Common Misconceptions Regarding Healthcare Entity Valuations

Five of the 10 Leading Misconceptions (Part I of II)

The following discussion summarizes and responds to common misconceptions that many analysts have with regard to the valuation of healthcare entity property and/or services transfers. These analyst misconceptions typically involve a misunderstanding of one or more of the relevant regulatory provisions. These analyst misconceptions typically relate to an erroneous understanding that “the Service only accepts this” or “the Office of Inspector General doesn’t accept that.” These analyst common misconceptions are addressed from the perspective of the regulatory compliance of the valuation analysis. In Part I of II, the article covers five of the 10 leading misconceptions.

Introduction 

A valuation analyst (“analyst”) may be asked to prepare a fair market value valuation related to a health care provider transaction.  Such a transaction could include either a property transfer (such as the acquisition of a professional practice or hospital) or a services transfer (such as the entering of an employment contract or management services contract).  All health care entities are subject to certain government regulations (such as the Medicare fraud and abuse regulations or the Stark Laws).  This is because these entities receive government reimbursement for the medical services they provide.  Among these various regulations is the provision that the health care entity may not pay more than fair market value for certain property and services transfers.  In addition, these statutes provide that the health care entity cannot make any payments in exchange for patient referrals.

 

Many health care entities operate as a tax-exempt entity for federal income tax purposes.  These health care entities have to comply with additional regulations with regard to the fair market value valuation of property and services transfers.  Of note to analysts, a tax-exempt entity cannot enter into a property or services transfer that results in private inurement.  If a tax-exempt health care entity enters into a private inurement transaction, the Internal Revenue Service (“the Service”) may impose the Internal Revenue Code Section 4958 intermediate sanctions.

 

A description of the general health care provider laws and the tax-exempt entity regulations is beyond the scope of this discussion.  A description of the generally accepted valuation approaches and methods is also beyond the scope of this discussion.  Readers are assumed to be familiar with these valuation approaches and methods.  Rather, this discussion summarizes common misconceptions analysts have with regard to preparing health care entity valuations.

 

Analyst Misconceptions Regarding Healthcare Valuations 

The following discussion summarizes and responds to common misconceptions many analysts have with regard to the valuation of health care entity property and/or services transfers.  These analyst misconceptions typically involve a misunderstanding of one or more of the relevant regulatory provisions.

 

These analyst misconceptions typically relate to an erroneous understanding that “the Service only accepts this” or “the Office of Inspector General doesn’t accept that.”  These analyst common misconceptions are addressed from the perspective of the regulatory compliance of the valuation analysis.

 

There is a Preferred Valuation Approach or Method 

Some analysts believe that certain health care transaction audit or regulatory authorities have a preferred valuation approach or method.  None of the health care transfer statutes or regulations mandate a property or services valuation preferred approach.

 

Any of the generally accepted property or services valuation approaches and methods may be used in a health care entity transfer analysis—as long as the analysis conclusion is fair market value.

 

There is a Prohibited Valuation Approach or Method 

Some analysts erroneously believe there is a prohibition against using certain valuation approaches and methods.  For example, some analysts believe the income approach, and particularly the discounted cash flow method, is inappropriate to health care property or services valuations.  The basis for this erroneous belief is that such a methodology has to include the income from prohibited patient referrals.

 

Of course, no health care entity can pay a transaction price that includes patient referrals.  However, that statement does not invalidate the use of the income approach.  The analyst simply has to be careful to exclude any income from post-transaction prohibited patient referrals in the income approach analysis.

 

Likewise, some analysts believe an adjusted net asset value method is inappropriate if it incorporates some type of a capitalized excess earnings procedure.  The basis for this erroneous belief is that no health care entity is allowed to collect excess earnings.

 

In fact, there is no prohibition on using this valuation method.  There is no prohibition on any particular health care entity earning a high profit margin (as long as there is no fraud and abuse contributing to that income, of course).

 

For purposes of the subject valuation, let’s assume excess earnings are defined as the excess above the median profit margin level for that health care industry segment.  Based on that excess earnings definition, half of all of the entities in the industry segment may earn excess earnings (i.e., half of the health care entities will earn income above the median level, and half of the health care entities will earn income below the median level).  Therefore, it is not unreasonable to expect some health care entities will generate excess earnings.

 

All Healthcare Valuations Should be Performed on a Before-Tax Basis 

In order to adjust for the fact that some health care industry acquirers are tax-exempt and some are for-profit entities, some analysts ignore income taxes altogether—and perform all valuations on a pretax basis.

 

Some analysts erroneously believe this procedure prevents the tax-exempt entity from paying more than fair market value for a target health care entity.  This objective is certainly appropriate.  However, there is no regulatory requirement that all health care property (or services) valuations be performed on a pretax basis—or on an after-tax basis, for that matter.

 

Typically, if the property (or services) valuation variables are derived in a consistent basis, then the subject health care property (or services) should have one fair market value—whether the variables are measured on a pretax basis or an after-tax basis.  That is, the valuation can be performed with all valuation variables (discount rates, capitalization rates, pricing multiples, income metrics) derived on a pretax basis.

 

Alternatively, the valuation can be performed with all valuation variables derived on an after-tax basis.  The fair market value conclusion should be about the same.  So, there is no regulatory (or theoretical) preference—or prohibition—for performing health care property (or services) valuations on a pretax basis compared to an after-tax basis.

 

There Should be no Goodwill Included in the Health Care Valuation 

Some analysts erroneously believe that audit and regulatory authorities do not allow the inclusion of either an individual practitioner’s goodwill or an entity’s institutional goodwill in a health care property transfer valuation.  These analysts may conclude that any goodwill value includes the value of prohibited patient referrals or the value of excess (and suspicious) earnings.

 

However, there is no legislative or regulatory prohibition on the health care entity (tax-exempt or otherwise) paying for the goodwill of a target health care entity.  And, there is no prohibition on including the value of goodwill in the health care property valuation.

 

Goodwill can be measured many different ways.  But, goodwill is basically the value of the health care entity’s ongoing business operations in excess of the value of the entity’s tangible assets.  For a successful going-concern business operation, the analyst would expect the health care entity to have some amount of goodwill.

 

Of course, the goodwill value should not include future prohibited transactions or expected post-acquisition synergies or economies of scale.  But, if the target entity’s historical results of operations indicate a positive goodwill value, then that goodwill value should be included in the health care property transfer valuation.

 

Typically, the goodwill value is included in the asset-based approach valuation analysis of the target entity value.  And, that goodwill value may be measured in either the asset accumulation method or the adjusted net asset value method of the asset-based approach to business enterprise valuation.

Robert Reilly is a managing director of Willamette Management Associates based in Chicago, Illinois. His practice includes business valuation, forensic analysis, and financial opinion services.  Mr. Reilly is a prolific writer and thought leader who can be reached at: (773) 399-4318, or at: rfreily@willamette.com.