September 28, 2020

Determining Fair Market Value in Healthcare Transactions

Point by Point

This episode of Point By Point was produced prior to the combination of Waller and Holland & Knight.

Jason Ruchaber, founder and managing partner of Root Valuation, joins Waller attorneys Eric Scalzo and Morgan Ivey to discuss how healthcare valuations have been impacted by COVID-19 and examine the outlook for the sector - including the potential impacts of the 2020 election.  


Morgan Ribeiro: Welcome to PointByPoint. This is Morgan Ribeiro, Waller’s Chief Business Development Officer and the host of the podcast. On today's episode, I am joined by transactional advisors who will give us insight into the world of fair market value on healthcare transactions as a result of COVID-19.

We have with us today Eric Scalzo and Morgan Ivey, attorneys in Waller’s corporate practice group who advise physician practices and investors on healthcare transactions, and Jason Ruchaber, the founder of Root Valuation, a firm providing valuation services to hospitals, health systems and physicians. Morgan, Eric and Jason, thank you for joining me today.

Jason, I'd like to start with you. How has the work your firm does in the last six months or so changed and what's shifted compared to say, the end of 2019?

Jason Ruchaber: Overall, it's the practice patterns that have been a little bit different; I would say that's probably the most obvious thing. With the shutdown of elective surgeries and disruption to the healthcare space caused by COVID-19 and all the planning around it, we followed a similar pattern.

For the deals that we were working on, the valuation projects we were working on immediately prior to April, we had a big rush of projects leading up to the first part of the year was probably the busiest we've ever been. And then late March into April, we almost shut down, at least in terms of doing valuation work. That followed the deals that were being done because everybody pulled the emergency brake and stopped everything until they could figure out what was going to happen. And that uncertainty really continued through that two month period. We had a lot of advisory projects, a lot of conversations around, what should we be thinking? What are the issues that you see happening as a result of this? How should we think about repricing deals? But then also on services arrangements, as we shifted to the remote or virtual health platforms: hospitals and health systems scrambling to figure out how to price those services and how to maintain continuity of care for existing patient populations.

And even though we had blanket waivers, most of our practice is focused on regulatory compliance and Stark/anti-kickback. So with the broad waivers, it was a bit of a free for all just getting stuff done, but starting to think through how should we be pricing these? What sorts of steps should we put in place to have a review process once we get through this immediate crisis for virtual care? And then, how do we start thinking about pricing these services once those waivers expire? So that was a lot of dialogue happening in those two months.

And then all that pent up deal demand released, going into May and June. And we went right back to as busy as we were prior to COVID. Now getting into September, I would say things have leveled off a little bit. And part of that was just a normalization of the demand that got paused. But now, going into September, we're seeing things be a little bit more steady and cautious. And certainly, the sectors where deals are happening have shifted a little bit too. But, again, there's so much going on right now, even just beyond COVID, with the election and the economy generally, it's a figure it out as you go sort of process for everybody in the deal space. And we're certainly in that scenario as well, where things are coming up that we hadn't anticipated previously, and we're responding in different ways than we did pre-COVID. But we're still seeing deals, we're still seeing deal flow, we're still seeing valuation work, and overall practice patterns are more or less back to what they look like pre-COVID, at least for us.

Morgan Ribeiro: Morgan or Eric, is that similar to what you're seeing and hearing from clients?

Morgan Ivey: Yes, Morgan, it is. As Jason mentioned, the first couple of months after the pandemic hit, there was a lot of caution taken, everything sort of froze, people were trying to figure out what the best next steps were, and there was not a lot of deal activity. Since then we have seen sort of a resurgence in deals, and there has been more activity with some adjustments. And as Jason mentioned, we're seeing buyers and sellers proceed forward just in a steady and cautious manner.

So we're seeing deals differ in a few different ways. One in particular is the valuation and coming up with creative purchase price terms. As we've seen buyers’ and sellers’ appetites for growth and stability increase, we have been seeing more creative purchase price terms and adjustments. We're seeing larger rollovers, and we're seeing seller notes, earnouts and other contingent payments. And buyers are finding ways to resume this deal work while still protecting against some of these uncertainties that the pandemic has injected into the market, and sellers are appreciating and seeking the benefits that private investment can bring to the table, such as the financial security and the business acumen that allow them to really focus on honing their craft, which is treating patients.

