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The Due Diligence Imperative for the Valuation of Healthcare

Enterprises, Assets, and Services

With the emergence of value-based reimbursement, such as accountable care organizations (ACOs), clinically integrated networks (CINs), and bundled payment models, which rely on achieving the “Triple Aim” of healthcare at lower cost, U.S. hospitals are increasingly looking to change how services are being delivered by seeking more collaborative relationships with physicians, including vertical integration strategies such as the acquisition of healthcare-related enterprises, assets, and services (e.g., physician practices), direct employment, co-management, and joint venture arrangements with physicians and other providers. This abridged article was the first in a series of articles that appear in The Value Examiner.

With the emergence of value-based reimbursement, such as accountable care organizations (ACOs), clinically integrated networks (CINs), and bundled payment models, which rely on achieving the “Triple Aim” of healthcare at lower cost,[1] U.S. hospitals are increasingly looking to change how services are being delivered by seeking more collaborative relationships with physicians, including vertical integration strategies such as the acquisition of healthcare-related enterprises, assets, and services (e.g., physician practices), direct employment, co-management, and joint venture arrangements with physicians and other providers.  This abridged article was the first in a series of articles that appear in The Value Examiner.  The QuickRead and The Value Examiner editorial staff extends its sympathy to the family of Robert Cimasi, a prolific writer and thought leader, who passed away earlier this month.  We also thank Todd Zigrang and Health Capital Consultants for their thought leadership.

The rise of these emerging healthcare organizations (EHOs) to address value-based reimbursement initiatives has led to a growing number and complexity of transactions in the healthcare delivery marketplace, accompanied by increased federal and state regulatory scrutiny regarding the legal permissibility of these arrangements.  Most notably, government regulators (more specifically, the Office of the Inspector General [OIG] of the U.S. Department of Health and Human Services [HHS], and the U.S. Department of Justice [DOJ]) have, in some cases, more aggressively challenged an increasing array of these transactions under various federal and state fraud and abuse laws.

Therefore, now more than ever, conducting a level of due diligence appropriate to the scope and complexity of a given assignment is critical to the development of the valuation opinion.

Due diligence may be defined as:

  1. “such a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstances; not measured by any absolute standard, but depending on the relative facts of the special case”
  2. “a fact-finding project…designed to find hidden risks”[2]
  3. “an investigation in order to support the purchase price of the business”[3]

There are two distinct classes of information generally required for due diligence related to healthcare valuation: (1) general research; and, (2) specific research.[4]

General research is typically comprised of information and data related to national and regional healthcare industry trends; reimbursement trends; competitive marketplace assessments; medical industry specialty and technological trends; transactional data; and, investment risk/return data, as well as, other research not specifically related to, or obtained from, the subject enterprise, asset, or service being appraised.  General research is obtained to providing a context within which the analyst considers the specific research and information gathered.[5]

Specific research is related to information to the historical operational performance and financial condition of the subject enterprise, asset, or service, as well as, the pertinent clinical related data.  Specific research is typically obtained from the client or the appropriate contact designated by the client.

General research may be attained from a variety of sources, including:

  1. Books and monographs
  2. Journals and periodicals
  3. Government agencies;
  4. Proprietary data aggregators and portals
  5. Professional societies and trade associations
  6. Conferences and webinars
  7. Online databases
  8. Academic and industry “think tanks” and research foundations[6]

In contrast to general research, specific research is information and data that is directly related to, or obtained from, the subject enterprise, asset, or service being valued.  A sample of some of the requested preliminary legal/organizational and transactional documents in a healthcare transaction due diligence process are as follows:

  1. Legal/Organizational Documents:
    • (a) Articles of Incorporation, Limited Liability Company (LLC) Formation Agreements, Partnership Certifications, Certificates of Trust;
    • (b) Bylaws, Operating Agreements, Trust Agreements;
    • (c) Shareholder Agreements, Member Agreements, Partnership Agreements;
    • (d) Pertinent Executive Meeting Minutes;
    • (e) Existing Employment Agreements and Curriculum Vitae for Key Personnel;
    • (f) Real Property Lease Agreements;
    • (g) Personal Property Lease Agreements;
    • (h) Existing Buy-Sell Agreements;
    • (i) Existing Consulting or Management Services Agreements;
    • (j) Loan Agreements;
    • (k) Related Party Vendor/Supplier Agreements;
    • (l) Third Party Payor Agreements;
  2. Transactional Documents:
    • (a) Asset Purchase Agreements;
    • (b) Stock Purchase Agreements;
    • (c) Bills of Sale;
    • (d) Asset Contribution Agreements;
    • (e) Buy-Sell Agreements;
    • (f) Standstill Agreements;
    • (g) Non-Disclosure & Confidentiality Agreements;
    • (h) Letters of Intent;
    • (i) Transaction Term Sheets;
    • (j) Proposed Employment Agreements;
    • (k) Proposed Lease Agreements; and,
    • (l) Proposed Compensation Plan Details.

