Developments in Valuation of Healthcare Services

8/7/2019 Developments in Valuation of Healthcare Services

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Business Valuation Associationof Chicago

Developments in the Valuation of

Healthcare Service Businesses

Presented by:

ROBERT JAMES CIMASI, CBCPresident

HEALTH CAPITAL CONSULTANTS10420 Old Olive Street Road, Suite 200

St. Louis, Missouri 63141-5938(800) FYI-VALU

www.healthcapital.com

March 23, 2000 Chicago, Illinois

.

Robert James Cimasi, CBC

This presentation addresses information and developments in the admittedlybroad and rapidly changing area of business valuation as it relates to healthcare

professional practices. Neither the presenter nor the sponsor intend this

presentation to render any legal or accounting advice, but rather to provide

general information and sources. Neither the presenter nor the sponsor assume

any liability with respect to the use of information contained in this presentation.

For le al or accountin advice individuals and their irms are ur ed to consult


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DEVELOPMENTS IN THE VALUATION OF

HEALTHCARE SERVICE BUSINESSES

Business Valuation Association i Robert James Cimasi, CBCMarch 23, 2000 - Chicago, IL HEALTH CAPITAL CONSULTANTS

Table of Contents

I. INTRODUCTION..............................................................................................................1

A.Do You Know What the Trends and Developments Are in the Healthcare Industry?........1B.Importance of a Professional Valuation...............................................................................2

II. OVERVIEW OF MAJOR HEALTHCARE VALUATION CONCEPTS &CHALLENGES..................................................................................................................4

A.Healthcare Valuation Context .............................................................................................4B.

Basic Healthcare Valuation Tenets .....................................................................................4

C.Reliance on Historical Data ................................................................................................6D.Value as Incremental Benefit ...........................................................................................8E.Scope & Nature of Valuation Engagements are Changing-Aspects to Consider .............11F.The Range of Services for Healthcare Valuation Reports.................................................13

III. INDUSTRY BACKGROUND ISSUES..........................................................................14

A.The Shifting Universe of Healthcare Delivery ..................................................................14B.Trends in Physician Supply, Workplace and Specialization .............................................17C.Changes in the Professional Practice Competitive Environment .....................................21D.Reimbursement Issues and the Transition to Capitation ..................................................27

IV. THE RISE OF EMERGING HEALTHCARE ORGANIZATIONS (EHOS)...........34

A.Types of EHOs...................................................................................................................37B.Challenges to the Valuation of Emerging Healthcare Organizations (EHOs)...................49

V. TRENDS IN HEALTHCARE TRANSACTIONS........................................................51

A.Physician to Physician Transactions .................................................................................51B.Physician Practice Management Company (PPMC) Transactions ...................................51


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Business Valuation Association ii Robert James Cimasi, CBCMarch 23, 2000 - Chicago, IL HEALTH CAPITAL CONSULTANTS

Table of Contents (continued)

C.Hospital Transactions .......................................................................................................55D.Cost Containment-Regulatory Agenda is Changing the Market Terms and Structure of

Healthcare Transactions ..................................................................................................55

APPENDICES:

General Research Sources and Information:

A. Selected Healthcare Articles Bibliography

B. Emerging Healthcare Organizations Articles Bibliography

C. Valuation Books

D. Glossary of Healthcare Terms

E. Additional Sources of Information


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Business Valuation Association Robert James Cimasi, CBCMarch 23, 2000 - Chicago, IL HEALTH CAPITAL CONSULTANTS

1

I. INTRODUCTION

With the rise of managed care over the last decade, the healthcare provider environment has

experienced significant and often chaotic transactional activity. Physician integration /

affiliation arrangements, practice and other healthcare entity acquisitions and mergers, and

industry-wide provider roll-ups and consolidations as well as other creative equity sharing

integration activities have often been seen as the key to the capital formation strategies

necessary for developing integrated delivery systems that can compete in the highly

competitive managed care environment of the 90s. More recently, some of these integration,

consolidation, and provider entity roll-ups have experienced divestiture and dissolution in

recognition of the failed expectation of capital markets as well as a lack of understanding as

to the difficulty of managing physicians. In either scenario, i.e. consolidation or divestiture,

the valuation of these healthcare provider entities is at the core of each of these transactional

activities.

A. Do You Know What the Trends and Developments Are in the Healthcare

Industry?

Questions to ask!

1. Do you stay informed about the almost daily changes in the industry; thevarious specialties; payment reform and reimbursement trends; the

payer/delivery system mix; costs; emerging healthcare organizations; and

regulatory & enforcement issues related to the health care professional

practice market in general and your practice service area in particular?

Do you have access to a research department that subscribes tohealthcare industry newsletters, journals, and health law & policy

reporters?


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Do you stay in touch with healthcare associations, medicalsocieties, practice brokers, managed care and hospital/system players?

Do you attend conferences, symposiums, workshops, andhealthcare industry seminars?

2. Do you demonstrate requisite skills and consistent effort to make all

appropriate adjustments to the subject practice earnings stream,

professional owner compensation as well as risk adjustments to discount

and capitalization rates?

3. Do you perform regular reviews and reassessments of all reports to insure

compliance with healthcare regulatory and legal constraints and

requirements?

B. Importance of a Professional Valuation

Professional valuations serve a number of important functions for both owners, other

interested or related parties, and potential buyers. For potential transactions, these

include the disclosure of facts, preemption of objections, and establishment of an asking

price. However, one of the most important of these functions may be to avoid potential

legal issues related to Fraud & Abuse laws as described below.

Fraud & Abuse Issues and Endangerment of Charitable Tax Status. A non-profit,

charitable organization (e.g., hospital, foundation) may have its tax exempt status

revoked if it pays more than fair-market value for a medical practice. Internal Revenue

Code (IRC) Section 501(c)(3) tax-exempt organizations must be organized and operated

exclusively for charitable, religious or educational purposes. The tax law contains

prohibitions against private inurement and private benefit for tax-exempt entities. Under

this rule, certain insiders of a tax-exempt entity, including directors/trustees, officers and

certain physicians, may not engage in a non-fair-market-value transaction with the tax-


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exempt entity. If the entity allows such inurement and the private benefit conferred on an

individual is not merely incidental to the exempt activities of the organization, the

organization may have its exempt status revoked by the IRS. On December 22, 1992, aletter from D. McCarty Thornton, Associate General Counsel of OIG of the Department

of Health and Human Services was sent in response to an IRS inquiry regarding kickback

concerns related to an acquisition involving a charitable 501(c)(3) buyer. Mr. Thornton

stated that that any amounts paid to physicians in excess of Fair Market Value of the

practice's hard assets is suspect and could be considered improper inducement for

referrals. It is critical for both the buyer and seller of a medical practice to be assured

that the appraiser is aware of the regulatory issues that govern healthcare business

transactions. Otherwise, both parties may be at risk.


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II. OVERVIEW OF MAJOR HEALTHCARE VALUATION CONCEPTS &

CHALLENGES

A. Healthcare Valuation Context

1. The "IRV" pyramid - The process related to the financial valuation of

professional practices can generally be discussed within the context of two

(2) determinants: (See Exhibit I)

a. "I" = The determination of the appropriate

Income/Earnings/Benefit Stream for the subject practice.

b. "R" = The development and selection of the appropriate risk

adjusted discount rate/cap rate/multiple to apply to the income

stream selected.

2. Therefore, items that are related to each determinant, such as the rapidlychanging reimbursement and regulatory environment, are important to the

appraisal process.