We're also seeing that this pandemic is causing buyers and sellers, and causing us as lawyers and counsel, to redefine and reevaluate what market terms mean. What is market during a pandemic? We don't know; we're sort of defining that as we go along. And parties are having to address and negotiate how to treat these uncertainties and these risks and how to allocate that risk in the context of a transaction.

There are numerous COVID relief programs that have resulted from this pandemic. Just to name a few you have the SBA paycheck protection program, and more people are seeking out the benefit and support from EIDL loans as well. You have Medicare advanced payments, provider relief fund disbursements from the HHS. There's also deferred payroll taxes and payroll retention credits that buyers and sellers can benefit from, and precedent is being established as we speak.

Eric Scalzo: We're also seeing some sellers expressing some hesitancy to do transactions when a good portion of the purchase price is still at risk. A lot of the smaller physician groups have weathered the storm, they're on the other side of this, or hopefully what we think is the other side of this, and they're seeing themselves in a position where they have to decide to do a transaction or continue owning what they've built for a couple more years, get the benefits of that, and then take it to market for what they're thinking is going to be a full purchase price. And so we are seeing some buyers stepping up back to some pre-COVID levels, without some of these protections or with some of these protections scaled back because of the desire to get deals done, especially for those mid-size platforms that have weathered the storm and see themselves in a good position going forward.

Morgan Ribeiro: Jason, valuations were at an all-time high before all of this happened. You mentioned your deal volume was very high leading right up into COVID and the pandemic. Has this reset things a little bit, or are they staying where they were?

Jason: Reset would be too dramatic of a word. I think there's certainly been some repricing of deals. And I think that repricing really happened most acutely during that two to three-month time period: March, April and May. Now if you look at deals, generally, we're still seeing interest rates and capitalization rates in the same zone as they were before. When we talk about the really frothy pricing and multiples, a lot of that was driven by the private equity space. They still have huge dry powder to spend. At least for right now, some of the risk associated with this has been rationalized. And I think a lot of the private equity participants are anticipating some degree of return in normalcy.

But if you dig deeper, there are a lot of sub currents, many of which are unprecedented. And that may be confused the deal market a little bit. We had a period of negative interest rates, we still have really, really low interest rates; a lot of that is spurred on by government stimulus and quantitative support for the markets. But at the same time, we have limited access to that. So as it's very cheap, we're seeing leverage in deals and underwriting of deals being more critical and more cautious. So you have this competing force of low interest rates or cheap money, but some restrictions on certain sectors of the capital markets that make it a little tough to do leveraged deals. So overall, that's going to have an impact of multiples; all things being equal, highly leveraged deals can be priced at a much higher multiple than the deals that require more equity. But again, there is a lot of money to spend in the private equity space, and that's still creating some pressure and some support for the multiples.

If you look at it from a purely quantitative or technical standpoint, you take some of the demand side impacts out of the equation, we do have low interest rates, but the overall volatility of the markets and the uncertainty is certainly much higher now than it was before. And if you look at graphs showing the stabilization that existed immediately before COVID impact, the super high swings that happened during the two to three months, and then coming out of it, you still have pretty significant volatility. So from a technical standpoint, that should have a suppressive impact on multiples and valuations. And I do think for all practical purposes, it has; I just don't think that we've seen as dramatic of a shift or as dramatic of a reduction that we might have expected if we thought about this rationally.

And again, there's more than just COVID happening because we have an election coming up, which certainly could have very significant impacts on tax policy, and certainly significant impacts on healthcare policy. We also have all sorts of changes happening with regard to reimbursement in the healthcare space. But the broader trends of shifting regulatory policy and focus in terms of where the money is going to go, where we're going to focus on easing restrictions that maybe previously existed, that has a sub current that shifts multiples in certain areas. And as investors, as health systems, as physicians retool their thinking about that, I think for the time being, the easier action is to keep things stable. Think about the outlook. Certainly, folks are being more cautious with diligence and really spending a lot more time thinking through proformas and other elements of the deal to make sure that it's appropriately priced.

