After the failed attempt to repeal and replace the Affordable Care Act (ACA), House speaker Paul Ryan stated that "We're going to be living with Obamacare [ACA] for the foreseeable future."
That was already the case for the Medicare Access and CHIP Reauthorization Act (MACRA). In fact, MACRA is not part of the ACA—it was bipartisan federal legislation that was made official in October 2016. MACRA has prompted physicians, hospitals and health systems to evaluate which value-based quality payment program they want to be reimbursed under: the Merit-Based Incentive Payment System (MIPS) or the Advanced Alternative Payment Model (APM). Both payment models represent major changes to historical reimbursement models.
Intentional or not, the MACRA payment model changes and related requirements are causing physicians to consider affiliating or selling their practices to health systems or hospitals. Having health system and hospital infrastructure and resources is attractive to physician practices because it would reduce the capital costs and the administrative burden necessary to successfully manage their business. Health systems and hospitals are interested because a broader physician network may offer a competitive market advantage.
Purchasing a physician practice is complicated, and comprehensive diligence beyond the traditional financial and legal evaluations is important. Before making a transaction, hospital management teams should answer eight important due diligence questions.
1. What are the practice dynamics? Acquiring a practice is a strategic decision that should take into account the practice's mission, service offerings and compatibility with the acquiring hospital or health system. Besides financial considerations, hospitals should evaluate how clinical outcomes and continuity of care may improve with the acquisition. Pertinent questions include: Does this group of physicians apply the appropriate care to the appropriate patients in the appropriate venue? Does the physician practice evaluate clinical workflow and guidelines? How does it evaluate and reward quality management? Does it appreciate the role of data analytics?
2. How does the practice's historical financial performance compare with its forecast results? Traditional financial diligence includes analyzing the historical "quality of earnings" to normalize the impact of nonrecurring items and non-operating costs and revenues. Common diligence procedures also analyze trends in revenue and margins by specialty, and analyze and evaluate operating expenses for potential cost synergies. After past performance is analyzed, it is used to bridge historical performance to management's projections. Prospective buyers should ask themselves: Is this forecast achievable based on historical results? What are the key drivers and strategic rationale for the transaction? Have we assessed the impact of local demographics and competition?
In addition to traditional diligence, the increasing availability of data has also given rise to the use of advanced tools and techniques to visualize, analyze, and derive better and deeper insights during the diligence process.
3. What are the practice's working capital and capital expenditure requirements? The overall cash cycle and working capital requirements of the practice can be assessed by analyzing historical trends. The time to convert a medical procedure into cash can be evaluated as well as how much of the actual gross billing can be collected. Some physician groups may also own an insurance plan requiring that certain cash levels are maintained for state solvency requirements. Capital expenditures and investments related to physical locations for urgent care centers, ambulatory centers, medical equipment and information technology are necessary for physician groups to compete in the changing marketplace.
4. How significant is the practice's debt? In general, it is not advisable for a health system or hospital to assume the debt of a practice it wishes to acquire. During due diligence, it is important to identify "debt-like" items, including commitments or contingencies that may or may not be recorded on the balance sheet but may require funding post-transaction. Examples include the cash costs of unfunded pension liabilities, change in control payments (triggered upon a transaction), and differences between amounts recorded for professional liability claims and claims that have been incurred but not reported. If debt-like items are noted, buyers can negotiate who assumes these obligations or, at a minimum, incorporate the estimated future cash outflows into their financial model.
5. What investments need to be made in the practice's information technology (IT) infrastructure? A practice's IT infrastructure is a critical asset that should be evaluated during diligence. Hospitals should assess the cost of consolidating and implementing the IT systems needed post-transaction. Often physician practices underinvest in their IT needs and interoperability, making it a guaranteed future cost for the hospital to integrate. Buyers should include the projected investment required to standardize and integrate the practice.
Protection of patient information is also a diligence concern. The portability of Protected Health Information (PHI) means there should be baseline security controls in place. Noncompliance could result in penalties ranging from $100 to $50,000 per record.
6. How should physicians be compensated? Many physician groups are structured as partnerships, which means physicians are their own bosses. If acquired, they will have to adjust to being employees. Naturally, physicians expect to maintain or increase their income under their new employer.
Today's physicians are accustomed to being paid on a fee-for-service basis, which lends itself to a volume-driven business. New compensation program designs are likely to bear little resemblance to those that physicians have experienced in the past. Patient outcomes will soon outweigh volume as the measure of a physician's productivity. The Merit-Based Incentive Payment System program is designed to incorporate pay-for-performance incentives with the fee-for-service system. More financial upside is available in the Advanced Alternative Payment Model due to the associated risk. However, physicians must decide whether they are open to and understand new compensation structures. During transaction negotiations buyers should meet consensus with acquired physicians and consider the prospective compensation model within their forecast models.
7. Does the practice have a sound compliance program? Understanding a practice's discipline around coding and billing compliance is another important step during due diligence. If there is no formal compliance program, or if coding and billing practices seem questionable, that is a red flag. Practices should have an effective compliance program in place, including a compliance officer, policies and procedures, training and education programs, and auditing and monitoring processes.
Revenue Cycle Management (RCM) compliance diligence typically overlaps with financial diligence. If there are identified weaknesses in the RCM function or historical coding has been irregular or inconsistent with the acquirers' coding practices, the run rate of the revenue stream used for the model may be flawed or open the buyer to payer scrutiny and recoupment risks. For example, buyers should analyze the historical results and status of both government and commercial payer audits and recoupments. The results could impact both debt and financial run rate considerations.
8. Does the physician practice fit in with our culture? Every hospital and physician practice has its own culture. The cultures do not need to be identical, but if they are not built on the same foundational values, the marriage may be doomed from the start. Hospitals should step back and ensure the physician practice will appreciate the values of the health system and ensure their short-term and long-term visions are aligned, or take steps to align a collective vision.
As the physician payment model changes and care delivery models change, a comprehensive multi-disciplinary diligence process is more important than ever when evaluating a practice for acquisition. While traditional financial and legal diligence is important, buyers should also take into account other variables, such as clinical quality, compensation, compliance, tax structuring and IT. These variables are essential for a successful acquisition and are key valuation considerations that should not be overlooked. No deal is perfect, but after evaluating the findings from a robust due diligence process, hospitals can approach their acquisition strategies with confidence.
Glenn P. Barenbaum, CPA
Atlantic Coast Transaction Diligence Leader
Grant Thornton LLP
Glenn Barenbaum leads a range of merger, acquisition and divestiture services for corporate and private equity companies as a senior manager in Grant Thornton LLP's Transaction Services practice. He has a decade of experience in the healthcare sector, including work with health insurance/managed care organizations, health systems, general acute-care hospitals, physician practices, surgery centers, long-term care, rehabilitation and home care providers, and clinical laboratories. Barenbaum received a bachelor's degree in accounting from Syracuse University.
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