Zeroing in on the value drivers in healthcare: What’s
hot, what’s not, and what’s going to pot
Part 1 of 2 (View Part 2)
By Don Barbo, CPA/ABV, Hill Schwartz Spilker Keller, LLC
Carol
Carden, CPA/ABV, ValuePoint Consulting Group, LLC
Mark
Dietrich, CPA/ABV, Dietrich & Wilson
Members of the Financial Consulting Group
Published in Shannon Pratt's Business Valuation Update, January
2006
Conditions in the market drive the value of a given business.
At different times, different types of businesses are “hot” and
command higher valuation multiples than others. Sometimes, however,
market prices lag knowledge of changes in the underlying facts
of a market; and, in healthcare, reporting of transactions often
lags the current market conditions.
In this article, we highlight the current state of a wide range
of healthcare industry sectors, focusing on impending changes in
reimbursement and regulations that should affect a valuation based
upon the Income Approach—even if the market
has not yet taken note. “Fair” market value contemplates
reasonable knowledge of relevant facts, not ignorance of them,
and this article aims to assist valuation professionals in determining
as accurately as possible such market value.
How to use value driver data
Valuation analysts can use the information in this article in
two general ways: Either by quantifying the change and modifying
revenue and cash flow assumptions appropriately; or, in the absence
of sufficient information or uncertainty about a proposed change,
by modifying the subject risk premium when developing a discount
rate.
Most of the observations and analyses in this article apply to
all geographic areas of the United States. However, there are regional
differences in certain aspects of healthcare, because of the relative
supply of certain providers, the penetration of managed care and
in utilization patterns for ancillary technologies.
Florida, Texas and New York City, for example, have very high
utilization in the Medicare population. Manhattan is a highly desirable
place for many young physicians to practice so the supply of specialists
is good. Boston is notorious for low reimbursement for services
due to managed care penetration and a high cost of living, making
recruiting difficult.
Rural areas, particularly in the South, have such recruiting difficulties
that physicians often have relatively high incomes, despite the
low cost of living. For-profit healthcare providers are far more
common in the South and Southwest, where managed care is less prevalent,
whereas nonprofit providers are more common in the Northeast. The
prevalence of for-profit providers has a substantial influence
on utilization patterns and market strategies. Analysts need to
thoroughly understand local market conditions to apply the principles
herein to a particular engagement.
Ratings: From “hot” to “not hot”
The balance of this article groups healthcare business practices
and strategies into several categories, from “hot” to “not
hot” in descending order. While clearly subjective, these
categories characterize for the analyst the current state of healthcare
value drivers.
HOT
Access to and success in risk contracts
Risk contracts are typically a profit
(or loss) center for physician groups and Integrated Delivery Systems.
In an era of continually rising premiums (if at a slower rate),
successful management of risk-based contracts involving capitation
remains a big opportunity. In its most desirable form, capitation
represents a negotiated percentage of the premium paid to a provider
entity in exchange for the assumption of the risk of providing
care to all insureds in that provider entity’s system covered
by a given insurer. It works best in larger entities with significant
numbers of patients covered, which reduces the actuarial risk associated
with catastrophic cases and variability in patient care costs.
Analysts should be leery of the underwriting cycle,
which is the business cycle of the industry. During the various
periods in the cycle, cost increases may outstrip premium increases,
just as at other times premium increases outstrip cost increases. (1)
Medicare Risk Contracts under the Medicare
Advantage program remain a particularly solid area of profitability
for practices dedicated to the managed care model for elderly patients.
Under traditional Medicare, patients are free to self-refer and
attempt to coordinate their own care—rarely a successful
undertaking. In Medicare Advantage, patients exchange self-referral
for a tight managed care program, along with additional benefits,
such as reduced or no deductibles, co-insurance and other benefits.
The recently announced acquisition of Medicare HMO specialist Pacificare
by United Health, the largest health insurer in the country, portends
expansion of the program and an increase in value for those providers
with capitation experience. Primary care physicians often get paid
significantly more than Medicare rates for managing and treating
patients. The monthly capitation rates vary by market, but could
be $35 or more. Profits from the capitation could be as little
as zero or a loss, to as much as $75 per member per month or more.
