The following article is written by Nicholas J. Janiga and Jason L. Ruchaber, CFA, ASA of HealthCare Appraisers.
CPT copyright 2010 American Medical Association. All rights reserved. CPT is a registered trademark of the American Medical Association.
Over the past 24 months, HealthCare Appraisers has performed valuation services in connection with hundreds of physician practice acquisitions across the country. In connection with these acquisitions, HAI is frequently asked to review or rebut competitors' valuation reports, typically as a result of one of three scenarios: i) HAI is asked to review an analysis that a party to the acquisition does not understand or agree with; ii) HAI is asked to refute or temper the work performed by a valuation firm or consultant that is willing to push past the limits of fair market value (e.g., potentially in violation of Stark Law or Antikickback Statute); or iii) HAI is asked to correct another appraiser's mistakes.
From these experiences, HAI has compiled the following list of 11 common ailments observed with physician practice valuation.
1. Mistaking investment value for fair market value
In the healthcare industry, regulations such as the Stark Law and Anti-Kickback Statute mandate that permissible transactions involving parties who are in a position to refer patients (e.g., physicians) must be priced at fair market value. FMV is defined by these regulations[1] in a manner that is more nuanced than the standard definition of FMV[2], and may preclude consideration of economic benefits that might otherwise be priced into a transaction.
Though the specifics of these laws and definitions are beyond the scope of this article, it is common to encounter investment banking, accounting, consulting and general valuation firms (i.e., valuation firms not specialized in healthcare) who incorporate significant levels of synergies into their FMV opinions (these synergies result in an investment value opinion which is not consistent with FMV). Common synergies include adjustments involving the following: increased reimbursement under provider based billing, downstream revenues, improper ancillary carve-outs, lower expenses achieved by the acquirer, indirect consideration of referrals and others. The result of incorporating the aforementioned synergistic adjustments is a change to the standard of value and, therefore, an unusable valuation opinion.
2. Failing to analyze operational data
Appraisers unfamiliar with healthcare frequently fail to consider and analyze key operational data. Operational data includes detailed CPT code reports, provider mix, payor mix, place of service, patient zip code and other related reports. These reports allow valuation analysts to analyze historical trends, prepare a Medicare (or new commercial fee schedule) impact analysis, understand revenue concentration, project changes in revenue, benchmark the subject practice to the industry, analyze relative value units of the subject physicians, assess unsystematic risk and many other supplemental analyses. Without these schedules it is difficult, if not impossible, for the valuation analyst to properly value the subject physician practice.
3. Forgetting the impact of an electronic health record system
Many physician practices have implemented or are in the process of implementing an electronic health record system. Significant direct and indirect costs are incurred during the implementation process, with physician practices expecting to achieve both direct and indirect benefits from the undertaking. The main direct financial benefit includes CMS' subsidy revenue of $44,000 per physician (paid over five years at $18,000, $12,000, $8,000, $4,000 and $2,000 per year), which is subject to current stage one meaningful use requirements and future implementation achievements (CMS intends to propose, through future rulemaking, two additional stages of the criteria for meaningful use). In addition to the expected direct revenue over the first five years after implementation, many valuation analysts forget to analyze the potential lost productivity during implementation and potential improved productivity going forward.
On the expense side, many valuation analysts forget to examine changes in operating expenses during and after the implementation of an EHR system. An example of this is forgetting to analyze historical consulting and other one-time implementation expenses that should not be projected going forward. Another example is forgetting to project the full amount of increased software, server, computer, hardware and maintenance expenses that will be incurred to maintain the EHR system at the subject physician practice. A final common error, assuming the subject physician practice has implemented voice recognition hardware, is the valuation analyst forgetting to project a decrease in transcription expense (either in-house or contracted service). All of the examples illustrated in the previous paragraphs have an impact on a subject physician practice's future cash flow and, thus, impact the concluded FMV of a subject physician practice.
