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Valuing the Transaction and Strategic Value?

At yesterday’s session on Cost of Capital with Carol Carden at the BV Conference, one of my colleagues raised the question from the floor about whether “valuing the transaction” in healthcare constitutes strategic value. It clearly does not.  Among the many aspects of the healthcare industry is the regulatory construct which requires fair market value as a standard in all valuation engagements.  Therefore, one of the things that an appraiser must learn in practicing in the healthcare industry is how to apply the FMV standard of value to valuation models where someone unfamiliar with the regulatory construct might inadvertently develop strategic value – or, for fear of developing strategic value, default to valuing some “hypothetical” transaction. 

 “Terms Make the Deal” is a common cliché’ in transactions but it is not an indicia of strategic value.  As a simple example, consider the value of a noncompete agreement as part of the enterprise value of a given medical practice.  Assume that the seller has the ability and intent to compete post-transaction absent a contractual provision precluding that competition.  A Hypothetical Buyer would pay less for the business – if pay anything at all – absent the noncompete, while a hypothetical seller expects to be paid for not competing in addition to being paid for the value of the other assets being sold.  Thus, the noncompete has an identifiable value - that can be determined through a “with and without” analysis – and two different Fair Market Value prices would be determined for the Enterprise based upon the Terms of the Deal.  The question is not whether the presence or lack of a covenant presents Strategic Value – it does not – the question is what Hypothetical Buyer and Seller would reach as a purchase price for the business with and without the noncompete.

 The discussion cannot stop there. The Terms of the Noncompete itself determine its value.  Thus, a noncompete with a geographic restriction of 10 miles might be expected to have a value less than one with a geographic restriction of 25 miles, assuming that the catchment area of the medical practice extended beyond 10 miles.  The sale of the practice with a 10 mile noncompete provision versus one with a 25 mile noncompete provision would have two Different Fair Market Values! Nothing about the geographic range of the noncompete term represents strategic value so long as the Appraiser focuses his or her attention on what a Hypothetical Buyer and Seller would agree to as a transaction price.

 As I responded in yesterday’s session, Appraisers need to focus on what actual assets are being transferred.  One of the important lessons learned from the literature on FAS 141/142 and the focus on valuing the left – Asset - side of the Valuation Equation is that the Market Value of Invested Capital is the aggregate of the Assets of the Business.  If the Transaction Documents pull out certain of those assets – like Accounts Receivable net of payables, for example, which is a common exclusion in a medical practice sale – a Hypothetical Buyer and Seller would and in fact must adjust the actual Transaction Price, notwithstanding any conclusion of MVIC – or, risk regulatory review due to paying for something you did not receive, a primary indicator that a prohibited buying-of-referrals motive was present.

 As I further stated several times during the presentation, the 2008 Tax Court Case Derby makes it very clear that the Appraiser must – read that must – review the actual transaction documents specifically with respect to the post-transaction compensation and terms of the noncompete in order to determine the value of what was transferred.  If the actual documents are not available, key assumptions such as post-transaction comp and noncompete terms must be obtained from the client and they should be 1) specified in the Report and 2) considered for a Representation Letter. This is a left-hand side or Asset approach to valuing transaction in contrast to the simpler, default right-hand or Invested Capital Approach.  Assets have a Fair Market Value just as does Invested Capital and due to the Terms of the Deal, the two may not always be equivalent because either 1) some element of the Invested Capital is not transferred like working capital or 2) the terms of the transaction transfer more or less value that what the Appraiser’s generic concept of the transaction might be, such as a noncompete with a 10 versus 25 mile radius.

 In healthcare transaction we encounter these nuances more often than not. We are expected under the regulatory standard of practice to assign value to these nuances, otherwise the transacting parties and the Appraiser risk civil or criminal prosecution. 

 As a final thought, real estate appraisal and transaction are no different!  If a hypothetical buyer makes an offer on a home and the Building Inspection determines that the heating system is about to fail and will cost $10,000 to replace, one expects that the Hypothetical Buyer and Seller will make an adjustment to the Offer Price – or else a transaction will not take place.  Simpler still, if there are two otherwise identical 4 bedroom homes located in the same neighborhood and one has been recently renovated with new kitchen cabinets, bathroom fixtures and a deck and the other requires updating, they will have two different prices.  The reason is that the condition of the underlying component assets being transferred differs!  The utility and the present value of expected future outlays by the owner to maintain House 2 are greater than House 1 making House 1 more valuable today!

