Bridging Business & Healthcare : Healthcare Management Consultants for Dispute Resolution, Valuation & Clinical Compliance

This post addresses the issue of fair market value in connection with “buy and employ” transactions involving hospital acquisitions of physician practices. First, it’s important to understand just what fair market value is.

The most commonly used definition of fair market value is: “the price at which the property or service would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of the relevant facts..

The above definition is consistent with the Stark Law definition of fair market value and general market value, which are as follows:

Fair Market Value: “The value in arm’s length transactions, consistent with the general market value.”

General Market Value: “The price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.” (Federal Register / Vol. 69, No. 59 / Friday, March 26, 2004 / Rules and Regulations)

Key components of the above definitions are:

1. willing buyers and sellers (i.e. as opposed to specific buyers and sellers),
2. no compulsion,
3. reasonable knowledge of the relevant facts by both parties, and
4. without consideration of one party’s ability to generate business for the other (note: the obvious concern here is that a hospital might overpay for the practice in return for referrals from the physicians).

A similar issue is that fair market value does not take into consideration any potential synergies or other benefits that a particular buyer (i.e. hospital) might be able to achieve post acquisition (such as higher volume or reimbursement rates). Consideration of such synergies would generally change the standard of value from fair market value to investment value. This is often a challenging issue for physicians to grasp and accept because they understand that such synergies often do exist.  

Another challenging issue is when the practice being acquired has significant technical revenue (such as diagnostic testing equipment or a cath lab). In such cases, the technical revenue and expenses will generally need to be separated from the professional components of the practice for purposes of estimating future cash flows and accurately determining fair market value.  

In summary, physician practices come in a wide variety of shapes and sizes. Some are small/single specialty practices that primarily depend upon the reputation and goodwill of the individual physician, and others are large /multi-specialty practices with significant technical revenue and enterprise goodwill. To put it another way, some practices are merely extensions of the individual physicians and have little or no intangible value as standalone enterprises and others have substantial intangible value.

For more information about buy and employee transactions see the first two posts in this series.

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Friday brought about a bit of good news for cardiologists. The Centers for Medicare and Medicaid Services (CMS) released a technical correction to the Physician Fee Schedule resulting in significant increases in fees for cardiac CT, cardiac catheterization and myocardial perfusion imaging procedures. Jack Lewin provides this summary of the corrections.

This change does not completely right the ship for cardiology services, but it may slow down the rush to employment. It certainly will have a positive impact on valuation of cardiology practices that have a significant volume of ancillary services.

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I read a few interesting articles regarding planned expansions by the nation’s largest retail pharmacies in Business Week and this one in Health Leaders. CVS, Walgreens and Wal-Mart have all announced plans to greatly expand their in-store clinics in anticipation of primary care shortages due to healthcare reform and the increase in the number of Americans with insurance coverage.

While the clinics themselves do not typically generate a profit, the additional foot traffic will likely improve profits for retail pharmacies resulting in increases in their value. It will be interesting to see if the regional and local pharmacies (to the extent these still exist) follow suit resulting in an overall upward movement in acquisition multiples for pharmacies across the nation.

For those of us involved in the healthcare valuation industry, we will need to keep this shift in operations and its potential impact on the valuation of not only pharmacies, but also on primary care practices in mind.

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We are  frequently asked to value ASCs and comment on “typical” multiples of EBITDA for ASC transactions. As those in the industry know, the value of an ASC is highly dependent on the procedure mix, with some procedures much more lucrative than others. This variability makes quoting a “typical” multiple of EBITDA tricky and a somewhat dangerous proposition.

An interesting article on the Becker’s ASC Review website discusses multiples in three different tiers, based on the risk characteristics of the ASC.

While I would be hesitant to quote a specific multiple of EBITDA based on the Becker guidance,  I believe it does provide an interesting framework to see where your specific ASC might fall. In the final analysis, three primary factors drive the value in the ASC setting:

1. Procedure mix
2. Payor mix and managed care contracting leverage
3. Medical supply expense management.

If you perform well in these three areas, you can expect your ASC to sell at multiples at the higher end of the ranges expressed in the Becker article. 

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As mentioned in my last post, hospitals are increasingly buying physician practices and then entering into productivity based employment arrangements with the individual physicians. These buy and employ transactions generally make good business sense for both the hospital and physician(s) but also include certain risks – especially for the hospital. Accordingly, an appropriately structured “buyer’s side” due diligence engagement can be an effective way to minimize those risks.

Buyer’s side due diligence is generally focused on the assets being acquired and liabilities assumed - including those not directly reflected on the balance sheet. Additionally, some level of due diligence regarding practice operations is also helpful for purposes of identifying future operating risks and/or opportunities for improvement. Such due diligence can vary substantially depending on the circumstances. For example, large physician practices with multiple offices and substantial ancillary revenue will generally require more in-depth due diligence than small practices with no ancillary revenue. Accordingly, each due diligence engagement will vary depending upon the particular facts and circumstances of the practice.

