1 | McKinsey & Company CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

Provider M&A: the evolving landscape

November 9, 2016

Rupal B. Malani, M.D., M.S.

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

2

Dynamics acrosshealthcare sub-

sectors

Dynamics withinhealthcare sub-

sectors

Dynamics from outside healthcare

Several forces have led to shifts in the healthcare market

SOURCE: Levin; NAIC 2013-14; Interstudy managed market surveyor, January 2015, assumes Centene/Health Netmerger, Aetna/Cigna merger, and Anthem/Cigna merger; McKinsey analysis; MPAC data

Major trends:

▪ Significant payor, provider, and PBM consolidation

▪ Increased pressure on growth and profitability

Medicare Advantage MLR

increased ~0.4% p.a. 2010-14

3 payors cover 44% of US

lives; 22 PBMdeals since

2010

▪ PE and REITs buying post-acute assets and other microtargetedprofitable healthcare players

Over $63 Btotal price of providers sold to non-provider

investors2010-2015

▪ Payors rapidly building capabi-lities outside of managed care

▪ Provider systems acquiringstrategic non-acute assets

▪ Disruptive players likeDaVita expanding scope

22 DaVita deals

disclosed since 2004

Non-acutetarget in

~20% of all hospital-led

deals

>30 deals 2010-15 with

payors acquiring non-

payors

3

Health systems are using M&A to gain scale and achieve efficiencies

SOURCE: AHA hospitals report 2013; Medicare cost report 2013

1 Weighted average share of inpatient admits across MSAs where system provides care; high = weighted avg share > 30%; moderate = weighted avgshare 15-30%; low = weighted avg share 2-15%. Excluding three very large MSAs: New York City, Chicago, and Los Angeles

10.3

8.4

Low per-MSAshare (N = 39)

High per-MSAshare (N = 11)

7.4

6.3

Low per-MSAshare (N = 39)

High per-MSAshare (N = 11)

Average share in top 50 MSAs1

Non-AMC providers operating expenses per case mix index-adjusted admission, $ thousands

AMC providers operating expenses per case mix index-adjusted admission, $ thousands

4

40 3948

4034

51

70 84

6877 70

911

29

Q2’1615

74

2005

43

06 08

34

1

40

2

50

40

07

3 2

13

62

78

86

1

09 11 14

41

79

1210

69

Strategic deals (acquirer is hospital/health system) PE deals

Hospital M&A has accelerated significantly in recent years

NOTE: Only deals involving the acquisition of a hospital or health system target are included. The acquirer was either a hospital/health system or private-equity investor (the private-equity investments were either buy-outs or add-on investments). The counts do not include joint ventures, partnerships, or deals involving specialty hospitals (e.g., behavioral, rehabilitation, or inpatient cancer facilities)

SOURCE: McKinsey analysis of Levin data

Hospital M&A activity, number of deals

5

PE investment in the provider space – 1995 to 2015

PE investment has been increasingly spread across the care continuum

87

07 08

87

61

148

11

110

09

124 128

10 1312

114

14 15

123

04 05 06

57

85

22

48

21

01

1824

12

0399 022000

9

1995 98

13

96 97

108

69

Q2’16

Practitioners5 Health plans

Hospital

OP and diagnostic facilities3Health IT1

Business/ medical support4Post-acute2

NOTE: Majority transactions are buy-out’s and add on’s but also includes growth capital, recaps, public to private etc. Does not include PE investments in pharma, medical devices, DME/HME etc.; 2015 transactions until November

1 Comprised of SaaS, EMR, enterprise software, digital health, automated workflow solutions etc; 2 Comprised of LTAC, SNF, Assisted Living and Home Health; 3 Comprises of ASC, Diagnostics/Imaging, Urgent Care, Oncology, Hospice, Behavioral and Dialysis; 4 Comprised of Physician practice management, MSOs, RCM/receivables, outsourced support services, IT consulting management, cost containment solutions and other non-clinical support services; 5 Comprised of physician practices, physician staffing and other clinical staffing

SOURCE: PreQuin; McKinsey analysis

6

Non-M&A transactions1 by type, 2010 – 2016 YTD

2032 26

48 45

9

11 15 98

16

59

2013

4132

2014

6

2012 2015

60

20162010

9

72

2011

525

114

JV PartnershipsNumber

1 Transactions include deals made on a continuum of ownership models (other than full merger oracquisition); in these models, assets could be partially owned and/or managed by one of theparties involved in the deal

SOURCE: Press search, team analysis

In addition, providers are exploring alternatives deal structures

▪ Non-M&A transactions, driven mainly by partnerships, grew over 10x from 2010 to 2016

▪ Partnerships are often struck to enhance care coordination within a region, retain and attract physicians or establish value based contracts (e.g., ACOs)

7

Size of deals, total number of facilities and acquired revenues

USD Billions

Aggregate revenues of M&A targets

Number

Total number of hospitals acquired

110

303.5x

2004 - 2009 2010 - 2015

750

350

2004-2009

+115%

2010 - 2015

145

90 +65%

2010 - 20152004 - 2009

Aggregate M&A hospital deal value has tripled

NOTE: Does not include specialty hospitals; does not include Private Equity transactions; revenue numbers are nominal (medical services CPI grew by 3% CAGR from 337 in 2005 to 476 in September 2015)

SOURCE: Levin; McKinsey analysis

USD Millions

Average revenue/hospital acquired

8

Systems with revenues over $1 billion are expanding geographically and gaining market share

CAGR, % 2007-14 CAGR, % 2007-14 CAGR, % 2007-14

2

2

3

1

-6

-3

1 Systems with zero or negative reported revenue are excluded, as well as systems with zero acute beds reported. Top market share is determined by the number of admissions.

