Executive Summary: Guide to Communities Considering Hospital Conversion in the Carolinas

In recent years, hospitals in the Carolinas and elsewhere have faced an increasingly competitive and cost-conscious market resulting from aggressive efforts by payers (chiefly employers and government) to restrain health spending. This has led to a search for greater efficiency through consolidation of facilities, especially in order to remain competitive in given the rapid growth of managed care. Consequently, a growing number of communities are faced with the decision about what to do with a local hospital. In these communities, county officials or non-profit boards must decide whether ownership or control of the community hospital should change.

From 1983 to 1997, 18 Carolinas hospitals changed to for-profit status and 11 public hospitals converted to not-for-profit control. There remain more than 150 public and not-for-profit hospitals in the Carolinas that may explore a change in ownership or control in the future.

The hospitals involved in these changes of ownership or control (or "conversions") are worth tens or even hundreds of millions of dollars. The decisions affect entire communities, including a diverse array of interests ranging from hospital employees, medical staff, hospital patients, local businesses whose economic health is linked to the hospital's and indeed, the entire community, whose peace of mind may be affected by knowing there is ready access to needed services. Hospital conversions are very complicated transactions, yet critically important to a community. They involve issues of the hospital's mission, how to pay for essential health services, and how to use the proceeds if the hospital is sold. To make choices in the best interests of the community, these decision-makers and the public need objective information. They need an impartial framework for thinking clearly about what is at stake in a conversion decision; how to structure and think about the alternative choices faced by their hospital's unique circumstances; and how to assess the community benefits and potential risks associated with various alternatives. Above all, they need the distilled wisdom from other conversion experiences to guide the process of making a decision that they will later view as the best for their community.

This guide is designed to provide information to help guide such decisions for public and not-for-profit facilities. Since 1983, there have been 18 conversions to for-profit status by public or not-to-profit hospitals and 18 conversions of public hospitals to not-for-profit status. The manual is based in part on original case studies of 10 of these 29 conversions, using interviews with key informants and analysis of local data to assess the impact of conversion on each community. The manual relies also on further data analysis of all hospital conversions in the Carolinas, reviews of 21 additional case studies of conversions outside the Carolinas and a comprehensive literature review to better understand what happens to a community following conversion.

Chief motivations leading to hospital conversion include: a) obtain access to sufficient capital at a reasonable cost to remain competitive or expand; b) become part of a larger hospital or health system to better be able to contract with managed care plans or other large payers; c) continue a historical mission by averting probable closure; and d) redeploy community taxes or charitable assets. Particularly in smaller communities, survival of the hospital in some form often is an overriding consideration.

There are a number of options a hospital might consider when assessing a change in ownership. Basically, these options represent alternative approaches to balancing community ownership and control against the continued healthy survival of the hospital in some form. At one end of this continuum is a freestanding community hospital owned and controlled by county officials or a not-for-profit board. At the other end is the sale of such a hospital to a new owner such as a regional hospital, system or national chain. In this latter case, the "community" may have lost day-to-day ownership and control, but received something valuable in exchange, be it a new foundation or new tax revenues. Moreover, the community may also have attached conditions to the sale—such as an agreement to continue providing care to the uninsured—which ensure that the facility will continue to provide community benefits even though community ownership and control have disappeared. In between these two extremes are options such as a) a lease arrangement; b) transfer of public hospital assets to a community-controlled board; c) a joint venture; d) a subsidiary merger into a parent corporation; or e) a full merger of assets.

To assess a community hospital's options, decisionmakers must first reach agreement on the hospital's mission and what is desired from a transaction, including which community benefits now provided by the hospital should be retained. Community benefits related to access include: a) uncompensated care to uninsured or indigent patients; b) access for public patients, such as those on Medicaid; c) provision of unprofitable services such as a 24-hour physician-staffed emergency room, burn centers, trauma units, neonatal intensive care units, substance abuse treatment and AIDS clinics; d) reducing geographic barriers to access through free or low cost transportation for low income patients, or subsidized clinics in underserved areas; and e) reducing other access barriers such as language or cultural barriers to adequate care.

Community benefits related to costs include: a) greater efficiency; b) lower prices; and c) flexible billing arrangements such as not using pre-admission deposits or permitting small periodic payments, both of which may make local citizens less inhibited about using the hospital.

Community benefits related to quality/satisfaction include: a) general quality; b) medical education and research whose costs may not be fully covered by Medicare or other sources; c) other quality-related activities, such as clinical preventive services (e.g. disease screening); disease management programs (e.g., free or low cost care for those with chronic diseases); and support groups (e.g., for patients with chronic illnesses such as Alzheimer's).

