Issues Raised by the Purchase of a

Physician Practice

First Illinois HFMA Accounting and Reimbursement Program

October 20, 2011

Overview As hospitals continue to acquire physician practices,

an understanding of valuation and relevant compliance considerations is critical for management.

This presentation will provide an overview of these concepts and help management be aware of valuation pitfalls that could result in compliance risks.

Presentation Summary

Objectives Articulate the differences between alternative standards of

value including investment value, fair market value and fair value

Gain a general understanding of the key value drivers to consider when evaluating a purchase or sale of a healthcare entity including: The relationship between future compensation and

practice value. The factors that support a payment for an intangible

asset. Understand the impact of new purchase accounting

standards to a hospital’s financial statements following an acquisition

Presentation Summary

Standards of Value Fair Market Value Investment Value Fair Value

Appropriate standard is driven by purpose of engagement

Standards of Value

Fair Market Value “The price at which property would change hands

between a hypothetical willing buyer and a hypothetical willing seller, both being adequately informed of the relevant facts and neither being under any compulsion to buy or sell” – IRS Revenue Ruling 59-60

Required standard of value stipulated by IRS and OIG

Further clarifications under Stark Law and the Anti-Kickback Statute

Standards of Value

Fair Market Value (continued) “Commercially Reasonable” concept for transactions

involving physicians 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 (or family member or group practice) of similar scope and specialty, even if there were no potential DHS referrals

Hospitals cannot pay physicians for referrals –outpatient, inpatient or ancillary services

Standards of Value

Fair Value Required standard of value for accounting matters “The price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction between market participants at the measurement date” – Accounting Standards Codification (“ASC”) Topic 820 (formerly SFAS 157)

“Exit Price” Concept Typically, fair value is assumed to be equal to fair

market value although the values could be different

Standards of Value

Investment Value Considers the attributes of a

specific buyer or situation Can be significantly higher than

fair market value Often seen in mergers and

acquisitions involving strategic buyers – may include synergies

Hospital management may be interested in calculating investment value for internal planning purposes

Standards of Value

Value Differences Each standard can result in a different value for the

same asset/interest Fair market value versus investment value in an

acquisition of a physician practice Due to Stark Law and the Anti-Kickback

Statute, the value cannot be tied to the value or volume of future referrals

Value associated with referrals can be significant for many specialties

Standards of Value

Publicly-Traded Stock

Levels of Value

Non-Marketable Minority Value

Marketable Minority Value

Financial Control Value

Strategic Control ValueStrategic Control

Premium

Marketability Discount

Financial Control Premium

Minority InterestDiscount

Fair Market Valueof 100% Interest

Investment Valueof 100% Interest

Primary Valuation Approaches Asset Approach Income Approach Market Approach

Nature of asset or interest will influence selection of approaches

Income and/or asset approaches typically used in healthcare valuations

Valuation Approaches

Asset Approach Net Asset Value method Asset context Cost to create exact or similar asset

Business context Value of equity = value of assets – value

of liabilities (both at fair market value) May require appraisal of equipment and real

property Establishes minimum value for asset or

business Orderly liquidation vs. value in use

Valuation Approaches

Income Approach Value determined based on present value of future

economic benefits of ownership Considers market rates of return for similar investments Methods: Discounted Cash Flow Multi-year projection discounted to present value

Capitalization of Cash Flow Multiple (or capitalization rate) applied to

representative cash flow

Valuation Approaches

Market Approach Identify exchanges of similar

assets/interests in the marketplace Draw inferences for use in deriving

estimate of value of subject asset/interest Methods: Guideline (Public) Company Merger & Acquisition Transactions of public and private

entities Transactions in company stock / bona

fide offers for purchase

Valuation Approaches

Considerations Asset Approach Only quantifies the value of tangible assets unless

other approaches are utilized for intangible assets Income Approach Adjustments to operating expenses – physician

compensation, rent, etc. Medical Group Management Association

(“MGMA”) data Predictability of future operating results Determination of an appropriate discount rate

Valuation Approaches

Considerations (continued) Market Approach Availability of relevant financial detail needed for

analysis Changes since transactions occurred Comparability to company being valued Payer mix Size / geographic location Service diversification / specialties

Valuation Approaches

Physician Integration – Practice Acquisitions

Physician integration trend is fueling physician practice acquisitions

Each practice has unique attributes Must evaluate recent trends in

performance: Payer mix Volumes and procedure mix Physician compensation Staff turnover

Physician Integration – Practice Acquisitions

How motivated are the physicians? Fear factor - future

reimbursement Value expectations

Are all physicians on board with selling?