 Don’t fall victim to the tired argument that valuing the actual assets transferred in a transaction somehow constitutes strategic value.  Only the Fool of Circus-man PT Barnum’s famous adage would pay $10 for a $5 bill.

Abuse of the Cost Approach

This topic is more like one of the Zombies in Night of the Living Dead as opposed to the arguably cute Eveready Bunny; nonetheless, it keeps on goin.'

It has come to my attention that one reason for the inaccurate, improper and altogether wrong use of the Cost Method to value physician practices for hospital acquisition is due to the fact that the version of the 1996 IRS EO CPE text on Valuation of Medical Practices ( eotopicq96.pdf at http://www.irs.gov/pub/irs-tege/) does not contain Exhibits A and  B which are referenced therein - and quite clearly (let me say it again, QUITE CLEARLY) demonstrate that Business Enterprise Value was determined using the DCF Method under the Income Approach (that's the Income Approach, Beavis) not the Cost Approach. The Cost Approach was only used to allocate the Intangible Value determined under the Income Approach to specific intangibles, as is clearly stated elsewhere in the document, to wit: "The value of goodwill can be allocated to specific intangible assets; the value of the latter is limited to the value of the former, as calculated under the income approach. For example, if the total value of the individual intangible assets exceeds the total value of the medical practice net of the aggregate fair market value of the tangible assets, the amount of value that can be allocated among the intangible assets is more limited. Also, it is important to note that intangible value may not always be present in a medical practice."

Articles and such

My article with longtime colleague and collaborator Kathie Wilson on Understanding and Using the Technical and Professional Component of Ancillary Revenue will be published in the April Edition of Business Valuation Update. I am also pleased to report that another article I wrote, Why Transaction Structure Affects Value and Other Nuances of Valuing Medical Practices, will be published in the Spring edition of CPA Expert. Both pieces address issues I will also discuss in the March 16 seminar for VPS.

Thought for the Day: Always stand upwind of the fan.

The Market Approach and Market Data

I had several discussions today concerning alternatives to the Income Approach when valuing medical practices for sale to a hospital. At the risk of repeating myself, the hypothetical investor of the fair market value standard is interested in income returns; is risk adverse (see any text book discussion of the CAPM and diversification); views normalization adjustments cautiously, and does not anticipate synergistic opportunities from the investment, e.g., a lower cost of capital than the target entity on a stand alone basis, revenue to the acquirer over and above that available to the target on a stand alone basis, etc. Synergistic expectations are a feature of Strategic Value, not Fair Market Value. As such, they are not consistent with appraisal for the healthcare industry where Stark, the AKS, or tax exemption issues are present.

One issue that sometimes presents itself in an appraisal is the relevance of the Market Approach. My article Healthcare Market Structure And Its Implication For Valuation Of Privately Held Provider Entities: An Empirical Analysis appeared in the Summer 2008 Edition of Business Valuation Review and addresses many of the peculiar issues that exist with this Approach in the Healthcare Industry. In order to use "comparable" transactions in a regulated healthcare valuation, the appraiser must be cognizant of the underlying motivations of the parties who engaged in the reported transaction. If the value of past, present or future referrals were considered in the determination of the transaction price, the data would be "tainted" and not an appropriate source of a multiple, of course. For transactions that are not fully reported - which is just about all of them - there is insufficient data from which the appraiser can assess the motivations of the transacting parties. Furthermore, as I have said many times, "The Plural of Anecdote is not Data." Finally, there is a substantive question as to whether "market" data available only to a restricted audience is appropriate for use in a fair market value appraisal. "Market" data contemplates hypothetical buyers and sellers who have reasonable access to relevant facts. Confidential data is not consistent with that requirement.

IRS Nonprofit Guidelines

The IRS has posted a Guide Sheet for Examining Agents to be used in audits of tax-exempt entities, including hospitals. Of particular note are items 13 and 14 with respect to approval of compensation arrangements.

Payments to existing physician staff members (or physicians already located in the catchment area) such as those based on replication cost of Intangibles in a practice acquisition where the Income Approach shows no value could run the risk of being considered as compensation. Something to think about.

http://www.irs.gov/pub/irs-tege/governance_guide_sheet.pdf

Meanwhile, "back at the ranch," the instructor in Fair Market Value 101 is asking the students: "How many of you would pay $500,000 to replicate a business from which business you could earn no income?" Sampling of answers to follow...

