PYA Presentation: “Thorny Issues in FMV and Commercial Reasonableness"

April 16, 2014

Prepared for Greater Kansas City Society of Healthcare Attorneys

“Thorny Issues” in Healthcare Valuation

W. James Lloyd, CPA/ABV, ASA, CFEPrincipal, PYA

W. Lyle Oelrich, MHA, FACHE, CMPEPrincipal, PYA

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Agenda• Hypothetical Case Study Scenario

• Regulatory Framework – Definitions

– Fair Market Value

– Commercial Reasonableness

• Key Concepts and Thorny Issues

– Business Valuation

– Compensation Valuation

• Commercial Reasonableness vs. Fair Market Value

• Questions and Answers

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• Large orthopaedic practice located in a highly competitive metropolitan market.

– Approximately 20 physicians across several sub-specialties.

– Multi-locations in close proximity to several hospitals.

– Significant ancillary services including PT, DME, imaging, and an ASC.

• Ancillary services represent approximately 50% of revenue.

– Significant impact on pre-acquisition physician compensation.

• Hospital is negotiating to acquire the practice and employ the physicians.

Hypothetical Case Study Scenario

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Hypothetical Case Study Scenario• Hospital utilized two outside appraisal firms:

– One to value the business.

– Another to evaluate the fair market value compensation for the physicians’ post-transaction employment arrangements.

• Proposed transaction terms:

– $20M upfront cash for the practice.

– 25% increase in the physicians’ post-transaction compensation.

• Hospital’s general counsel requests an independent commercial reasonableness assessment and fair market value opinion before signing off on the transaction.

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Regulatory FrameworkStark Law – Fair Market Value

• Fair market value means the value in arm's-length transactions, consistent with the general market value.1

• "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, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.2

Internal Revenue Service Revenue Ruling 59-60 – Fair Market Value

• The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

1 Estate Tax Reg. 20.2031.1-1(b); Revenue Ruling 59-60, 1959-1, C.B. 237.2 Federal Register / Vol. 69, No. 59 / Friday, March 26, 2004 / Rules and Regulations.

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Regulatory FrameworkCommercial Reasonableness

• Department of Health and Human Services Definition1

– An arrangement which appears to be a “sensible, prudent business agreement, from the perspective of the particular parties involved, even in the absence of any potential referrals.”

• Stark Definition2

– “An arrangement will be considered ‘commercially reasonable’ in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar size and a reasonable physician of similar scope and specialty, even if there were no potential designated health services (“DHS”) referrals.”

• OIG Threshold3

– Compensation arrangements with physicians should be “reasonable and necessary.”

1 63 Fed. Reg. 1700 (Jan. 9, 1998).2 69 Fed. Reg. 16093 (March 26, 2004).3 “OIG Compliance Program for Individual and Small Group Physician Practices,” Notice, 65 Fed. Reg. 59434 (Oct. 5, 2000); OIG Advisory Opinion No. 07-10, September 20, 2007, pg. 6, 10; “OIG Supplemental Compliance Program Guidance for Hospitals,” Notice, 70 Fed. Reg. 4858 (Jan. 31, 2005).

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Key Concepts and Thorny Issues:Business Valuation

Valuation Methodologies:

Income Approach

o Discounted Cash Flow (“DCF”) Method

o Capitalized Income (“CapInc”) Method

Market Approach

o Merger & Acquisition Transactions Method

o Guideline Public Company Method

Cost Approach

o Net Asset Value (“NAV”) Method

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Attributing substantial value to intangible assets of a physician practice without sufficient cash flow to support from an income approach perspective (i.e., no economic benefits to support the intangible asset).

Sum of the parts (tangible and intangible assets from using the cost approach) should generally not be greater than the whole enterprise value determined from the income or market approaches.

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Bifurcating and separately valuing the professional and ancillary components of a physician practice using different methodologies with a resulting combined value substantially in excess of the value resulting from either method individually.

e.g., using the DCF method to value the ancillaries and the NAV method to value the remaining (i.e. professional services) portion of the practice with a combined value > the results from using the DCF or NAV methods for the whole practice.

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Post-transaction physician compensation should be taken into account when valuing a physician practice. Otherwise, there is potential for double counting the same benefits.

Buyer synergies (such as provider-based reimbursement rates) generally should not be taken into account if the standard of value is “fair market value.”

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Hypothetical Case Study (Application)

• Business appraiser bifurcated the practice and valued the professional and ancillary service lines separately.

– Ancillary service lines valued based on Discounted Cash Flow Method.

– Remainder (professional component) valued based on Net Asset Value Method.

– The two value indications combined = the $20M purchase price.

• However, the value of the combined practice using either of the DCF or NAV methods was substantially less.

– Reason: No physician compensation expense included in the ancillary cash flow projections; however, the ancillary cash flows contributed significantly to the physicians’ historical compensation.

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Compensation Valuation Methodologies

Key Concepts and Thorny Issues: Compensation Valuation

• Income Approach – sum of present values of expected future benefits

• Market Approach – comparison to what is actually being paid in the market place (e.g., published surveys)

• Cost Approach – value underlying assets or resources (e.g., cost-to-replace, cost-to-recreate)

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• Productivity

• Experience

• Service type (e.g., clinical vs. admin)

• Supply/demand

• Benefits

• Credentials

• Specialized training (e.g., robotic surgery)

• Other

Factors Considered:

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• Using multiple, objective surveys remains a prudent practice for determining fair market value compensation.

• Data:

– Definitions

– Tainted?

– Regional variations

– Outdated?

