Uncovering the Gem: Hidden Elements in ASC Valuation

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• Uncovering the Gem Hidden Elements in ASC
  Valuation
• Presented by
• Lorin E. Patterson, JD, Partner, Reed Smith LLP
• Todd J. Mello, ASA, AVA, MBA, Principal,
  HealthCare Appraisers

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Presentation Outline

• Regulatory Considerations
• Practical Considerations
• Valuation Framework Issues Specific to ASCs
• Factors Affecting Value
• Selection and Application of Appropriate
  Valuation Methodologies
• Other Relevant Issues (Partnership Life Cycle
  Impact of Changes in Reimbursement Minority
  Interest and related discounts Industry
  Multiples)
• Managing the Valuation Process

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Regulatory Considerations

• Cardinal Rule In healthcare ventures, ALL
  relationships MUST be conducted on FAIR MARKET
  VALUE terms.
• Adherence provides participants the best
  protection against possible liability under
  Federal and State anti-kickback statutes and
  other applicable laws.
• Kickbacks can include any form of remuneration,
  including overpayments or underpayments for
  interests in physician-owned ASCs.

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Regulatory Considerations

• Risk Scenarios Surgery Center grappling with
  the Price of Success.
• Years of successful operations result in
  prohibitively high unit prices making recruiting
  additional investors difficult.
• Unreasonably low price or easy terms offered to
  heavy hitter physician investors.
• The spread between FMV value and price offered
  could be a kickback.

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Regulatory Considerations

• Risk Scenarios
• Hospital anxious to maintain market share and
  appease groups of specialists overpays for share
  in existing ASC or offers to provide services or
  benefits (e.g., below FMV rent) to the venture on
  non-FMV terms.
• Again, spread between FMV and actual terms
  could be deemed a kickback to procure referrals.
• Real world example Advisory Opinion 07-05
  (6/19/2007). OIG issues unfavorable opinion
  where Hospital buys units in ASC directly from
  orthopedic surgeon at possibly inflated prices.

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Practical Considerations

• When validating FMV, a third-party appraisal by
  an experienced third-party appraiser will be the
  best means of procuring protection.
• Not necessarily required.
• Keep in mind that businesses are being valued
  not referrals.

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Practical Considerations

• Occasions where third-party valuations may be
  appropriate or necessary
• Combination between two existing healthcare
  ventures.
• Out of the ordinary course sale of interests in
  existing ASC to group practice, corporate partner
  or hospital.
• Commencement of service or other relationships
  between referral sources.

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Practical Considerations

• Out of the ordinary course buyouts of
  participants in existing healthcare ventures.
• The commencement of a re-syndication by an
  existing ASC to a number of physician investors.

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Practical Considerations

• Occasions when obtaining an appraisal may not be
  necessary
• In connection with the raising of capital by a
  newly formed healthcare venture (value of
  interests will be speculative).
• True arms-length negotiations between
  participants of a healthcare venture.
• Buyouts of existing participants where means of
  valuation is set forth within the governing
  documents (e.g., through the use of a formula).

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Valuation Framework

• What is the ownership interest being valued?
• What is the purpose of the valuation?
• Pending transaction (e.g., a physician buy in/out
  or a transaction with an ASC company)
• Compliance with federal ASC safe harbors and IRS
  private inurement issues
• Shareholder disputes/litigation
• What is the standard of value?
• Fair Market Value (FMV)
• Fair Value
• Investment Value
• What is the premise of value?
• Going concern
• Liquidation

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Definition of FMV

• IRS Definition In Revenue Ruling 59-60 the
  Internal Revenue Service defines fair market
  value as the amount at which property would
  change hands between a willing seller and a
  willing buyer when the former is not under any
  compulsion to buy and the latter is not under any
  compulsion to sell and when both have reasonable
  knowledge of the relevant facts.
• CMS Definition the value in arm's-length
  transactions, consistent with the general market
  value. General market value means the price
  that an asset would bring, as the result of bona
  fide bargaining between well-informed buyers and
  sellers who are not otherwise in a position to
  generate business for the other party, on the
  date of acquisition of the asset. Usually, the
  fair market price is the price at which bona fide
  sales have been consummated for assets of like
  type, quality, and quantity in a particular
  market at the time of acquisition.