B. Basic Healthcare Valuation Tenets

1. The importance to the practice valuation process of a thorough knowledgeof both the current status of the healthcare industry and practice

marketplace, and the future trends of each is illustrated by the following

basic tenets of practice valuation:

a. Value is forward looking.

b. All value is the expectation of future benefit.

c. The best indicator of future performance is usually the

performance of the immediate past.

d. Historical accounting and other data are useful primarily as a

road map to the future.


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Business Valuation AssociationMarch 23, 2000 - Chicago, IL HEA

5

Exhibit I

I

R V

Income/Earnings/Benefit Stream as defined by appraiser & appropriate to

Risk Adjusted Discount Rate/Cap Rate/Multiple risk adjusted and applica

income stream

V A L U E


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2. In light of these basic valuation tenets, the historical performance of asubject practice under the traditional provider delivery system may not be

a valid indicator of its future performance within the context of areimbursement and regulatory environment driven by cost containment,

managed care, and capitation.

C. Reliance on Historical Data

1. Traditional professional practice valuation methodologies have relied

upon the analysis of historical accounting and other data as predictive of

future performance and value. The current turbulent status of the

healthcare industry has introduced intravening events and circumstances

that may have a dramatic effect on the revenue or benefit stream of the

subject practice, i.e. the "road map of historical performance" becomes

less predictive of future performance. An example of events that may

change the prediction of future performance is set forth on Exhibit II.

2. The Total Net Revenues/Practitioner Benefit Stream of the subject

practice, as derived from historical data, must be adjusted to reflect the

most accurate and appropriate information available on the "as of date" to

arrive at an estimate of the "normalized earnings" for the practice. These

adjustments might include:

a. Actual or expected increase/decrease(s) in fees and reimbursementfor services by regulation or competitive market pressures.

b. Projected increase/decrease(s) in practice operating expenses &non-provider compensation related costs based on new practice

operating parameters and market realities.

3. Expectations of the future stability and growth of revenue streams andearnings are difficult to predict and sustain within the context of a chaotic

healthcare industry and practice market place.


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EXHIBIT II

RELIANCE ON HISTORICAL

Q: HOW USEFUL IS PAST IN DETER

AS OF DATEPAST

(5) (4) (3) (2) (1) (1) (2)

Relatively stable Regulatory and

Reimbursement Environment

Traditional fee for service Provider Delivery System

Price to Earnings

Reimbursementincreased for

Primary CareProviders(PCP)

Managed capanel shuts practice -takes patien

PCPs seefewer

patients wihigher Grow/ capitatio

Reimbursementslashed forspecialists


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D. Value as "Incremental Benefit" (See Exhibit III)

1. The economic "Principle of Substitution" states that the cost of an equallydesirable substitute, or one of equivalent utility, tends to set the ceiling of

value, i.e. it is the maximum that a knowledgeable buyer would be willing

to pay for a given asset or property. As applied to the professional

practice appraisal process, this concept is embodied and exemplified in

the "discounted future benefits" method that recognizes that the Fair

Market Value of a professional practice is the aggregate present value of

the total of all future benefits from the subject practice, in excess of the

level of benefits that may be projected to accrue from a hypothetical start-

up practice of the same specialty, setting, format, and location

("Incremental Benefit"). The challenge for the professional practice

appraiser is to arrive at a determination of the present value of this

"Incremental Benefit" within the context of an industry undergoing a "sea-

change" of massively shifting markets, cost structures, and provider

expectations.

2. Determination of hypothetical start-up scenario has become more

complex.

a. The appraiser's determination of the level of benefits derived froma "blended alternative scenario" (a concept which incorporates

the estimated net benefits from a hypothetical start-up of a practice

of the same specialty, setting, format and location, and the

alternative compensation available to the practitioner in the

physician manpower marketplace) must rely on historical data

which is subject to the vagaries of industry changes discussed

above.


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b. The "equally desirable substitute" for professional practitionersthat is required by the "principle of substitution" is more difficultto hypothecate or project at a time when historical trends and

assumptions are often no longer deemed valid by prospective

purchasers.

3. Hypothetical Start-up Earnings are subject to similar uncertainties.

a. It is difficult to gauge the depth of the Professional Practice

Marketplace's perception that the probability of success for

practice start-ups has been diminished by reimbursement and

regulatory pressures.

b. Data related to the costs and earnings of practice start-ups is scarce

and problematic at best.


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EXHIBIT III

VALUE AS INCREMENTAL BENEFIT

INCREMENTAL BENEFIT

(1) (2) (3) (4) (5)

HYPOTHETCAL

STARTUP

THE TOTAL INCREMEBE SAID TO REPRESENOBTAINING AN EQUALSUBSTITUTE TO THE EPRACTICE, i.e. REPLICSTARTUP.

ESTABLISHED, ONGOINGSUBJECT PRACTICE

NUMBER OF YEARS REQUIRED TO REPLICATEESTABLISHED PRACTICE FROM STARTUP


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E. Scope & Nature of Valuation Engagements are Changing - Aspects to

Consider

1. The consolidation and integration of practices have resulted in a largernumber of FTE MDs & larger revenue size of new practice entities.

a. Valuation engagements for a specified minority interest owned by

a provider in larger practice entities can be more complex.

b. Larger practice entities are often multi-specialty with a more

complicated income distribution plan, requiring a diversity of data

for compensation, costs, performance, etc.

c. Larger practice entities limit the universe of potential buyers to

those parties who can handle larger transactions. This places a

great impact on the conceptually favored "market approach"

methodology in that it limits the number of transaction data.

d. IPAs, PHOs, GPWWs, MSOs, and other Emerging Healthcare

Organizations (EHOs) result in unique new practice entities with

altered, scattered asset bases that must be identified, disaggregated

and analyzed.

2. The selection & definition of an appropriate Standard of Value is

problematic with changes in the professional practice market place.

a. Fair Market Value (FMV) presumes a "universe of potentialbuyers" in an open market. Regulatory edicts, such as the

Thornton letter, discourage certain classes of buyers and types of

transactions.

b. Changing reimbursement patterns, payer mixes, and provideralliances make the market for medical practices harder to define &

hypothecate.

c. Market changes due to regulatory and reimbursement demands

may reduce the universe of potential purchasers into a specific

class of potential purchasers. This may change the standard of


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value sought to "acquisition value" vs. Fair Market Value.

3. Government Regulatory Scrutiny & fraud and abuse law prohibitions may

dictate the premise and Standard of Value and, therefore, the methodologyemployed, as well as determine the "permissible assets" for acquisition.

a. Thornton's letter has made suspect any estimates of "goodwill,"

"intangibles," & "future projections."

b. The "premise of value" debate; i.e., "Value in use" (an ongoing

enterprise) vs. "Value in exchange" (liquidation - forced or

orderly) is complicated if the appraiser cannot consider or project

future revenues.

c. Even if the tangible assets of the subject practice are the onlyassets considered, the issue of "Book Value" vs. "Adjusted Book"

also arises. The appraiser ordinarily determines adjustments to

Book Value by first determining the Fair Market Value of the

underlying component assets. Fair Market Value may not be

appropriate as a standard of value under some regulatory

conditions.

d. In response to the "Thornton letter", hospital purchasers are nowoften employing Machinery & Equipment appraisers to value

"hard" or "tangible" practice assets only. Most often they employ

a standard of value called "Fair Market Value in-use-in-place",

rather than liquidation value. It should be noted that "Fair Market

Value in-use-in-place" also relies, in part, on the continuity of a

future earnings stream to support the feasibility of purchase and

maintenance of the underlying tangible assets. There seems to be

an apparent contradiction with the use of this approach to avoid

placing "value" on intangibles.

