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Distressed M&A? Look toward SNFs

by contributors Jeffrey R. Manning and Jerry Shapiro, BDO | Published May 17, 2012 at 3:10 PM

Skilled nursing facilities fill a middle ground, providing care for patients who need full-time care but not hospitalization. After surviving a major hit in the late 1990s, SNFs recovered temporarily but have been on a downward spiral in recent years -- making the industry a prime target for distressed M&A activity in 2012. The first blow to SNFs came in 1999 when the Health Care Financing Administration announced a significant change in Medicare reimbursement, leading to a wave of SNF bankruptcies. Under the new reimbursement system, SNFs received fixed, predetermined rates for each day of care, as opposed to cost-based reimbursement, as under the old system. This change was followed by a period of relative stability, if not prosperity. However, prompted by a weakened economy as a result of the Great Recession, another round of massive changes in funding sources could lead to the downfall of SNFs, and there is no clear end in sight.

SNFs rely heavily on funding from government programs. Increasing costs of care in a weak economy have resulted in fewer and fewer individuals being able to meet the expenses of nursing on their own. In fact, about 85% of SNF residents depend on government funding to cover all or part of their costs. Two main programs are Medicare -- the federally funded and operated program for individuals age 65 and older, and the qualified disabled -- and Medicaid -- a state operated program for low-income and disabled individuals. Under current policy, Medicare only covers the first 100 days in an SNF. After 100 days, the responsibility falls to Medicaid, the policies of which can vary state to state. Together, Medicare and Medicaid account for nearly two-thirds of all SNF payments.

In the coming years, demand for SNFs is likely to increase as baby boomers age and managed-care organizations push to keep costs down by moving patients out of hospitals and into lower-intensity-care settings as medically appropriate.

Furthermore, the state and federal funding systems that act as SNFs' support are themselves feeling pressure. The economic downturn has created unprecedented budgetary pressures at the state and federal level. On Oct. 1 the Centers for Medicare & Medicaid Services announced an 11.1% cut in federal Medicare reimbursement rates -- a cut twice the size of the reduction that SNFs were expecting. In a field where profit margins are already narrow -- Ibisworld Inc. estimates them at about 3.3% -- this cut represents a $79 billion reduction over 10 years. As pressure continues to mount to cut costs at the state and federal level, future reductions are a definite possibility, potentially further worsening the situation. In difficult financial times, many states look towards cuts in Medicaid reimbursement to save money, directly impacting cash flow at SNFs.

These pressures leave SNFs with little choice but to shift costs to private payers (such as individuals, HMOs, insurers and self-insured employer-sponsored plans), all of whom are also feeling economic pressure and attempting to negotiate more aggressively to cut costs, often resulting in higher levels of financial responsibility being shifted to enrollees in the form of higher deductibles and coinsurance.

Other changes in government policy have also had a measurable impact on SNFs. In an attempt to reduce Medicare spending, the Balanced Budget Act Amendment of 1997 gave the states the power to mandate enrollment in managed-care plans for individuals wishing to receive Medicaid coverage for nursing home services. As managed-care plans, by definition, aim to minimize costs by negotiating reduced rates, this has resulted in lower profit margins for SNFs.

In 2010, healthcare reform legislation again increased difficulties for SNFs. The Patient Protection and Affordable Care Act is designed to promote more at-home care. As a result, patients who do end up in SNFs are often the most frail and expensive to care for.

Their dependence on government funding, which is proving to be a fickle friend, makes SNFs particularly vulnerable to changes in policy brought on by ideological shifts or financial hardship.

SNFs also face environmental challenges that make their situation significantly more difficult. In addition to the damages of direct funding cuts, industry stock prices plummeted on the news of the Medicare reimbursement cut.

The situation is further complicated by the depressed real estate market. Despite the fact that the population demographic is shifting in a way that should increase demand for SNFs, fewer and fewer individuals are able to afford long-term care -- partly as a result of seniors being unable to sell their homes and use this nest egg to pay for care. In addition, other options, such as home healthcare and retirement communities offering continuing care, are attracting a growing proportion of the population who, in the past, would have depended on SNFs.

SNF debt levels remain high. SNFs often incur uncollectible fees as nearly all unpaid Medicare co-payments to SNFs are owed by state governments, which are increasingly choosing not to pay in efforts to reduce their own budget deficits. In addition, SNFs have significant operating costs, the largest of which is employee compensation. While SNFs may attempt to reduce costs in this area, nursing is a skilled profession, and demand is high, making it increasingly difficult for SNFs to compete as an appealing employer.

As all of these factors coalesce into the financial and social environment, it is not surprising that the number of SNF companies has declined by 3.1% annually over the past five years. Further cuts in government payments could quickly result in zero or negative profitability for the industry.

There does not appear to be any happy ending on the horizon for SNFs. The already slim profitability margins of the industry combined with changes in reimbursement and mounting economic pressure could make SNFs a vulnerable target for distressed M&A in the coming years. These takeovers may be the only way for the industry to survive.

Jeffrey R. Manning is managing director of the special situations practice at BDO Capital Advisors LLC. Jerry Shapiro is a managing director at BDO Consulting Corporate Advisors LLC.

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