Are you interested in employing all physicians following the acquisition?

Physician Integration – Practice Acquisitions

Key questions for management: Is payment for an intangible asset

supportable? The answer depends on whether or not a

premium price over tangible asset value can be supported under the fair market value standard of value

The following examples will help demonstrate when a premium over tangible asset value may be supportable

What level of compensation should be paid to the physicians? How should the compensation arrangement be structured?

Practice Acquisition Examples

Practice Example #1 Cardiology Practice High physician turnover Physician compensation below levels supported

by MGMA data High operating expenses and history of operating

losses No significant change in operating performance

was expected

Practice Example #1 (continued)

Practice Acquisition Examples

2008 2009 2010Revenue 3,482,487 3,578,226 4,028,932

Operating Expenses(1) Physician Compensation 1,315,000 1,116,154 1,330,481

Other Operating Expenses 2,211,871 2,453,018 2,742,427 Total Operating Expenses 3,526,871 3,569,172 4,072,908

Operating Income (Loss) (44,384)$ 9,054$ (43,976)$

(1) Actual physician compensation was below levels expected to be paid by the prospective hospital acquirer andlower than levels supported by the MGMA data.

For the Year Ending December 31,

Practice Example #1 – (continued) The level of physician compensation that the

practice’s operations could sustain were below levels supported by MGMA data

The standard compensation package to be offered by the prospective hospital acquirer was expected to result in compensation in excess of the levels historically paid at the cardiology practice

Since the cardiology practice was not expected to generate positive cash flows under the hospital’s compensation structure, no intangible value was indicated

Practice Acquisition Examples

Practice Acquisition Examples

Practice Example #2 Surgery Practice

Generates revenue from surgical procedures and ancillary services

Physician compensation at high end of range indicated by MGMA data

Positive cash flow No significant change in operating performance

was expected

Practice Acquisition Examples

Practice Example #2 – (continued)

2008 2009 2010Revenue 4,259,317 4,060,522 4,341,484

Operating Expenses(1) Physician Compensation 2,131,174 1,881,589 2,010,541

Other Operating Expenses 1,967,383 2,105,245 2,180,039 Total Operating Expenses 4,098,557 3,986,834 4,190,580

Operating Income (Loss) 160,760$ 73,688$ 150,904$

(1) Actual physician compensation was above levels expected to be paid by the prospective hospital acquirer andat the high end of the range indicated by the MGMA data.

Historical Operating Results

For the Year Ending December 31,

Practice Acquisition Examples

Practice Example #2 (continued) The surgery practice generated positive cash flow

while paying its physicians compensation near the upper end of the range included in the MGMA data

The anticipated compensation package to be offered by the prospective hospital acquirer was expected to result in physician compensation below the levels historically paid at the surgery practice

Since the surgery practice was expected to generate positive cash flows under the hospital’s compensation structure, intangible value was indicated

Practice Acquisition Examples

Practice Example #3 - Neurosurgical Practice ABC Hospital was considering an

acquisition of a neurosurgery practice ABC Hospital anticipated an increase in

admissions from new referrals generated from the neurosurgery practice

The fair market value of the practice was determined without regard to the incremental contribution margin the new referrals were expected to generate at ABC Hospital

The investment value to ABC Hospital was in excess of the fair market value of the practice – ABC Hospital could have supported a purchase price in excess of fair market value

Practice Acquisition Examples

Practice Example #4 – In-Vitro Fertilization Practice XYZ Hospital acquired an in-vitro fertilization

practice XYZ Hospital engaged a valuation firm to

determine the fair market value of the practice The fair market value analysis reflected a

“market” level of compensation for the primary physician of $400,000 per annum

Following the transaction, XYZ Hospital paid the primary physician $800,000 per year

XYZ Hospital could be at risk if the transaction is investigated by IRS or OIG

Valuation analysis should reflect compensation that is expected to be paid by acquiring hospital

Practice Acquisition Considerations

Professional vs. Technical Component Revenue Is revenue sustainable?

