As the U.S. faces an unprecedented era of heightened uncertainty stemming from the outbreak of COVID-19, we as a nation have been starkly reminded of the critical role our hospitals and healthcare systems play in the provision of essential clinical services to communities and patients across the country. While under immense systematic pressure, exacerbated by COVID-19, it remains of vital importance for hospital and healthcare system leaders to actively monitor organizational readiness, embrace value-based care initiatives, and financial sustainability. In this report, FocalPoint’s Healthcare Investment Banking team discusses the current state of the hospital and healthcare system sector as well as key elements facing providers as our healthcare system continues to transform.

The Hospital and Healthcare System Landscape

The past several years have been characterized by an ever-increasing number of hospital and healthcare system providers falling into one of two distinct segments—the “haves” or the “have nots”. The “haves” are described as providers with ample access to capital and resources to ensure organizational longevity and service continuity while the “have nots” are described as those lacking the size, scale and access to capital to ensure sustainable clinical operations:

This increasing divergence of hospital and healthcare system sector participant categories is highlighted through a historical analysis of recent hospital and healthcare system merger and acquisition (“M&A”) trends. In both 2018 and 2019, of the M&A transactions that involved hospital and healthcare system target organizations, the vast majority were organizations characterized by relatively smaller net patient revenue bases. In 2018, of the 107 targets that reported revenues, nearly 80% were organizations with less than $500 million in net patient revenue, while 36% fell below the $100 million threshold. This trend persisted in 2019. Of the 86 hospital and healthcare system target organizations that executed M&A transactions in 2019, approximately 80% had a net patient revenue base below $500 million, with approximately 43% generating less than $100 million in total net patient revenue.

Not-for-Profit Hospital/Healthcare System M&A Targets by Total Revenue

Sector Report: COVID-19 Impact on Hospitals and Healthcare Systems

Healthcare Investment Banking

FOCALPOINT l Sector Report: COVID-19 & U.S. Healthcare 1

HAVES: Ample capital resources, resulting from strong market presence, size, and scale, grants the ability to keep pace with a rapidly evolving healthcare landscape.

HAVE NOTS: Expense inflation outpacing revenue growth, resulting in liquidity constraints and limited capital resources, thereby compromising system competitiveness.

The growing divide between the “haves” and “have nots” has been a key contributor to increasing consolidation in the hospital and healthcare system sector. This trend will further be fueled by the current COVID-19 crisis as hospitals and healthcare systems face an increasingly diverse set of challenges driven by heightened economic pressures and volatility.

Operational Considerations

Over the past several years, hospitals and healthcare systems of all sizes have experienced a challenging operating environment as a result of stress on both revenue profiles and expenses bases. Consequently, both operating margins and cash flow margins have deteriorated, resulting in a corresponding decline in liquidity positions. However, in recent years many providers with thin margins have successfully mitigated downturns in core clinical operating performance by relying on non-operating or supplemental income sources, namely investment income and revenues from State and Federal programs. With the recent macroeconomic upheaval and continued uncertainty posed by COVID-19, organizations must assess the future state impact on their operating profiles and their ability to pivot organizational priorities accordingly.

Volatile Financial Markets

Since the financial downturn ending in 2009, healthcare providers, alongside other investors, have benefited from a nearly 10-year bull market run in the equity markets. Strong annual investment income on profit-and-loss statements, as well as growing unrestricted investment portfolios have “propped up” hospital and healthcare system balance sheets across the nation. Yet, with equity markets experiencing precipitous declines in the last few weeks alone, and fixed income yields compressing due to unprecedented measures taken by The Federal Reserve to inject liquidity into the economy, healthcare providers who have been successfully offsetting operating losses via investment income returns will face severe downward pressure to their bottom lines.