F. The Range of Services For Healthcare Valuation Reports


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Different types of healthcare organizations and circumstances require valuation

related calculations and valuation reports for a wide range of needs. These needstranslate into an expanded range of services and corresponding reports for

valuators including the following types.

Desktop Analysis & Review: Provides valuation related calculations.No formal correlation, synthesis, conclusion, or certified opinion of value is

provided. Report should provide adequate spreadsheets and notes to support

each of the valuation methods utilized. Report states a range of value

estimates ONLY.

Oral Reports: Requires the same analysis and valuation work-up aseither a "desktop analysis & review" or a "basic narrative valuation report,"

but provides either a range of value estimates or opinion orally, to be followed

by formal letter.

Letter Reports: Requires the same analysis and valuation work-up as a"basic narrative valuation report" but is reported with a letter format with

attached appendices of spreadsheets and data.

Basic Narrative Report: Formal narrative report with table of contentsand attached appendices.

Comprehensive Narrative Report: Basic report plus additional marketanalysis, e.g., utilization demand of practice's services; MD/ population ratios;

incursion of managed care.


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This presentation will briefly touch upon some of the industry background issues and how they

apply to major healthcare valuation concepts and challenges.

III. INDUSTRY BACKGROUND ISSUES

A. The Shifting Universe of Healthcare Delivery (see Exhibit IV)

1. Hospital Centric to Covered Life Centric

2. Market Evolution factors driving move to very large purchasers and verylarge provider networks. (See Exhibit V)

3. Markets have evolved through several stages toward greater consolidation.As markets evolve and enrollment in managed care plans increases, HMO

revenues per member per month decrease along with medical and other

costs.


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EXHIBIT IV

The Shifting Universe of Healthcare Deliv

Hospital

Prevention PrimaryCare

Specialist

Hospital

Access

Mechanism

Wellness

Covered L


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EXHIBIT V

Market Evolution

Economies of ScaleFORCES: Negotiating Power Competitive Pressures

STAGES:IndependentProviders &

Ownership

LooseModels of

Affiliation

TighterLinkages and

Consolidation

M

C

RESULTS:Heightened

Accountability For

Cost and Outcomes

Very Provid

Purch

Integrated Systems

Development

I II III I


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B. Trends in Physician Supply, Workplace and Specialization

1. Trends in Physician Supply - Total MD/Population Ratios have increasedover a thirty (30) year span with a projected increase continuing

throughout the 21st century. The American Medical Association

estimated the ratio of total doctors in patient care per 100,000 population

rose from 132 in 1965 to 226 in 1996, representing an increase of 71.2%

in just over 30 years.1 (See Exhibit VI) With the rapid increase in MD

supply, the patient base per MD is declining, resulting in increased

competition. In concept, this might make it more attractive to acquire an

existing practice that already has a patient base. However, this concept is

challenged by the issue as to whether the patients still "adhere" to

practices or to payers (e.g. insurance plans).

U.S. Physician/Population Ratios2:

Year Total Physician Population Physician/Population Ratio

1950 219,997 1:703

1960 260,484 1:703

1970 334,028 1:623

1980 467,679 1:494

1990 615,421 1:410

1996 737,764 1:360

2022 860,000 1:3393

1 Physician Characteristics and Distribution in the U.S. 1997/98 ed. American Medical Association, 1997, p. 34.2 Ibid.3 Seeking a balanced physician workforce for the 21st century. JAMA, V. 272 (9), Sept. 7, 1994, p. 680-687 (seefig. 2).


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EXHIBIT VI4

2. The Proliferation of Medical Groups and Employed Physicians - In the

1960s and 1970s, the physician enterprise was characterized by solo-

practitioners. In 1965, 11% of physicians practiced in groups with other

physicians. By 1995 this figure had risen to 34%.5 As the financing of

healthcare changed, the organization of physicians has also changed. The

proportion of employed physicians has risen from 26.2% to 39% between

1991 and 1997.6 The change can be attributed primarily to hospitals

purchasing medical practices in an effort to create integrated delivery

systems and the emergence of PPMCs.

3. Trends in the Specialization of Professional Practices - While the trend of

4 Source: Rovner, Julie, The State of Health Care in America Business & Health Magazine: 19965 Medical Groups in the US: A Survey of practice characteristics. 1996 ed. American Medical Association, p. 45.

6 Physician Marketplace Statistics, 1997/98. AMA, 1991& 1997, p. 8, 109.

0

50

100

150

200

250

300

350

1960 1970 1980 1990 2000 2010 2020

Physicians per100,000

population


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physicians entering medical school since the 1960s has been focused on

specialization, attempts are being made to turn the focus to primary care as

the specialty of choice. With the rise of managed care, the increased roleof the "gatekeeper," and the rapid consolidation of healthcare providers

into integrated delivery systems, a premium in "value" has been placed on

primary care physicians in some markets. Not withstanding this and

government sponsored efforts to effect a change, recent surveys indicate a

majority of medical students still plan to specialize.

Surveys based on 1998 data have surmised that the United States would

need about 17,000 fewer medical specialists, 19,000 fewer surgical

specialists and 29,300 additional primary care physicians (including

obstetrics and gynecology) if everyone in the country was enrolled in an

HMO.7

One could attribute the fact that medical students are still specializing, to

the growing aging population. According to data from the Center for

Health Statistics patients age 65 and over have an Average Length of Stay

(ALOS) for short-stay hospitalizations of 6.3 days compared with 4.3 days

for population under 65 years old. 37 % of all procedures for discharges

from short-stay hospital are for patients 65 years and older. Those over 65

years old are responsible for 65% of all discharges from short-stay

hospitals.8 For some specialties, such as cardiology, the effect is even

greater. The number of office visits to cardiologists is over 10 times

higher for patients age 65 and over9, while discharges from short-stay

7 Physician Resource Planning, 9th Edition, Sachs Group, 1998.8 Lawrence L, Hall MJ. 1997 summary: National Hospital Discharge Survey. Advanced data from vital and healthstatistics; no. 308. Hyattsville, Maryland: National Center for Health Statistics. 1999, p. 3, 5, 12.9 Schappert SM. Ambulatory care visits to physician offices, hospital outpatient departments, and emergencydepartments: United States, 1996. National Center for Health Statistics. Vital Health Stat 13(134). 1998, p. 9.


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hospital for heart diseases are three times higher.10 Due to the patient age

mix, there seems to be an increased need for specialists which may

suggest a balancing effect on supply and demand.

Overall, the trend of practice continues to move toward specialization and

away from primary care. While it is expected that patient care demand

will continue to grow, it is not projected to be enough to absorb an

expected oversupply of specialists, according to the Council of Graduate

Medical Education (COGME). While recent efforts to redirect medical

students to primary care are significant, long term results are still

inconclusive.

In 1996, 40% of all physicians were primary care physicians only slightly

less than the 41% which were in primary care in 1970. However, within

primary care there was a trend toward subspecialization and away from

general practice. Of the primary care specialties as of December 31, 1995,

Internal Medicine is the largest at 41%, with Family Practice second at

21%, followed by Pediatrics (18.5%), Obstetrics/Gynecology (13.4%),

and General Practice (6%).11 (See Exhibit VII) These specialties have

become more attractive and such practices are often highly sought after as

patient care "gatekeepers" in managed care oriented delivery systems.

