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Healthcare Markets, Part Deux

I heard yesterday that my Paper on healthcare markets tentatively titled Healthcare Market Structure And Its Implication For Valuation Of Privately Held Provider Entities: An Empirical Analysis will appear in the Summer Edition of Business Valuation Review - barring unforseen delays. In addition to speaking in part on this topic at the AICPA/ASA BV Conference, I will also present portions of it at the AICPA Healthcare Conference in September and the Tennessee Society of CPAs Healthcare Conference on December 2.

Now that the paper has been accepted for publication - after pre-submission peer review and critique -  I think it is reasonable to state that it has fairly dramatic implications for the use of out-of-market transaction data when using the Guideline Publicly Traded Company method or the Guideline Merged and Acquired Company method.

Healthcare Markets

As participants in the February BVR Teleseminar heard, my detailed research into for-profit and not for profit healthcare markets in the US yielded some striking differences and underlying structural reasons for those differences.  A brief synopsis follows.  I hope to see the related Paper published later this year and the findings will be one of the topics discussed at my Joint Presentation with Don Barbo at the AICPA/ASA Business Valuation Conference in November.

The degree of revenue and profit for healthcare provider entities varies significantly from state to state and even within different regions of individual states.  As a threshold matter, areas with high healthcare spending and particularly high Medicare[1] spending tend to offer the greatest opportunity for profit.  The elderly, of course, receive the bulk of medical care.  Given that high localized spending is the primary driver of profit, the other factors contributing to the pattern of location of larger for-profit providers include: 

• The presence and market strength of Blue Cross plans,
• The degree of market strength of local nonprofit hospitals versus for-profit hospitals,
• The degree of market strength of local nonprofit health insurers versus for-profit health insurers,
• Certificate of Need laws and
• Other local demographic and economic factors.

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[1] Medicare spending varies considerably from region to region with states such as Florida, Texas, California and Tennessee having high per capita and total dollar spending and many for-profit providers.

Cash Equivalence

In my previous post, I raised the problem with determining the cash-equivalence required by the definition of "fair market value" when using "deal-based" market data. Besides the database that bears his name, Dr. Shannon Pratt (and his co-authors) devotes a chapter (#27) in Valuing Small Businesses and Professional Practices to the topic. Of particular interest is the comment regarding personal guarantees on page 494 (suggesting an interest rate premium over bank lending rate of 3% where there is no personal guaranty) and the example on page 500 dealing with contingent buyout payments. In that example, the cash-equivalent price is 55% of the deal price.

Nuff said.

Fair Market Value in Cash or Cash Equivalents

Caveat: I should preface my comments below by stating that this is not intended to be relied upon by others as statistical analysis –you have to do that analysis for yourself.

I have been evaluating dental transactions in the database Pratt’s Stats.  From my analysis of 230 post-1/1/2000 transactions, 102 had an answer to the question of whether or not there was a personal guaranty of a note given by the buyer in connection with the purchase. Of those, 56% had an answer of "no personal guaranty." 47 (20%) of the transactions reflected a down payment of 100% and the median down payment for the 230 transactions was 28.4%. This suggests to me that the notes given in those transactions do not represent a cash equivalent, even if secured by the underlying assets, since the seller would have to retake possession and incur the costs (e.g., legal fees!) of the repossession of assets.  This would be a difficult task, for example, for a seller who has retired and relocated. In addition, the notes are non-negotiable to begin with, negotiability is a requirement for being considered “cash-equivalent.”  Further, a bank or other lender in the business of making loans, as opposed to a seller financing the sale of his or her practice, is in a much better position to enforce collection activity.

This highlights one of the many problems with the market approach for a determination of fair market value in cash or cash equivalents – as required by the FMV definition accepted by all the major valuation and appraisal organizations and most Courts.  Converting a secured note absent a personal guaranty to a cash equivalent is a difficult task.  IF one could find empirical evidence of what a third party lender would charge for interest on a personal note lacking a guaranty but secured by equipment, then that would be a start.  Bear in mind that the majority of the value of a dental practice is typically intangible and not equipment.  Lenders generally do not loan unsecured money on intangible assets and certainly not without a personal guaranty – that is why only 44 of the transactions had down payments of 100%.  Absent a transaction involving a Dental Practice Management Company or similar operation, it is unlikely that another dentist purchasing a practice from the seller would have 100% of the purchase price lying around in cash.  Whatever the problems, you have to make some type of an adjustment to equate the underlying data to cash-equivalent.  The problem here is not with the data, which is pretty comprehensive as databases go and may well be the best, the problem is using it without studying it.

CCFs, MVIC and BEV

A number of recent reviews of other's reports have prompted me to make this post.  There seems to be a segment of the valuation world that does not understand the definition of operating assets or operating cashflows. There are three principal components on the left side of the accounting equation or balance sheet that equal the right hand side of the accounting equation or Market Value of Invested Capital (MVIC): Working Capital, Fixed Assets and Intangible Assets or BEV. This is easily seen in the discussion of cashflow in the annual Ibbotson Yearbook or in classic valuation texts such as Pratt's (4th Edition, page 70) or Hitchner's (2d Edition, page 118). Discount rates developed from Ibbotson data therefore apply to ALL operating cashflows, not just to, for example, fixed assets and intangible assets.

Near as I can tell the "confusion" or mistakes result from looking at market data where the transaction price excludes working capital, as it often does for many small businesses. For some reason, the individuals making the mistake assume that because a small business transaction does not include working capital, the cashflows from that business do not require working capital! In fact, the purchaser of a small business who does not acquire the working capital MUST infuse that working capital.  Thus, for market data, one would have to add working capital to the values to get the MVIC. This must NOT be done however for the CCF or DCF methods, which ALREADY INCLUDE the working capital value.

When one derives valuation multiples from transaction databases that include operating cashflow and transaction data with only fixed assets and intangibles, the numerator (the transaction price) is lower than the MVIC of the business, while the denominator (cashflow) is the same.

For example, assume the business has cashflow of 3 and transaction value of 12; required working capital is 3 so MVIC is equal to 15.  Thus, fixed assets and intangibles  have an apparent valuation multiple of 4 times operating cashflow, while MVIC would have a multiple of 5 times the same operating cashflows. Inexperienced or poorly trained valuators confuse the different numerators when trying to compare transaction data to income methods.  All things being equal, the example indicates that the cap rate for cashflows to MVIC would be 20% (1 divided by 5) and result in the value of 15. Adding the 3 to the 15 is CLEARLY a double count,  Not surprisingly, I often find valuators who make this mistake getting higher value numbers under the income approach than the market approach due to the double count.

As I stated in my peer-reveiwed Journal of Accountancy article in 2005 and numerous other places, the excess earnings method is no more than a two-stage CCF, with separate rates of return assigned to the left hand or asset side of the accounting equation, which, again MUST be equal to the right hand or equity and long-term debt side.  For an in-depth, classic explanation of this topic, see Pratt's 4th Edition, Chapter 13 explaining the excess earnings method.