Investing in Healthcare — Compliance and Diligence Observations — Buyers, Sellers and False Claims

The healthcare sector saw a significant decrease in the number of private equity transactions completed last year. Pitchbook (see: reported that approximately 125 deals were completed where private equity funds invested in healthcare companies in 2009. This is down from 233 in 2008. This reduction takes into account both general economic conditions which saw declines in almost every sector, the overhang of healthcare reform where many investors saw tremendous uncertainty in the healthcare sector due to the potential for healthcare reform and the concern that some funds were over-invested in healthcare. Interestingly enough, much of the over-investing in healthcare resulted less because sponsors increased their percentage of investment in healthcare but more due to significant reductions in the values of the other investments which left their overall percentage of investment in healthcare higher both on the equity or debt side and thus over invested in healthcare.

2010, however, has already seen significant pickup in healthcare investing and new interest in the healthcare sector. This article briefly discusses four key concepts.

1. Types of buyers. The types of buyers of healthcare companies can be divided into two core categories. First, there are strategic buyers which are companies that are already in the specific market as an industry participant. Second, there are financial buyers which are more traditional financial sponsors and funds that invest but themselves are not already participants in the market.

The financial buyers can then be further divided into two categories — one, regular participants in the healthcare sector and two, participants that periodically or infrequently invest in the healthcare sector. From a compliance standpoint, the easiest buyers to represent are first, strategic buyers and second, financial buyers that are very sophisticated and spend a lot of time in a specific sector. They often know exactly the types of diligence issues that they are concerned about and the types of issues that can cause significant problems for a company.

In contrast, financial investors who are "tourists" or who don't often invest in healthcare businesses or a particular healthcare sector have additional challenges when assessing targets from a compliance and diligence standpoint due to their lack of experience in the industry. There are often situations where these such investors are unaware of the key potential compliance issues surrounding a particular industry.

When assessing healthcare compliance issues, there are several areas in which there are questions about whether a particular activity or aspect of a business falls in a so-called "gray area" or an absolutely clearly problematic "black area" and questions about where the real risks lie in a business. The more knowledgeable the investor, the easier it is to work through and reason through these types of issues. Investors who are new to a sector of healthcare should deeply review all relevant compliance concerns with experienced advisors.

2. Types of companies – A compliance perspective. We divide companies that are looking for investment (or looking to sell) into three different categories when assessing compliance efforts.

First, there are those companies that have a clear culture of compliance. Certainly they can have bad luck and have certain finite compliance concerns, but more often than not they are likely to avoid serious problems unless there is a "macro" issue that hits their entire industry. Further, when companies such as these are run well with a constant eye toward compliance issues, it is less likely that they will have to change a core business practice such as how they relate to or compensate physicians or how they bill for services. This bodes well for the long term sustainability of the business. Certain changes in business practice driven by compliance concerns can have a long-term impact on the financial viability and the strength of a company.

The second type of company that we see is the quick growth company. This company is often wholly focused on making sure revenues exceed expenses and has not yet made the effort to focus more fully on compliance. This company is not a bad actor but does need to very quickly start focusing more heavily compliance issues so that this does not later become a problem. We have seen situations where companies have completely ignored compliance beyond their original stages and investors have then shied away from those companies or discounted valuations due to compliance-related risk.

The third type of company that we see is what we refer to as "mavericks." These are the companies that conscientiously choose to not focus on compliance issues and have a number of practices that are either overly aggressive or merely sloppy such as in their relationships with referral sources or their billing and collection compliance. These practices that can lead the company into, at a minimum, a change in business model or practice when compliance issues eventually come to the forefront, which can have a serious impact on the way in which they operate and their ability to sustain or enhance past financial performance. Such practices can also give rise to serious governmental investigations resulting in potential civil and criminal liability for the company, its management and its investors.

3. Healthcare diligence. Due diligence, when performed well, whether by accounting firms, law firms or internally, requires great knowledge of the particular industry and the 10 to 12 key issues in any business within that industry that are likely to be most material both in terms of risk to the business from a revenue-generation and compliance perspective and the potential to require a significant operational change or other interruption in cash flow. The best kind of diligence is highly focused, highly efficient and very informative to a potential investor. The worst kind of diligence, in contrast, is that which appears to be no more than a mere cataloging of items and issues (e.g. a situation in which lawyers or accountants or internal analysts review many boxes of documents and produce solely a long list of issues and checklist of documents reviewed rather than focus on real analysis). A deep understanding of the industry and business model of the target company and a thoughtful analysis of the risks of investment by the outside or internal diligence analyst is the most valuable to the buyer in assessing an opportunity.

4. False Claims recoveries. The federal government is currently more focused on healthcare fraud issues and recoveries under the False Claims Act than ever before. The U.S. Department of Justice reported that in fiscal year 2009 (October 2008 through September 2009) total false claims recoveries were $2.4 billion. This represents the second largest annual recovery of civil fraud claims in history, and brings total recoveries since 1986, when Congress substantially strengthened the civil False Claims Act, to more than $24 billion. Of these FY 2009 recoveries, $1.6 billion were from healthcare false claims, with the bulk of the healthcare recoveries going to the Department of Health and Human Services for its Medicare and Medicaid programs, followed by the Office of Personnel Management for its Federal Employees Health Benefits Program, the Department of Defense for its TRICARE insurance program and the Department of Veterans Affairs, among others.

The main healthcare targeted industries in the FY 2009 recovery efforts included pharmaceutical companies, medical device companies and hospitals. The pharmaceutical and medical device industries together accounted for $866.7 million, including settlements with Aventis Pharmaceuticals Inc., Bayer HealthCare LLC, Eli Lilly & Company and Quest Diagnostics Inc., and its subsidiary, Nichols Institute Diagnostics Inc. In addition to federal recoveries, these pharmaceutical and medical device cases returned $402 million to state Medicaid programs. However, there was a broad range of investigations and providers targeted throughout FY 2009.

The government's focus on healthcare enforcement actions is further evidenced by the creation on May 20, 2009 of the new interagency task force, the Health Care Fraud Prevention and Enforcement Team (HEAT). There have also been special anti-kickback task forces set up in several different regions of the country. In these areas of the country, there are a substantial number of investigations presently underway, particularly in certain healthcare sectors. A careful investor in the healthcare sector will always assess a target's exposure to potential false claims liability. This can be achieved through a focused evaluation of billing and coding, relationships with purchasers and referral sources and a review of the target's compliance procedures.

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