2 The number of systems in each size category is held constant at 2014 levels to accurately show change in market share within each category3 Analysis does not include independent hospitals

Systems with $1-$5B revenues3

Systems with over $5B revenues1,3

Systems with <$1B revenues3

Number of MSAs2

Growth in top market share

# of MSAswhere #1 or #2

9

Aggregate target revenues, %2

2004 - 2010

19%

2010 - 2015

36%40%

32%

28%

45%

<$1B$1B - $5BOver $5B

Mid-size systems are increasingly becoming both acquirers and targets of M&A

2010 - 2015

16%

25%

18%

2004 - 2009

82%

59%

0%

<$1B$1B - $5BOver $5B

$39B $120B

1 Acquirers are quantified by the number of deals instead of aggregate target revenues because the latter skews the analysis in favor of larger systems (on average, they make larger acquisitions)

2 Targets are quantified by their revenues to maintain consistency with all other exhibits and analyses in this article. Targets include health systems as well as independent hospitals 3 Q2’2016 data has been annualized

248 465

Number of deals by buyer size, %1

10

11%

Religious

AMC

Other

2010 - 20151

48%

28%

2004 - 2009

24%

71%

18%

$30B $110B

AMC and faith-based systems have recently become more acquisitive with AMCs using M&A to gain in-market scale

SOURCE: Levin; McKinsey analysis

Acquisitions by system type

Aggregate target revenue, $ Billions

13Over 100 miles

50 - 100 miles 12

Under 50 miles 61 71

14

15

AMC M&A deals 2010 – 2015(N = 86)

% of total deals

11

Providers can unlock a range of value levers through scale …

Patientaccess

Capacityrationalization

Scale economies

Network strength Skilleconomies

▪ Consolidating sub-scale clinical units

▪ Consolidating ancillary functions

▪ Leveraging brand and other privileged assets

▪ Offering a broad, accessible network

Capitalefficiency

▪ Combined capital base

▪ Enhancing capital market attractiveness

▪ Enhanced value proposition to partners

▪ Combining special assets

▪ Assuming morerisk

▪ Purchasing and supply management

▪ Back office / support functions

▪ Management / overhead ▪ Clinical operations

effectiveness▪ Performance mgmt.▪ Utilization mgmt.▪ Best practice

sharingScale and skill economies key to capturing value within service lines

Scale can give broader geographic reach, supporting strategic objectives

Defensive positioning

▪ Prevent competitor from acquiring strategic assets

▪ Avoid disruption to stakeholder relationships

Opportunism

▪ Capture under-valued assets

▪ Leverage proprie-tary knowledge of market

Value potential from competitive differentiation

12

…However systems risk net value destruction in poorly executed scale strategies

Cost of coordination, safeguarding, complexity, etc.

Performance of stand-alone entities

▪ Agency issues (ambiguity over accountability, risk)

▪ Unanticipated culture challenges

Structural leverage

▪ Diversify risk and pursue broader partnerships

Scale / scopeeconomies

▪ Value through increased efficiency

Skill economies

▪ Share capabilities and build deeper specialization

Certain value destruction:Costs inherent in organizing as a multi-site provider network

Conventional wisdom:“Corporate center creates value through financial discipline and scale”

Key to value creation: Skill economies

Economies of scale / scope are enough to drive value in some deals

Value destruction, common for providers and in M&A more generally

Value creation, possible through strong strategy and distinctive execution

Impact of partnerships and M&A on value

13

More organizational complexities

Two factors may challenge M&A as a path to achieving scale

Fewer traditional synergies

▪ Traditional synergies such as back-office administration do not help realize value and only deliver marginal returns

▪ Value-creation opportunities lay in areas more difficult to capture, especially those more clinical in nature

▪ Challenges are acute when the integration involves a health system rather than a single hospital

▪ Acquirer needs to manage a range of multifaceted organizations and employ more complicated value-capture levers

As health systems grow larger and reach scale, there are two main challenges

14

Despite increase in deal activity, the provider landscaperemains fragmented

SOURCE: HealthLeaders Interstudy, Modern Healthcare, AHA 2013

If the threeannounced payordeals go through, the top five payors’ share of the commercial market will likely increase from …

In comparison, from 2010 to 2014, the top 20 health systems’ share of overall healthcare spending rose only from… 2014

61%54%

28%26%

In 75% of the top 25 MSAs, the provider landscape is still more fragmented than the payor market

15

Looking forward, pressures on growth and profitability may create an environment ripe for opportunistic acquisitions

SOURCE: SK&A Physician datafile 2008, 2010, 2013; Merritt Hawkins 2009 Review of Physician and CRNA Recruiting Incentives; McKinsey PRISM model; McKinsey Health Reform Team analysis

Regulatory

▪ Continued regulatory uncertainty with ACA

▪ Growing impact from DSH decrease and Medicare growth rate declines, growing from ~1.5 to ~4.2% EBIDA impact, 2015 to 2019

▪ Downward pressure on reimbursement from payorconsolidation, growth of narrow networks

▪ Changes to care models, including payment innovation and shift to value-based care (e.g., episodes of care, PCMH, risk sharing, etc.) requiring new skills

Payors

▪ Shift away from IP care: Each of next 3-4 years we expect 1% annual decline in IP discharges, 2-3% annual increase in OP visits

Patients

▪ Magnified competition among non-hospital providers, including those previously cooperative

▪ Disruptive players targeting profitable services; top 2 dialysis providers share increased from 70 to 85% from 2012-15

▪ MD employment by hospitals grew from 17% in 2008 to 24% in 2013

Providers

Key forces