Eric: Which raises an interesting question, a lot of our clients over the past six months have significantly slowed down or stopped their acquisition process to reflect internally on what they're doing and who's part of their team. And there have been some reductions across various industries in terms of workforce and personnel. And I want to get your thoughts on how you are looking at the quality of the management team and how that goes into your work in terms of determining valuations of more established platform companies for the high-quality assets.

Jason: For the high-quality assets, high-quality practices that have really strong management teams and have a demonstrated track record of performing in all sorts of difficult situations, those assets are still high-quality assets. They've been able to respond to this pandemic in a way that is more positive than other practices have. And so I think the impacts on those have been less. I think the quality of those assets may be even shines more in times like this because they have a team that's designed protocols, safeguards and other financial and other steps to maintain the stability of the practice.

It's really the marginal practices where there was a bit, and I used the term risk rationalization before, but you would see the tuck-ins and the smaller deals that were getting the benefit of some of the platform multiples and the quality dollars, if you will, because the thought there was, we don't really care about the quality management, we have the platform, and we can add this to that. And we can really, through that diversification of our holdings, improve them to something similar to what the platform looks like, or give them the benefit of that.

For many of those practices now, though, the question is, is that really true? Can we do that? How critically do we need to look at the quality of the management team and the ability to integrate them into our platforms? And that's not just for private equity; that's also true for health system players, where they're looking at their integrated delivery model and their own practice groups. How do you integrate these practices? It doesn't really make sense to add a lower quality asset, to get involved in a lot of small physician practice deals.

And I will tell you, this has been extraordinarily disruptive for them. And not even just the lack of depth of management or management at all, in some cases, but also the ability to weather the storm financially. The working capital crunch and you're waiting on PPP loans or trying to get some of the economic injury and disaster assistance, they just don't have the economic resources to weather it. And so we've seen more distressed assets. And I think that, rightfully so, market participants will look at those assets and say, why should we throw a lifeline out there? Why don't we see if this is something that we can either scoop up as a distressed asset, or see if they can improve their operations on their own before we step into those shoes. So I haven't seen this directly. But I anticipate that this has happened, and I've certainly had conversation around that exact concept. But I do think that we'll see some more aggressive buying on the low side for these distressed assets. And we'll start to see a lot more activity in that space, as we shift funds to basically getting deals and trying to find deals. I don't mean transactions, I mean, discounts, getting bargain purchases on distressed assets. So there is a lot of stuff going on in the world that makes it tough to isolate. But on the whole, I have not seen a significant shift for the high-quality assets. I think they're already viewed as favorable, and they've been able to do this a lot better than others.

Morgan Ribeiro: So Jason, digging beneath the surface, how have expectations changed post-COVID, such as changing practice patterns, disruptions to volumes, changes in reimbursement? I know we've touched on some of those, but maybe you can dig a little deeper into those specifically?

Jason: The biggest shift overall is that there was a bit of intellectual laziness on proforma development that existed prior to this where, and this is true for both valuators and for health systems and for practices, which is this notion that we've been trucking along at a pretty stable level, and our past experience is highly indicative of what we can expect to accomplish going forward. And so the stability in terms of reimbursement, getting a 2 to 3 percent increase in volumes, cost structure staffing, most proformas were being developed with a mindset of these things are almost a given, that they're going to continue to function in a highly repetitive and consistent manner, similar to what has been experienced in the past. And more than anything, from a financial perspective, that COVID has shown us that there are things that can derail that proforma it to a much greater degree than we perhaps thought possible previously.

The notion of a pandemic has been talked about for years. This is not something that came out of nowhere. We've been hearing about a major flu pandemic or something similar for many years now. But I don't think that anyone really had the ability to model what that might look like. And as we go through this, now, we're having to develop proformas, with much better support for all the underlying assumptions. And not only that, but in many cases, rather than assuming a base case scenario, and applying a risk-adjusted rate of return to that proforma, we're now developing scenario analyses. So what's the best upside? What's the base case? And then what's the downside case, and that's going to be developed based on a series of different assumptions related to volumes, reimbursement, staffing, etc. So that is a departure from what we did previously.