Personal interaction skills of physician
The old “aaa” formula for success in a medical practice—availability,
affability and ability—is still true today, although in the
primary care practices, affability may be most critical. In an
era increasingly dominated by long patient waits and short encounter
times, the patient’s perception of the quality of their time
with the physician is the key measure of short-term success. Depending
upon the reason for the valuation and underlying jurisdictional
rules, this form of personal goodwill may need to be identified
for marital dissolution purposes, tax asset allocation or damages
in a personal injury or similar proceeding.
Cardiac catheterization lab arrangements
Cardiac catheter labs (or cath labs)
are used by cardiologists to perform various invasive diagnostic
and interventional procedures on their heart patients. For instance,
a physician may perform a diagnostic procedure, such as a left
heart cardiac cath procedure, to determine the location and extent
of a blocked artery. Once located, the physician may then perform
an intervention procedure, such as an angioplasty, to unclog the
artery. The aging population and improving technology and medications
have increased the volume of procedures performed in a cath lab
setting.
In some markets, hospitals and cardiologists have entered into
various arrangements involving cath labs to better utilize existing
facilities and to better serve the local patient population. Such
arrangements may enable a hospital to lease out an under-utilized
yet fully equipped and staffed cath lab to a cardiology group.
For the cardiology group, it may allow them to consolidate cases
into a facility that may be more convenient for its patients and
physicians. Furthermore, such arrangements may prevent duplicate
facilities from entering the market place, which frequently occurs
with physician-owned ambulatory surgery centers and hospital outpatient
surgery departments.
In these cath lab arrangements, the hospital may lease, on a
turnkey basis, a fully equipped and staffed cath lab to a cardiology
group. The cardiology group will pay a fair market value lease
rate to the hospital and then use the cath lab for its own patients.
The cardiology group will then bill the technical fee to the patient
or payor, along with its professional fees. In some situations,
the cardiology group and hospital will also enter into an under
arrangements or provider-based billing agreement, whereby the cardiology
group provides cath lab services to the hospital’s patients
and bills the hospital (instead of the patient or payor) a fair
market value fee based on a contractual fee schedule.
In its Special Advisory Bulletin dated April 2003, entitled “Contractual
Joint Ventures”, the Office of Inspector General of the Department
of Health & Human Services, discusses its concerns with a variety
of hospital and physician joint ventures and business arrangements.
(2) Although a cardiac cath lab leasing arrangement is not specifically
identified as being problematic in this OIG bulletin, it does have
some features in common with some of the problematic ventures identified
by the OIG in the bulletin.
Consequently, cath lab leasing arrangements are complex and involve
various legal and valuation ramifications. Hospitals and cardiologists
interested in pursing these arrangements should have experienced
healthcare legal counsel and should engage a valuation firm with
specific experience in this area.
HOT, BUT BEGINNING TO COOL
Ambulatory surgery center transactions
Ambulatory surgery centers (or ASCs)
provide day-surgery services on an outpatient basis. Inpatient
surgeries are performed in hospitals. As technology has advanced
and as patients and payors have increasingly accepted ASCs as an
efficient and convenient alternative to hospitals, the number of
allowed surgical procedures that can be performed in an ASC setting
has also increased. Consequently, more and more cases are shifting
from hospitals to ASCs.
In recent years, the market for ASC joint ventures and transactions
has been very hot, fueled by physicians desiring to supplement
their incomes, by safe harbors in the Anti-Kickback statutes, which
allow physician ASC ownership under certain terms and conditions,
and by the investment community attracted to the strong financial
returns associated with these centers.