Upon the valuation analyst’s review and analysis of the preliminary documents and information provided, a customized supplemental request for documents and information should be developed in consideration of the unique attributes and circumstances in that healthcare transaction, including, but not limited to, the items set forth in the November/December 2017 issue of The Value Examiner.

As part of the requisite due diligence associated with a specific engagement, the valuation analyst should conduct independent research, specific to the subject enterprise, to supplement any information provided by the subject entity, in line with the old Russian proverb, “Trust but verify.”[7]

The valuation analyst should also restate and adjust the subject enterprise specific financial data received to: (1) facilitate industry benchmark comparisons of the specific line item allocations of the subject entity’s financial statements to comparable industry indicated benchmark norms for those line items; and, (2) reflect the true economic operating performance and financial status of the subject enterprise.  Accordingly, the valuation analyst should carefully consider restating certain line items related to the revenue and expenses of the subject entity, e.g., owner compensation and benefits; discretionary expenses not required to support the projected revenue of the subject enterprise; and, extraordinary non-operating income and expenses.

The next step in the due diligence process is to determine the extent and the probability of the continuity of the subject business’s benefit stream and competitive advantage into the future.  A valuation analyst who leads such a process must follow three credos to “discover the truth”:

  1. “Be skeptical”—always seek corroborative evidence
  2. “D&D: Disclose and Disclaim”—The due diligence process is, by its very nature, a documentation-intensive engagement
  3. “Follow the Scientific Method”—The successful valuation analyst will generate hypotheses, establish method(s), test hypotheses, report results, and develop conclusions in an orderly, documented, and replicable manner

The due diligence process of a healthcare transaction is a critical exercise for the valuation analyst.  This is especially important in consideration of the Four Pillars of Healthcare Valuation, i.e., regulatory, reimbursement, competition, and technology, which are unique areas of risk that shape the market forces within the U.S. healthcare industry, in the valuation of healthcare enterprises, assets, and services.  A complete and thorough due diligence of the subject interest is an iterative process that requires a consistent and persistent approach, and is not for the faint of heart.

[1]       “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA, Volume 1, Hoboken, NJ: John Wiley & Sons, 2014, p. 231–244; “The Adviser’s Guide to Healthcare, Second Edition” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA & Todd A. Zigrang, MBA, MHA, FACHE, ASA, Volume 1, New York, NY: AICPA, 2015, p. 138.

[2]       “Valuation for M&A: Business Value in Private Companies” By Chris M. Mellen and Frank C. Evans, Second Edition, Hoboken, NJ: John Wiley & Sons, 2010, p. 322–325.

[3]       “Business Valuation Resource Guide” By Stephen Bethel, Glendale, CA: Mattatal Press, 2003, p. 283.

[4]       Chapter 12: Research and Financial Benchmarking in the Healthcare Industry, By Robert James Cimasi, Todd A. Zigrang, and Anne P. Sharamitaro, in “Financial Management Strategies for Hospitals and Healthcare Organizations” David Marcinko, M.D., MBA, CMP and Prof. Hope Rachel Hetico, RN, MHA, CMP Ed., Boca Raton, FL: CRC Press, 2014, p. 300–306.

[5]       Ibid., p. 300.

[6]       “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA, Volume 2, Hoboken, NJ: John Wiley & Sons, 2014, p. 241–242.

[7]       Attributed to Vladimir Lenin and popularized by U.S. President Ronald Reagan.  See President Reagan’s “Remarks on Signing the Intermediate-Range Nuclear Forces Treaty” December 8, 1987, https://reaganlibrary.archives.gov/archives/speeches/1987/120887c.htm (Accessed 9/21/17).

Robert James Cimasi, MHA, ASA, FRICS, MCBA, CVA, CM&AA, is chief executive officer of Health Capital Consultants, with over thirty-five years of experience in serving clients and a professional focus on the financial and economic aspects of healthcare service sector entities, including valuation consulting and capital formation services; healthcare industry transactions, including joint ventures, mergers, acquisitions, and divestitures; litigation support and expert testimony; certificate-of-need; and other regulatory and policy planning consulting.

Mr. Cimasi passed away on December 6, 2017.

Todd A. Zigrang, MBA, MHA, ASA, FACHE, is president of Health Capital Consultants, where he focuses on the areas of valuation and financial analysis for hospitals and other healthcare enterprises. Mr. Zigrang has significant physician-integration and financial analysis experience and has participated in the development of a physician-owned, multispecialty management service organization and networks involving a wide range of specialties, physicianowned hospitals as well as several limited liability companies for acquiring acute care and specialty hospitals, ASCs, and other ancillary facilities.

Mr. Zigrang can be contacted at (314) 997-7641 or by e-mail to tzigrang@healthcapital.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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