4. Failing to analyze local demographics, industries and economies
Valuation analysts may determine that the subject physician practice has the capacity to further grow revenue, whether it is through increased productivity or expanding services, but this does not always mean they have the ability to do so. The ability of a subject physician practice to grow, or even maintain existing productivity levels, is highly dependent on factors within the local demographics and economies. Healthcare is geographically constrained by a patient's willingness to travel and, therefore, local healthcare demand should be analyzed thoroughly, including analyses of historical and projected changes in population, age, workforce, income levels, major employers and industries, prevalence of disease and other factors applicable to the subject physician practice's region.
5. Disaggregating business and compensation valuations
In the valuation of physician practices, physician compensation and business value have an inverse relationship. To the extent physicians are going to receive an increase in compensation relative to historical levels, the result is a decrease in projected cash flow and, thus, a decrease in value (and vice versa). It is common to review valuation reports in which the valuation analyst or client has disconnected the business and compensation opinions either through the use of multiple appraisers or a compartmentalizing of information. A business appraisal that fails to account for a 20 percent increase in compensation post acquisition does not properly impact projected cash flows and overstates the conclusion of value for the subject physician practice. This is akin to someone winning the lottery and choosing to receive the upfront payment and the annuity payments for 20 years (i.e., have your cake and eat it too).
6. Erroneously valuing in-office ancillaries
Many physician practices have both professional collections related to physician services and technical collections related to in-office ancillaries such as diagnostic imaging. In certain instances it may be appropriate to value these separately; however, there is a correct and an incorrect way of separately valuing in-office ancillaries. Similar to disaggregating business and compensation valuations, many valuation analysts create unsustainable business models and do not account for the portion of physician compensation that is generated from in-office ancillaries.
An example is valuing the in-office ancillaries of a cardiology practice where the cardiologists generate a significant portion of their compensation from in-office diagnostic imaging (e.g., as high as 50 percent of total compensation). If the in-office ancillaries are sold, the cardiologists will no longer be able to bill for these services and, as a result, the subject physician practice will have to pay the cardiologists a reduced level of compensation based solely on professional collections. Valuation analysts cannot simply use survey data (e.g., MGMA, AMGA, etc.) via the market approach for determining physician compensation, as the survey data does not adequately bifurcate compensation related to professional services and in-office ancillaries. Thus, after adjusting for the impact of in-office ancillaries, a distributable earnings method or pre-compensation earnings method should be used in determining the appropriate physician compensation.
7. Benchmarking improperly
Valuation analysts should benchmark the subject physician practice to industry metrics. Failure to do so generally results in unsupportable business models and provides very little value-added to the acquirer. Through the use of published surveys, such as the MGMA Cost Survey, and through reviewing previous valuations of similar entities, the valuation analyst should be able to identify certain revenue and/or expense abnormalities as well as adjustments that a normal operator would be able to achieve. Common adjustments include poorly (or absently) negotiated payor contracts that result in below-market reimbursement; excess (or insufficient) staffing levels; excess (or insufficient) leased space; underperforming in-office ancillaries (i.e., negative income and cash flow); and non-operating and non-recurring items.
While some valuation analysts do not benchmark the subject physician practice to the industry, others develop unreasonable financial statement adjustments through assuming all physician practices can achieve "median performance levels." These valuation analysts fail to truly analyze the unique characteristics of the subject physician practice relative to what is "common" within the industry. An example is adjusting clinical support staffing levels to a "median level" for subject physicians that achieve productivity above the 90th percentile. This may be obvious to most, but the subject physicians likely need clinical support staffing levels at the 90th percentile (or above) in order to be so productive.
8. Incorrectly utilizing the market approach
The comparable transaction method of the market approach is the most commonly misused method in determining the FMV of a physician practice. Many valuation, consulting and investment banking firms attempt to apply valuation multiples from closed transactions in valuing a subject physician practice, particularly multiples of revenue. There are a number of downfalls to this approach, including the following: the transactions may not represent FMV; the transactions could involve the subject physicians receiving a pay raise (or pay cut) that is not reflected in the deal data; the inclusion or exclusion of specific assets or liabilities in the transactions that is not reflected in the deal data; and unknown levels of ancillaries, mid-level providers and other important information. Furthermore, assuming the valuation analyst has enough information about a set of closed transactions, it may be inappropriate to apply valuation multiples from closed transactions that have occurred outside of the local market of the subject physician practice. Given the local nature of healthcare services, particularly physician practices, there can be many differing factors across market areas (e.g., reimbursement).