However, as is the case in our free enterprise system, successful
business models with strong financial returns attract competition,
and, in healthcare, also attract the attention of the reimbursement
and regulatory community. As a result, ASC operators are beginning
to feel the pinch in a variety of ways, including:
- Insurance payors beginning to resent the practice of “out
of network billing” practices by ASCs and raising patient
co-pays and deductibles before paying the ASCs for services rendered;
- Workers’ compensation reimbursement rates, (3) which
in the past have been very favorable for ASCs, are now being
challenged as being too high and face the prospect of being lowered
substantially; in some situations, they are being reduced to
bring them closer in line with Medicare rates;
- Publicly-traded and privatelyowned ASC development and management
companies are increasing in numbers and going after physician
surgeons, particularly those in attractive specialties, such
as orthopedics;
- The number of free-standing ASC centers are continuing to grow
and increase competition;
- Reluctance of buying-in physicians to pay high multiples for
their interests when they could develop their own centers;
- Local hospitals challenging applications for new ASCs in states
with CON (Certificate of Need) requirements.
As a consequence of strong acquisition activity in the past, the
number of available ASC acquisition candidates have begun to dwindle.
(4) However, ASC development activity for new ASC facilities is
still very strong. One explanation for this dynamic is that younger
physicians, and physicians that were excluded from previous ASC
partnerships, are more interested in developing a new ASC than
paying a premium to buy into an existing partnership. And, there
are plenty of development companies and investors willing to participate
in these deals.
As the marketplace for ASCs begins to saturate, some of the earlier
investors in ASC partnerships may begin to experience lower distributions.
These older ASCs face high capital investment needs to replace
depreciating equipment and facilities. Also, as their physicianinvestors
begin to age and their surgery volumes decline, they also face
challenges in recruiting younger physicians. Additionally, the
stagnant reimbursement environment is likely to continue to squeeze
profits. Facing this outlook may cause these earlier ASC investors
to divest their interests and may cause others considering such
investments to reconsider the risk/reward relationship. This scenario
would decrease valuation multiples.
HOT, BUT IS TROUBLE LOOMING ON THE HORIZON?
Joint ventures
As physicians continue to feel their bottom lines squeezed due
to rising operational costs, reduced reimbursements from payers,
and escalating malpractice insurance costs, many are looking for
ways to supplement their practice income. One of the ways to accomplish
this is to participate in a revenue stream that is generated from
ancillary services they utilized for their patients.
Many hospital CFOs find themselves in the untenable position
of either sharing a revenue stream that they previously owned exclusively,
or having key physicians leave and branch out on their own as a
competitor. Hospitals can be facing significant lost revenue if
the physicians opt to establish an independent entity, because
the physicians ultimately control the referrals.
The result of this trend is that hospitals and physicians across
the country have created joint ventures that allow revenue streams
to be shared. However, there are tricky regulatory waters that
must be navigated, such as the Internal Revenue Service, Stark
and Anti- Kickback regulations.
Many times, healthcare providers are faced with the dilemma of
trying to balance the logical business decision with one that will
not cause them undue risk from a regulatory standpoint. Additionally,
not-for-profit hospital providers, who are faced with possible
loss of tax-exempt status in addition to Stark or Anti-Kickback
penalties, are put in the unenviable position of trying to educate
physician partners on regulatory risks to which they may not have
been previously exposed. The level of joint venture activity during
the past couple of years indicates that both hospitals and physicians
view these arrangements as being worthy business models. As a result,
providers spend a significant amount of money in legal fees ensuring
that joint venture arrangements will withstand regulatory scrutiny.
These joint ventures rely upon socalled “provider-based” or “under
arrangements” billing. In such an arrangement, a hospital
typically spins out a particular service unit into a new entity.
Physicians purchase an ownership interest, and the new entity leases
the facilities and staff back to the hospital. The hospital then
bills for the services under its own provider number and pays the
joint venture the agreed upon lease payment. The lease payment
typically moves what would otherwise be profit or at least marginal
gross profit from the hospital to the joint venture. These are
discussed in more detail below.
Ancillary services that have been particularly ripe for joint
ventures include ambulatory surgery centers, cardiac cath labs,
diagnostic and imaging centers and dialysis clinics. Because the
initial capital costs of an ancillary service can be quite high,
up to $3 million for the latest high intensity magnetic field MRI
technology, physicians are willing to share the rewards with partners
that are willing to share in the financial risk of the venture.
