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Imaging and the Anti-Markup Rule

CMS adopted the changes it proposed this past summer in the 2008 MPFS Proposed Rule with respect to the so-called anti-markup provision.  The effect of these new administrative rules which occur outside the Stark regulations is to effectively make the “in office ancillary services exception” (IOASE) practically moot.  The IOASE, issued in Phase 2 of the Stark regs after complaints from various physician groups, allowed physicians to get around the general prohibition against referral to a DHS entity through sharing equipment located in a building in which they provided some non-DHS services.  Structures such as block leases were commonly used.  It appears that the interpretation of the requirement that DHS equipment be located in the “same space” means the same office suite.  Office suite likely means commonly connected contiguous space.  Thus, even a DHS facility on the same floor as the physicians’ non-DHS space would not qualify if there are third parties located in intervening space or even if a common space hallway is used to access the DHS facility.

As a slide in my 2005 presentation at the AICPA’s National Valuation Conference stated: “MedPAC also suggested Stark be expanded to cover physician ownership of equipment, or entities that provide equipment and services, used in imaging centers.”  Thus, we have yet another circumstance where MedPAC recommendations to reign in spending in high utilization areas are adopted several years later with catastrophic results for those affected.  To reiterate what I been saying in print and lecture since the turn of the millennium, these changes are foreseeable.  The same thing has already occurred, for example, with the addition of PET services to the Stark regulations effective this past January and we are going to see a need for the wholesale sell-off or closure of facilities violating the anti-markup provision before the effective date of January 2009 just as we did for PET.

When market participants do not appear to respond to the foreseeable changes, a consequential valuation issue arises.  There may be several possible explanations for this.  One is regulatory ignorance, which at least in my view is inconsistent with the requirement under the fair market value standard for “reasonable knowledge of the relevant facts.”  My career-long experience suggests that this does, in fact, account for a large amount of the failure to respond in the physician community, although certainly not in the broader business community of imaging operators.

A second possibility involves the belief that the exit price for the to-be-banned business will compensate for the loss of future operating cashflows.  This is arguably rational under the fair market value standard, but let’s look at it more closely.  With respect to facilities operating under the soon to be defunct IOASE, it is difficult to see that this explanation passes the rational muster because a fire sale scenario invariably results.  The owner-seller has two choices: sell and get something or close and get less than nothing, given the abandonment of the tangible asset investment.  This does not set up a good negotiating scenario nor a strong basis for a going concern premise of value.

Physicians and their advisors structuring future joint ventures in high utilization areas where there is subsequent regulatory change risk should pay careful attention to exit clauses with the nonphysician joint venturer.  Buy-out or buyback language should call for the valuation to be done using a going concern premise of value.  The nonphysician buyer will be concerned about possible subsequent volume drops and the impact on both the valuation and the transaction price.  Careful attention needs to be paid to the language of the agreement as well as the assumptions in the valuation model because the government is known to be concerned about the implications of “future referrals” being the basis for a purchase price when the DHS is located within the selling physician’s office. 

Although very bad news for referring physicians engaged in such structures, it is very good news for hospitals, non-referring physicians, e.g. radiologists and entrepreneurs located within the referring physicians’ service area. 

Consolidation Trends

In the June 2002 Business Valuation Review, I had an article addressing the crossover of fair market value and strategic value in consolidating industries.  In that article, I looked at the history of the Physician Practice Management Companies and how the buying frenzy of the 1990s had driven up the price and lowered the perceived risk of physician practices.  My article with Ken Patton of Mercer Capital in the current (Fall 2007) edition of CPA Expert addresses a similar issue with respect to the purchase of Home Health Agencies in the Deep South during the mid-1990s in anticipation of the replacement of Medicare’s cost-cased reimbursement system by a PPS.

A variety of market conditions can lead to consolidation. One such circumstance appears to be developing now with respect to Imaging Centers.  The dramatic cutbacks in MR, CT and PET from the Deficit Reduction Act have significantly reduced the revenue and therefore the profits of physician-based imaging.  Not widely recognized is that the practice expense component for imaging under Medicare's RBRVS assumes that imaging equipment is utilized only at 50% capacity; the House version of the vetoed SCHIP legislation would have raised the volume assumption to 75%.  Thus, the high fixed overhead of expensive imaging technology is recovered over a low volume of procedures, resulting in a high revenue per unit!  This type of structure makes high volume providers very profitable, while low volume providers – and particularly those below breakeven - may be big losers.  The impact of the DRA has been to raise the breakeven volume requirement for imaging and to make sale to a higher volume, or combination with another low volume, facility a more likely course of action.

Thus, I think we are seeing a developing trend of consolidation of low volume providers by financially stronger entities who can take advantage of the low marginal cost of imaging beyond breakeven volume.  A principal issue for the selling entity is the capital invested in the equipment and whether the selling price is sufficient to pay off outstanding debts, such as long-term equipment leases common to the industry.  Those potential sellers facing the choice of investing in new (or refurbished) equipment may find selling more desirable, particularly if the buyer has already invested in the newer technology.  The buyers will find the added volume very attractive of course, particularly given some of the indications that future cuts may be forthcoming, resulting in lower margins per unit beyond breakeven volume.

The valuation analyst has to consider what normalization adjustments are appropriate in such a circumstance.  As I noted in the Caracci article “it might be appropriate to value a subject in a sector that is being consolidated on the basis of consolidator transactions if the consolidators are active in the subject’s service area. In that case, otherwise strategic adjustments such as a lower cost of capital, higher growth rates, and lower operating costs might be appropriate normalization adjustments in an income approach.”  This is consistent with long-established if not well-understood valuation theory about the meeting of strategic and fair market value.