Even with a recent trend towards "right-sizing," i.e., the reduction in

specialists allowed in managed care networks or panels, the trend toward

specialization continues, as insurance plans provide Point of Service

(POS) options which allow patients the option of directly selecting

specialists for a higher copay. This approach, often called the Open

10 Benson v and Marano MA. Current estimates from the National Health Interview Survey, 1995. National HealthInterview Survey, 1995. National Center for Health Statistics. Vital Health Stat 10(199). 1998.11 Physician Characteristics and Distribution in the U.S., 1997/98 ed. American Medical Association, 1997, p. 279-280.


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Access Specialty Based Model, becomes particularly attractive for HMO

plans that develop disease management carve-outs and integrated

specialty care aimed at a specific disease with at risk managed carecontracts.

EXHIBIT VII

C. Changes in the Professional Practice Competitive Environment

1. The emergence of competing providers from Allied Health Professions,

physician extenders and para-professionals, as "lower cost providers"

has increased competitive pressures on physician practices.

a. Competing Providers - Allied Health Professions

(1) Psychiatrists - versus -Psychologists - versus -Licensed

41%

21 %

19%

6%13 %

InternalMedicine

Family Practice

Pediatrics

OB/GYN

General

Practice

Distribution of Primary Care Doctors by Specialty

Source: 1997-98 Physician Characteristics and Distribution in the US. AMA, 1997.


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Psycho-therapists

(2) Ophthalmologists - versus - Optometrists -versus - Opticians

(3) Orthopedists - versus - Osteopaths - versus - Chiropractorsb. Physician Extenders or Para-professionals can either compete or

add practice revenues. Para-professional have the effect of also

increasing practice productivity and revenue.

(1) Physician's Assistants (PA) - The Association of Physician

Assistant Programs reported 2.3 job offers for each PA

graduate in 1997.12 The ratio of Physician Assistants per

100,000 is 11.7. The U.S. Labor Department predicts that

the number of PA positions will grow 47% by 2006.13

(2) Nurse Practitioners (NP) - According to the Nurse

Practitioner Support Service, the number of NPs is 33.6 per

100,000 population.

(3) Nurse Midwives

(4) Certified Registered Nurse Anesthetists (CRNAs)

2. Managed care plans have challenged the traditional providers hold onpatient loyalty and referral patterns. As a result of the demand for cost

containment, there has been a rapid growth in the number of patients

covered by managed care. (See Exhibit VIII) Health Maintenance

Organizations (HMOs) and Preferred Provider Organizations (PPOs),

have sought to combine the role of the insurance company, utilization

review organization, and medical services provider in order to offer

prepaid medical plans to subscribers thereby forcing cost containment by

integrating operational and financial functions.

12 Perceptions of Marketplace Demand: Results of National Survey of 97 Physician Assistant Graduates.Perspectives on Physician Assistant Education, Vol. 9, no. 14, Autumn 98, p. 192-196.13 U.S. Department of Labor. Monthly Labor Review, Vol. 120, no. 11, Nov. 1997, p. 65.


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a. The growing acceptance of managed care in the healthcaredelivery system is exhibited by ongoing enrollment trends. In

1996, 160 million people were estimated to be enrolled in amanaged care plan, up from 112 million in 1995.14 The number of

Americans insured by HMOs grew nearly 15 percent from 57.2

million to 65.6 million in this same time period with HMO

enrollment up almost another 13 percent to 73.8 million from 1997

to 1998.15 Such enrollment growth should continue as public and

private payors transfer more covered lives into managed care

programs.

b. Employers of all sizes and in all regions of the country saw

increases in managed care enrollment.

(1) HMO enrollment among large employers nationwide rosefrom 72% of all eligible employees in 1997 to 87% in

1998, again exceeding indemnity plan enrollment.16

Dramatic growth rates are occurring among small business

employers.

14 The Guide to the Managed Care Industry. HCIA, 1998, p. xi.15 The Guide to the Managed Care Industry. HCIA, 1999, p. XV.16 InterStudy Competitive Edge Part II: HMO Industry Report. InterStudy Publications, Jan. 1, 1997, p. xiv, 2, 34 and Jan. 1, 1998, p. 6.


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Exhibit VIII

c. Corporate Employer Alliances and Healthcare Provider Networks are

being formed and driven by corporate healthcare buyers who want

one-stop healthcare shopping with cost containment and quality

outcome measurement.

d. Provider Sponsored Organizations (PSOs). PSOs have been

developed in order to allow providers to accept financial risk in

providing services to Medicare and Medicaid enrollees. The 1998U.S. fiscal budget defined PSOs as majority provider owned

entities providing all medical care for 1500 or more Medicare

enrollees in urban areas and 500 in rural. PSOs are licensed by the

states and will bear the full financial risk in contracting with

Medicare. Payment will be on a capitated basis, with per member

Managed Care Continues to Edge out Indemnity CoveragePercent of Employees Enrolled by Region and Plan Type

Source: The managed-care juggernaut: Explosive growth nationwide. Medical Economics, April 15, 1996.

00.05

0.1

0.15

0.2

0.250.3

0.35

0.40.45

West

Midwest

South

Northeast

Nationwide

Indemnity

POS

PPOsHMOs


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per month (PMPM), payments. State solvency standards vary for

PSOs. Federal solvency standards of $1.5 million, with half in

cash or cash equivalents.

e. The Rise and Fall of the Gatekeeper System.

The Gatekeeper System, where patients may not consult specialists

without first obtaining a referral from a primary care physician, is

another cost containment measure impacting practice today. This

system elevated the value of primary care physician practices

within markets dominated by the gatekeeper system.

In the last few years, health plan designs are offering more

consumer choices, especially the open access, specialty based

model which does not rely on PCPs as gatekeepers but uses other

medical management tools to allow patients to see the most

appropriate provider for their condition.

Patient protection legislation including limited direct access to

specialists continues to be debated by Congress as the result of

public outcry against the restrictions of managed care including the

gatekeeper system. A bipartisan bill was introduced in October of

1999 that would ensure that decisions on medical necessity would

be made by physicians alone, that enrollees have the right to select

a point of service plan option, direct access to OB/GYNs and

pediatricians, better disclosure of information about health plans, a

prudent layperson standard for emergency coverage, the

prohibition of gag clauses in physician contracts, and external

appeals of health plan decisions. The rights of patients to sue their


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HMOs has also been the subject of recent legislative debate.

In addition to public scrutiny of their medical managementtechniques, HMOs are facing increasing financial pressures as

competition and the negotiating power of purchasers keep

premium growth below rises in medical and administrative costs.

HMO profitability fell between 1994 and 1997 with median HMO

operating losses of 3.5% in 1997 and 1998.17

Even the largest HMOs have not been immune to these public and

financial pressures. Aetna, the largest U.S. healthcare benefits

company, lost two thirds of its stock price between 1997 and the

spring of 1999. This was despite growth in revenues (largely

through acquisitions, notably Prudential Healthcare in July 1999)

and earnings with approximately $1 billion in earnings in 1999.

Resulting shareholder pressure has led to the unexpected

resignation of Aetnas chairman and CEO, Richard Huber, and the

decision to split the company into two independent publicly traded

companies and to sell off its international assets as part of its

reexamination of all its business strategies including its all-

products policy requiring physicians to contract for all of Aetnas

products if they wish to provide any of them.