9. Assuming statistically flawed levels of physician compensation
Certain valuation firms, consulting firms, acquirers and attorneys believe every physician practice should be compensated at or above the median compensation per work relative value unit reported in published surveys (even when the subject physician practice has not been able to historically generate such levels of compensation per wRVU). By definition, a median value reflects the midpoint of a data set. Accordingly, 50 percent of physicians make less than and 50 percent make more than the median reported compensation per wRVU rate.
It is also important to understand what the data in these surveys reflect and how the data is intended to be used. For example, MGMA has specifically addressed the fact that for the majority of physician specialties there is a declining compensation per wRVU rate as overall productivity increases. Generally, this indicates that physicians who produce at the 75th percentile should not be paid at the 75th percentile rate per wRVU. There are many factors that contribute to this relationship, and even with a declining rate per wRVU as productivity increases, physicians still have increasing total compensation in all reported quartiles, as illustrated in the following graph.
Every physician practice has its own unique operating characteristics and levels of technical and other service revenues. Some physicians use more resources (e.g., clinical support staff, space, etc.) in generating wRVUs, have more ancillary utilization and generate higher levels of other service revenues (e.g., on-call, directorship, co-management, interpretation, etc.). These operational characteristics and additional revenues impact a physician practice's compensation per wRVU rate. As a result, it is possible to have two physician practices across the street from each other that realize disparate compensation per wRVU rates.
10. Failing to understand what is reflected in the FMV opinion
Acquirers of physician practices are typically structuring the purchase as an asset deal (instead of a stock deal). The acquirer frequently relies on the valuation firm to help determine the FMV of acquired assets (and liabilities to the extent that any are transferred). Under the asset approach, it is fairly simple to analyze and adjust the FMV balance sheet to include only the assets and liabilities that are expected to be transferred. It is common for valuation analysts to make mistakes when analyzing the FMV of acquired assets (and liabilities to the extent that any are transferred) when using the income approach.
Using debt-free cash flow under the income approach, an analyst develops a conclusion of the market value of invested capital. From the concluded market value of invested capital, the valuation analyst has to subtract assets that are not going to be transferred. Typical adjustments include the exclusion of net working capital, inclusion of inventory and inclusion of debt on transferred fixed assets. Once the deal terms are known, the appraiser should be consulted to verify that the purchase price is reconciled for the inclusion or exclusion of any assets and liabilities.
11. Failing to go on site to visit with management and physicians
There is only so much information that can be gleaned from financial and operational reports. Valuation analysts who do not go on site to meet with the administrative team and physicians have a higher propensity to miss certain nuances of the subject physician practice or bury themselves in the numbers and forget the big picture. In meeting with the administrative team and physician group, an appraiser can gain insight into the practice patterns of the subject physicians, condition of the office and ancillary equipment, depth and quality of the administrative team and other information important to the valuation. Although a site visit can be dependent on the scope and timing of the engagement, conducting a site visit is an integral part of the valuation process.
Conclusion
As evidenced in the list above, there are many areas where valuation analysts err in valuing physician practices. Acquirers must be very careful in selecting a valuation firm to help determine the FMV purchase price of a physician practice; an interview process is necessary in order to appropriately vet the hiring of a valuation firm.
In addition to this article, HAI has recently authored a position paper outlining HAI's methodologies for valuing physician practices titled "A Balanced Approach to Valuation of Physician Practices." If you have any questions about current or future physician practice valuations, you can contact the authors at (303) 688-0700 or njaniga@hcfmv.com. Learn more about HealthCare Appraisers.
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[1] See 42 U.S.C. § 1320a-7b(b) and 42 U.S.C. § 1395nn
[2] See the International Glossary of Business Valuation Terms