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Valuation Issues Specific to ASCs

• Physician ownership makeup or lack thereof is
  critical
• Physician risk is the most important risk factor
  in ASC valuation
• Value related to distributions (i.e., dividends)
  as compared to capital appreciation much higher
  liquidity built into investment
• Divestiture typically required upon retirement,
  relocation, and inactivity buyout typically
  formulaic or fair market value
• Importance of restrictive covenants
• Numerous regulatory hurdles anti kickback
  statutes and potentially private inurement
  regulations
• Publicly traded corporations are generally not
  relevant comparisons
• Sales of similarly sized blocks of stock often
  not comparable
• In valuing entity, important to understand
  uniqueness of industry

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Primary Factors Affecting Value
TWO PRIMARY DRIVERS OF ASC SHAREHOLDER VALUE

• Future Cash Flow available to shareholders
  (Distributions)
• Volatility or Risk associated with future cash
  flow
• There are a multitude of variables that impact
  the assessment of risk and the projection of
  future cash flow.
• The value of a business is not based upon
  historical earnings but rather future earnings!
• Historical earnings are only relevant to the
  extent they help predict future earnings. Future
  earnings in a surgery center partnership can be
  very volatile!
• Proper partnership management can reduce
  volatility.

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Factors Affecting Risk of Future Cash Flow

• Cash Flow Projection Factors
• Case volume, mix, and reimbursement
• Expected changes in volume and reimbursement
• Opportunities for expansion (rooms, surgeons)
• Stability of operating expenses
• Risk Assessment Factors
• Diversification (e.g., of surgeons, number
  type of specialties, payors)
• Size and demographics of physician ownership,
  appropriate non-competes and ability to attract
  new investors
• Financial leverage, working capital, and on-going
  capital expenditures
• Nature of payor contracts is there a substantial
  portion of out of network?
• Quality and age of facility and equipment
• Competent management
• Barriers to entry (e.g. CON)

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Valuation MethodologySelecting the Valuation
Approach

• Asset-Based Approaches
• PURPOSE Measures the value of an ASC by
  identifying and individually valuing the ASCs
  tangible and intangible assets and liabilities.
  Based upon the Principle of Substitution i.e.,
  the premise that a prudent individual will pay no
  more for a property than he/she would pay to
  acquire a substitute property with the same
  utility.
• Asset-based approaches are useful when
• The ASC has no expected earnings or other
  attributes of value whereby an orderly
  liquidation value yields the highest valuation
  or
• To establish a floor of value when using other
  valuation methods

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Valuation MethodologySelecting the Valuation
Approach

• Market Approach
• PURPOSE Measures the value of an ASC by
  evaluating comparable companies and/or
  transactions in the marketplace.
• Market Valuation Methodologies include
• Guideline Publicly Traded Company Method
  generally not applicable
• Comparative Transaction Method depends
• Market Approach may be useful if
• Valuing a controlling (as opposed to a minority)
  interest
• Truly comparable entities are available

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Valuation MethodologySelecting the Valuation
Approach

• Income Approach
• PURPOSE Measures the value of an ASC by
  determining the present value of its expected
  future cash flow stream.
• Income Methodologies include
• Capitalization of Earnings
• Discounted Cash Flow
• Income Approach is useful when
• The ASC is generating significant, normalized
  cash flow from operations to fund ongoing
  distributions
• When valuing minority interest in cash flowing
  centers
• When the ASC has significant intangible value and
  when reasonable market comparables are not
  available

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Valuation MethodologyDecision Tree
ASC Attributes
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Other Relevant Valuation Issues

• ASC Partnership Life Cycle
• Minority vs. Controlling Interest Valuation
• Pending Changes in Medicare Reimbursement
  potential impact to non-Medicare payors
• Industry Consolidation, Valuation, and
  Competition

