The behavioral health industry is undergoing a wave of consolidation with the emergence of multi-location chains and growth of for-profit operators.
A major reason behind this growth has been regulatory changes including the 2016 revision of the Medicaid Institutions for Mental Diseases (“IMD”) Exclusion, the Mental Health Parity and Addiction Equity Act of 2008, and the Affordable Care Act of 2010. These legislative changes have expanded insurance coverage for mental health services, lifted restrictions on freestanding facilities, expanded the demand for behavioral healthcare in general and increased reimbursement. This along with a limited supply in the number of psychiatric beds nationwide has driven higher levels of private investment in the industry spurring consolidation trends.
Although not as common as outright acquisitions, joint venture transactions between non-profit health systems and for-profit operators have started to become more prevalent. The two largest for-profit behavioral health companies are Universal Health Services, Inc. (“UHS”) and Acadia Healthcare Company, Inc. (“Acadia”). Recent examples of joint venture transactions with these operators include Acadia’s 2016 announcements of separate partnerships with Ochsner Health and Greenville Health System to build inpatient psychiatric hospitals. In addition, UHS announced joint ventures with Lancaster General Health and Providence Health Care to build inpatient psychiatric hospitals.
Steven Filton, Senior VP and CFO of UHS, highlighted the joint venture trend on the latest UHS earnings call1:
“We have talked a great deal of the last few quarters about the fact that we are having much more frequent conversations with acute care hospitals about, in some way, penetrating and sharing in the economics of their behavioral health facilities”
“We probably have about a dozen other conversations that I would describe as likely resulting in some sort of arrangement but still a little too early to discuss them with any level of specificity.”
Joey Jacobs, CEO of Acadia, echoed these sentiments on the latest Acadia earnings call2:
“We also remain actively engaged with our acquisition pipeline and we continue to believe that our 2017 acquisition and joint venture activity will be heavily weighted to acute facilities in the U.S”.
“We also look very good – I think in my last count, we have about 16 discussions with joint ventures, with large not-for-profit systems”
These joint venture models are similar in structure to transactions widely employed by different verticals within the healthcare industry. Examples of this include the arrangements United Surgical Partners International (“USPI”) has with non-profit health systems in the ambulatory surgery center space. In addition, HealthSouth, Inc. has utilized similar models in the inpatient rehabilitation market. Generally speaking, transactions consist of a health system contributing its service line and use of its brand while the for-profit operator contributes capital and provides management services post transaction.
4 Reasons to Joint Venture
Based on the comments from the large public operators’ executives and recent transactions, it seems likely that joint venture activity will be common for the foreseeable future. Health system executives should be aware of this trend and understand how a potential joint venture could possibly benefit their organization.
- Increase profitability – Sometimes behavioral health units are poorly managed and/or unprofitable. For-profit operators have considerable expertise with behavioral health businesses and many times can increase profitability post transaction through their expertise and management of expenses.
- Assist with capital constraints – A health system may desire to monetize their behavioral health business segment to pay down debt. In addition, the physical plant for the inpatient psychiatric unit may be aging and need replacement/upgrading. The joint venture model enables the infusion of new capital and the partner oftentimes has access to better financing terms.
- Free up emergency rooms/inpatient capacity - Emergency rooms provide care to a large number of patients with mental health issues. A joint venture allows a hospital to admit these patients to a facility off campus, continue to realize a financial benefit from treating said patients, and free up inpatient capacity.
- Assist with a shortage of psychiatry providers - For-profit operators often have physician recruiting departments and a large existing network of psychiatric providers. The national operators can leverage these relationships to help attract new providers to the joint venture post transaction.
Fortunately, there are also a unique set of benefits in the joint venture model for the for profit owner/operator. These include: access to new markets, the opportunity to leverage the hospital reputation and managed care contracts, and the ability to improve the expense profile of facilities post transaction through superior staffing models, supplier/pharmaceutical contracts, etc.
So what do hospital executive need to know if they want to consider a behavioral health joint venture? As with any healthcare transaction, ensuring the transaction is structured consistent with regulatory guidelines and established at a fair market value price will be essential.
