Hospitals Choosing to Join Networks Instead of Merging

Health care's tectonic plates are shifting. Despite persistent predictions of a merger stampede, a growing number of hospitals and health systems are moving in a fundamentally different direction. They are seeking the benefits of combined effort without giving up ownership. Quietly but pervasively, a shift toward new structures, not based on consolidation of assets, is occurring. Major efforts are under way among providers in several states, including Colorado, Georgia, Iowa, Missouri, North Carolina, South Carolina, Tennessee and Wisconsin. These models are emerging under a variety of such labels as alliances, affiliations, collaboratives and cooperatives. All are variations on network organizations.

The Future of the Merger Model

The shift to network models may reflect a growing recognition that mergers often fail to deliver their promised benefits. The rationales for mergers are frequently spurious and the obstacles understated. Chief among the benefits touted is the promise of economies of scale. Economies of scale derive from a fall in unit costs as volumes grow. But such efficiencies are invariably proximity-based. In other words, production, be it of a tangible product or an intangible service, must be concentrated in locations that are sufficiently proximate to one another for the economies to take effect.

The opportunities to concentrate volume through merger are relatively rare in health care. A situation in which concentration of volume might be possible would involve two hospitals located across the street from one another. In such a case, one of the hospitals could be closed and its volume shifted to the other. Alternatively, service lines, as opposed to entire institutions, might be consolidated. For example, obstetrics could be closed at one hospital and utilization moved across the street, so one obstetrics program would replace what had been two. But such across-the-street opportunities are fairly scarce, and where they exist they already have been exploited. Growing Federal Trade Commission concerns regarding pricing leverage of such deals has heightened their risk.

Another frequently touted rationale for merger is access to capital. This, too, is often an illusionary benefit. When the arguments are made for the deal, attention is invariably directed to the total asset base of the acquiring organization. Missing is the simple arithmetic necessary to determine what capital might realistically be available to an acquired or merged organization. There are many examples of hospitals that have joined a multihospital system with an impressive asset base only to find themselves in a queue, along with the other hospitals in the system, lobbying for a share of capital. In some cases, these hospitals might have generated more capital if they had remained independent.

Another argument for mergers has been savings associated with consolidating administrative functions. These opportunities do indeed exist, but it's important to recognize that administrative overhead averages about 15 percent of total operating expenses for a hospital, so the opportunity for savings is limited to some percentage of 15 percent. There are also inefficiencies often associated with such consolidation, including time and travel for executives to attend "system meetings." While the savings opportunities are limited, administrative consolidation requires a significant amount of time to put together and manage.

Mergers consume energy for a variety of reasons, including the reallocation of authority and designing new organizational structures. While there are many distractions for the executive team, the rest of the organization experiences tremendous ambiguity and anxiety as employees speculate on how changes will affect them.

It is not unusual for hospitals and health systems involved in mergers to become essentially paralyzed as they focus on the deal. Mergers cause organizational attention to focus inward. External threats are ignored and opportunities slip away.

In addition, there are considerable legal and financial requirements associated with mergers. The cost of even a relatively straightforward merger is likely to exceed several million dollars. Those are dollars that could have been invested in other important strategic initiatives. And such direct expenses don't include the difficult-to-define but considerable costs of opportunities forgone.

Then there's the high potential for failure. Failure can occur during the efforts to consummate the merger or after the deal is signed. There are numerous examples of hospital mergers that have blown up on the runway. Of even greater concern are the costs of mergers that fail after they are closed, then end in dissolution. Finally, there are mergers that stick but underperform, perhaps failing to recover even the cost of the transaction while not delivering the strategic advantages promised. Indeed, most studies of mergers suggest that they either add little or destroy value.

In health care, many merged models have continued to operate more as holding companies than unified enterprises. Not surprisingly, they often generate little differentiated value beyond what they demonstrated prior to being brought under common ownership. Thus, they are increasingly recognized for what they are: empty vessels connected by meaningless brand identities.

The problem with the merger model was the problem with dinosaurs and extinction. Mate two dinosaurs and you get more dinosaurs. If the parents weren't well-fitted to their environments, the offspring are just as likely to be misfits not long for the world.