17 The InterStudy Competitive Edge: HMO Industry Report 9.2. InterStudy, 1999, p. xi.


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D. Reimbursement Issues and the Transition to Capitation

Physician compensation levels have come under increasing pressure with theintroduction of managed care and governmental cost control efforts. However,

despite these pressures, the average annual percentage change in median net

income after expenses before taxes, for nonfederal physicians, 1986-1996 was

5.2%.18

(See Exhibit IX)

EXHIBIT IX

Physician Compensation19

Groups Hospital/Systems Managed Care

Full-Time $187,827 $170,258 $156,954

Part-Time $64,660 $105,966 $108,123

Have contract 50% 62% 42%

Contract/years 2.3 1.7 1.9

Severance/months 10 8 11

Physician Income by Size of Practice20

# of Practice MDs: Solo Two Three 4-8 Over 8

Median Net Income $150,000 $188,000 $200,000 $250,000 $230,000

The following chart (Exhibit X) illustrated trends in physician compensation by specialty

over the last several years.

18 Physician Marketplace Statistics 1997/98. American Medical Association, 1998, p. 85.19 A Report of Surveys of Managed Care Organizations, Hospitals/Systems and Group Practices. The Instituteof Physician-Management Relations, Witt/Kieffer, Ford, Hadelman & Lloyd, 1996.20 Physician Marketplace Statistics 1997/98. American Medical Association, 1998, p. 87.


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28

Exhibit X

$0

$25,000

$50,000

$75,000

$100,000

$125,000

$150,000

$175,000

$200,000

$225,000

$250,000

$275,000

1994 1995 1996 1997 1998 1999

Anesthesiology

Cardiology

Emergency Medicine

Family Practice

General Surgery

Hospitalists

Internal Medicine

Neurology

OB/GYN

Oncology

Pathology

Pediatrics

Psychiatry

Radiology

Urology

Physician Compensation Trends 1994-1999

Source: Modern Healthcares annual report on physician compensation, 1994-1999.


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1. Healthcare Industry Symptoms Drive Payment Reform

a. The idea of payment reform has been spurred by the perceivedfailure of healthcare industry cost containment. The perceptionhas been driven by:

(1) Lack of Accountability for Cost

(2) Supply Driven Inelastic Demand

(3) Excess Capacity of Providers and Specialty Imbalance

(4) Cost-Plus Reimbursement

(5) Unsustainable High Profit Margins of Industry andProfession

b. The transition from the passage of Title XVIII of Social Security

Act 1965 until the passage of the Omnibus Budget Reconciliation

Act (OBRA) of 1989 included:

(1) OBRA '85 directed the development of RBRVS

(Hsiao/Harvard Studies).

(2) OBRA '86 reduced payments for cataract surgery &anesthesiology - setting out the concept of "inherent

reasonableness" for the first time.

(3) OBRA '87 provided payment reductions for 12 additionalgroups of "over-valued" procedures.

(4) OBRA '89 established volume performance rates, replacedCPR with a fee schedule based on relative values (RV), and

replaced the maximum actual allowable charge (MAAC)

restriction on non-participating MDs with a new limiting

charge. States shrink caps.

(5) OBRA '90 [Public law 101-508] made revisions to OBRA


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'89 RVs, asserted "budget neutrality", and set transition

rules.

(6) Final rules & schedules were published by HCFA in theU.S. Federal Register 11/25/91 which took effect 1/1/92.

(7) OBRA 93 rewarded primary care, exempted "clinicswithout walls," further adjusted reimbursement to

specialists and surgeons.

c. The implementation of the Resource Based Relative Value Scales

(RBRBS), completed from 1991 to 1996, as the new Medicare fee

schedule has played a significant part in changing reimbursement

patterns and practice revenues. RBRVS assigns medical

procedures with Relative Value Units (RVUs) based on the

necessary resources used to perform a medical service: i.e.

overhead, malpractice insurance costs, and physicians' work.

Payment levels are based on the RVUs for a procedure,

geographically adjusted, and multiplied by a Conversion Factor.

In assigning the relative values to procedures and in making yearly

updates to these levels, the government has deliberately shifted

payment levels to primary care specialties in order to redress what

they believe are historic inequalities perceived to cause medical

students to over specialize and thereby raise healthcare costs.

These adjustments in reimbursement levels have and are forecast

to have significant impacts for many specialties as is illustrated in

Exhibit XI.


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31

Exhibit XI

-40%-35%-30%

-25%-20%-15%-10%

-5%0%5%

10%15%

20%25%30%35%40%45%50%

FamilyPractice

GeneralPractice

InternalMedicine

Otolaryngology

Neurology

Pulmonary

Dermatology

Nephrology

Urology

OrthopedicSurgery

Pathology

Gastroenterology

Cardiology

GeneralSurgery

Radiology

PlasticSurgery

Neurosurgery

Ophthalmology

Anesthesiology

ThoracicSurgery

Pe rcent Change in Medicare P ayments 1991-2002

Sources: Created through the composite analysis of various reports from the Physician Payment Review Commission, Physicians Payment Update, and HCF


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2. Will RBRVS be Abandoned?

a. Healthcare payment reform is gaining momentum, having shiftedfocus from the federal to the state level. With continued costcontainment pressure, RBRVS is likely to be replaced by capitated

plans, at least in those areas where excess provider capacity has

been squeezed out of the system.

b. Diverting from a fee for service to a capitated basis may have amore significant impact on practice value than the implementation

of RBRVS, due to the shifting of "risk" from payer to provider.

c. Notwithstanding the above, RBRVS has become the standard forthe negotiation of most commercial managed care contracts

supplanting the utilization of St. Anthonys Relative Values for

Physicians (fka McGraw-Hill) which has historically been

preferential to specialists and surgeons.

3. The transition from a fee-for-service form of reimbursement to capitation

will cause healthcare providers to alter their ways of delivering care.

a. The transition to capitation may offer positives to providers.

(1) Provides for immediate access to reimbursement(2) Gives freedom from insurance utilization controls and pre-

authorization requirements

(3) Is considered attractive to payers(4) Potentially increases information sharing

b. Capitation also has several restrictions that should be considered in

the valuation process.

(1) Fixed reimbursement requires significant and consistentutilization management and the tracking of referrals with

their incurred but not reported (IBNR) liabilities.

(2) Quality of care may be compromised in certain casesbecause of inadequate treatment or extended waiting times


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33

(3) Establishing parameters and administrative guidelines canbe complicated

(4) Adverse selection in small populations can inhibit costcontainment

4. Government Reimbursements Change to Prospective Payments Systems

Medicare and Medicaid originally paid for hospital services using a cost

plus reimbursement basis, where hospitals were paid for all of their costs

and more. The rising costs associated with this system led to the

introduction by the federal government of a prospective pricing system

for hospital payment, where hospitals are reimbursed an average, qualified

amount for each patient treated with the same type of diagnosis specified

by Diagnostic Related Group (DRG). The government is currently

developing prospective pricing systems for reimbursement for ambulatory

surgery centers, hospital outpatient services, home health care, skilled

nursing facilities, and rehabilitation facilities. There are also plans for a

prospective pricing system for long-term hospital care. Since the

government is the single largest payor for healthcare services, these

changes exert enormous pressure on providers to reduce costs.


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34

IV. THE RISE OF EMERGING HEALTHCARE ORGANIZATIONS (EHOS)

In response to the market forces described above, providers are consolidating and

integrating into new organizational forms, called Emerging Healthcare Organizations

or EHOs, to attempt to compete more effectively. The business objective in healthcare

now is control over covered lives. Emerging Healthcare Organizations are generally

formed to pursue this goal.

