Five Common Valuation Errors
This Bulletin is brought to you by AHLA’s Enterprise Risk Management Task Force.
- April 10, 2020
- Karen Kole , ECG Management Consultants
- Adam Klein , ECG Management Consultants
Health systems engage in transactions of various businesses (e.g., ancillary services, medical practices, service lines, hospitals, payers). Any such deal can be complex, but one of the most daunting challenges is ensuring the transaction meets the regulatory requirements of fair market value (FMV).[i] Common sense and conventional wisdom are rarely sufficient to minimize the risk of noncompliance with FMV. Complicating matters further are the dynamic nature of these deals and the need for business leaders, attorneys, and appraisers to remain in sync.
Simply having an opinion letter that states the purchase price is within FMV does not necessarily mean the purchase truly is FMV; rather, it means one expert thinks it is. FMV, if called into question, could ultimately be determined differently by a judge or jury, especially if the expert’s opinion report has vulnerabilities. While no opinion is immune to regulatory risk, a less vulnerable opinion can better mitigate that risk. In addition, there can be assumptions and limitations in even the most thorough FMV opinion. If an organization doesn’t recognize or account for those assumptions and limitations, the opinion may ultimately not be considered relevant to the actual deal that was done.
In a similar vein, most FMV opinions include a disclaimer about data provided by the appraiser’s client—it is often accepted by the valuator with minimal or no validation. Thus, when the valuation firm receives data that is incomplete, unverified, or inaccurate, it will generally rely on the data nonetheless. Likewise, when the engaging party assumes certain requested data is not necessary or pertinent, it could limit the valuator’s ability to render an accurate opinion.
In this article, we highlight five common errors that are especially relevant to parties that engage valuators and rely on their opinions to demonstrate compliance with the law. They are all relatively easy to avoid; by doing so, valuation opinions are more likely to withstand scrutiny. In addition, the conclusions will be more relevant to the facts and actual circumstances so that the user can make an informed decision.
Error One: Not considering all arrangements in the transaction
In the course of a transaction, if other arrangements with the seller are also being contemplated outside of the business enterprise value (BEV), it is important the appraiser is aware of this so they can determine whether the other arrangements will have an impact on the BEV. One common misconception is that if an arrangement is separate, it should be treated separately and the appraiser does not need to see the agreement.
For example, health system executives are sometimes interested in acquiring a business to better serve the needs of the community. However, the health system realizes it might not have the expertise in house to manage that service line, and a management agreement is put in place between the selling business’ management team and the health system. That agreement is part of the acquisition and must be evaluated with the business enterprise. The health system runs the risk of inappropriately valuing the transaction, the arrangement, or both if these are viewed in isolation.
This is especially the case for physician-owned entities. After the transaction closes, the physicians might continue to manage that business and any future related services. The physicians are receiving the up-front purchase price as well as any future profit from the management services. In addition, if the current entity lacks a management fee because the physicians were owners and received all remaining income at year end, it is necessary to consider that the hypothetical buyer would need to have a manager overseeing operations and thus must incorporate that cost into the cash flow, which would lower the value. The cash flow should represent costs necessary for the hypothetical operator to run the business by incorporating a management fee.
Error Two: Instructing an appraiser to reach a conclusion before the final transaction terms are known
The terms of a transaction often evolve throughout the course of a negotiation, and even small changes can materially affect an appraiser’s opinion. One of the most common examples of this occurs when the ownership interest that is valued is not the same ownership interest that is ultimately sold. This may be because the final ownership interest is not known when the valuation report is requested or changes occur during transaction discussions that are not conveyed to the appraiser. Either way, the valuation results may no longer be relevant.
Similarly, if an appraiser is told to value a certain percentage of an entity, but a different percentage is ultimately transacted, it could have a significant impact on discounts used or excluded in the valuation. What was once an acquisition of a controlling interest could become the acquisition of a minority interest, which can result in vastly different values.
An appraiser needs to be included in these types of discussions. Share the definitive agreements and operating agreements with the valuation firm, and inform the appraiser of open items. If a discount is warranted but not factored in and a minority interest is acquired, the purchase could be above FMV.
Error Three: Failing to identify which assets and liabilities are included and under what terms
One party to a transaction might think they understand a valuation opinion and offer the highest BEV, only to later discover that the BEV includes all assets of the practice, because no one communicated to the valuator that certain assets should be removed.
This challenge frequently occurs with working capital, especially when the deal terms have not been clearly specified. For example, if the valuator is unaware that a seller wishes to retain the accounts receivable (A/R), the BEV will likely be overstated. BEVs generally consider expected future cash flows, and those projections relate to cash flows that are available for distribution to owners. If a business does not have adequate working capital, it will need to replenish those levels before being able to make distributions to owners. This must be considered in the valuation. Most valuation analyses will assume all assets are included and then adjust to the indicated BEV for any excluded assets.
It is important to inform the valuator of any specific agreements regarding which assets and liabilities will transfer to the new owner and under what terms. Moreover, if those details have not yet been determined, the valuator can help in advising how value would be affected by each considered scenario.
Error Four: Providing data that does not accurately reflect the post-transaction venture
This error most commonly occurs when a hospital is engaging in a joint venture with, or selling, a business. For example, if a hospital is contributing a HOPD surgery center to a joint venture, multiple adjustments likely need to be made.
- Revenue will not accurately reflect the reimbursement received for a freestanding ASC.
- Expenses likely include hospital overhead that is not necessary to operate a freestanding ASC.
- If the hospital does not charge overhead to the ASC, a management fee should be considered to account for future ASC administrative services.
- If the hospital owns the real estate, there likely was no rent historically charged to the surgery department, and rent should be included.
Error Five: Giving credit for synergies
In some cases, the buyer might advise the appraiser to consider pro forma cash flows that involve buyer-specific reimbursement increases or expense reductions (synergies). If this happens, the value is likely strategic and not FMV. The projections should be based on how the entity can perform without the buyer. There must be support for the financial projection, and projections with significant growth should not be considered unless a high discount rate is utilized. It is important for legal counsel to push back when they see this in the valuation, as the opinion is more likely to be challenged.
Summing Up: Communication Is Everything
Many of these issues are avoided when health care executives, legal counsel, and the valuators all discuss key transaction terms and what the valuation results mean throughout every phase of the deal. Involving the appraiser before reaching agreement between the parties can reduce transaction and regulatory risk. The valuator should continue to be consulted as transaction terms change in order to assess how those changes are likely to impact the final conclusions, at least directionally. Then, before a formal opinion is rendered, the appraiser should receive the final documents to ensure the valuation reflects the actual transaction.
Karen Kole is a Senior Manager at ECG Management Consultants’ Chicago office. With over ten years of health care transaction and advisory experience, managing over 100 transactions, Karen has been a welcome and active addition to AHLA’s Enterprise Risk Management Task Force Leadership Development Program. Karen has extensive financial modeling expertise and provides fair market value opinions for various transactions and hospital-physician arrangements. Editing assistance was provided by Adam Klein, a Principal from the firm’s San Diego office who leads the Valuation Services practice. Adam’s practice focuses on valuation and litigation support for health care business arrangements in academic and community settings including physician practice acquisitions, business formations, consolidations, restructurings, and divestitures.