Other Forces Favoring a Shift to Networks

Besides skepticism regarding mergers, there are other forces behind a shift toward networks. In some markets, there are fully owned health systems that have achieved enough value-added integration and geographic influence to cause independent hospitals and health systems to recognize the need for some sort of unified competitive response.

Then there is the inexorable pressure to lower the cost of care. This pressure probably would have led to the emergence of new organizational relationships and structures regardless, but the reimbursement reductions designed into health care reform certainly have served as a catalyst.

And for those who have committed themselves to the accountable care organization model set forth by the Accountable Care Act, a network model can provide a workable approach by linking providers across a significant geography. Additionally, reimbursement targeted to populations rather than individual encounters has created a recognition that sustainability may depend on geographic reach beyond what a single health system can deliver.

Finally, the infrastructure necessary to support integrated care and responsiveness to health care reform requires significant investment that can provide an adequate return on investment only if it is amortized across a broader operating base.

Characteristics of Emerging Networks

The emerging network organizations in health care tend to share some common characteristics. They:

• seek to reduce the unit cost of care for the participating organizations;
• stop short of combining overall ownership of assets;
• attempt to avoid re-creating the wheel when it comes to deploying strategic initiatives;
• amortize experience and capabilities for multiple organizations;
• recognize and leverage the unique capabilities the participating organizations embody;
• pursue collaborative leadership in which executives, physicians and managers from participating organizations work together as relative equals

The Network Advantage

Network organizations may at first look like a compromise when compared with ownership-based models. In fact, they embody in their looser structure the potential for greater long-term sustainability.

In his book New Rules for the New Economy, Kevin Kelly describes the inherent power of a network: "Mathematics says the sum value of a network increases as the square of the number of members. In other words, as the number of nodes in a network increases arithmetically, the value of the network increases exponentially. Adding a few more members can dramatically increase the value for all members.

"This amazing boom is not hard to visualize. Take four acquaintances; there are 12 distinct one-to-one friendships among them. If we add a fifth friend to the group, the friendship network increases to 20 different relations; 6 friends makes 30 connections; 7 makes 42. As the number of members goes beyond 10, the total number of relationships among the friends escalates rapidly. When the number of people (n) involved is large, the total number of connections can be approximated as simply n x n, or n2."

The network is the shape of things that last. Multiple connections per node reduce the risk of a breakdown because they diversify inputs and outputs. Multiple organizations bring a network the potential for a healthy mix of capabilities, experience and talent. The principle of diversification suggests that an organization connected, no matter how tightly, to just one other organization is at greater risk than an organization connected to many organizations on some meaningful basis.

Such vulnerability becomes clearer when the connections reflect "dependence." If one organization or connection among many in a network fails, that network is less likely to fail because it is dependent on more than just a couple organizations. However, if an organization is dependent on just one other organization and that organization fails, dependence turns into liability. If one partner to a merger fails, it can clearly compromise the other. Thus, the position of a strong merger partner can be diluted to benefit a weak partner.

Economies of Connection

Rather than economies of scale, it is economies of connection that give networks their power. Economies of connection are not proximity-based nor do they rely on concentration of volume to generate efficiencies. Instead, their volume and efficiency are widely spread across many distributed nodes. While the volume per node may be relatively small, the volume from all the nodes is often substantial; much more volume is generated than might be effectively concentrated in a single node.

In an organizational network, the node can be an institution, a group, a team or an individual. The connections are phone calls, Internet interchanges, video links and so on, not to mention person-to-person encounters.

There is usually infrastructure needed to support a network, but the cost of such infrastructure can be so widely amortized that it becomes remarkably affordable on a per participant basis. The Internet is often used to demonstrate the power and value of economies of connection. There are many billions of dollars worth of hardware and software supporting the Internet, but because so many nodes are connected to and through that infrastructure, the cost per node becomes negligible. As a result, individuals and small groups with little capital are able to accomplish what only a well-funded corporation might have been able to accomplish in the past.

Amortization of financial expenditures, talent and time are as applicable to networks as they are to consolidated ownership models. Such an amortization advantage can be achieved without ownership — through agreements and contracts. If consolidated ownership is a vehicle for anything, it is for consolidated control. Underlying a desire for consolidated control is an assumption that it yields greater unity of leadership and efficiency. But both advantages often prove illusionary in practice. As anyone who has spent time working in organizations characterized by consolidated ownership and control can attest, they are perfectly capable of disjointed leadership and inefficiency.

