Healthcare facility valuation don't forget the physician factor

Healthcare Financial Management, August, 2005 by Christopher McCord

Your hospital plans a partnership buy-in that involves its ambulatory surgery center. One of the first things you need to do is have an analyst perform a valuation to determine the facility's fair market value. Sound simple? Keep in mind that the devil is in the details, and you need to make sure the analyst considers all the competitive alternatives involving your physician customers before determining a fair market value for the surgery center.

Fair market value is the valuation standard promulgated by the IRS and other governmental authorities for most healthcare transactions. Whether the transaction involves the transfer of interests comprising a controlling interest of the equity in a facility or a minority equity interest associated with partnership buy-ins or buyouts, a fair market valuation must be performed to price the transaction. In transactions that involve hospitals and physicians, the federal antikickback statutes dictate that any benefit to physicians in excess of fair market value may be construed as an inducement to refer patients. As such, all transactions between physicians and hospitals should be consummated based upon an assessment of fair market value.

When analysts perform a valuation on a healthcare facility, they consider the history, outlook, financial condition, and market conditions relating to the facility. The competitive environment is typically central to all of the considerations involved in a fair market valuation and, accordingly, has the most significant impact on the valuation results. To appropriately price the value of a transferring interest in a facility, the competitive factors must be evaluated and understood.

In healthcare organizations where physician referrals determine patient volumes and drive top-line revenues, the competitive environment ultimately affects the sustainability and risk associated with patient volumes at the subject facility. Sustainability of volumes is affected by barriers to entry, which may include competition and covenants not to compete, regulatory issues, economic considerations, the payer environment, and factors unique to a facility's market and ownership structure.

The Physician Customer Base

Within healthcare services, the "physician factor" introduces a unique dynamic to the competitive environment. In certain facilities, such as surgery centers, cath labs, and cancer centers, one may generally think of a physician user of a facility as a customer and the combined physician users as a customer base, whereas in other healthcare facilities, such as dialysis clinics or imaging centers, patients are considered the customers because they choose to use that facility. Part of the consideration of fair market value and the pricing of a transaction is the risk attributed to the facility's customer base. Much like the analysis involved in other industries outside of health care, to determine the value and risk associated with a customer base, a valuation analyst needs to fully understand the competitive alternatives available to that customer base. If the customer base is composed of physicians, a valuation analyst needs to evaluate all of the competitive alternatives available to the physician users as part of the due diligence process, which includes interviews with center management and physicians and an analysis of the center's market.

Using an ambulatory surgery center as an example, physician customers provide the potential for various competitive situations. These competitive situations have different impacts on healthcare facility valuations. In the simplified valuation examples shown in the exhibit, an enterprise value is estimated based on a multiple of earnings before interest, taxes, depreciation, and amortization. Enterprise value is defined as all interest-bearing debt plus equity. The valuation multiple is defined as the center's total invested capita] divided by its EBITDA. The selected multiple and resulting enterprise value are based on an analysis of the surgery center's history, outlook, financial condition, market conditions, and competitive environment. The exhibit does not include the detailed valuation modeling necessary to generate a fair market value opinion. These models include the determination of value utilizing the three commonly accepted valuation approaches: the market approach, income approach, and cost approach.

Situation 1: Covenant not to compete. Assuming all other factors are equal, the implementation of a covenant not to compete will result in a higher valuation for a surgery center since the covenant limits the competitive alternatives available to physician users of a center. Such a covenant prohibits physicians from owning or managing a competing center for a certain time period and within a certain radius of the existing center. In various situations, some surgery centers involve both comprehensive and incomplete covenants not to compete. For example, assume such a covenant for a surgery center did not exclude ownership in hospitals. As a result of this oversight, the valuation of the facility could deteriorate if physicians develop or participate in a local surgical hospital. Each situation is unique to the terms of the covenant not to compete and marketplace of the center.