Although most physician practice acquisitions are structured as asset purchases with representations and warranties from the seller, appropriate buyer’s side due diligence will assist with identifying and minimizing the hospital’s risk associated with the transaction. Such risks are not only from a financial “benefit of the bargain” standpoint but also from a regulatory compliance perspective as well; since paying more than fair market value for the practice could result in penalties or sanctions under the Stark law and/or Anti-Kickback Statute.

For more information regarding buyer’s side due diligence in connection with hospital acquisitions of physician practices, see my article “Financial Due Diligence Issues in Connection with Hospital Acquisitions of Physician Practices.” 

Also, you may view the Buyer’s Side Due Diligence Checklist - Hospital Acquisitions of Physician Practices below, or you may download the PDF of the checklist here.

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Over the past several years, our firm has experienced a tremendous increase in the demand for fair market value assessments of physician compensation.  Because of recent governmental interest, an interesting offshoot of this work has developed involving whether the underlying arrangements are “commercially reasonable.” 

We have followed recent litigation and regulatory opinions [PDF], focusing almost exclusively on the commercial reasonableness of arrangements and not necessarily the value of the dollars exchanged. In one instance, the government challenged a hospital’s medical director agreement is not based on value but on the fact that the hospital did not need various separate medical directors given its circumstances. [PDF]

Because of these developments, we began to take a closer look at our clients’ physician-hospital arrangements. Simply because these arrangements may result in fair market value dollars does not indicate that they are commercially reasonable. We have encountered several examples:

• A hospital paying a cardiologist specialty compensation rates for administrative work requiring only a primary care physician;
• A health system maintaining medical director agreements at two of its facilities which contained duplicative protocols and policy responsibilities; and,
• A hospital failing to maintain proper oversight of the effectiveness and necessity of its physician services arrangements.

In each of these situations, we could easily determine fair market value rates given the specific facts and circumstances provided by our clients. But in calculating a fair market value rate, we were assessing the range of dollars only and not necessarily questioning the overall reasonableness of the arrangement. Healthcare entities should be careful of this pitfall, given that failure to ensure reasonableness may invoke liability under the False Claims Act.

Because the government has recently focused on this issue, we are starting to rethink how our clients can ensure that their arrangements meet the standard of commercially reasonable. Determining reasonableness may require our clients to consider a broad range of facts, and we have constructed a five-part analysis to help simplify the process. These clients have already begun to use this analysis including detailed discussions with legal counsel or as part of existing fair market value assessments. In our experience with commercial reasonableness evaluations, a carefully organized analysis becomes manageable even among complex circumstances. PYA's complete five-part analysis includes the following components:

1. business purpose analysis
   
2. provider analysis
   
3. facility analysis
   
4. resource analysis
   
5. independence and oversight analysis

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Hospitals are increasingly entering into “buy and employ” transactions with key physicians as part of their strategy to provide high quality patient care and grow market share. This buy and employ model is where the hospital acquires the medical practice and then employs the physician(s) – generally under some type of productivity based compensation arrangement. Although these transactions often make good business sense for both the hospital and physician(s), there are a number of important issues that must first be addressed in order to successfully achieve the desired outcomes. Some of the more significant issues include:

1. Structuring the deal
2. Performing financial and operational due diligence
3. Determining the “fair market” value of the physician’s practice
4. Assuring the transaction is commercially reasonable to the hospital
5. Structuring the physician’s post acquisition employment arrangement

Deal Structure

Of the above list of issues, the deal structure will normally be the simplest with which to “deal.”  Generally speaking, acquisition transactions are structured as either “stock” (i.e. equity) or “asset” transactions. With stock transactions, the acquiring hospital buys the outstanding shares of the practice entity and gets everything owned or owed by it (known or unknown); whereas, with assets transactions, the buyer acquires only agreed upon assets and assumes only agreed upon liabilities.

Sellers normally prefer stock transactions due to the tax benefits (capital stock is considered a capital asset subject to the 15% capital gains tax as opposed to the much higher ordinary income tax rates that would likely apply to the underlying assets). Buyers on the other hand usually prefer asset transactions because 1) there is usually less risk of inheriting undisclosed/unknown liabilities of the seller, and 2) the ability to “step up” the tax basis in the underlying assets for future depreciation purposes.  

However, aside from these general preferences, the ultimate deal structure will be significantly influenced by the organizational structure of the acquiring hospital and physician practice. For example, if the acquiring hospital is organized as a non-profit entity, it probably won’t be very concerned about the additional depreciation deductions available from the stepped up tax basis of the assets, and therefore may be more willing to do a stock deal.

Another concern from the physician practice perspective is the possibility of double taxation that can result from asset transactions when the practice is organized as a corporation.  Asset acquisitions, in such cases, should generally be structured such that the hospital acquires only certain assets (e.g. the tangible fixed assets). The physicians would retain the remaining assets (including accounts receivable) and, to the extent possible, distribute the net proceeds as compensation.   

Obviously, there are many other factors that will need to be considered in connection with structuring the transaction; however, the point is that the deal structure can have a significant impact on the ultimate outcomes from the transaction, and therefore, should be planned accordingly.

We’ll take a closer look at the other issues over the next several posts.

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