An emerging healthcare organization is an organizational form

consisting of hospital(s), physician(s), and/or health plan(s) that have

consolidated, merged, integrated or affiliated in response to managed

care and integration forces in their market.21

The critical element to this broad definition is the reason for an EHOs existence. Market

forces, primarily demands for lower prices and/or improved outcomes, catalyze EHO

development and operations.

EHOs are vehicles for physician integration. In a cost-sensitive managed care

environment or a more progressive outcome-focused one, it is critical for payors and

others who bear risk for health services to have strong relationships with physicians. The

rationale is simple: physicians direct care, thereby giving them considerable control over

healthcare expenditures and medical outcomes.

Physician integration models such as EHOs combine groups of providers to compete in

the market as the "highest quality, lowest-cost provider" of healthcare services.

However, along with the growth and penetration of managed care, the evolution of these

systems, organizations, and networks challenges the traditional healthcare delivery

21 Capital Survey of Emerging Healthcare Organizations. Second Annual Report 1996, Integrated Healthcare


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35

systems, especially the traditional, independent private practice of medicine. As

physicians integrate to seek leverage in the marketplace they lose varying degrees of their

practice autonomy. The relationship between autonomy and leverage is illustrated inExhibit XII.

Report, Medical Group Management Association, and Ziegler Securities, 1996, p. 1.


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36

EXHIBIT XII

Autonomy/Leverage Diagram

L E V E R A G E

SOLO PRACTITIONER

INDEPENDENT PRACTICE ASSOCIATION (IPA)

GROUP PRACTICE WITHOUT WALLS

MANAGEMENT SERVICES ORGANIZ

A

U

T

O

N

O

M

Y

PHYSICIAN/HOSPITAL ORGANIZATION (PHO)

AUTONOMY /PRACTICEINDEPENDENCE

HOSPITAL

DEPENDENT

PRACTICE

FLEXIBILITY OPERATING

EFFICIENCIES

(SHORT TERM)

MANAGED CARE ATTRACTIVENESS

SECURE REFERRAL SOURCES

OPERATING EFFICIENCIES (LONG TERM)

PRACTICE STABILITY

MANAGEMENT SERVICES BUREAU (MSB)

FULLY INTEGRATED

MEDICAL GROUP (FIMG)

INTEGRATED DSYSTEM (ID

FINANCIAL REWARDS

START-UP CAPITAL/FINANCIAL COM

FINANCIAL/OPERATING RISK

COMPLEXITY (LEGAL, OPERATIONA


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37

A. Types of EHOs

1. Classification

EHOs take numerous forms to fill may functions in todays marketplace. To

simplify the complex situation, this course focuses on six major EHOs:

1. Independent Practice Association (IPA)

2. Physician Hospital Organization (PHO)

3. Physician Practice Management Company (PPMC)

4. Management Services Organization (MSO)

5. Fully Integrated Medical Group (FIMG)

6. Integrated Delivery Systems (IDS)

In addition to these models, a section on Group Practices Without Walls

(GPWWs), a less prevalent model, but one which is important in the history of

EHOs, is included.

2. Type and Degree of Integration (See Exhibit XIII)

By definition, EHOs are integrated businesses. However, EHOs level of

integration varies in degree and in forms, whether horizontal or vertical.

Horizontal integration is the acquisition and consolidation of like organizations

or business ventures under a single corporate management, in order to producesynergy, reduce redundancies and duplication of efforts or products, and achieve

economies of scale while increasing market share.22 When hospitals join

together and create hospital systems or when physicians join forces to form

22 Peter Boland. The Capitation Sourcebook. Boland Healthcare, 1996, p. 618.


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38

organizations that primarily offer physician services, horizontal integration is at

work.

Vertical integration involves to joining of organizations that are fundamentally

different in their product and/or services offerings. It is the aggregation of

dissimilar but related business units, companies, or organizations under a single

ownership or management in order to provide a full range of related products and

services.23 The evolution of many healthcare markets is being driven by a vision

for fully-integrated organizations.

Exhibit XIII

23 Ibid, p. 629.

Evolution and Continuum of Physician Integration

Shared Economic RiskLEAST MOST

MOST

LEAST

Solo

Practice

IndependentPractice

Association

Group Practice

Without Walls

Open PHO

Closed PHO

Comprehensive

MSO

FoundationModel

Equity

Model

Staff/EmployedModel

Management

Service

Bureau

Fully Integrated

Group Practice

IndividualDecisionMaking

MSO


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3. A Framework for Understanding EHOs.

A framework for the emerging enterprises in the business of healthcare is shownin Exhibit XIV below. Its rows classify each EHO by its function and level of

integration (least integrated at the top) and the columns denote integration type

(horizontal versus vertical). In less technical terms, it is a two by three matrix

where the short axis represents the type of integration and the long axis represents

the type of business operations.

Exhibit XIV

Each of the three levels can be identified according to their business strategy:

PHO

MSO

IDS

IPA

PPMC

Multi-Specialty

Group Practice

WHYWHAT

Horizontal Vertical

Maintain Status Quo

Cost Containment

Change Care Process

Managed Care

contracting

Operations / Economies

of Scale

Population-based healthmanagement

EHO Models


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40

I: Resistors. Organizations designed to maintain the status quo, fend off managed

care, or slowly learn how to successfully operate in a managed care environment.

IPAs and PHOs

II: Cost Containers. Organizations that are capable of controlling healthcare

costs through economies of scale. Their ability to contract effectively with

managed care organizations and systematically reduce utilization of services is

limited, however.

PPMCs and MSOs

III: True Integrators. These are organizations that are so financially integrated

through risk contracting or ownership, true integration of care processes is

possible. There are very few true integrators operating in the United States, but

many EHOs see themselves as evolving toward true integration.

FIMGs and IDSs

4. Independent Practice Associations (IPAs)

The acronym IPA stands for Individual Practice Association or Independent Practice

Association. It is a legal entity of independent physicians that contracts with health

insurance companies to provide medical services. IPAs are generally not-for-profit,

although it is not a requirement. Individual physicians operate under their own tax IDs,

Medicare provider numbers, etc. and generally do not share administrative overhead or

centralized systems such as billing and claims processing information systems. Although

some IPAs include investment by hospitals, this section focuses on the horizontally-

integrated IPA which excludes hospitals and other non-physician-controlled businesses.

Refer to Exhibit XV for an illustration of the organizational form of an IPA.


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41

Over 1200 IPAs have been identified by the American Hospital Association, but because

they are forming so quickly, the actual number may be twice this many. In 1997, 50

percent of physicians participated in managed care contracts via IPAs, and for theaverage physician these contracts represent about 20 percent of their revenues.

Exhibit XV

5. Physician Practice Management Companies (PPMCs)

a. Definition

Although Physician Practice Management Companies have been classified as

simply publicly traded MSOs, there is a more refined definition. First, to be

classified as a PPMC, an organization must be physician-dominated. PPMCs are

INDEPENDENT PRACTICE ASSOCIATION (IPA)

Physician Practice

IPA

Billing and Collection

UM/QA

Usually, Risk-sharing or

Capitation Accounts

IPA-ContractedPayor

Non-IPA ContractedPayor

Provider Agreement

$ (multiple reimbursement mechanism)

Provider Agreement

May be fee-

for-service or

capitation

$

Ownership

$

(usually

capitation)


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42

management firms that specialize in the management of large group practices or

IPAs through ownership, management agreement, or both. PPMCs generally own

the physician practices with which they affiliate via subsidiaries. In the last fiveyears, PPMCs have acquired increasing numbers of physician practices.

