Feature / Under the microscope

Careful, close attention to due diligence is vital in the transfer of community services to new host organisations, says KPMG’s Piers Ricketts

The Liberating the NHS white paper confirmed the requirement for all primary care trusts to divest provision of community services by 1 April 2011. This represents an extremely tight deadline for completing up to 152 major corporate transactions in the NHS, involving services worth about £8.5bn a year.

These transactions are an essential part of achieving fuller separation of provision from commissioning, a process started under the last government’s transforming community services (TCS) initiative. However, more tangible benefits include increasing the range and quality of services for patients and leveraging the acquirer’s cost base over a higher level of income. Primary care trusts, as the ‘vendors’ in these transactions, have a duty to ensure their provider arm is being ‘sold’ to the organisation most likely to realise these benefits.

But achieving the benefits in practice will be difficult unless proper preparation is undertaken at an early stage. This is why extensive due diligence and integration planning are so important. By understanding the baseline of the organisation being acquired and producing a robust plan for the achievement of synergies, organisations will maximise the chance of improving value.

There are parallels here in the private sector, where KPMG has periodically carried out research into the success of corporate mergers and acquisitions across all industry sectors. In our most recent survey, All to play for, 73% of deals failed to enhance value, while 39% actually destroyed value as a result of:

• Lack of adequate post-deal integration planning, or starting the planning too late
• Failure to realise synergy and performance improvement targets
• Differences in organisational culture, with 80% of companies not well prepared to handle this challenge.

Many of these failings should have been avoided by carrying out more focused due diligence and integration planning prior to completion of the deals. These lessons are equally applicable to TCS.

So how do you plan and execute a TCS deal successfully? There is plenty of guidance, notably in Monitor’s Transforming community services: transactions guidance for NHS foundation trusts. But in short, the work required to complete a transaction falls into three stages – planning, evaluation and completion.

1: Transaction planning

For acquirers, this first stage starts with setting your overall clinical and corporate strategy and considering whether a major acquisition is needed to achieve the overall aims. Once a ‘target’ for merger or acquisition has been identified, pre-deal evaluation of available information should begin.

With PCT provider arms, this may initially be only publicly available information because of concerns over confidentiality with unsuccessful bidders. A PCT, as vendor, will need to establish the criteria for selecting bidders and then start to gather the information bidders will require. The criteria should be aligned to the health needs and desired health outcomes for the patch. The bulk of this work – on both sides – should have now been undertaken for the majority of TCS transactions.

2: Transaction evaluation – due diligence and integration planning

This is the stage most organisations have already reached. The design of the competitive bid process will vary from one PCT to another but, as a general rule, bidders will have to produce more detailed submissions as the process continues, specifying how they plan to improve community services while also reducing costs. Due diligence and integration planning are required to inform these submissions.

2a: Due diligence

Due diligence is the term given to the detailed inquiry into the target’s books to inform the acquirer’s decision on whether or not to commit to the transaction. Many NHS trust and foundation trust executives and non-executives will be familiar with the term through the assessment work undertaken on their organisations by Monitor and the accounting firms as part of the FT application process. The two due diligence processes and objectives within FT application and TCS transactions are similar – namely, to understand the financial and operational baseline of the applicant FT or the provider arm. Indeed, much of the information required will be similar.

The obvious difference is that, in an FT application, the objective is for Monitor to understand whether an applicant is financially sustainable and well-governed. With a TCS transaction, the acquirer needs to understand whether the acquisition will help to create a sustainable improvement in the quality of care it provides, with at least no adverse impact on its own finances.

Early on in the transaction, acquirers will need to consider the extent to which they use professional advisers. As Monitor makes clear, early engagement is advised, since advisers can help to make sure that the work addresses the most likely risks. But the detailed due diligence is where the bulk of the advisers’ work is traditionally done. While there is no legal or regulatory requirement to retain professional advisers, the complexity and materiality of many TCS transactions is such that, without them, executive teams are unlikely to be able to convince their boards and stakeholders they have adequately assessed and planned for the key risks.

The due diligence work should be designed to achieve an understanding of the drivers of the target’s historical and current operational performance. This will enable receiving organisations to build a baseline view of the provider arm, which can then be used as the basis for financial modeling and synergy calculations. The scope of due diligence on a TCS transaction is likely to include:

• Analysing normalised or recurrent earnings compared with EBITDA/surplus/deficit
• Commentary on the key risks and opportunities arising from financial projections and discussion of potential mitigating actions
• Key operational and clinical issues and trends in KPIs and how they are reported
• Understanding commissioner intentions (and who the commissioners will be in future)
• Extent of non-clinical services to transfer – estates, IT, payroll and finance and so on
• Service quality indicators
• Staff metrics such as turnover, productivity and use of agency staff
• Nature of any assets to transfer – for instance, IT systems and real estate.

For PCT management teams, who need to compile the information to inform the above, this may present an onerous task, as operating metrics are not generally as well developed for community health services as they are in, say, acute trusts. This may require bidders to be pragmatic about the scope of work they undertake – levels of due diligence should always be adjusted to be consistent with the amount of information available.

Acquirers can then seek protection against some of the key risks, notably any pre-existing liabilities at the transaction date, by attempting to negotiate changes to the sale and purchase agreement (transfer agreement) or particular aspects of it – through warranties and (preferably) indemnities.

2b: Detailed separation and integration planning

With due diligence under way, the detailed integration planning needs to begin, covering:

• Separation planning for the provider arm from the PCT – identify the ‘touch points’ between the two entities as these are more complex than is often realised early on.
• Synergy assessment – this should feed the business plans and the financial modelling for the deal and covers:
  • clinical synergies (including pathway redesign)
  • clinical support functions such as diagnostics, medical waste, catering and cleaning
  • back office functions, including estates, IT, human resources and finance – acquiring organisations should aim to remove 20% of the combined back office cost base
  • a realistic assessment of the one-off costs needed to deliver the savings and the phasing impact of the cashflows.
• A 100-day plan, which covers the actions the successful acquirer will take during the first 100 days post-completion. This is essential to lay the ground for longer term integration success and will require:
  • day-one plan for taking control, service continuity and managing clinical risks
  • a good view of future combined vision and operating model
  • joint working, with robust governance and executive sponsorship.

In addition, communication across managers and staff at all levels within the two organisations will be of paramount importance during this process.

3: Transaction completion

This section includes the final commercial negotiations, signature of the sale and the purchase agreement and service level agreements signed between the enlarged provider organisation with the PCT and/or third-party providers for the provision of (generally) back office services.

The following is a list of the key lessons learned from KPMG’s involvement in these transactions:

• What is the deal being offered – what are the commercial terms over cost reduction and the services to be taken on?
• What is the commissioner’s strategy going forward – and, indeed, who is the commissioner?
• Is the provider arm genuinely ready for separation?
• What is the estates proposition? Will the acquirer have the flexibility to rationalise the estate?
• Quality of information is generally poor or undeveloped. This includes a lack of the financial forecasts essential both to assess financial viability and to plan synergies.
• Output/productivity metrics not measured accurately or well understood.
• Clinical synergies and integration plans are often under-developed – detail required and time taken to prepare is often underestimated.

These are frequently complex issues and the financial outlook for the NHS has added a layer of tension to negotiations between acquirers and vendors. In these circumstances, effective project management from both sides is essential to complete the deal in the timescale. Only organisations that have addressed these issues early on will be in a position to reap the rewards from April 2011.