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ASC Partnership Life Cycle
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ASC Partnership Life CycleConsequences of
Decline Stage

• High Staff Turnover
• High Volume Physicians Slowing Down
• Non-Owner Physicians Disgruntled/ Exiting
  Facility
• Lack of Sufficient Capital to Reinvest in
  Business
• Capital Calls
• Deferred Maintenance on Equipment and Building
• ASC becomes less attractive to outside physicians

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ASC Partnership Life CycleRelationship to Value

• Unmanaged Partnerships will Eventually Enter into
  Decline Stage
• Profits Decline Faster than Revenues
• ASC Partnerships are difficult to turn around
• Quality Governing Documents Assist in Extending
  the Life Cycle (e.g. divestiture guidelines,
  restrictive covenants, safe harbor requirements)
• Accurate Valuations are Crucial to Sustaining ASC
  Partnerships
• Future Cash Flow and risk are related to life
  cycle

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Valuing Minority Interests

• Simply stated Interests providing absolute
  control (i.e., greater than a 50 interest
  whereby key aspects of control are not diminished
  by governing documents or otherwise) are worth
  more than interests which do not have the same
  control rights
• Control granted by the governing documents
  (examples on next slide)
• Concept of effective control physicians
  control with their feet
• Valuation Guidance absence of control
  adjustments in financial projection (preferable
  approach) or application of minority interest
  discount (reliance on published studies or other
  more difficult to quantify and support)

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Valuing Minority InterestsMatters Subject to
Control

• Capital Calls
• Admission of new investors
• Borrowings greater than a certain amount
• Acquisition of equipment greater than a certain
  amount
• Selling, assigning or otherwise disposing or
  encumbering assets
• Entering into material contracts
• Selling, liquidating, or merging the entity
• Changing the core governing documents
• Typical ASC ownership agreements are very
  friendly to the minority shareholder
• Note Physicians display a certain level of
  control regardless of ownership interest level

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Additional Valuation Considerations

• Medicare reimbursement reasonably certain
  through 2011 additional uncertainty and hence
  risk related to non-Medicare payors
• Despite declining public EBITDA multiples between
  2004 and 2006 (see next slide), market multiples
  for controlling interests remain strong a 12/06
  survey performed by HealthCare Appraisers
  indicates that 92 of ASC respondents are
  observing multiples of 6X EBITDA or higher
• Multiples paid also driven by private equity
  transactions (e.g. USPI and Symbion)
• Despite continued consolidation within industry,
  per an August 2007 Market Letter published by
  Verispan the top 5 outpatient surgery center
  chains still account only for 10.5 of the market
  share
• Minority interest multiples are based upon the
  individual centers facts and circumstances and
  are more difficult to determine
• Market multiples are interesting rules of thumb
  and are easy to calculate however, do not
  generally constitute an appropriate method for
  calculating fair market value

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Additional Valuation Considerations
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Managing the Valuation Process

• Opposing parties will have inherently conflicting
  interests during the valuation process.
• Adding structure will streamline the process
  significantly.
• Avoid dueling valuations unless a means of
  reconciling differences is agreed upon.
• Consider joint engagement of a single appraiser
  selected from a list of qualified appraisers.

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Managing the Valuation Process

• Determine the degree of involvement of both
  parties in the valuation process.
• Both parties may have the right to individually
  meet with the appraiser and submit factors which
  they feel are most pertinent.
• Both parties may have the right to receive drafts
  of the appraisal report and comment upon it.
• Agreement may be reached as to what price within
  the range of fair market value in the final
  report value (e.g., mid-point) will be used in
  the purchase agreement.

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Todd J. Mello, ASA, AVA, MBA
PrincipalHealthCare Appraisers, Inc.858 Happy
Canyon Road, Suite 240Castle Rock, CO
80108(303) 688-0700tmello_at_hcfmv.com Lorin E.
Patterson, JD, PartnerReed Smith LLP3110
Fairview Park Drive, Suite 1400Falls Church, VA
22042(703) 641-4368lpatterson_at_reedsmith.com