Understanding & Valuing the Medical Practice

My course named above was favorably received in Arizona this past September, with the participants giving me a 4.76 for knowledge and 4.41 for presentation on the 5.0 scale.

Post-Transaction Compensation

I received a question the other day inquiring as to the basis for  my statement in the November 2005 Journal of Accountancy that "the IRS says physician compensation in a valuation model should agree with any post-transaction employment contract."  I thought my response to that question would assist a lot of other appraisers.

This concept originally appeared in a letter attached to the valuation submitted in connection with the exemption ruling for the Friendly Hills Transaction as described below:

Quote from my book:

“The Friendly Hills HealthCare Foundation was the first ruling by the IRS in favor of tax exemption for an Integrated Delivery System (IDS) involving physician compensation in tax-exempt settings.  Certain aspects of the Ruling, including the use of the Discounted Cashflow Method, were later elaborated upon in the 1995 Exempt Organization Continuing Professional Education Technical Instruction Program Textbook.  Notably, the value determined in Friendly Hills was based, in part, on an agreed-upon reduction in physician compensation.”

“In fact, the valuation submitted in connection with the Friendly Hills transaction  contains a letter signed by the managing partner stating that the partners recognized they were selling a portion of their earnings and that their future incomes would be less by virtue of that sale.  In relevant part he states “... It has been clearly stated to the partners that, in the past, their compensation reflected not only the value of their medical services, but also the profits attributable to their ownership of the Network; that the latter element will be replaced by a cash payment, which they can invest ... that the Medical Group’s income will thereafter be derived from arms-length contract for medical services; and that these rates will necessarily be significantly lower than the total historical income they have been receiving ...” (emphasis added).  (Friendly Hills Valuation Report)”

See the 1994 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS (eotopicn94.pdf) and 1995 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS AND JOINT VENTURE DISSOLUTIONS UPDATE (eotopicl95.pdf).  Note in particular bottom of page 8 forward in 1994 text and the general discussion of compensation in 1995.  You can obtain these at http://www.irs.gov/pub/irs-tege/. These are still cited as recently as 2004.

Fundamentally, why would a hospital buy a practice for a value based upon the physicians receiving X compensation for their future services, when the Employment contract provided they would be paid X+?  You would not buy my practice, or I yours, for a $1 million and continue to pay me/you everything it generates, I suspect.  For a hospital to do so raises serious inurement and excess benefit issues, and more importantly, Stark and AKS issues.

MPFS Proposed Rule changes to Stark

Imaging remains under attack on all fronts it seems. CMS suggested in the 2008 Proposed Rule that it may limit the applicability of the in-office ancillary services exception and prohibit use of per click mechanisms where physician-lessors of equipment also refer to the facility-lessee; perhaps more significant, so-called "under arrangements" structures would be constrained or eliminated.

Legislation currently in Congress would replace the current single conversion factor with six - with a lower one for imaging! - and pay for the SCHIP expansion with further reductions in imaging reimbursement.

All of these potential changes increase the risk of future cashflow from Medicare-sourced procedures and need to be considered in an appraisal or valuation.

Report on the Healthcare Economy

Purchasers of my now sold-out book and those who purchase the updated chapter on valuation methods in Adobe .pdf format have received a free copy of my most recent Report on the Healthcare Economy. Many of the statistical studies cited in that Report are released between June and September each year, and as such the new edition is only now available.  It reflects updates from: the Census Bureau's just released report on health insurance, the National Center for Health Statistics reports on Ambulatory Medical Care and Hospital Utilization, MedPAC's 2007 Report to Congress, Physician Utilization and Specialty Distribution, trends in Average Length of Stay, Inpatient Utilization and Cost per Day and Phase 3 of the Stark II regulations, released August 27, 2007. Many of the readers of my book find this helpful in their valuation practice.

Future editions of the Report on the Healthcare Economy will generally be released in November or December after the publication of the final Medicare Physician Fee Schedule Rule by CMS; in February after the publication of the annual National Health Expenditures projections; and again in the Spring.  These are currently available for $20 each; prior editions can also be purchased.

Phase 3, Stark II regulations

Phase 3 of the Stark regulations came out yesterday (thanks to colleague Reed Tinsely for the early heads up). I am still plowing through the 500 or so pages, but the Safe Harbor for physician compensation based on the various compensation surveys is gone. Seems as though CMS received numerous comments from affected parties that the Safe Harbor was not workable - and they agreed! Now we are back to traditional tests of fair market value compensation rather than the artificial Safe Harbor.

http://www.cms.hhs.gov/PhysicianSelfReferral/04a_regphase3.asp#TopOfPage

Forthcoming Article

In the next edition of Financial Valuation and Litigation Expert I will have an article summarizing the changes in ASC payments by Medicare, the Medicare Physician Fee Schedule Proposed Rule and most importantly, CMS' hinted changes in the Stark law regulations, which will likely have significant impact on discount rates and/or cashflow forecasts for the affected sectors.

Caracci

I am pleased to report that the article I wrote with Ken Patton of Mercer Capital on the Caracci case will be published in an upcoming edition of the AICPA's CPA Expert.  Ken and I worked hard to maintain the point-counterpoint structure of the article which takes two different perspectives on the appropriateness of the market approach in valuing single market entities by reference to multi-market public companies, as well as the import of MVIC or right-hand side of the balance sheet approaches to valuation versus left-hand or asset side approaches.

AICPA Healthcare Expert Panel

I received notification this week that I have been appointed to the AICPA's Healthcare Expert Panel for the upcoming year. One of this Panel's key tasks is to provide assistance with respect to the Healthcare Industry Audit and Accounting Guide. With the pending expansion of SFAS 141 and 142 to the not for profit sector, valuation issues are likely to be significant for the Healthcare Industry Expert Panel in the coming year.