Q: How do you see the Medicare conditions of coverage impacting the ASC marketplace?
Becker and Abraham: We see the changes in the condition of coverage having less impact on ASCs than the impact the changes in Medicare payments will have. With respect to conditions of coverage, these changes will allow a much greater variety of cases to be performed in surgery centers. However, the currently issued conditions of coverage cause some concern as to 23-hour cases, which are not specifically important for gastroenterology and endoscopy centers, but are important for more complex cases. The big question is whether this 23-hour limit will apply to commercial cases as well as Medicare cases. Further, as surgery centers have increasing ability to handle the same kinds of cases as hospitals, these changes may also lead to an increased amount of cases performed in offices. In short, as people start to develop their offices into mini surgery centers, they will also have the ability to chip away at the cases performed in surgery centers.
Thompson: The changes to the conditions of participation for ASCs are some of the most significant revisions in a long time. Many are administrative in nature, but the definition of “Overnight Stay” and a new rule applicable to patient transfers could make it difficult for ASCs to negotiate an acceptable arrangement with hospitals in their marketplaces. This may add to the tension between hospitals and physician-owned centers.
Panczner:The new Medicare conditions of coverage will require additional administrative
efforts for operators of ASCs and a review of the scope of center services. Although not unduly burdensome, the additional required documentation and internal processes will result in additional costs for centers already facing reductions in Medicare reimbursement.
Q: When is the right time to sell equity in your center, and how will a potential increase in the capital gains tax impact these transactions?
Becker and Abraham: Selling a center is typically driven by the desire to take “cash off of the table” or because you need help in managing or turning the center around. In simple terms, there is both a mathematical answer to this question, as well as a personal comfort answer to this question.
Remember, after you sell a majority interest in the center, for the remainder of your career, you will receive a lesser amount of distributions because you will own a lower percentage of the center after the sale. This is typically the case. Further, when you finally sell the remainder of your interest, you will sell those interests at 3 to 4 times earnings as opposed to the 6 to 8 multiple that you might receive when you sell a majority of the equity in a transaction.
From a mathematical and economic perspective, note the following: If you sell your interest in a surgery center at about 7 times earnings, you typically receive mostly capital gains tax treatment on that sale. This essentially means that if you held the same interest in the center rather than selling such interest, it would take you about 10 to 11 years after taxes to receive the same amount of money for that interest as you would receive in a sale transaction. Then, at the end of 10 to 11 years, you still own the interest in the center.
Given that one cannot forecast the future of a surgery center for this length of time, one might argue that it is always time to consider selling your center if you can receive 6, 7, or 8 times earnings for the center. With that stated, when you reinvest the money that you receive from the sale, it is unlikely that you will receive anywhere near the return on investment month to month from other investment opportunities that you would receive from your surgery center investment. Thus, you are gaining a certain amount of comfort and financial security by selling a center, but you are giving up current and ongoing cash flow.
If your operational perspective is very long term, there is a strong argument that you should hold on to your equity in the center. The closer you are to retirement, the stronger the incentive to sell the center and to be part of a selling group because that is the only time you will have a chance to receive 6 to 8 times EBITDA. The only time that you should always consider selling is if you see the center projected to go in a downward direction. However, one of the challenges is that many buyers will also sense the same concern. An increase in the capital gains tax rate would lessen the amount of time it takes to receive the amount of after-tax income from simply holding on to the center. For example, if it takes about 10 to 11 years to get what someone received in a 7 times EBITDA transaction if they just held their equity, then if the capital gains tax rate were to go up significantly, the length of this holding period starts to decrease to closer to the multiple that you have received in a sale transaction.
For example, if you get paid 7 times earnings and the capital gains tax rates are close to ordinary income tax rates, then the hold period to break even with a sale transaction is about 7 years.
Thompson: Whether and when to sell equity in your center is driven by a number of factors including anticipated capital needs, the need to “refresh” the complement of surgeonowners, the need for a third party manager/owner, and/or the desire of current owners to “cash out” some or all of their equity in the center. Tax planning is another consideration. Currently, the capital gains tax rate is 15%, but that rate is scheduled to expire in 2010 unless Congress otherwise takes action. The capital gains rate is unlikely to decrease anytime soon. A rate hike is the more likely scenario.