Valuing the Behavioral Health Unit
The respective equity ownership for parties in a joint venture is established by their relative contributions to the new entity. The contribution from a hospital perspective in these transactions usually consists of the behavioral health service line along with use of the hospital trade name. The for-profit operator will then usually contribute enough capital to reach the mutually agreed upon ownership percentages. From a financial point of view, establishing an accurate valuation of the hospital’s contributed service line is a critical component of the joint venture process.
Notwithstanding financial/business considerations, the valuation of the service line has regulatory and compliance implications as well. Generally speaking, the hospital will be a large referral source to the new joint venture and as a result, any transaction must be compliant with regulations such as the Stark Law, the Anti-Kickback Statue and possibly private inurement considerations when the hospital is a non-profit entity. In order to ensure compliance with these regulations, the valuation of the hospital’s behavioral health service line should be consistent with fair market value (“FMV”)3.
Ensuring that the value of the contributed service line is consistent with FMV and does not include any consideration for the volume or value of referrals is critical from a regulatory point of view. As is making sure the valuation properly considers all the facts, data and financial expectations, from a business perspective.
The valuation of a behavioral health service line is a complicated process that requires expertise in valuation techniques as well as a deep understanding of the healthcare industry. Steven Filton, Senior VP and CFO of UHS, stated the following on how UHS approaches the valuation process of service lines for joint ventures4:
“In terms of commenting on valuations of the two businesses, I think it's difficult for us to do. We clearly look at individual acquisition opportunities on a standalone, discrete basis and the growth potential in an individual behavioral facility or individual behavioral company versus an acute is really dependent on the markets they're in, what their specific market position is, what the strategies are for growth, et cetera. So we certainly don't go into any acquisition, either acute or behavioral, with a notion of kind of there's a fixed sort of a valuation that make sense.”
As indicated by Mr. Filton, each valuation has its own set of unique facts and circumstances that must be considered. Using a blanket type approach does not usually result in a value conclusion that accurately reflects the current state of operations.
If your health system does not have expertise in business valuation, and you need to engage a third party appraiser, ensure that they have extensive expertise in the healthcare industry and understand the unique environment surrounding behavioral health businesses. When reviewing an FMV analysis for any business, one should make sure that the Income, Market, and Cost Approaches to value are all addressed. In most cases, the Cost Approach is utilized to establish a floor value of an enterprise and is not relied upon when the Income and Market Approaches generate values greater than the cost to recreate the identified assets. The following briefly outlines considerations under the Income Approach and Market Approach.
Income Approach
Under an Income Approach it is important that both revenue and expenses are properly reflected and consistent with regulatory guidelines related to FMV. Specifically, the FMV standard assumes a hypothetical buyer/seller and as a result, the expenses/revenues included in an analysis should reflect what a typical buyer/seller can reasonably expect to incur. In other words, an FMV appraisal must simulate operations of the service line on a freestanding basis.
When operating as a department of a hospital, service lines many times do not directly record certain expenses incurred by the parent on their departmental financial reports. Examples of these expenses often include facility related costs, billing & collection, management functions, insurance, etc. Due to certain expenses either not being recorded at all or allocated in an imprecise fashion, the expense profile on departmental financials is oftentimes not an accurate representation of costs to operate the service line on a freestanding basis. Respected healthcare valuation firms usually have extensive experience with similar businesses, access to proprietary databases and other market information that are critical to simulating the line of business as a standalone enterprise accurately.
When a new facility is being constructed as part of the joint venture, an FMV rental rate for this property should be included in any cash flow projections. In this scenario, the hospital is not contributing the current real estate to the joint venture, so operations must be burdened with FMV rent to reflect an accurate representation of the contributed assets.
In addition, reimbursement for the service line when structured as a department of the hospital might not be achievable on a freestanding basis. Reasons for a revenue differential could include the inability of a joint venture to assume hospital commercial contracts post transaction, additional reimbursement for the hospital having an emergency department and add-ons for trauma or other forms of acute care provided. An FMV analysis should adjust the revenue stream to reflect freestanding market reimbursement to ensure consistency with FMV.