And I do think that all of the stakeholders in the process, as they go through diligence, they're being much more critical about the valuation inputs and assumptions, particularly around the proforma. I spent a lot more time on the phone, frankly, getting beat up about assumptions that are built into the model and trying to think through those, which is right. That's what should happen in the diligence process. It's not always comfortable, but it really needs to happen. Because again, no one has a crystal ball, but being able to think through and rationalize, what does this look like under a couple of different scenarios, helps you get to the right answer. So a lot more critical thinking and critical questions being asked as we're developing those proformas.

Eric: Jason, in terms of the proformas for probably a down case scenario, what are you looking at in terms of government reimbursement rates? And how does the recent increase in government spending increase the risk that reimbursement rates are at risk? It’s another thing that we've been talking about for a very long time, right? Government money is not always going to be there, even though it has been for as long as we can remember. What are you thinking about in terms of that, and how are you modeling for that?

Jason: It really depends on the sector, right? And we're talking about even among physician practices, thinking through the medical specialty has a significant impact on what that looks like because of the payer mix. And also the geographic area of the country. If you have a pediatric practice, for example, and you have a high Medicaid population, maybe the Phoenix area, there's just no dollars. That's a scenario where you really have to think critically about whether or not that practice not only can maintain existing reimbursement levels, or expect some sort of less than inflationary uptick on an annual basis.

But you need to think critically about what does this look like under a revision to the downside and reduction in reimbursement or Medicaid? Unfortunately, we don't know the magnitude of that adjustment. All you can do is put some scenario analysis around that where you say, what happens if we have 1% reduction in Medicaid, what happens if you have a 5%, and see how dramatic that impact on valuation or profitability is going to be for the practice.

On the other side of the equation, Medicare reimbursement. We've not had for most sectors significant Medicare reimbursement upside outside of the hospital space, and certainly, HOPDs have continued to benefit inpatient services. We've had some decent reimbursement, but post-COVID, even there, we're having significant reductions in overall reimbursement. A lot of the parties that did take Medicare advanced payments are now facing cash flow crises. But even on Medicare, rather than thinking about it broadly, I think the bigger question is, where do funds get reallocated?

Morgan Ivey: And Jason, you are talking about how you're anticipating a reallocation of dollars and there may be a shift toward reimbursing more for virtual or telehealth, Eric and I are seeing from the transactional side an increase in telehealth, and we're seeing that different industries are able to accommodate this trend more than others. Dermatology, for example, I believe I've seen some new platforms specifically to allow for the increase in the utilization of telehealth, and couple that with some HIPAA waivers as well.

You mentioned some Stark and AKS waivers that we've seen since the start of the pandemic, and we're seeing them also in this telehealth space. So to the extent that sellers are relying on those and then pairing to recover their services as they were pre reliance on these waivers, how are you seeing buyers and sellers modeling for that as they transition more to a telehealth practice?

Jason: The hardest part about that is it's really unknown. The temporary payment parity is highly unlikely to continue. But what we will have is significantly increased access and reimbursement for virtual visits. Where that falls on the spectrum from, what might have been $40 for a virtual visit under highly restricted circumstances previously, is now all-access full reimbursement, $150 to $200 for the visit. But you're going to start seeing a lot more hybrid models. What we really focus on more than anything is the overall volume of visits, whether they be virtual or in person, and I have tried to think through with clients on this too, because it does, again, depending on the individual practice and the individual space, space being medical specialty, thinking through what their plans are to accommodate this, what they're hearing in their trade organizations, amongst their peers and with their lobbying groups.

And again, it varies by individual practice, sector, geography, but overall, the shift of virtual health and virtual care is actually going to be a net positive because it provides access not only for folks that don't want to go to the doctor because of COVID, but for folks who previously had limitations on their ability to travel. And maybe they live in an area that didn't have the specialists, etc. But I think what you're going to have is much higher volumes on virtual visits; it's also much more convenient for physicians to be able to do virtual visits than triage through different rooms and their own offices and schedule visits in that way.