Who is a potential buyer in the marketplace? Hospitals / Practices / Other

Does the analysis reflect assumptions that only one potential buyer could achieve or only the current owner could maintain?

If yes, the value may not be consistent with Fair Market Value

The target entity must be expected to provide a reasonable return on investment for the “hypothetical” acquirer Cash flows (without regard to referrals) must support any premium

paid over the value of tangible assets If cash flows do not support a premium, the net asset value of

tangible assets should be the basis for the purchase price

Practice Acquisition Considerations

Level and Structure of Compensation Arrangement If a payment for an intangible is not supportable, many hospitals

are choosing to offer generous compensation arrangements to physicians The following charts compare median compensation for

hospital employed and private practice physicians for selected specialties. Data was compiled from MGMA physician production and compensation surveys.

Many arrangements are tied to production (work RVUs or collections)

It is important to understand the likely increase in compensation to the physicians that will result from the contemplated arrangement An attractive compensation arrangement may motivate

physicians to finalize a transaction even if the purchase price excludes a payment for an intangible asset

Hospital vs. Private Practice Compensation

$351,960

$367,500

$414,223

$439,967

$468,970

$459,168

$376,663

$367,704

$409,204

$424,458

$396,738

$369,156

$300,000

$320,000

$340,000

$360,000

$380,000

$400,000

$420,000

$440,000

$460,000

$480,000

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

nCardiology: Noninvasive

Hospital Owned Non-Hospital Owned

Hospital vs. Private Practice Compensation

$49.93

$53.11

$54.50

$55.82

$55.35

$59.14

$52.98

$52.30

$49.34

$53.46

$51.28

$55.33

$44.00

$46.00

$48.00

$50.00

$52.00

$54.00

$56.00

$58.00

$60.00

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

n pe

r W

ork

RVU

Cardiology: NoninvasiveHospital Owned Non-Hospital Owned

Hospital vs. Private Practice Compensation

$404,987 $404,612 $398,905

$469,989

$516,413 $526,398

$417,352

$429,540

$455,619

$450,086 $452,128

$482,928

$350,000

$370,000

$390,000

$410,000

$430,000

$450,000

$470,000

$490,000

$510,000

$530,000

$550,000

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

nOrthopedic Surgery

Hospital Owned Non-Hospital Owned

Hospital vs. Private Practice Compensation

$55.08

$56.60 $56.36

$60.91

$61.71

$62.96

$53.73

$57.95

$55.21

$58.36 $58.02

$57.56

$48.00

$50.00

$52.00

$54.00

$56.00

$58.00

$60.00

$62.00

$64.00

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

n pe

r W

ork

RVU

Orthopedic SurgeryHospital Owned Non-Hospital Owned

Hospital vs. Private Practice Compensation

$155,932

$160,332

$167,231

$177,311

$183,152

$186,048

$169,566

$168,877

$185,273

$183,084

$185,234

$195,027

$150,000

$155,000

$160,000

$165,000

$170,000

$175,000

$180,000

$185,000

$190,000

$195,000

$200,000

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

nFamily Practice without OB

Hospital Owned Non-Hospital Owned

Hospital vs. Private Practice Compensation

$38.78

$40.83

$38.60 $38.80

$39.04

$39.73 $39.03

$41.80

$39.40

$39.84 $39.52

$42.79

$36.00

$37.00

$38.00

$39.00

$40.00

$41.00

$42.00

$43.00

$44.00

2005 2006 2007 2008 2009 2010

Med

ian

Com

pens

atio

n pe

r W

ork

RVU

Family Practice without OBHospital Owned Non-Hospital Owned

New Purchase Accounting Guidelines As of December 15, 2009, all acquisitions

completed by not-for-profit entities are subject to the purchase accounting guidelines outlined in ASC Topics 350, 360, 805, 954 and 958 Prior guidelines included SFAS Nos.