Joint venture valuation considerations
Several key issues should be considered when performing a valuation
for one of these joint ventures. One significant factor is to ensure
that you do not include anticipated volume or operational changes
in your valuation assumptions. In other words, the service being
joint ventured must be valued as it currently exists, without consideration
for changes that will occur subsequent to the joint venture. For
example, volume assumptions should be based on the ASC as it exists
on the valuation date regardless of the fact that surgery volumes
will certainly increase when physicians become owners of the center.
Additionally, anticipated expense changes, such as leaner staffing
or purchase of less costly supplies, should not be taken into consideration
in valuation assumptions. However, if the joint venture entity
will be subject to a different fee schedule due to a change from
outpatient hospital billing to freestanding billing, the analyst
may need to forecast revenues under the new fee schedule.
A key factor for consideration when appraising joint venture
arrangements involves ensuring that the financial projections include
all indirect and overhead expenses. Many times prior to the joint
venture, these services are hospital based. Typically, hospital
department financial statements include only gross revenues and
direct expenses such as salaries and supplies. Therefore, as the
valuation analyst, it is your challenge to ensure that all indirect
and overhead expenses are included in the valuation projection.
Another valuation issue that can become quite challenging when
the joint venture involves a leasing arrangement is determining
the appropriate rate of return. Typically, the leasing arrangement
includes tangible fixed assets as well as some portion of the operations
such as direct salaries and supplies. It is possible to find reference
points for rates of return on fixed equipment, but determining
an appropriate rate of return on a full or partial lease of “operations” can
be very difficult.
There are movements in some states that may change all of this
as these types of joint ventures come under increasing scrutiny.
For example, Louisiana’s State Board of Medical Examiners
has publicly stated that they deem the typical form of an imaging
lease deal to be an illegal kickback. There is also an ongoing
investigation by the U.S. Attorney’s office in Miami and
the Department of Justice in Washington D.C. into a similar joint
venture in Florida. Scrutiny such as this will most likely negatively
impact these types of joint ventures, and could lead to civil and
possibly criminal sanctions.
HOT, BUT HEADED FOR THE POT?
“Upcoding” by physicians
One of the commonly cited reasons for failure to modify the calculation
of Medicare Conversion Factor is the ability of physicians to manipulate
their income through the billing code they choose to assign a particular
service (analogous to charging extra hours into an engagement).
As Exhibit 1 demonstrates, there has been a steady increase in
the level of coding for the 5 most common office visit services.
Office visits account for 38 percent of Medicare spending. Basically,
the table reflects a decrease in usage of the less expensive 99212
and a corresponding increase in usage of the more expensive 99214.
A valuation of a medical practice should typically include a
coding analysis by comparison to statistical norms from the Medicare
database—or the lack of a coding analysis should be addressed
in the Statement of Assumptions and Limiting Conditions. The five
codes described in Exhibit 2 account for the majority of income
in primary care practices, and a significant portion of income
in many medical specialty practices such as cardiology.
Analysts should be cautious about how any evidence of up-coding
is addressed in a report. A conclusion of up-coding can only be
substantiated by a review of patient chart documentation by a qualified
individual, and incorrect coding can lead to civil or even criminal
penalties. Nonetheless, the analyst cannot avoid the issue for
lack of chart review. Coding at significant variance from the statistical
norm is unlikely to be replicated by a hypothetical buyer, requiring
a normalization adjustment to forecasted revenue or at the minimum
an increase in the discount rate.
(1) Lehman Brothers provides excellent
analysis in this area through analyst Joshua Raskin.
(2) Special Advisory Bulletin, April
2003, Office of Inspector General, Department of Health and Human
Services
(3) Meaning the rate paid by Workmen’s
Comp insurers for ASC services.
(4) See “Understanding the Difference
between Strategic Value and Fair Market Value in Consolidating
Industries,” Mark O. Dietrich, CPA/ABV, Business Valuation
Review, June 2002.
View Part 2
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