Physician Practice Management Companies offer access to the capital markets

that physicians have not historically had. With capital, physicians in PPMCs have

been able to build surgery centers, expand service lines, and bolster contracting

leverage with managed care organizations, hospitals, and health systems.

b. PPMC Business Performance

The publicly traded industry has undergone large swings in its market

capitalization. As discussed earlier, several of the major publicly traded PPMCs

have gone bankrupt or decided to leave the practice management business. Poor

financial management including over aggressive acquisitions have contributed to

this recent industry shakedown. The number of public PPMCs could continue to

fall in the short term as some of the remaining companies restructure or close

their practice management operations. Generally multispecialty PPMCs have

performed far worse that those which focus on a single specialty or condition.


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43

Exhibit XVI

6. Physician Hospital Organizations (PHOs)

A Physician Hospital Organization (PHO) unites a hospital or group of hospitals

with a physician organization through a contractual relationship. The PHO is

usually owned by the physicians and/or hospital and, in many cases, is a non-

profit organization. In Exhibit XVII, individual physicians own shares of a

physician organization that enters a joint venture with a hospital called a PHO.

Physician Practice Management Company (PPMC)

Equity Model

The PhyCor Model

MOST COMMONPPMC

Local Subsidiary of PPMC

(50/50 Governance)

(Not Always Implemented)

Professional

Association/Corporation

MDsAssets

Non-MD Staff Initial 3-5 yr Contract

Long-termAgreement


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44

Exhibit XVII

7. Management Services Organizations (MSOs) (Exhibit XVIII)

An MSO is a legal entity owned by physicians, hospitals, or lay investors that

provides an array of practice management services. Traditionally, MSOs have

provided a variety of services to both medical practices and hospitals. An MSO

can also be referred to as a PSN, or Physician Services Network; an MSB, or

Management Services Bureau; or a Practice Asset Organization.

In their [most] basic form, MSOs sell practice management services for a

Medical

Group

Medical

Group

Medical

Group

Physician Hospital Organization Hospital

Physician Hospital Organization(PHO)Joint Ownership Structure

Shareholders Shareholders


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45

monthly fee,24 but the services provided by MSOs encompass a broad range and

include, but are not limited to: operations management, marketing, contract

negotiation, new assets acquisition, personnel management, leasing, providingsupport services to other organizations (i.e., hospitals), physician recruitment,

MIS development, purchasing, and facilities development.25

Exhibit XVIII

8. Group Practices Without Walls (GPWWs) (Exhibit XIX)

A Group Practice Without Walls (GPWW), also called a clinic without walls, is a

24 Perry, Kristie, Would an MSO Make Your Life Easier? Medical Economics, April 10, 1995.25 Goldstein, Douglas, From Physician Bonding to Alliances: Building New Physician-Hospital Relationships,Capital Publications, Inc, 1992, and Peters, Gerald R., Esq., Healthcare Integration: A Legal Manual forConstructing Integrated Organizations. National Health Lawyers Association, 1995.

Management Services Organization (MSO)Joint Venture Hospital Physician-Owned

MSO Payors

Non-owner

Physicians

Owner

PhysiciansHospital

Medical

Services

Ownership

Managem

ent

Services

$

$

Ownership

Management

Services $$

Medica

l

Service

s

ProviderAgreement

ProviderAgreement


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46

network of physicians who have merged into one legal entity but maintain control

over individual practice sites. A GPWW does not include the participation of

hospitals or other non-physicians. In forming of this type of organization,physicians aggregate their practice assets (tangible and intangible) into one entity,

providing them with contracting leverage with managed care organizations.

GPWWs differ from MSOs in two ways:

1) only physicians may be owners of GPWWs, and2) a GPWW acquires all assets, while an MSO acquires just tangibles.

Exhibit XIX

9. Fully Integrated Medical Groups (FIMGs)

A Fully Integrated Medical Group (FIMG) is a highly integrated medical group

Group Practice Without Walls (GPWW)

Site A Site B Site C Site x

GPWW

Physician Owner

Payors

Provider Agreement

$


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47

practice organized as a single legal entity. Management is centralized and has

sufficient authority to effectively manage both the medical and business

operations of the group allowing FIMGs to integrate clinical, financial, andoperational aspects of the practice. An income distribution plan aligns the

incentives of the physician and the group. FIMGs are organizations often called

physician equity groups, which can vary in their level of integration from that

of traditional practices to that of FIMGs. The real differentiating factor between

group practices and FIMGs is the level of integration a subjective quality.

Exhibit XX

10.Integrated Delivery Systems (IDS) (Exhibit XXI)

As providers consolidate and Managed Care Organizations seek to contract on a capitated

basis for the provision of all of the care that patients require, hospitals and physicians, as

Fully-Integrated Medical Group (FIMG)

Provider Agreement

$

Payor

Non-Owner

Physicians

Owner

Physicians

Medical Group

Employment

Agreement

$

Compensation

Emplo

yment

Agreement

$

Compensation

Ownership


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48

the traditional providers of care, are destined to become more and more integrated into

single organizations. Most existing Integrated Delivery Systems (IDS) began when

hospitals acquired or affiliated with physicians through PHOs or MSOs for the purposeof managed care contracting.26 These organizations desire to expand the range of

services they provide has led to their merger, acquisition, or affiliation with other types of

facilities such as long-term care, skilled nursing facilities, and ambulatory surgery centers

as well as with ancillary providers including laboratories and diagnostics.

Exhibit XXI

26 DeMuro, Paul R. Managed care & integrated delivery systems: Strategies for contracting, compensation &reimbursement. Irwin Professional Publishing, 1995, pp. 13-14.

Integrated Delivery System (IDS)

Hospitals

Outside Payor

Physician

Organization

Provider Agreement

$

Provider Agreement

$

Provider Agreement

$

Provider Agreement

$

Provider

Agreements$

$

$

$

Other Providerslabphysical therapyhome healthetc.

HMO

(optional)


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49

B. Challenges to the Valuation of Emerging Healthcare Organizations (EHOs)

1. Identifying the Relationships Among All Entities (See Exhibit XXII) Ownership of both tangible & intangible assets Identification of structure, governance, control & risk relationships

within entity

2. Tracking the Cash Flows

Value is related to the probability of the continuity of net cash flows The quality and expected duration of the cash flow must be determined Unrecognized liabilities, e.g. IBNR and related matters must be

accounted for

3. The Developing Market

Transactions involving IPAs, MSOs, and other EHOs are currentlybeing seen in the marketplace, and these transactions require

valuations

Both Transactions and Guideline Companies are available forcomparison utilizing market concept valuation approaches


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50

EXHIBIT XXII

Emerging Healthcare Organizations

Q. What holds the value?A. It depends on the legal and organizational structure

Intangible Assets may include:

Service Contracts with Third Party Payors & MCOs Strength of Agreements with all Providers Management Services Agreements Provider Services Agreements

Capture of the Ancillaries (Lab, Diagnostics, etc.) Other Intangibles

Tangible Assets may include:

Cash and Accounts Receivable Hard Assets: Furniture, Fixtures, & Equipment (FF&E) Real Estate and Buildings Durable Medical Equipment (DME) and Supplies


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51

V. TRENDS IN HEALTHCARE TRANSACTIONS

A. Physician to physician transactions

1. As managed care penetration increases, physicians are reacting to the

market's signals. According to a 1997 Medical Economics survey of

11,104 practicing physicians, 38% had structurally changed their practices

or planned to do so in 1998.27

Types of physician-physician transactions

include:

a. Recruitment of new associates or partners

b. Medical practice sale by a retiring physician

c. Medical practice expansion through acquisition

d. Establishment of practice satellite location

e. Group practice formation

f. Establishment of a physician organization (PO)

2. While these types of transactions have been frequent in the past, the total

number of physician to physician transactions has been significantly

reduced as a result of integration/consolidation efforts.