141R, 142, 144, and 164 The standard of value to be used for

financial reporting is fair value, which is governed by ASC Topic 820

For-profit entities have been subject to these guidelines since 2002

Purchase Accounting

Requirements A purchase price allocation must be performed after the

transaction closes pursuant to ASC Topics 805, 954 and 958 The fair value of all tangible and intangible assets need to be

determined Potential intangible assets include:

Assembled workforce Trademarks Certificates of need Non-compete agreements Physician guarantees Goodwill

Lives will need to be assigned to each intangible asset

Purchase Accounting

Long-Lived Assets Tangible assets are subject to the

purchase accounting guidelines presented in ASC Topic 360 Real estate Equipment

Intangible assets are subject to the purchase accounting guidelines presented in ASC Topic 350 Non-compete agreements Patents Favorable leases

Purchase Accounting

Long-Lived Assets (continued) Impairment testing is only required if a

triggering event has occurred Triggering events include:

Decrease in market price Adverse change in extent or manner of

use Adverse change in legal factors or

business climate Accumulation of costs in excess of

amount originally expected Current operating cash flow loss

combined with history of operating cash flow losses or a projection of continued losses

Sale or disposal well before useful life ends

Purchase Accounting

Long-Lived Assets (continued) If a triggering event takes place, impairment testing is a two-step

process Step 1 – Recoverability test

Develop cash flow projections for asset (or asset group) Projections should only include cash flows that could

be generated from existing asset base If the sum of UNDISCOUNTED cash flows exceed the

carrying value of the asset (or asset group), the asset is considered “recoverable” and no impairment is recorded

If the sum of UNDISCOUNTED cash flows are less than the carrying value of the asset (or asset group), proceed to step 2

Step 2 – Determine the fair value of the asset and record impairment (if any exists)

Purchase Accounting

Indefinite Lived Assets Intangible assets are subject to the

purchase accounting guidelines presented in ASC Topic 350 Trademark / trade name Certificate of need

At a minimum, testing for impairment must be completed annually

Determine the fair value of the asset and compare it to the carrying value If the fair value of the asset exceeds the

carrying value, no impairment exists If the fair value of the asset is less than

the carrying value, impairment is recorded

Purchase Accounting

Goodwill Goodwill is subject to the purchase accounting guidelines

presented in ASC Topic 350 At a minimum, testing for impairment must be completed

annually Goodwill impairment testing is now a qualitative and quantitative

process New standard issued in September 2011 allows an entity to

first assess qualitative factors to determine necessity of prior two step quantitative impairment test. Effective for fiscal years beginning after December 15, 2011

If after considering all relevant events and circumstances, it is “not more likely than not” (meaning a likelihood more than 50 percent) the fair value is less than carrying value, then two step process is not necessary

Purchase Accounting

Goodwill (continued) Step 1

Determine the fair value of the entity and compare it to the carrying value If the fair value of the entity exceeds the carrying

value, no impairment exists If the fair value of the entity is less than the carrying

value, proceed to step 2 Step 2

Prepare a “hypothetical” purchase price allocation based on the fair value of the entity calculated in Step 1

The goodwill value resulting from the hypothetical purchase price allocation is then compared with the carrying value of goodwill to determine the amount of impairment (if any exists)

Purchase Accounting

Fair market value is the relevant standard of value – investment value to a hospital may not be equal to fair market value

Expected cash flows are key to supporting a premium over the value of tangible assets and must reflect the physician compensation arrangement that is expected to be paid following the acquisition

Be cautious about compensation arrangements that are expected to result in physician compensation well in excess of the level that the physicians historically earned (for the same level of production)

Be mindful of the financial reporting guidelines that require fair value analysis for acquisitions at the date of purchase and impairment testing in subsequent reporting periods

Final Thoughts

Questions?

Contact Information

Matthew J. Wescott, ASA1111 Michigan Ave., Suite 100 East Lansing, MI 48823Phone: 517-336-7525Email: matt.wescott@plantemoran.com

Ed Slack, CPA2155 Point Boulevard, Suite 200 Elgin, IL 60123Phone: 847-628-8796Email: ed.slack@plantemoran.com