Just as in the 1990s, there is a wave of consolidation in the health-care industry today that is affecting both the perception and the reality of physician practice value. In many cases, the economics of today’s transactions are similar to the ’90s and that does not bode well for the future. At the end of that decade, many of the acquisitions proved to be disastrous financially to the hospitals and both private and public equity purchasers, resulting in divestiture of the practices.
The legal community may seek an appraisal or valuation of a physician practice for many different purposes, including marital dissolution, acquisition by a hospital, sale of an interest to another physician or in a commercial litigation context where damages are being sought. Regardless of the reason for the valuation, there are certain fundamental elements that must be considered by the appraiser.
The amount available to be paid to the physician after all operating expenses are paid is commonly referred to as predistribution earnings. A PDE typically consists of two components: the value of labor and the value of the return on the investment in the net assets of the practice. Thus, the most fundamental task for the appraiser is to differentiate between the two. There are several means of accomplishing this task, but the most common is to measure what the appropriate value of the services rendered by the physician is, and then subtract that from the available PDE to determine the profit on ownership of the assets. Once that profit is known, value can be determined through use of several approaches and methods. An alternative approach is to isolate the revenue and expense from income-producing assets of the practice. This is commonly done when the practice owns equipment such as a blood chemistry machine, X-ray or nuclear medicine camera that the health insurance system pays for with a separate revenue stream distinct from that for the physician’s personal work.
By definition, reasonable compensation is the salary necessary to hire a nonowner replacement physician of equal experience, given demographic considerations. Reasonable compensation is often confused with the “median” compensation from a survey or what a new recruit would be paid. There are a variety of surveys used in valuation as an element of this reasonable-compensation determination. The most common is the Medical Group Management Association’s (MGMA) Physician Compensation and Production Survey. Common errors in the use of the MGMA data include failure to understand that approximately 60 percent of the physicians by count are employed by hospitals. This portion of the data may not be relevant, for example, when valuing an interest in the practice for sale to a new partner. An even more basic error is failure to realize that “all health-care payment rates are local,” to paraphrase Tip O’Neill’s famous statement about politics. It may not be possible for a physician in a given geographic area to earn the same amount as a purportedly “comparable” physician in the MGMA survey because that subject physician may not be paid as well for his or her services as the aggregate of all physicians in the MGMA survey. Thus, it is necessary that the appraiser have a solid understanding of the rates paid by insurers in the local community for physician services.
More important, reasonable compensation should be measured based on common reference points for the individual physician’s productivity. The two most common references are collections for the professional services performed by the physician and work relative value units, commonly abbreviated as wRVUs. By way of analogy, wRVUs are a measure of physician work effort just as hours billed are a measure of an attorney’s work effort. The more work undertaken, the greater the amount of expected compensation, assuming that the work done generates collected revenue.
In addition to reasonable compensation adjustments, other factors need to be addressed to appropriately measure the value of the services rendered by the physician. A coding analysis should be performed to understand if a practice’s procedures comport with the industry. While a practice’s procedures may deviate from the industry, it is important to understand why such deviances are occurring and if they will change in the future. Furthermore, a coding analysis will enable near-term forecasting of reimbursement rates based on Medicare physician fee schedule rules that are published annually and are typically the baseline for which private insurers set fee reimbursement rates. Given today’s fast-paced health-care-industry changes, it is important to identify unsustainable sources of reimbursement. Similar to the importance of understanding wRVUs, a complete analysis of the technical and professional components of ancillary revenue will also provide needed insight into a practice’s future cash flow.
Future cash flows not only require knowledge of the subject practice, but also the marketplace and regulatory environment. Understanding the rapidly changing health-care industry is paramount to forecasting future cash flows. Local market trends will determine payor contracts and competition, as well as patient growth, retention and turnover. The present value of future cash flows is, after all, what accounts for the value of a business or practice.
As indicated above, the critical task for the appraiser is to isolate the cash return on investment earned from the assets of the practice. In real-world transactions, a buyer expects to exchange cash for the assets (or stock) of the seller and earn an appropriate rate of return. In most cases, that return will need to be consistent with the fair market value (FMV) standard. Examples of where FMV is required include both sales of physician practices and employment of physicians by hospitals. Other standards of value may be appropriate in litigation settings.
In its simplest terms, valuation under the income approach methods is about a measure of future cash flow capitalized (multiplied) by a factor that reflects the risk of receiving that future cash flow. As such, the assessment of risk is the next critical task for the appraiser. Common mistakes in the measurement of risk include failure to consider government or regulatory risk, market concentration risk and, most important, the risk of payment rate cuts by the Medicare program, which are then usually adopted by private insurers such as Blue Cross Blue Shield. Primary care practices (internal medicine, family medicine) are generally the least risky practices in the current environment and therefore would have the highest valuation multiples per a dollar of cash return on investment. The greater the risk, the higher the return (capitalization rate) and the lower the valuation multiple.
Health-care reform is the leading factor of today’s industry consolidation; however, consolidation is occurring in many incarnations, all of which have distinct and nuanced risk factors. One of the foremost changes implicit in health-care reform is that value, not volume, is the new guideline of quality performance in patient-centered health care in which payors are now negotiating pay-for-performance contracts. Independent physician practices and hospitals unable to adapt are struggling to meet this new paradigm. To remedy this, hospital and physician practice collaborations are happening through the formation of accountable care organizations, clinically integrated networks, joint ventures and clinical comanagement arrangements, to name a few types of successful venture arrangements. Where are your stakeholders falling in this continuum of health-care organizations? Ultimately, the answer to this will indicate the sources of risk, as well as the sources of opportunities that can benefit all parties involved.
Obtaining an accurate valuation of a physician practice requires expertise in a broad variety of subject areas, including valuation, expert testimony, regulatory matters, standard of value, and local insurer and economic conditions. •