S&P 500 10-Year Performance (March 20, 2010 – March 20, 2020)

Year-Over-Year U.S. Treasury Yields (March 20, 2019 – March 20, 2020)

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— 1 Yr — 10 Yr — 30 Yr

Governmental Budget Constraints

While hospital and health systems are set to receive near-term relief—stemming from the $2-trillion stimulus package passed by Congress—it is yet to be determined how healthcare providers may also be adversely impacted by mid- to long-term, COVID-19-related governmental funding constraints. State and Federal governments are anticipated to revert all available economic support into COVID-19-related stimulus packages, with healthcare programs such as 340b drug pricing, disproportionate share hospital (DSH) payments and broader Medicare/Medicaid funding potentially being reduced to secure requisite emergency funding. This will likely result in a material reduction of funding available to support hospitals and healthcare systems. Further, State and Federal governments may also face immense pressures related to decreased tax revenues. As a result of a shift in consumer spending habits resulting from social distancing protocols, sales tax revenues will likely see steep drops. Likewise, decreases in income tax revenues from the looming wave of unemployment claims by impacted sectors of the economy (i.e. restaurants, bars, hospitality and travel) also pose a threat to government budgets, and thus, will also negatively impacting funding programs historically used to support hospital and healthcare systems across the country.

Payor Mix Shift

Even under a best-case scenario in which Medicare/Medicaid reimbursement rates are not impacted from a shift in govern-mental resources, the impending increase in unemployment rates will have a meaningful impact on payor mix and associated revenue trends for hospitals and healthcare systems. Organizations that are presently operating on razor thin performance metrics will experience additional margin pressure, as payor mixes shift from commercial patients who are reimbursed at higher levels, to governmental patients who are reimbursed at relatively lower levels.

Payor Mix for High-Rated vs. Low Rated Hospital/Healthcare Systems

Clinical Operation Disruption

Not to be forgotten is COVID-19’s real-time disruption on the provision of core clinical services, which should continue to impact the day-to-day operations of hospitals and healthcare systems. A shift in patient patterns, as well as in the types of procedures performed should invariably effect hospital and healthcare system revenue mix and overall operating performance. For instance, many hospitals and healthcare systems have already begun the deferment of higher margin elective procedures in order to focus organizational priorities on COVID-19 patients in greater need of immediate clinical attention and care.

While all organizations will be impacted to some degree by the intensified pressures caused by COVID-19, hospitals and healthcare systems with relatively stronger financial profiles will be best equipped to navigate both the near-term challenges to operating performance.

• Aa2 hospital/healthcare systems compared to Baa3 providers have an incrementally 7.9% superior government payor mix.

• Conversely, Baa3 providers compared to Aa2 have an incrementally 10.1% unfavorable commercial payor mix.

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Liquidity and Capital Considerations

A hospital and healthcare system’s balance sheet strength is an important barometer of long-term organizational sustainability. The increasingly challenged operating conditions and resulting strain on hospital and healthcare system margins resulting from the COVID-19 crisis will likely impact the overall balance sheet strength of many hospitals and healthcare systems.

Days Cash on Hand

From a liquidity perspective, days cash on hand calculations for hospitals and healthcare systems will be impacted by the precipitous drop in the equity markets and potential declines to margins from shifting payor mixes and changing patient patterns. Over the past 10 years, as margins have declined and caused diminishing cash to flow, hospitals and healthcare systems have largely offset the impact of these operating losses on their unrestricted cash position through outsized investment portfolio performance. With financial markets in a state of disarray due to COVID-19, liquidity positions that were already operationally constrained will now experience further declines. Hospitals and healthcare systems with rela-tively stronger liquidity positions will still be negatively impacted, but better able to weather the storm.

