquisition of FHP makes a fascinating contrast. The deal seemed to give PacifiCare an opportunity to increase its dominance in the then highly profitable Medicare risk market segment, to expand its geographic reach in the Midwest and in Northern California, and to become the fourth-largest HMO in the United States. But PacifiCare made overoptimistic assumptions about the ease of integrating FHP, failed to identify opportunities for quick savings, and underestimated the difficulty of managing the costs of FHP’s noncapitated providers. (PacifiCare’s physicians were fully capitated and therefore bore the risk and responsibility for managing utilization and costs.)
This poor diagnosis was compounded by PacifiCare’s failure to integrate the acquisition effectively, which generated a 40 percent fall in margins. FHP’s operations were responsible for 70 percent of this decline. After putting off the divestiture of underperforming operations in Utah, for example, PacifiCare had difficulty finding buyers for them, and an increased backlog of claims in Colorado Springs (arising from FHP’s unsuccessful consolidation of claims processing) made it impossible for PacifiCare to provide accurate and timely information about medical costs. That in turn made the company misprice the next year’s commercial premiums in the Utah and the Colorado Springs markets.
The contrast between United Healthcare’s smooth acquisition of MetraHealth and the bumpy ride that PacifiCare experienced with FHP shows how carefully even hunters must move to create value for their shareholders. But if M&A will continue to be risky for the hunters, consider the lot of the hunted. Vulnerable companies must develop strategies to defend their independence, either by becoming protected niche players (in particular customer segments, for example) or by turning into hunters themselves. 
About the Authors
Jim Kalamas is a consultant and Gary Pinkus is a principal in McKinsey’s San Francisco office. Ning Wang is a consultant and Roger Zino is a principal in the Los Angeles office.
The authors would like to thank Michael Moore and Wei Zhang for their contributions.
Notes