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Fresh options fuel lab asset reshuffle

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Anne Paxton

May 2016—Father Guido Sarducci (Don Novello), of Saturday Night Live fame, boiled college business class down to one principle in his satirical “Five Minute University”: You buy something; you sell it for more.

One can only dream of business being that simple in health care. But for laboratory, hospital, and health system executives who are weighing new business strategies for laboratory services, some would argue that the pressures of the economy, the regulatory environment, and hits to reimbursement boil down the choices to three: grow, outsource, or sell.

First of two parts. June 2016: All for one, one for all? Laboratory consolidation

There are many variations in how those choices are playing out, laboratory industry leaders say. But in CAP TODAY interviews, laboratory executives and consultants in mergers and acquisitions suggest that new business deals, whether in the form of outsourcing, mergers, management agreements, or joint ventures, are reshaping the landscape for independent and hospital-based laboratories.

“All the larger macroeconomic forces are driving change in health care—the transition from fee for service to fee for quality, bundled payments, the growth of networks, and the pressure on payers and providers to be as efficient as they can,” says Patrick Allen, managing director with the mergers and acquisitions practice of Kaufman, Hall and Associates in Skokie, Ill.

“Five or 10 years ago, health care systems and providers wanted to do any and all services they could do reasonably well, and get paid for them. I think systems are transitioning now and trying to understand what their strengths are. There’s really more of a competitive analysis.”

Allen

Allen

Much of Allen’s work involves strategizing with hospitals and hospital systems on whether, in providing laboratory services, they need to divest, or partner, or joint venture with some of the for-profit players. Some 100 health care organizations a year are now striking such deals, he says, compared with 40 or 50 a year in 2006. “We’ve seen a pretty good ramp up in the number of transactions,” he says. As to the mergers of billion-dollar-plus hospital systems, or what the Wall Street Journal has referred to as “supersizing” of hospital networks, “we’ve had more in the past three or four years than in the previous 25.”

For laboratories, a critical part of the trends is the changing role of outreach. For years, outreach has been a way of leveraging a hospital asset, says Robert DeCresce, MD, MBA, director of clinical laboratories at Chicago’s Rush University Medical Center. “Laboratories would take advantage of their underused capacity and get new business from the surrounding area, and people still want to do that. But one of the things that often happened is that the outreach programs would use their hospital provider number for billing. So a lot of insurance companies might pay the hospital significantly more for lab tests than they would pay a commercial lab, just due to the nature of the contracts they have with hospitals.”

That model has started to unravel, says Dr. DeCresce, who is the Harriet B. Borland professor and chair emeritus, Department of Pathology, Rush Medical College. “With accountable care organizations, the idea is that doctors, hospitals, and health plans are going to be responsible for the total cost of the patient encounter. So having high prices for laboratory tests doesn’t necessarily help.” (Dr. DeCresce serves on a health care roundtable at Madison Dearborn Partners, a Chicago firm that invested in Kaufman Hall last year.)

Outreach is still a profit center for many centers, Allen says, noting that for some academic medical centers, outpatient testing is done at a 100 to 125 percent markup. But patients saddled with higher-deductible plans are starting to ask how much their tests are costing. And so are insurers. “We saw this with some of our clients in Massachusetts, where insurers would say, ‘You need to get your inpatient rates closer to outpatient rates, because if tests can be done outside the hospital, we’re going to start reimbursing you at outpatient rates.’”

“Institutions committed to outreach can be successful, but the industry has changed,” says David Nichols, MBA, president of Nichols Management Group in York Harbor, Me., which provides laboratory consulting, including strategic planning, operations optimization, mergers and acquisitions, and joint ventures.

“It is not like 10 or 15 years ago, when you could make minor investments to get in the business, such as hiring a sales rep or two, buying a few courier cars, and opening two or three draw stations. Now it requires strong management to be able to execute because the margins are tighter due to reimbursement decline and it’s more difficult to thrive and compete with the national reference labs without larger investments in IT infrastructure and support functions.”

So hospitals and health systems now have a question, Dr. DeCresce says. “Do they want to keep all their business from all their doctors and do it themselves? Or should they partner with someone who is better at doing it and can do it at a lot lower cost?”