Once standalone operations are accurately simulated, an Income Approach analysis would project patient volumes, length of stay, reimbursement by payor, operating expenses, incremental working capital and capital expenditures to calculate net discretionary cash flow into perpetuity. A valuation should pay particular attention to capacity constraints (private vs. semi-private beds), regulatory changes, relative staffing levels, competitive position in the local market and other factors when projecting future financial performance. These cash flows would then be discounted back to present value utilizing the weighted average cost of capital to establish a value indication under the Income Approach methodology. The weighted average cost of capital should account for the specific risks related to the entity under question as well as for the aggressiveness/conservatism of the financial forecast.
Market Approach
The logic behind the Market Approach is that similar assets should sell for similar prices in a free and open market. Under this approach, the value of comparable businesses is considered based on similar transactions and is typically calculated as a ‘multiple’ of some financial/operational metric. Based on our experience and discussions with industry professionals, the most common multiples quoted in the behavioral health industry are in terms of revenue, earnings before interest taxes & depreciation (“EBITDA”) or licensed beds. These multiples are then applied to the subject entity’s metrics to establish a value indication under the Market Approach.
Generally speaking, the hospital is contributing its entire behavioral health service line to the joint venture, and therefore, the valuation should be performed at a controlling or enterprise level of value. As a result, market multiples utilized in a Market Approach analysis should be on a controlling level of value (as opposed to a minority/non-controlling level) to be comparable.
Access to accurate, comparable transaction data is critical to any Market Approach analysis. Well established valuation firms with experience in the healthcare industry usually have proprietary transaction databases with relevant information, exposure to relevant market participants and experience dealing with similar transactions. Multiples obtained from available market data should be adjusted for factors such as size, geography, diversification, access to capital, growth prospects, profitability and liquidity among other factors. In addition, transactions for multiple facilities typically result in significantly higher multiples paid than for a single location. Finally, an FMV analysis should avoid related party transactions and transactions where the seller is financially distressed as the indicated multiples would not be consistent with the definition of FMV.
As for current multiple trends in the behavioral health marketplace, Joey Jacobs CEO of Acadia, gave some general insight on a recent Acadia conference call5:
“John, I would think the larger transactions are going to get around that nine times. A single transaction is probably going to get closer to the seven times. I think the bankers are beginning to realize that the multiples have come down and are coming down. And if they want to engage Acadia in the process that we've set those expectations that we're going to verify the trailing EBITDA earnings and that's the multiple we put to it.”
Conclusion
Once the Cost, Income and Market Approach have been considered, the strength of the approaches are weighed and a FMV range is typically established. If certain assets necessary to operate the business are not contributed to the joint venture, an adjustment to the value indication should be made. Examples being when the equipment and current staff will remain with the hospital post transaction or the joint venture will not be able to utilize the health system tradename or branding. As a result, estimates for the value of the equipment, trained workforce, and hospital tradename should be deducted from the value indication of the enterprise.
In summary, with a growing trend of behavioral health joint ventures, coupled with increased regulatory scrutiny, it is critical that the value of the contributed service line be consistent with FMV. Going through a thorough process will not only assist with compliance but should assist with making a sound business decision for your health system.
1Seeking Alpha - UHS 4th Q 2016 Earnings Call Transcript
2Seeking Alpha – ACHC 4th Q 2016 Earnings Call Transcript
3NACVA Professional Standards, http://web.nacva.com/TL-Website/PDF/ NACVA_Professional_Standards.pdf. “The price, expressed in terms of cash equivalents, at which a property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s-length in an open and unrestricted market, when neither is under compulsion to buy nor to sell, and when both have reasonable knowledge of the relevant facts.”
4Seeking Alpha - UHS 3rd Q 2016 Earnings Call Transcript
5Seeking Alpha - ACHC 3rd Q 2016 Earnings Call Transcript