1. Confusing the standard of value
Fair market value (“FMV”) shouldn’t be confused with the ASC’s investment or strategic value.
The definition of fair market value is slightly different for healthcare, as “the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell…between well-informed parties who are not otherwise in a position to generate business for the other party…” The key in this definition is the implication of “hypothetical” parties.
The potential hypothetical parties include hospitals, physicians, investors and other parties involved in the ASC.
Strategic value takes qualities into account that are very specific to one buyer or group of buyers. Mr. Mello gave examples including a hospital purchasing 100 percent of an ASC; in this scenario, one could assume the hospital would bill insurance companies at the hospital outpatient department rate instead of the ASC rate. A different party — including corporate partners and venture capital investors — couldn’t bring the same managed care rate bump to the acquired ASC. As a result, the valuation factoring in a hospital’s fee schedule would not be considered FMV.
2. Blindly applying valuation multiples
A multiple is shorthand for a mathematical equation: 1/(k-g) where “k” represents the rate of return (risk) and “g” represents the growth rate of the earnings stream. The multiples are “a mathematical expression of risk and growth, which when applied to a perpetually recurring earnings stream result in an indication of value.”
Each year HealthCare Appraisers publishes a survey of multiples observed within the market. “Market multiples are good evidence of what is going on in the industry in connection with controlling and non-controlling interest transactions,” said Mr. Mello. In determining the impact of both risk and growth on the calculation of a multiple, if we hold risk constant and we increase (or decrease) the growth rate, the multiple goes up (or down), respectively; if we hold growth constant and instead increase (or decrease) risk, the multiple goes down (or up), respectively.
“While multiples provide market evidence, simply choosing one and applying it to your center should not be construed as a valuation,” said Mr. Mello. “There are many factors which influence center value and need to be analyzed in connection with valuing an ASC.”
3. Incorrectly specifying risk
“While multiples can be misapplied, as set forth above, there is also risk related to arriving at a valuation conclusion which doesn’t make sense,” said Mr. Mello. “If someone comes up with 15X multiple for a controlling interest, for example, consider whether that makes sense with the multiples observed in the general market. The market values and market multiples can be used as a general litmus test but not an overall tool.”
4. Failure to specify OON risk
Inexperienced valuators don’t always understand risk associated with out-of-network (“OON”) centers. A center with a significant amount of OON business is usually more risky because it’s uncertain when and how much rates can be reduced in the future. “If there is reasonable certainty that there will be a conversion from out- to in-network, it’s better modeled into the cash flows, as opposed to being built into the cost of capital/discount rate,” said Mr. Mello.
Out-of-network contracts aren’t always a risk, however. If the ASC is the only surgery center in a market with just one hospital, out-of-network contracts may not be at risk for conversion, assuming that the center is still a cheaper quality alternative to the payers and patients than the hospital in the marketplace.
5. Failure to normalize earnings streams
ASCs can experience one-time expenses like atypical legal and consulting fees, or related party rent which is not consistent with FMV. These expenses can inappropriately alter the expense structure and distort true earnings without normalization.
“When we are valuing a center, we need to make sure that we are looking at an earnings stream which is representative of what the operators of the center expect going forward. There may be one-time expenses or other issues which need to be normalized from the earnings stream because these items aren’t reflective of what will happen in the future,” says Mr. Mello.
Normalizing adjustments can go either way and impact revenue in some situations.
6. Income-based valuation techniques at inception
ASCs often create forecasts at their inception to model different outlooks for their center. However, the forecasts are often based on prospective physician investor contributions and are considered highly speculative.
“ASCs routinely create forecasts at the inception, which allow owning parties to develop some ideas as to what the center looks like over time, which is perfectly logical; what you shouldn’t do is base your share prices on those projections, however” says Mr. Mello.
Conduct start-up valuations with a cost approach wherein total project costs are estimated and decisions made with respect to the debt and equity financing.
7. Varying share prices for MDs
All stakeholders should purchase shares at fair market value.
8. Mismatching of invested capital and equity earnings
Invested capital is the total amount of money endowed into a company by shareholders and other interested parties. It’s determined by adding the total debt and lease obligations to the equity in the firm and then subtracting non-operating cash and investments.
“To the extent considered in a valuation, EBITDA multiples should be applied to invested capital earnings streams and not equity earnings streams,” says Mr. Mello.
Furthermore, to arrive at an equity value when starting with a valuation based upon invested capital, you need to subtract the debt.
9. Limitless capacity
There is a limit to the number of cases ASCs can accommodate per day, whether due to staffing, space, time or cost constraints. “If it’s even possible to start increasing case volume, make sure you account for additional, incremental capital expenditures necessary to accommodate the additional case volume,” said Mr. Mello.
10. Failure to make other necessary valuation adjustments
It’s generally regarded as a mistake not to consider the impact of taxes in valuing your ASC. “With respect to taxes, it’s not uncommon for not-for-profit healthcare acquirers to buy surgery centers,” said Mr. Mello. Even though that specific acquirer may not pay taxes, the FMV standard would dictate that other possible buyers would include those parties who do have to pay taxes. Even ASCs that are “flow through” entities like LLCs will require owners to pay taxes on distributions, and market-based cost of capital inputs are calculated after-tax. Failure to tax effect would be inconsistent with these after-tax costs of capital and would result in an overstatement of value.
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More articles on surgery centers:
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