Not-for-Profits Mergers & Acquisitions: The Case for an Outright Sale Versus a Merger

Why Merge?

Often, especially in times of economic turmoil (as has been the case since COVID), we’ll see a struggling NFP merge with a more fiscally solvent NFP to stabilize finances without disrupting the communities they serve or compromising patient care and coverage. In a related situation, NFPs sometimes merge to seek out economies of scale that often (though not always) come with size. And sometimes the NFP with a specialty in one health care segment will merge with another that specializes in a complementary service line to expand their clinical capacity.

All reasonable goals.

But not necessarily the best option for the community the NFP serves.

Right off, the economies of scale rationale is questionable. But given the length of the explanation, we’ll cover that in a special section at the end of this piece.

The other reasons are solid. So, what’s the problem?

One Plus One Equals Three

In supporting an acquisition, we often hear that due to service and operating efficiencies, “one plus one equals three.”

In truth, such M&A math is extremely elusive. In fact, sometimes one plus one doesn’t quite add up to two.

But transactions involving the outright sale of not-for-profits?

The math holds up extremely well.

Let’s explain.

But one caveat.

In order to make the case, we have to make broad generalizations based on what we have observed. While we believe that such generalizations apply to wide swaths of health care service NFPs, every provider, situation, and transaction is unique, and may not follow the succeeding script.

So, when two NFPs merge, how does the community benefit?

Do coverage areas or services provided expand?

Except in the case of a merger of two NFPs with different specialties, probably not.  

Sure, in the case of a failing provider, a merger is one option to protect access to care.

But what happens in an outright sale to a for-profit buyer?

Access to care is largely the same (more on this below). In the case of the failing provider, much like an NFP merger partner, a buyer will also stabilize the business (otherwise, why buy it?) In fact, with potentially greater access to resources, a for-profit buyer may (and we emphasize may) be more successful. 

But here’s the big difference. 

In an outright sale, the seller gets cash – sometimes a lot of cash – that can be deployed to provide new services or opportunities to benefit the community.

An addictions treatment program. 

A mental health clinic.

A grant to a local independent NFP hospital to expand their service capacity.

A grant to fund health care research.

Simply put, an outright sale provides the NFP Board with an extraordinary opportunity to not only identify needs in the community but also have the resources available to address them.

One of the first objections to this strategy that we hear is, “What about indigent care? A for-profit isn’t going to offer it.”

And you’re right. 

That’s why, in the outright sale of a not-for-profit to a for- profit provider, one option is to set aside some of the proceeds from the sale to create a special fund to cover free care.¹ A side benefit to doing this is that the buyer will now be able to serve patients that may not have qualified for traditional Medicare or Medicaid. More revenue. More profit. And potentially, a higher sale price.

“What about quality of care? It wouldn’t be the first time that, in an effort to generate more profits, quality suffers.”And you would be right again.

That’s why finding the “right” buyer will likely be equally, if not more important, than price. Buyers do have track records. Some make profit the primary objective. But others see quality of care as the pathway to winning more business, retaining staff, and by extension, growing profit.

But let’s look at the worst-case scenario where there is a decline in the quality of service provided. For example, where a buyer’s productivity initiatives compromise the amount of time a clinician can spend with a client.

Then the Board is faced with a math problem.

Is one plus one equaling 2.75, or even 2.5, better than one plus one equaling two as would likely be the result of a merger?

We’re not being flippant here.

This is not an easy decision.

But in many cases, the opportunity to provide the community with access to new and life-changing health care services outweighs a fall-off in the special – if not absolutely clinically necessary – care a not-for-profit often provides.

So…In an effort to meet fiduciary responsibilities, before reflexively pursuing a merger with another not-for-profit, shouldn’t the option of pursuing an outright sale earn at least a line item on the Board of Directors’ agenda?

The Trouble with Economies of Scale

As we alluded to above, the rationale of merging to generate economies of scale is problematic.

Because here’s the thing.

In most health care service sectors, such economies are really, really hard – and arguably almost impossible – to realize. 

Blasphemy, you say.

We get it.

But let’s explain why and offer you some proof to back up our claim.

The theory behind generating economies of scale is that once your fixed costs are covered, all of the incremental contribution margin generated in the regular course of business falls to the bottom line.

Pure Variable Costs

In health care services, contribution margin is akin to gross profit – revenues less all the direct costs incurred to generate them. Labor, supplies, travel – you know the drill. Such direct costs are close to “pure variables” in that they go up (or down) with every service rendered (or not).

Fixed and Step Variable Costs

For economies of scale to kick in meaningfully, much of the so-called G&A expenses (General and Administrative) need to be pretty “fixed.” We’re talking the ubiquitous “heat, light, and rent” as well as management, marketing, and technology expense, to name a few. The problem, however, is that in many health care service sectors, the majority of these “fixed” costs are really “step variable costs.” They may not vary directly with revenues, but they will go up once you cross a threshold (or step) of increased delivery of services.

And here, we’re talking about a substantial portion of your G&A. Namely case managers, nurse supervisors, and perhaps the biggest step variables of them all – patient intake, qualification, billing, and collections. You add enough revenue, each step variable will go up.  

In fact, in many cases, we see reverse economies of scale wherein the largest providers often need an additional level of management and oversight to operate the business without it spinning out of control. 

Now here’s the proof we teased at the beginning of this section.

Over the 380 plus health care transactions The Braff Group has completed, if we exclude companies that were under substantial duress, the profit margins of the buyer – you know, that bigger, often way bigger company that should be enjoying economies of scale – were less than the companies they bought.  In fact, one of the most common reasons buyers cite that limit purchase price multiples is that “we can’t operate the seller as efficiently as they have.”

That sound you heard was the mic dropping.

So, if the economies of scale rationale to pursue a merger is off the table, does that mean there’s nothing to consider?

Well, first off, if an NFP is seeking economies to shore up its finances, an outright sale may very well be a better option to insure long-term viability.

Moreover, even if two NFPs are fiscally solvent and are considering a combination to realize economies to generate additional resources to serve the community, we would posit that even if the economies were there, the benefit would be incremental.

But an outright sale that can fund entirely new programs and services? For the community it serves, that kind of benefit can be transformational. 

¹ Creating a “special fund” may require the establishment of another NFP or some other legal structuring to distribute funds and comply with guidelines unique to 501(c)(3) entities. Accordingly, in doing so, it’s probably a good idea to consult with an attorney. 

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