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By Shannon Farr, CPA•ABV•CFF
Why Hospitals and Physicians Are Aligning
 It has been two years since President Obama signed the Patient Protection and Affordable Care Act (PPACA). While its ultimate effect on our healthcare system remains to be seen, healthcare reform has spurred a growing movement among healthcare providers to integrate. Healthcare reform is not the only factor driving alignment. Rising overhead costs, declining reimbursements from Medicare and commercial insurance carriers, and increasingly complex billing and coding processes are motivating physicians to consider alternatives to owning an independent medical practice. Hospital systems are strategically aligning with physicians, and this alignment is occurring in many forms (see sidebar). One prevalent form of alignment is the acquisition of a physician practice with subsequent employment of the owner-physician(s).
The industry consolidation that occurred in the early 1990s is widely regarded as a failure. In hindsight, many hospitals overpaid for medical practices, either in terms of the deal price, the post-acquisition salary agreements of the selling physicians, or both. As a result, federal statutory and regulatory restrictions (discussed below) have evolved, along with the understanding that the post-acquisition compensation agreements must be considered when determining whether the acquisition purchase price represents fair market value. Another major distinction from the 1990s transactions is a move from salary guarantees to productivity- or performance-based compensation models. The new models take various forms, but generally leave some portion of the employed physician’s compensation at risk and tied to productivity or quality factors.
How the Employment Agreements Must Comply with Regulations
To comply with federal regulations, purchase agreements and physician employment agreements must be at fair market value and be commercially reasonable. “Healthcare fair market value” is defined by Stark Regulation 42 CFR 411.351, which states in part as follows:
The value in arms-length transactions, consistent with the general market value. ‘General market value’ means the price that an asset would bring as the result of a 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 a 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.
While the regulations do not define “commercially reasonable,” the Stark regulations commentary (69 Fed. Reg. 16093 (March 26, 2004)) states:
An arrangement will be considered ‘commercially reasonable’ in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician of similar scope and specialty, even if there were no potential designated health services (DHS) referrals.
Conceptually, fair market value relates to a numerical figure or range, e.g. a measure of what a hypothetical party would pay in the marketplace. In contrast, the concept of commercial reasonableness is a “pass or fail test,” a determination of whether or not an arrangement corresponds to “commonly accepted commercial practices.”
In addition to the regulatory concepts of fair market value and commercial reasonableness, hospitals operating as nonprofit entities under section 501(c)(3) of the Internal Revenue Code are forbidden from creating a more-than-incidental “private benefit.” In other words, a nonprofit hospital cannot create benefits for a private entity that are more than incidental in relation to the public benefit. The law also forbids private inurement, which is the diversion of any charitable funds to “disqualified persons” (insiders).
In performing healthcare valuations, two recurring themes usually appear. First, physician practices typically pay out any available cash flow to their owner-physicians in the form of compensation. The resulting physician compensation therefore may include not only compensation for the physician’s own professional efforts, but also a return on the physician’s ownership interest in the practice. Second, fair market value is not investment value, which by definition considers the value to a particular purchaser. Although the purchaser may want to analyze post-acquisition cash flows at its contracted reimbursement rates, such specific-buyer characteristics should not be included in the determination of fair market value.
Valuation methods under the income approach generally determine the present value of the expected future benefits associated with ownership of an asset (such as a physician practice). The income approach is often used in analyzing physician practice acquisitions and subsequent employment arrangements. The primary advantage of the income approach is the ability to model the effects of the post-acquisition compensation package on the fair market value purchase price.
In the cost approach, the value of the business is determined using one or more methods based on the value or cost of its assets. The starting point in this approach is typically the balance sheet. One of the key arguments supporting the use of the asset approach is that the buyer of an existing practice receives the benefit of a turnkey operation, receiving immediate value from its assets and avoiding the cost of accumulating similar assets.
In the market approach, the analyst compares the subject to similar guideline businesses that have been sold using operational or financial metrics such as transaction price per dollar of revenue, transaction price per procedure, transaction price per dollar of income, or any of a number of other pricing ratios. While the market approach has the advantage of reflecting the behavior of real buyers and sellers of businesses, data at the level of detail necessary to determine whether the guideline transactions are in fact similar to the subject business is often difficult or impossible to obtain.
We Can Help
At Decosimo, our team of experts is available to assist hospitals and physicians in determining fair market value and commercial reasonableness. Our valuation, revenue cycle, and physician practice management experts work together to provide top quality consulting services to the healthcare industry. Whether you need practice acquisition due diligence, the design of a performance-based compensation arrangement, a post-acquisition financial forecast, or a comprehensive determination of fair market value and commercial reasonableness for a proposed transaction, we can help. Please call us in confidence at 800.782.8382.
Brent McDade | Managing Director
brentmcdade@decosimo.com
Shannon Farr | Valuation Manager
shannonfarr@decosimo.co
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