– Cherry-picking

– Sample size

Published Surveys:

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• On-Call Pay for Employed Physicians

Origin of on-call pay (limited to no payment for service)

Benchmark data vs. employed compensation physician formula

Simultaneous, multiple campus coverage

• Challenges With Work Relative Value Unit (“wRVU”) Models

Base plus wRVU threshold/compensation per wRVU

2009 MGMA Study: Relationship between compensation and compensation per wRVU

“Reported” vs. “Calculated”

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• Illogical Part-time Employment Arrangements

Benefits

Exclusivity

Compensation Model

• Stacked Compensation

Bundle of services (i.e., each part and the whole)

Duplication of payment

Misinterpretation of benchmark data

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Commercial Reasonableness vs. Fair Market Value

Commercial reasonableness is different than fair market value

Does the transaction make cents sense?

Was this a good business arrangement to enter into in the first place?

Is there a legitimate business reason to enter into this agreement?

Did we contract with the most appropriate provider without duplicating facility need?Do the underlying economics of the transaction make sense?

Fair Market Value (NARROW)

Commercial Reasonableness (BROAD)

What is the range of dollars you are going to pay for the space/services?

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Commercial Reasonableness vs. Fair Market Value

Thus, FMV assesses the reasonableness of the “range of dollars” while CR looks to the reasonableness of the business arrangement as a whole.

Accordingly, a transaction or arrangement may be at fair market value but not commercially reasonable.

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PYA’s Approach for Evaluating Commercial Reasonableness

Refer to Commercial Reasonableness Outline Handout.

PYAAnalysis

Business Purpose Analysis

Provider Analysis

Facility Analysis

Resource Analysis

Independence & Oversight Analysis

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Business Purpose AnalysisDoes the proposed arrangement represent a reasonable necessity that is essential to the functioning of the hospital or other healthcare provider?

Is the proposed arrangement reasonably necessary to accomplish a rational business purpose?

Is the specific purpose of the arrangement clearly identifiable and appropriately defined?

Do the proposed services relate to the business and/or clinical plans and strategies of the healthcare provider?

Do relevant national, regional, and local economic conditions exist that may affect the appropriateness of the proposed arrangement?

Do the proposed services contribute to the provider’s profits and/or the development of a particular service line without requiring income from proscribed referrals?

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Provider AnalysisDoes the proposed arrangement require a physician to perform the services?

Does the proposed arrangement require a physician of a certain specialty to perform the services?

Does any specialized training and/or experience of the provider exist that should be taken into account when evaluating the proposed arrangement?

Are the particular nature of the duties and corresponding amount of accountability associated with the proposed arrangement clearly defined and reasonable?

Is the amount of time demanded of the physician under the proposed arrangement reasonable?

Do any salary considerations exist that should be evaluated in relation to providers of similar specialty and experience in comparable organizations and positions?

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Facility AnalysisAre patient demand, the number of hospital patients, and/or the community need sufficient to justify the services?

Are patient acuity levels such that the proposed services are necessary?

Do patient needs dictate the necessity for a separate and distinct provider for the proposed services?

Are the size of the hospital and the relevant department appropriate for the proposed services?

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Resource AnalysisIs the proposed arrangement a necessary addition to the managerial and administrative efforts already required by the medical staff bylaws?

Have the number of committees and/or meetings that otherwise require physician attendance outside of the proposed arrangement been considered?

If the healthcare entity is part of a larger health system, do patient care protocols and procedures exist that can be coordinated among its facilities in lieu of the proposed arrangement?

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Independence and Oversight Analysis

Does the healthcare entity have and subsequently use its performance assessments to determine whether new or existing provider arrangements should be reduced (e.g., hours condensed) or eliminated?

Does the entity maintain a formal process for executive management and legal counsel to review and approve the proposed arrangement?

Does the provider engage in appropriate monitoring to determine:

• Whether services specified in similar arrangements are actually performed?

• The total amount of funds spent for such services?

• A verifiable outcome resulting from the arrangement?

Does sufficient independence exist related to the board or committee that establishes the proposed arrangement?

Is there a written agreement that addresses the terms of the proposed arrangement?

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Examples of Potentially Commercially Unreasonable Arrangements

• A multi-hospital health system requires specialty specific telephonic call coverage and engages one physician at each campus to be on 24/7 call the same day.

• An employment agreement that incorporates a payment for quality without the ability to track improvement in patient care.

• A hospital paying a cardiologist a cardiology-specific compensation rate for administrative work requiring only a primary care physician’s skills.

• A hospital failing to maintain proper oversight of the effectiveness and necessity of its physician services arrangements. For example:

Calculating wRVUs (generally for personally performed services – should be modifier-adjusted).

Not performing quarterly, semi-annual, or annual contract reconciliations when required by the arrangement.

Key Concepts and Thorny Issues: Commercial Reasonableness

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Hypothetical Case Study (Application)

• Questions

– Is it commercially reasonable for the hospital to pay $20M upfront for the practice utilizing a bifurcated valuation approach when the non-bifurcated cash flows would have produced a much smaller value?

– Is it commercially reasonable for the physicians’ post-transaction compensation to increase by 25% when their historical compensation was significantly impacted by the ancillary services they anticipate selling to the hospital for $20M?

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Contact Information

Jim Lloyd, CPA/ABV, ASA, CFEPrincipal, Pershing Yoakley & Associates, P.C.

(865) [email protected]

Lyle Oelrich, MHA, FACHE, CMPEPrincipal, Pershing Yoakley & Associates, P.C.

(865) [email protected]

PYA Presentation: “Thorny Issues in FMV and Commercial Reasonableness"

Healthcare

Transcript of PYA Presentation: “Thorny Issues in FMV and Commercial Reasonableness"