Days Cash on Hand for High-Rated vs. Low Rated Hospital/Healthcare Systems

Debt Capital Markets

Hospital and healthcare system CFO’s will need to closely examine their debt and credit portfolios in light of COVID-19. The debt capital markets have been severely disrupted by COVID-19, primarily driven by investors across the globe quickly shifting their portfolios into cash and central banks slashing interest rates to inject liquidity into the domestic economy. As a result, while base rates (i.e. LIBOR, U.S. Treasuries and MMD) are extremely low compared to historical levels, credit spreads have widened as investors are pricing in increased risk amidst looming uncertainty. Moreover, both tax-exempt and taxable markets are struggling to function, as investors currently do not want to take on any risk, causing new debt issuances to receive minimal bids. The resulting immediate-term impact for hospitals and healthcare systems, regardless of credit rating, will be a lack of access to the capital markets despite relatively attractive current rates.

Aaa vs. Baa 10-Year Credit Spreads

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How is Your Organization Positioned to Respond?

Hospitals and healthcare systems should focus on ensuring the safety and well-being of the communities they serve as the nation battles a global pandemic. Simultaneously, hospitals and healthcare systems should remain cognizant of the increasing stress on sector participants across nearly every functional areas of the care delivery enterprise. Best practice and key considerations for hospitals and healthcare systems as they collectively work to navigate the COVID-19 crisis include:

3 Closely examine your organization’s investment policy and perform rigorous financial modeling to stress test the impact on operations as a result of a sizeable shift in clinical, financial and macro-economic market conditions;

3 Carefully analyze the impact on your organization’s financial profile caused by potential shifts in legacy government funding initiatives;

3 Reexamine financial and clinical resource needs as it relates to your organization’s goals and objectives for delivering care to the communities and patients you serve;

3 Consider where your organization currently fits on the spectrum of “haves” and “have nots” and how your organiza-tion may shift on this continuum in light of COVID-19.

James CastroManaging Director

jcastro@focalpointllc.com

Hector TorresManaging Director

htorres@focalpointllc.com

Matthew CumbeeSenior Vice President

mcumbee@focalpointllc.com

Eugene IzumoSenior Vice President

eizumo@focalpointllc.com

Aaron NewmanVice President

anewman@focalpointllc.com

Sources: Not-for-Profit Hospital/Healthcare System M&A Targets by Total Revenue - FocalPoint Partners, LLC proprietary database. • S&P 500 10-Year Performance - Yahoo Finance. • Year-Over-Year U.S. Treasury Yields - Treasury.gov. • Payor Mix for High-Rated vs. Low Rated Hospital/Healthcare Systems - Moody’s Investor Service: 2019 Median Flashcard. • Days Cash on Hand for High-Rated vs. Low Rated Hospital/Healthcare Systems - Moody’s InvestorService: 2019 Median Flashcard. • Aaa vs. Baa 10-Year Credit Spreads - fred.stlouisfed.org.

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About FocalPoint Partners, LLCFocalPoint is an independent investment bank specializing in mergers and acquisitions, private placements, financial restructur-ings, and special situation transactions. The firm provides advisory services to middle market clients in aerospace and defense, business services, consumer, energy, financial services, healthcare, industrials, and media/technology. With offices in Los Angeles, Chicago, New York, and Shanghai, and affiliated partner offices around the world, FocalPoint’s domestic and international coverage across eight key industry verticals is truly global. Visit focalpointllc.com and follow us on LinkedIn and Twitter.

About FocalPoint Healthcare Investment BankingFocalPoint’s Healthcare Investment Banking team provides differentiated M&A and financial advisory services to a wide range of healthcare providers and organizations. Our team’s experience and expertise includes advising hospitals and healthcare systems across the country in the analysis and execution of all forms of strategic transactions spanning from less-integrated strategic affiliations and joint ventures to fully-integrated membership substitutions, mergers, acquisitions, and assets sales and dispositions. FocalPoint’s in-depth knowledge of the clinical, financial and strategic factors impacting hospitals and healthcare systems enables us to serve a diverse client base ranging from rural community-based hospitals to multi-hospital, regional and national integrated health systems. Please visit focalpointllc.com/healthcare or contact a healthcare practice team member for more information.