Community benefits related to community health include: a) health promotion activities such as community education efforts, worksite health promotion, education programs for schoolchildren, and violence prevention; b) community needs assessment activities; and c) community development programs to improve housing or address environmental issues.

Community benefits related to economic impact include: a) local employment, including both hospital staff as well as other health-related employment; b) local purchases of supplies, equipment or capital construction needs and c) tax payments, particularly those made to the local community.

A second important step is to determine the value of the hospital, which can be done through one of three standard approaches to asset valuation: the income method, the market method or the cost method. This valuation is typically done by an independent firm and provides a benchmark that can be used in negotiating with potential buyers or partners. The valuation is intended to arrive at a minimum dollar value of the hospital and is not intended necessarily to represent the fair market value. In some cases, a hospital will seek a separate fairness opinion from another outside reviewer who documents and confirms that the valuation process produced a fair estimate from a financial point of view.

The third step is to seek out a buyer or partner. In some cases, those controlling the hospital may select a partner based on reputation and sign a letter of intent, which informs the community of the basic parameters of a transaction being contemplated. This allows the hospital owners to undertake a "due diligence" process to explore a potential partner/buyer's background in more detail and for both parties to work out details of an agreement. Confidentiality agreements may also be signed to avoid premature disclosure of details of the agreement (which may never become public), but it is very rare for a transaction to be finalized without any advance knowledge on the part of the community, the hospital staff or others affected by the transaction.

More commonly, selection of a partner/buyer occurs through a competitive process, such as a Request for Proposals (RFP) or informal "shopping" of a proposed agreement by an outside consultant. Competing bids increase the likelihood that a fair market value is paid for the hospital. An RFP can include minimum conditions designed to guarantee the continuation of specified community benefits. Typical conditions relate to the continuation of services, charity care, or guarantees against large layoffs. Hospitals may issue an RFP without specifying the nature of the transaction (lease, joint venture, sale), leaving it to the bidders to respond with a package designed to meet the desires and needs of the community as expressed in the RFP. Moreover, even after initial bids are submitted, there may be a very open process in which each party modifies their bid in response to other offers—further improving the prospects that a community will obtain fair compensation in exchange for loss of ownership or control.

In cases of bidding, the fourth step is to select a bidder/partner and negotiate the terms of the final agreement. If it has not already been done earlier in the bidding process, this stage allows for "due diligence" activities. Key elements of a final agreement include a) how equity in the converted hospital is divided, including responsibility for debt obligations; b) the cash price or lease payment amount; c) governance matters, including community representation on the board and how jurisdiction/power is divided between the old owner and new owner/partner; d) covenants or other conditions of sale, such as charity agreements, including how such covenants will be monitored and enforced.

The community also must decide what to do with the proceeds once the hospital is sold. Proceeds from the sale of a public hospital may either go into a county or city's general fund or be segregated into a special fund to be used only for health. In the case of a not-for-profit sale or joint venture, decisions must be made about a) whether a new or existing foundation should receive the charitable assets; b) the tax status of the receiving foundation (private foundation, public charity or other), as this will govern how it functions and how much must give each year; c) whether the proceeds should include only cash or also a residual equity interest in the new for-profit entity; d) the purpose or mission of a new foundation, including the geographic area served; d) governance issues, including community representation on the board and its independence from the "old" or "new" hospital; e) management issues, including selection of a foundation director and staffing/budget; f) how to assess community needs and set priorities for giving; and g) how to keep the community informed of foundation activities.

Regulatory considerations must be taken into account throughout the process. For example, what types of arrangements are feasible may be constrained by regulatory considerations, such as federal and state antitrust laws and guidelines. Nonprofit corporation law in both states requires advance notification of the Attorney General in the event of any pending lease, merger, sale or other transfer of assets. Such laws further govern how assets are valued and restrict how assets from a sale or joint venture may be used. Tax law and charitable trust law further govern what is permissible in terms of how the proceeds from the sale of a not-for-profit facility may be used. In the case of public hospitals, the process of conversion is governed by the Municipal Hospital Act in North Carolina and Freedom of Information Acts in both states.

There is no single "best" answer, which fits all communities. Whether conversion is a good idea depends on what a community wants and can get in exchange for loss of hospital ownership or control. Whether it is desirable or undesirable for a community to agree to a conversion arrangement with a for-profit company also depends entirely on local circumstances and preferences. A successful conversion is one in which the community has found a good "fit" between its needs and desires and what a prospective partner can offer. Conversion decisions are extremely important to a community, especially as they often are permanent or difficult to revoke. This guide was developed in hopes that when a community faces a choice about conversion, the owners can make a decision in the community's best long-term interests.