Most discussions of amortization center on spreading the cost of hard assets (e.g., facilities). But the benefits of amortizing the costs of soft assets may be even greater. Among these soft assets is market positioning reinforced by expenditures on advertising and branding, the benefits and costs of which can be spread across network participants.

Finally, economies of connection yield "increasing returns." In economies of scale, the more of a product you produce, the more efficient you become. Small efforts yield small results while large efforts yield large results. Returns derived from economies of scale are generated in a gradual, linear fashion. But the increasing returns that result from economies of connection are exponential. While the benefits of economies of scale are constrained to a single organization, the increasing returns from economies of connection are captured across all the nodes in the network, thus enhancing the competitiveness of the network overall.

Network Emergence

Networks aren't designed. Where there is a compelling purpose, networks can be counted on to gradually emerge, self-organize toward productivity, then dissipate like morning mist when they no longer deliver sufficient value.

While networks may emerge naturally and self-organize, they sometimes need help to deliver their full value. Networks grow vigorously once they are able to benefit from standardization. It's helpful to think of America's railroads that didn't weave into a high-value network until the gauge of their tracks was standardized. Likewise, the Internet didn't explode until computer operating systems and hardware reached a sufficient level of standardization. Standardization can emerge naturally in networks, but the process can be accelerated if network architects intentionally design it.

Another phenomenon of networks must be considered. They appear to have size and volume limits beyond which they can freeze up. Put in too many nodes or too much information, and a network can jam. But it's also likely that networks are self-healing. In other words, they unfreeze when some nodes fall off or information flow declines.

Of course, the networks emerging in health care don't consist of thousands or even hundreds of institutions — they include, perhaps, a dozen institutions. Still, the math is impressive: 52 equals 25; as suggested earlier, in merged organizations 1 plus 1 too often equals 1½ or maybe even just 0.80 because of distractions, lost opportunities, conflicts and bad chemistry.

But the key consideration really isn't institutional networks. The number of institutions in the network is really quite irrelevant. What matters is the number of people comprising the institutions. So if each hospital in a seven-hospital network employs on average 2,500 people — the relevant number is 2,5002 — well, you do the math.

High-Potential Network Opportunities

In health care, the emergent network of greatest importance will be composed not of hospitals but of physicians. The value of a hospital or health system will be more about the number of aligned physicians in its network than the dollars invested in buildings or parked in reserves.

Moody's and other rating agencies have expressed growing concern about the losses associated with the number of physicians employed by hospitals. This concern is tied to the subsidies paid to sustain physician compensation at preemployment levels in an environment where there is continuing downward pressure on reimbursement as well as rising expenses. It is common knowledge, of course, that such losses don't take into account offsetting revenues from direct hospital utilization by the patients of the "subsidized" physicians nor do they reflect the utilization derived from referrals to specialists or downstream revenues from ancillaries.

More importantly, Moody's doesn't take into account the potential value of an assembled network of physicians benefiting from economies of connection. However, Moody's is right not to assign value to these networks because, in truth, they have yet to fully develop.

Networks need something to emerge around. They need to know what the few things are they'll be tight about. These few nonnegotiable things are like the sand in the oyster. They provide a nexus around which the network can selforganize and become valuable. If networks can decide what they will be exceedingly tight about, they are likely to find they can be loose about the rest. Critical to the development of powerful and sustainable networks will be determination of the best opportunities for collaboration. Among the opportunities for network tightness that stand out are FTC-compliant clinically integrated networks, telehealth networks and regional information systems.

Clinically integrated networks. For a growing number of hospitals and health systems that are considering a meaningful integration of hospital-employed and independent physicians, creating an FTC-compliant CIN has become the logical next step. This arrangement allows independent physicians to enjoy the legal protections otherwise afforded only to physicians employed under a single organizational umbrella. A CIN is a complex, time-consuming and expensive undertaking in no small part because of the obvious need to engage physicians and cultivate their commitment.

According to advisory letters from the FTC, a set of criteria has solidified; physicians must meet them in order to operate legally as a CIN. These include:

• systems and programs to improve value, including quality and efficiency;
• selective participation of physicians;
• representation of most specialties;
• consistent practice standards;
• shared information systems;
• measurement and evaluation of results;
• shared investment;
• nonexclusivity in contracting;
• central oversight and control.