So I think, again, as the practice patterns shift, and they get better at doing that, the net positive on revenue is going to be, I would anticipate, pretty significant. But at least in the near term, it's been a net positive in that people can get to the doctor much more easily, and they're getting reimbursed at the same level. Even if we have a shift downward in virtual reimbursement, it's not going to be back to the prior levels; it's still going to be at something close to where it is now, in my opinion, that is going to have an overall positive impact on revenues for these practices.

Eric: I would think that it would be somewhat based on the sticking power. If you're looking at volumes of patients, it's a lot harder to change providers if you're showing up at a physical location. It might be a lot easier if you're solely doing telehealth access. And maybe you're transitioning to a newer shinier platform depending on how the technology develops. So I bet that's an interesting thing with all the unknowns, as you said, Jason, in the moving parts, interesting thing to be thinking through in terms of valuing these new players.

Jason: It goes back to your prior question also about the high quality and then well-established, high-quality practices, right, because those that had already invested dollars, resources, IT infrastructure to be able to have virtual care capabilities, they were way out ahead of the curve. And so this shift disproportionately benefited them. And those types of practices relative to your smaller solo practices, and some of them have just been completely lost in this virtual market. They don't exist. I had a pediatric practice that was a retiring doctor who had no virtual infrastructure whatsoever and the practice virtually shut down. And I don't think she'll recover.

Morgan Ribeiro: Jason, how have investors repriced risk, and how will this impact market multiples?

Jason Ruchaber: It's a little bit hard to answer because everybody has their own process for reassessing their risk tolerances and where they fall on that spectrum. Some organizations are more cavalier, some are very restrictive, and so it goes to that notion of volatility, where some sophisticated investors, but I would say probably those that have deeper pockets, can rationalize that risk more easily than can organizations that have smaller margins or have accountabilities that are different, whether that's to boards or charitable organizations, etc. So the repricing of risk, and how that's going to play out in multiples long term, is really hard to predict.

In the immediate post-COVID era, some of the risk has been rationalized away as people wait and see. I'm cautiously optimistic that we'll get back to a reasonable normal in the near future. But again, the sub currents of the market are very delicate, and a small shift could cause pretty significant negative ramifications. So I do think it's an asymmetric risk profile right now, where staying the course and returning normal is the best-case scenario, not the most likely scenario, and something less than that should be being priced in. We're just not seeing it right now. And again, that's a lot to do with quantitative easing and stimulus monies that are available right now. But it's not sustainable over the long term. So we've got to get back to work, we've got to get the economy back on solid footing. But again, in terms of the rationalization of risk and how it's being priced right now, we're just not seeing major shifts. That's true in the public markets as well as the private markets.

Morgan Ivey: And we're also seeing, in addition to just reassessing what degree of risk and what quantum of risk buyers and sellers are comfortable with, we're seeing that buyers want more knowledge about a seller’s or a target’s business and practice. We're seeing them approach transactions reexamining the breadth and depth of the scope of their diligence that they conduct on a target. They're taking a closer look at vendor contracts that previously may have just been slap a list on a page and a disclosure schedule. Now we're re-examining the substance of those agreements; what are your rights and obligations under those agreements? And if there is a breach, because say there's a delay in supply or PPE is required, and you can't get your hands on it. What are your obligations? What's your exposure under some of those contracts? We're seeing businesses really impacted by delays.

They're also taking a closer look at financial statements of targets. We're seeing buyers assess a seller's ability to adapt to new protocols that have been placed on these practices by the CDC and other government agency guidelines. What is your allocation of essential versus non-essential services? And how have you been able to withstand the mandated shutdowns thus far? They're also looking at your use and allocation of funds that you've received under these various stimulus programs, and also taking a much closer look at employment trends. Has your workforce reduced? Has there been significant turnover? Have you rehired or replaced your staff? Are you reducing their hours and/ or their compensation?

And, all of those touch on not just your potential forgiveness reductions under the PPP lens, to the extent a buyer or seller has that in place, but it also touches on the demands of the seller. On the other end of this transaction, do I need to replace a bunch of people who have just been let go and that sort of thing?