Sometimes partnerships can indeed be the answer. “If I have a big outreach business, that’s worth something to a commercial lab. They might actually buy it from me and I can have a joint venture with them,” Dr. DeCresce says. Alternatively, because reimbursement is declining, some hospital and health system executives are considering whether a third party can run their inpatient laboratories better than they do. “People are starting to think, if Quest or LabCorp can buy supplies a lot cheaper than I can and I’m sending my reference work to them anyway, maybe I should get one of them to run my labs.”

At Seattle’s Swedish Hospital, for example, LabCorp has run the laboratory on site for several years. That arrangement is a relic of LabCorp’s 2002 purchase of Dynacare Laboratories, which bought the pathology lab that serviced Swedish more than 20 years ago, says CAP TODAY publisher Robert McGonnagle. “It’s widely regarded as LabCorp’s most successful venture in this direction. And, again, many assume LabCorp would love to duplicate that in 20 metropolitan cities.”

Dr. DeCresce

Dr. DeCresce

That model is gaining more traction now, as hospitals feel more pressure on the cost side, Dr. DeCresce says. Information technology problems used to pose an obstacle to such arrangements, because it was always hard to trade data between different systems, but that problem has been largely solved, he adds. For example, “It’s not as big a problem now for Quest to send results to my Epic system.”

These factors are easing the way for increasing numbers of deals between hospitals and the national laboratories, including outright sales and joint ventures, Dr. DeCresce says. “Some people are just buying the outreach. The hospitals have an asset, and Quest and LabCorp need to grow to keep their stockholders happy. It’s becoming more and more difficult for these labs to grow, so acquiring hospital outreach business and even the entire lab business from a hospital may make some sense.”

Many similar acquisitions are in the offing. “Both LabCorp and Quest are challenged to get bigger, and what’s the biggest market in the entire U.S.? Hospital labs.” With about 67 percent of the market, the hospital laboratory business dwarfs that of all the physician offices. It’s an area, too, in which the big commercial labs have little penetration, so there’s a lot of room for them to grow there, Dr. DeCresce says.

Confronted with the make-or-buy question when it comes to laboratory services, hospitals can find infrastructure a stumbling block. At Rush, he says, “We used to have a very big outreach business, and we folded it back 15 years ago because we lost one of our biggest clients. And we really didn’t have the infrastructure in place to expand. That can include a client service, automobiles—a whole series of things that have nothing to do with running tests. And infrastructure is typically lacking at big hospitals.”

The hospitals also often have to decide: Is it better to spend $400,000 on cardiologists to bring more patients to the hospital or to spend $400,000 to fix the laboratory? “I think hospitals will focus capital on what brings patients to the hospital,” Dr. DeCresce says. “Labs are important. But the hospitals don’t necessarily have to own all of the lab to be successful.” Hospitals can avoid capital expenditure by having someone else take on their lab testing, he notes, just as other services might be outsourced.

Having acquired physician practices, “a hospital may find itself all of a sudden with such a flood of new tests, along with new technology demands and the basic organic growth of testing, that they’re faced with having to make a substantial investment in their lab operation,” McGonnagle says. “That often takes the form of building a large, expensive off-site lab with capital outlays of $15 to $40 million.”

Geisinger Health System in Pennsylvania was faced with this situation recently and opted to invest in Geisinger Medical Laboratories (see “New lab, new efficiencies: doors open at Geisinger,” CAP TODAY, July 2015, page 80). But hospitals that are thinking about such large outlays might talk with a mergers and acquisitions consultant about selling the entire lab operation. “Certainly, Quest and LabCorp are interested in purchasing the whole shebang, or they may want to operate it under a management contract,” McGonnagle says.

Both large companies have a business model that depends on growth, but a new wrinkle has surfaced. McGonnagle notes that, like all independent labs, “they’ve lost certain customers that have been acquired by systems.” The physician customers who used to make a decision in their favor may no longer be the decision-makers.

In the face of such challenges, Patrick Allen sees the large national labs as motivated to make deals on outreach business—and as creative in devising deals. “It’s really running the gamut of saying, if you want to sell it, we’ll buy it, or if you want to venture or joint partner with us in some responsible way, we’re willing to work with you on that front.”

The size of a facility or hospital network plays a key role in the decision to sell, partner, or outsource laboratory services, says David Nichols. “There are certainly economies of scale that exist. If a system is very large and they have penetrated their entire physician staff and there’s no more room to grow, it may be an opportune time to sell.”

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