B. Physician Practice Management Company (PPMC) transactions

Competing in todays marketplace calls for a rapid growth by physician-led

integrated health care organizations. Three market forces have caused physicians

to financially merge their medical practices: (1) the increased financial benefit

from revenue from owned related health services without violating Stark II, (2)

the ability to negotiate risk and non-risk managed health plan contracts with

sufficient leverage, and (3) the promise of creating a larger economic entity

capable of accessing outside sources of capital on favorable terms.

27 "Doctors on the move". Medical Economics, Vol. 74, No. 24, December 8th 1997, page 145.


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52

Publicly-traded Physician Practice Management Companies (PPMCs) emerged in

response to physician practices needs for capital, strong management and

managed care expertise in an increasingly competitive healthcare industry. In1997, 34 public PPMCs raised $2 billion28.

Physician practice acquisition has become a corporate deal that is no longer quiet.

As of early 1998, investor-owned PPMCs were buying physician practices at 5-

10 times EBIT29 with a high percentage of the price paid in stock and making

news in the Wall Street Journal. With hospitals and health systems (both for-

profit and non-profit) purchasing medical practices as well, the competition for

quality physician practices was high, and likewise the transaction prices.

1999 has seen the pace of practice acquisitions greatly slowed and in many

markets PPMCs and hospitals are divesting previously acquired practices. The

reasons for these sales are varied but they have in common the failed financial

and strategic performance of acquired practices resulting from overall poor

management. Many of these purchasers underestimated the complexity of

effective practice management.

Before the current downturn in acquisitions, it was estimated that PPMCs

acquired approximately 260 physician practices in 1997.30

Initially, stock prices

and growth of these companies outpaced stock indexes, but recently these

companies have underperformed the market. Despite their recent poor stock

performance as a group, PPMCs offer physicians an innovative mechanism to try

to regain control of the healthcare industry by providing physicians with access to

capital, management, and managed care expertise.

1. The Collapse of Publicly Traded PPMCs

28 Ibid.29 1998 PPMC Yearbook, Sherlock Company, May 1998..30 The 1998 PPMC Yearbook. Sherlock Company, 1998, p.17.


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53

PPMCs emerged over the past five years as a vehicle of change for physicians.

The companies initially enjoyed strong growth in revenue and earnings duringtheir first few years31. In 1998 Sherlock Co. identified 164 PPMCs, 39 of which

were then publicly traded.32 Thirty-four public PPMCs (as of April 14, 1998)

were affiliated with 5% of the nations active physicians.33 To support their

growth, PPMCs offered lucrative buy-out deals to physicians, especially

compared to the hospital buy-out offers and physician-physician deals. The

PPMC industry attempts to aggregate medical practices in order to build market

clout and boost their stock performance.

However, in the last year, PPMCs have suffered from various management and

financial problems and in the nine months ending September 1998, the market

capitalization for publicly traded PPMCs fell 58%. In the first half of 1999,

PPMC stocks have underperformed the market, falling over 30% compared with

the 8.8% growth of the S&P 500.34 Since last September, several of the largest

PPMCs have declared bankruptcy or have decided to exit the practice

management business. Some of the larger companies involved are noted below.

In July of 1998, FPA Medical Management declared bankruptcy, theresult of poor management, financial and otherwise, and over aggressive

acquisitions. Its stock price fell to $.18 per share from $18 per share four

months earlier. California physicians were shorted $60 million in payments

and physicians nationwide may have lost $200 million in payments.35

PhyMatrix announced in October of 1998 that it would divest its group31 ONeil, B, Manderfeld, T. Physician Practice Management: Searching for Value. Piper Jaffray, August 1997.32 1998 PPMC Yearbook. Sherlock Company, 1998, p. 3, 7.33 PPMC(newsletter). Sherlock Company. May 1998.34 PPMC. Sherlock Company, June 1999, p. 2.


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54

practice management business to focus on hospitalist practices and practice

networks management.

MedPartners, once the largest PPMC, announced its intent to divest it practicemanagement business in November of 1998 stating that the industry is

viewed unfavorably as presently configured.36

The PPMC suffered a loss of

$1.2 billion in the fourth quarter of 1998.37 On March 11, 1999 a voluntary

bankruptcy petition was filed by the conservator for MedPartners Provider

Network and a settlement was reached with the State of California in April

which provided for the orderly disposition of existing California operations.38

PhyCor, once the second largest PPMC, announced at the beginning of theyear that it did not plan on purchasing physician practices in 1999.39 The

PPMC lost $111.5 million in 1998 on revenues of $2.9 billion as compared

with a $3.2 million dollar loss in 1997.40

The number of publicly traded PPMCs had fallen to 22 by June of 1999.41 The number

of PPMC acquisitions of physician practices has declined in the last year and will

probably continue to decline in the short term. However, PPMC business strategies and

market positions vary considerably and the outlook is not entirely bleak. Single specialty

PPMCs are a potential notable exception to the current trends.

C. Hospital transactions

Hospitals purchase physician practices in order to further integrate with

35 How FPAs implosion buried its doctors by Robert Lowes. Medical Economics, Jan. 25, 1999, p. 141.36 Ibid, May 1999, p. 3.37 Ibid, March 1999.38 Ibid, June, 1999.39 Medical Economics, Jan. 25, 1999.40 PPMC. Sherlock Company, April 1999.


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physicians, to strengthen referral relationships, to add physician reimbursement to

their earnings pool, and to increase managed care contracting leverage. Since

1994, hospitals have acquired 5,000 doctors primary care practices per year,spending $100,000 per physician on average.42 A 17-hospital survey by Coopers

& Lybrand found that, on average, hospitals were incurring annual losses of

$97,000 per acquired physician due to high purchase prices and low

productivity.43

Another recent survey based upon 382 practices that were

acquired by hospitals between 1993 and 1996 revealed the following44:

Average physician salary paid was $154,464. Average forecasted profit in first year per physician was -$11,134.

With such losses recorded and poor strategic gains, hospitals are less likely to pay

high amounts for additional medical practices. Tenet Healthcare Corp. and

Columbia/HCA, the two largest hospital management companies, have both

stated that they are considering divesting physician practices.

D. Cost Containment-Regulatory Agenda is changing the market terms and

structure of practice transactions.

2. Tax Code - Increased scrutiny of 501(c) 3 status has affected the marketfor selling practices to charitable institutions, e.g., hospitals, foundations.

a. The primary concern is that the private benefit and private

inurement standards are fulfilled, along with other structural and

community benefit requirements. A sampling of relevant issues

41 Ibid.42 Hospitals that gobbled up physician practices feel ill. Wall Street Journal. June 17, 1997.43 Ibid.44 The 1997-98 Physician Practice Acquisition Resource Book. Center for Healthcare Industry PerformanceStudies, 1997, p. 4, 55, 65, 230.


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Developments in Valuation of Healthcare Services

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