US health systems: Diversify to thrive

US health systems are diversifying their businesses to unlock growth and support core hospital operations, carefully choosing investment areas and structures in line with their objectives.

In a challenging economic environment coming out of the COVID-19 pandemic, US health systems are accelerating diversification strategies to participate in new, high-growth healthcare segments and to support core hospital operations. They are seeking to simultaneously diversify revenue sources outside of core hospital operations and build (or acquire) capabilities that can also benefit the core—for example, by improving patient access, quality of care, experience, and affordability.

Sidebar

We surveyed health system executives to learn more about their diversification strategies (see sidebar “Survey methodology”). More than 70 percent of survey respondents said they intend to invest more in diversification over the next three years. This article explores the reasons health system executives are pursuing diversification strategies, the areas in which they plan to invest, the structures they could use to support their diversification objectives, and considerations for effective business building.

Diversification could bolster health system performance

At present, hospitals still represent the largest profit pool in the care delivery segment; however, other care segments are growing much more quickly and are projected to capture an increasing share of industry profits (Exhibit 1). 1 Meanwhile, industry trends may present challenges for health systems as the shift to care delivery in ambulatory settings accelerates; labor and supply costs rapidly escalate in an inflationary environment; insurance coverage shifts to government plans; and risk-sharing, value-based care models continue to gain momentum. 2

Segments with the highest projected growth rates are largely outside of acute care.
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As a result of these challenging fundamentals, industry median operating EBITDA margins for not-for-profit health systems have been gradually but steadily declining, from 11.6 percent in 2012 to 8.6 percent in 2020, with no reversal in sight. 3 In fact, Moody’s has issued a negative outlook for the not-for-profit healthcare sector for 2022. 4 Nonoperating investment income had largely offset declining operating income, helping health systems carry on despite challenging operating conditions. However, as of early 2022, many health systems experienced substantial investment losses, which, when combined with rising costs, exposed the gaps in the systems’ financial performance and prompted executives to step up their diversification efforts (Exhibit 2). 5

Rising operating costs and reliance on investment income leave health systems vulnerable to economic downturns.
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Meanwhile, health systems increasingly compete against well-capitalized incumbents from other healthcare segments and other industries—including payers, private equity–backed medical groups, pharmacy benefits managers, technology companies, and other healthcare services firms—that are aggregating care delivery assets to create large healthcare ecosystems. 6 In fact, five of the largest for-profit healthcare payers have already deployed more than $120 billion of capital over the past five years on diversified assets and will likely continue to invest at an accelerated pace. 7 Notably, they have largely excluded legacy acute care from those investments. 8

In this environment, health systems executives increasingly perceive diversification as critical to their future performance and growth. The most common reasons that health systems executives cited for diversification were generating cash flow and creating value and capabilities for their core hospital business (Exhibit 3). For example, a health system could acquire a risk-bearing primary care group, thus creating better alignment with physicians and improving continuity of care for patients while also integrating administrators and supporting technology into other geographies. 9

Most health systems build diversified revenue business units to grow and create value for the core acute-care business.
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Key questions for health systems pursuing diversification strategies

Based on our experience standing up diversified growth entities in healthcare and other industries, several questions and actions can help health systems optimize the value of their diversification efforts.

Answering questions related to the strategy (the “what”) and the business infrastructure (the “how”) are early decision points that can set up the diversified business for success (Exhibit 4).

Navigating early decision points can set the business up for success.
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Innovative health systems are investing in line with their growth strategies

Health system investments in diversification typically align with three growth strategies: monetizing existing capabilities, expanding beyond acute care, and building innovation capabilities (Exhibit 5). Health system executives can then consider the specific pathways to pursue to achieve their stated objectives. To monetize their existing capabilities, for example, they could transform a cost center (such as the revenue cycle or supply chain function) into a profit center, or they could extend internally developed care models to other providers (for instance, hospital-at-home providers).

Larger systems have been building businesses across three core growth themes.
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As they pursue strategies aligned with their diversification objectives, health systems can choose among many different healthcare segments to target for investment. We explored interest in these segments in the diversification survey and overlaid the results with our 2021–25 EBITDA growth projections (Exhibit 6). 10 Indeed, executives are showing a preference for investing in the highest-growth, most profitable segments.

Telehealth, value-based care services, and ambulatory surgical centers are the most desired investment areas for health systems.
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According to the survey, telehealth and remote patient monitoring is the opportunity with the highest area of focus, with 56 percent of respondents ranking it among their top five choices, followed by value-based services (53 percent of respondents), ambulatory surgical centers (36 percent of respondents), and health plans (34 percent of respondents).