Clarification on Cost Approach

I updated yesterday's post to clarify that the Cost Approach was not appropriate for valuing Intangibles unless there was value under the Income Approach - a reader caught that miss before I could get to it this AM. As to other assets like equipment, value is typically paid based on the fair market value under a Cost Approach rather than the Income Approach. In those cases one needs to look at the premise of value - as part of a going concern, as part of a mass assemblage of assets, etc.

Shades of Future Past ...

...or more accurately, Through the Past Darkly. Other cliches that come to mind: History Repeats Itself and PT Barnum was Right.

Despite a well-established regulatory construct that dates back to the IRS CPE Texts in the early 1990s, using the Cost Approach to value practices for acquisition by hospitals is back in fashion again, primarily by healthcare-appraiser wannabes. Less there be any misunderstanding, unless there is value under the Income Approach as determined from a well-reasoned DCF, use of the Cost Approach to value Intangibles is not appropriate, period. That's a PERIOD. What could be clearer than the Derby case?

Here are prior posts that summarize the Rules

http://cpanet.typepad.com/cpanet/2009/06/ahla-tax-finance-practice-group-member-briefing.html
http://cpanet.typepad.com/cpanet/2009/03/exempt-organization-cpe-text.html
http://cpanet.typepad.com/cpanet/2008/10/derby-et-al-v-commissioner.html
http://cpanet.typepad.com/cpanet/2007/10/post-transactio.html
http://cpanet.typepad.com/cpanet/2006/11/umdnj.html (!)

AHLA Tax & Finance Practice Group Member Briefing

My article Converting Physician Practices to Tax-Exempt Status: Is There an Upside to the Downturn? was published earlier this week as a Member Briefing by the American Health Lawyers Association. I would like to thank the editors, who included Travis Blaisdell at Mintz Levin, for their efforts in translating my submission into a form appropriate for the AHLA audience.  After my Journal of Accountancy article and ABA Health Lawyer article with Reed Tinsley, this is the third most edited article I have had published. The article contains some observations that are particularly important in the current environment.  Among these are the

1. Import in an appraisal of considering the tax impact of a liquidation when a taxable practice converts to exempt status

2. Continuing importance of the DCF method in determining whether and to what extent a practice has Intangible Value. I continue to believe that absent extraordinary circumstances, the Cost Approach should not supplant the Income Approach as the appropriate reference point in Healthcare Valuation.

3. Valuing the Transaction reflected in the transaction documents as required by the Derby case discussed elsewhere in this BLOG

4. Considering local law as to the enforceability of noncompete and similar provisions

5. Considering limitations on obtaining both debt and equity capital in the current environment on the discount rate and/or the consideration of marketability.

See this earlier Post: http://cpanet.typepad.com/cpanet/2009/03/exempt-organization-cpe-text.html

Managed Care and Taxation in the UK

I have been in London where I’ve had the chance to meet and consult with representatives of the burgeoning private practice physician organizations to discuss the progression of American-style managed care and regulation and what the stages might look like – and none too soon it would appear.  I was also granted the opportunity to give a seminar on valuation of physician practices for tax purposes and describe the significant differences between US and UK tax policy and how it might affect value – notably, there is no equivalent to IRC section 351 and the transfer of goodwill to a corporation by an unincorporated individual in the UK is a taxable event.  The taxation and value of physician goodwill have become quite important as the number of private physician practices has climbed in response to the partial move away from National Health Service (NHS) to a mix with private health insurance. Many doctors have begun private practices in addition to their weekly commitment as employees of the NHS. There are quite a few private hospitals in London as well, some owned by large American companies, notably HCA. Private health insurance and the related export of American-style managed care is somewhat surprising, particularly in light of present trends here in the US.

 

I have been invited to write an article for the leading physician trade magazine on managed care and its stages of progression and once it is published, I will post excerpts of it here.

Exempt Organization CPE Text

My October 10, 2007 discussed the several IRS CPE Texts that are relevant to valuing physician practices for purchase by hospitals or Integrated Delivery Systems. I should have mentioned an obvious one there, the 1996 EO CPE Text Valuation of Physician Practices (eotopicq96.pdf). Look at the discussion beginning at the bottom of page 22 and particularly that on page 23 with respect to Medical Records. This is where the IRS first made it clear that you had to have intangible value under the income approach before the cost approach became relevant. In my view, that is true anyway but particularly so in light of Derby, discussed elsewhere on the BLOG.

You can obtain eotopicq96.pdf at http://www.irs.gov/pub/irs-tege/.