Panczner: Ideally, the time to sell an equity interest in a center is when the value of the practice is high and tax rates are low. An increase in the capital gains rate may make it more lucrative to sell an interest before such change occurs, but it is often possible to structure the sale of an equity interest in a way to defer (but not eliminate) the recognition of the tax.
Q: What are the benefits of “minority” equity acquisition versus the historical “majority” equity model?
Becker and Abraham: The core benefit of a minority equity acquisition is that it allows the physicians to continue to hold a majority of the interests in the venture, which is good for the longevity of the venture. The core downside to the physicians is that one receives less of pricing in the sale transactions in which a majority interest is being sold (i.e., 6 to 8 times earnings). Thus, there is a disadvantage in pricing when selling a minority equity position versus a majority position. Also, it is the only time you can ever sell for 6 to 8 times interest. A minority investment option does not provide the same amount or liquidity exit value.
However, if a group of minority partners (e.g., a minority corporate partner and a group of physicians) collectively sell a majority interest in a center, they may still receive a 6 to 8 multiple with each seller receiving their pro rata share of the purchase price based on interests sold.
Thompson: The sale of a minority interest in a center allows the existing owners to retain effective governance and management control over the center, while at the same time realizing some of the appreciation in the value of the center. Of course, a minority interest is going to be valued less than a majority interest since the sale of a majority interest commands a “control premium.” This control premium could add anywhere from 1 to 3 times EBITDA to the sale price of a center.
Panczner: If the physician group desires to remain active in the business (e.g., not retiring), while generally based upon a lower valuation multiple, the sale of a minority interest in a center may be more advantageous. It may provide additional capital to expand the center or cash payments to the physician owners, while allowing the physicians to generally retain a significant level of control over the operation of the center.
Q: Is there an increased interest in ASC management arrangements between physicians and hospitals? If so, what are the benefits and/or risks involved?
Becker and Abraham: There is muted rncreased interest in ASC management agreements. These are often driven by the built-in reimbursemenl advantage that hospitals enjoy. In essence, hospitals have much more cash to play with in order to pay management agreements, and to pay medical director fees in order to retain physicians and prevent them from developing their own centers. At the same time, very negative comments from the government on these types of arrangements have muted the increased interest in the growth of these arrangements. However, the reduced reimbursement for GI centers is also leading more gastroenterologists to be more interested in looking at other options than their own ASCs.
Thompson: Yes. Hospitals are beginning to realize the value of having physicians actively engaged in the day-to-day clinical and administrative operations of an ASC, as well as the surgical service line of the hospital itself. Inpatient surgery services are notoriously inefficient and often in need of focused attention. These arrangements are designed to focus the surgeons on improving quality, patient safety, and efficiency-this pays dividends for both the hospital and the doctors.
Panczner: We have seen a renewed interest in physician-hospital joint ventures over the past few years. Physician-hospital joint ventures can provide an excellent opportunity to improve relations between the parties, enhance the quality of care in the community and allow for a sharing of expertise, risk and capital costs. Such relationships are, however, subject to increased regulatory scrutiny and must be appropriately structured and operated to limit legal risk.
Q: What changes have you seen in the physician-hospital joint-venture over the past few years that will impact these relationships in the future?
Becker and Abraham: The largest change that we see in physician-hospital joint ventures relates to physician-hospital relationships as a whole. In essence, we are seeing a greater number of situations in which physicians are being employed by hospitals than we have seen in several years. This lessens the pool of available gastroenterologists for endoscopy ventures or other types of ventures, and gives the hospitals additional control over case flow.
Thompson: Over the past few years, hospital-physician joint ventures have been subject to increased scrutiny by a host of regulatory agencies-such joint ventures are now subject to a labyrinth of complex rules, regulations and laws. In the future, I see these types of joint ventures focusing less on the economic return on investment and more on a ROI expressed in terms of quality improvement and the application of sophisticated information technology.
Panczner: Recent state laws regulating certain procedures in physician office settings and efforts by hospitals to improve relations with voluntary physicians will continue to be favorable factors for such ventures. Declining government program reimbursement and a heightened prosecutorial environment relating to physician self-referral, physician-hospital relationships and billing issues have been, and will continue to be, factors of concern in physician-hospital outpatient ventures.