Much discussion regarding the formation of CINs understandably focuses on legal and regulatory concerns. But there are other considerations that may figure more forcefully on the success of these ventures. These fall within the broad arena of differentiation. Networks of physicians and their hospitals will be compelled to demonstrate superior value. They will need to demonstrate better performance on the various components of the value equation — including quality, safety, access, satisfaction and resource use.

Creating awareness and preference for a difference that matters will be essential. In other words, a sustainable CIN will require marketing, including branding and advertising. But most importantly, it will require a significant number of physicians connected to relevant markets and geographies. In other words, it will require economies of connection.

Telehealth networks. Another potentially high-return undertaking well-suited to networks is telehealth. Whether the market served is rural or urban, time is a driver of value for patients and their physicians. Giving this opportunity velocity is the intensifying need to get the right care to the right patient at the right time and at the lowest cost.

Time spent by patients driving to specialists contributes nothing to quality and safety of care. It certainly doesn't contribute to patient satisfaction. And it's expensive. Even more expensive is the option of having physicians drive to see patients. Such patterns of delivering care are indefensible in the face of growing evidence that many forms of high-quality care can be delivered more affordably and expediently by electronic means.

Telehealth allows providers of care to move clinical capability to populations rather than expecting populations to travel to centers of clinical capability. The advent of less expensive, faster and higher-definition technology combined with a growing experience base across an increasingly dense set of connections has telehealth poised for explosive growth. Expanded reimbursement will add fuel to the fire. 

Telehealth already has demonstrated its value for a variety of applications including strokes, high-risk obstetrics and psychiatric care as well as a wide range of preventive and counseling services. Use of telehealth is expanding rapidly to include applications like dermatology, cardiology and rehab as well as pre- and postsurgical care. Real-time monitoring of patients is also growing in prevalence, as are physician-to-physician consultations. Electronic intensive care units are another form of telemedicine benefiting from network connections.

Regional information systems. Yet another high-potential opportunity for network organizations are regional health information organizations. RHIOs deliver standardized health information for a network of providers such as test results, lab reports, radiology results, medication history, insurance eligibility and more. Like telehealth, RHIOs have been stunted by inadequate funding. The need to manage the health of entire populations distributed across geographic regions likely will breathe new life into these webs of information. In 2009, there were close to 200 RHIOs under development and at least 50 were actively exchanging data.

More than 70 health care organizations in 13 counties of the greater Rochester, New York, region exchange patient information through the Rochester RHIO. A population of 850,000 patients have signed consent forms allowing their doctors to provide medical information to the RHIO. A study published in March 2014 by Weill Cornell Medical College has found that physicians and health care professionals who accessed patient information on the Rochester RHIO were more able to avoid unnecessary hospitalizations.

Helping to Support Network Development and Sustainability

As has been suggested, networks are capable of emerging and self-organizing without help, particularly when their purpose is sufficiently compelling. But they can benefit from some facilitation to catalyze and accelerate their development, most notably in setting standards and focusing attention on high-potential opportunities. From a structural standpoint, it may be appropriate to consider the formation of a joint operating company in which collaborative efforts will be focused, co-directed and potentially co-owned. Such a structure can preserve the independence of the participants in the network while facilitating and supporting active commitment, collaboration and coordination within the network.

If they choose to facilitate network formation, leaders will have to operate in two parallel worlds, the traditional hierarchy and the emergent network. Hospitals and health systems operate as hierarchies and appropriately so. But networks require an approach of equality among leaders. It doesn't really matter how many beds you have or what your asset base is. It will, however, matter how many physicians you can bring into a network in meaningful fashion. And that will require a mix of seemingly paradoxical methods.

In his book Wiki Management, Rod Collins captures the characteristics required to operate simultaneously in a hierarchical organization and a network organization. It's not a question of either/or but both:

One final observation related to network organizations is that they generally demonstrate a tendency to solidify over time. It can be difficult for new members to assimilate into a network once it has become established. There is, in other words, a likely advantage for early movers who join while the network is still emerging and self-organizing. If network organizations are the wave of the future, it may make sense to catch the wave soon.

Dan Beckham is the president of The Beckham Co., a strategic consulting firm based in Bluffton, S.C. He is also a regular contributor to H&HN Daily.