And one other way that we're seeing targets and buyers and sellers get more comfortable with deals and assessing the degree of risk that they're really signing up for is shifting some of that onto insurance. So we are seeing an increase in the utilization of rep and warranty insurance. And previously, especially in healthcare three years ago, there was hardly any rep and warranty insurance. It wasn't a product that was worth buying; it was too expensive. And insurers were not comfortable underwriting it. Healthcare deals were too risky. But thankfully, over the last few years, we're seeing that product becoming more appealing, more appetizing to buyers and sellers, especially if you have a seller who's going to remain on as a partner post-transaction. And so the insurance also is requiring a deeper and broader dive and diligence. And I think that those are a few ways we're seeing people become more informed about the risk they're willing to take on.

Eric: And to piggyback off of that, I think we've seen the death of the guaranteed monthly minimum or guaranteed salary and employment agreements, especially in the outset of all this. We got a good number of calls from clients and non-clients who had structured certain arrangements with some of their providers. And they're asking how they could appropriately walk those back or undo them, if you're going to get x thousand dollars a month as salary, but the practice isn’t open, it's hard to make those payments, but it's still a contractual obligation. So we're taking a look at that.

Morgan Ribeiro: I'm going to switch over to our favorite dinner table topic of conversation, which is the election. It's hard to believe that in the midst of all this, we have an election coming up in just a matter of weeks. I'd love to hear perspectives from all of you on how the shifts and taxes in particular can impact healthcare transactions currently in the works. Jason, you briefly touched on tax issues that come up. I'm curious how the election in particular might impact what you're seeing in the market.

Jason Ruchaber: I think it's another element of uncertainty. It is clearly the case that based on proposed policy taxes will go up and possibly significantly. Under a Biden/Harris administration, that is true generally for businesses and also for individuals. But I also think that it's going to have a significant impact on how those tax dollars are spent. Kamala Harris has already proposed a variation of Medicare for All. And so, that comes with both tax but also healthcare policy ramifications.

And I do think it's all been a certainty that taxes will go up under the Biden/Harris administration. So again, we're in a wait and see pattern right now. It's hard to believe that with only two months left, we have so little information about what's actually going on. You get little blurbs that do move the market. But again, some of that's going to be shifting policies, because sophisticated investors can mitigate tax obligation by entity structure and other sorts of vehicles to minimize that obligation. And so they'll fare well under any administration. But as we start dealing with the smaller practice deals and look at those tax issues, from a valuation theory standpoint, that tax rate has a direct and measurable impact on valuation multiples, we can calculate it. And so the higher tax rate of return is going to have a downward shift in multiples.

Eric: But, Jason, does this sentiment hold true about the more sophisticated or better-capitalized platforms being able to negate tax impacts, if one of Biden's plans is to increase capital gains significantly to ordinary income rates? I mean, there's not going to be a whole lot of getting around that in a transaction. So what are your thoughts on that impact if that does come to bear?

Jason: Yeah. So, my answer perhaps was a bit oversimplified. We look at valuation multiples, most of what we are talking about, at least in the valuation model itself are the income tax, specifically corporate income tax, but also individual income tax, the current tax rates level, the playing field between pass-through entities and taxable entities.

But if we start changing the way that private equity investors are taxed on their deals, and we shift not only tax rates, but tax policy, and again, you're right, there's a whole bunch of policy, at least indicated policy measures that could have a material negative impact on those sophisticated investors. And to my prior point, income tax rates alone are going to have a downward shift on multiples. If the highly sophisticated investors, if the private equity firms, start to face different tax obstacles as a result of significant shifts in tax policy, that's going to shift not only multiples from a mathematical standpoint, but it's likely also to shift the demand, at least for some period of time as they restructure their organizations and the way they structure their deals.

So again, it's hard to think through what that might actually look like without specific individual policy measures because there are so many different things that go into tax policy and how it impacts valuations. But the broader answer is it's going to have a negative impact on multiples if the Biden/Harris administration is elected; the degree of that negativity will largely depend on the policy and the structural shifts that we have as a result.

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