When making investment decisions, health system executives can take into account what previous McKinsey research has affirmed: top programmatic acquirers create an M&A blueprint or road map that states where and how M&A will enhance their competitive advantage. 11 In this case, for example, building a hospital shared-services platform (thereby transforming cost centers into profit centers) or offering cohesive ambulatory care services—rather than relying on episodic “big bang” transactions—is far more likely to achieve stronger performance and reduce exposure to risk. 12

Most health systems plan to use partnerships to support their diversification strategies

After determining their growth objectives, the specific strategies to pursue them, and the areas in which to invest, health systems can explore the various ways to structure their investments. At a high level, their options include external investment (for instance, making a venture investment or acquisition) or new-business building (for example, via internal innovation, codevelopment, or the monetization of existing capabilities).

Health systems that opt to make direct investments can enter at an early stage—that is, seed capital or Series A to Series C funding—to access more innovative healthcare companies via equity, thus creating strategic value, such as providing access to differentiated talent, technology, and market insights (Exhibit 7). These investments can also create financial value: the sale of equity as valuation increases and there’s future cash flow if the start-up eventually becomes profitable. Alternatively, those that aim to generate additional cash flow in the near term or defend share against disruptors typically invest in late-stage companies—Series D or buyout—to accelerate the speed-to-market of the new revenue with more predictable cash flows, thereby creating financial value.

Health systems generate value from diversification in many ways.
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Health systems that seek to create capabilities to boost their core hospital operations may invest in seed capital or Series A funding in healthcare start-ups. With an ownership share, the health system has access to products and can help shape their direction. In return, the health system creates value for the start-up by providing shared services, access to hospitals and patient populations to test and pilot products, and mentoring and coaching through access to the health system’s executives.

Sidebar

Corporate venture capital (CVC) funds are gaining favor across industries as a vehicle for housing diversification activity within large enterprises. Among Fortune 100 companies, 75 percent have an active CVC fund, and according to Silicon Valley Bank, the number of CVCs grew nearly 6.5 times between 2010 and 2020. 13 However, CVC fund performance has been mixed, and there is typically no significant relationship between CVC investments and financial outcomes. 14 Although achieving financial success with CVCs is relatively rare and takes longer to manifest than investments in the core hospital business, these funds can be beneficial for start-ups and corporate owners alike, with each enjoying access to fresh insights, collaboration opportunities, and capabilities. Ultimately, the decisions health systems make about how to structure their participation are informed by their specific financial characteristics and capabilities (see sidebar “Questions to guide investment decisions”).

Given the challenges associated with using CVCs as a diversification strategy, most health systems’ approaches to diversification have included partnerships or acquisitions, such as M&A, strategic venture investments, or codevelopment with a capital partner. In fact, 82 percent of health system executives who responded to the diversification survey expect to partner with others as they pursue their diversification strategies (Exhibit 8). Furthermore, the shift to care delivery in a variety of new settings favors participants with distinct capabilities (enhanced by greater national scale), which health systems can attain through partnerships and business building—in other words, setting up a new business consortium with multiple health systems to pursue common themes.

Systems are taking different approaches to revenue diversification, but most intend to partner with other organizations.
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However, these health systems have also outlined several guardrails, reflecting the need for a careful approach to form partnerships. Among the surveyed health system executives, 57 percent want to be majority owners, and 19 percent tend not to prioritize partnerships with private equity or venture capital (VC) firms. Beyond the need to invest within these guardrails, joint ventures (JVs) and partnerships present blind spots—for example, a rush to completion, lack of leadership continuity, declining parent involvement, and insufficient planning to respond to changes in risk profile—that health system executives can work to avoid. 15 A lack of attention to these nuances has led many efforts to fall short of expectations.

Getting started

Ultimately, revenue diversification strategies should create value for the core hospital business and the communities it serves and should support the mission, vision, and overall strategy of the health system. Health systems can consider jumpstarting their diversification efforts with a major acquisition or additional investment in internal assets, an approach taken by successful business-building organizations. 16

When choosing areas in which to invest, those with a clear path to generate value for the core (and ultimately the patients) are more likely to resonate with broader health system stakeholders, including physicians and nurses. Although the new business will likely need some support from the core (for example, shared services), delineating profit and loss between the two entities can assist with performance tracking and provide the new business with enough distance from the core to realize its goals.

Partnerships can accelerate growth and could allow health systems to tap into otherwise hard-to-access resources or expertise. However, health systems could benefit by thoughtfully considering the value they bring to the table in an effort to secure the right partners. Having clear goals and priorities will be important, but, as with any start-up, taking an agile, iterative approach and recognizing when to stay the course versus when to pivot will likely be critical.

Finally, we caution against expecting financial value prematurely; value creation typically takes time and patience. In the meantime, health systems can acknowledge the other benefits to diversification, including building capabilities to better serve patients and expanding knowledge of new markets.

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