More than at any time in its history, the healthcare market is experiencing a climate of consolidation in which the demand for acquisitions has never been greater. Not only has the further implementation of the Affordable Healthcare Act placed increased pressure on healthcare providers, but a host of other factors including the need for consumer growth, favorable economic conditions, introduction of new technology and products along with changing industry regulations are driving consolidation within the industry at a pace that appears to be unabated.
In a healthcare market filled with opportunities for cost-efficient synergies, valuation professionals will continue to be called upon to render values on the assets that are sold or acquired. Neither the seller nor buyer in any transaction seeks to land in a losing deal, and the combination of a thorough valuation process along with extensive due diligence is a key to keeping both parties well informed on all the relevant issues that must be considered. A transaction strategy that employs valuation with due diligence at its foundation ensures that accurate information is being exchanged, and it avoids the pitfalls of the “garbage-in-garbage-out” syndrome that can present devastatingly costly consequences.
When examining the current transaction landscape, the value of the target is obviously important. Experience has shown that, in most deals that close, the target is worth more to the buyer than to the seller. This is often a result of the synergies between the two parties, whereby the whole is more than the sum of the parts. The buyer sees an increased value of the target because the combined entity would be in a position to sell more goods or services, eliminate duplicated expenses and potentially obtain financing on more favorable terms.
However, due to federal regulations, many healthcare transactions must be valued at fair-market value (Stark law uses the term “general market value”). Fair-market value, by definition, is from the perspective of a hypothetical buyer and seller, and does not consider synergies that may be created by the deal. Still, a buyer may want to develop a valuation model supporting fair-market value for compliance purposes, and a second internal deal-assessment valuation model specific to the parties to measure against buyer’s internal metrics and goals.
Given the complexity and differing positions regarding value, it is important that the information provided by the seller is reliable and financially sound. Again, using the garbage-in-garbage-out axiom, opinions of value based on bad data most often result in a bad valuation, which then serves no use to either party in a transaction setting. Collectively, the due diligence and valuation processes can provide a framework for answering specific questions related to the financial statements, as well as the processes used in the operations of the business, to alleviate most pre- and post-transaction issues.
The Process of Valuation & Role of Historical Data
In most healthcare transaction settings, the valuation of a target company is based on historical data and projected financial information – reasoned estimates providing a view into realized and expected revenues, expenses and other economic benefits available to the target. Valuation standards provide suggested language to inform the reader of the limiting conditions applying to the use of the valuation. For example, valuation reports are likely to include language such as, “Financial statements and other related information provided by [ABC Company] or its representatives, in the course of this engagement, have been accepted without any verification as fully and correctly reflecting the enterprise’s business conditions and operating results for the respective periods, except as specifically noted herein. [Valuation Firm] has not audited, reviewed or compiled the financial information provided to us and, accordingly, we express no audit opinion or any other form of assurance on this information.” (Statement on Standards for Valuation Services No. 1)
The due diligence process can assist the valuation analyst with collection, assessment and analysis of the data that will ultimately be used in the determining the overall value of the company. Furthermore, due diligence provides, the buyer with a higher degree of reliability in the financial data. Though it’s obvious the two processes complement each other, not all transactions utilize valuation and due diligence in tandem.
Heightened Demand for Strong Due Diligence & Valuation Working in Tandem
The role of due diligence is now seen as a measure that can assist in ensuring non-negligence. The value of due diligence has increased as so many different parties become involved in the process, including investment banking firms, underwriters, lenders, private equity group investors, insurers, and individual investors or employees.
Accordingly, there is increased scrutiny around management forecasts which provide the foundation for valuation methods based on an income approach. Third-party valuation specialists are faced with the challenge of evaluating management forecasts for reasonableness.
The due diligence review process can involve significant questioning around the management’s forecasts. This process can often include the following considerations:
- Significant variances in year-over-year forecasts
- Failure to achieve previously forecasted results
- Major differences in monthly and year-to-date budgets during the initial forecast year versus actual monthly results
- Unreasonable or unsubstantiated growth rates and profit margins
The Impact of Due Diligence on Valuation
Particularly in today’s healthcare market, the condition of the financial information provided to a buyer directly impacts both the due diligence implications and valuation conclusions. Accordingly, it is important that management perform due diligence procedures on that information.
One of the initial considerations in this process will be to determine how much due diligence is appropriate for a given transaction. The planning and implementation of the due diligence approach and the circumstances in which it may require modification is another important decision for the buyer. As the process begins, the parties should be prepared to address red flags and other findings from the due diligence work. At the conclusion of the process, the central question will become the following: Have due diligence findings been utilized to assess and mitigate risk in the valuation and related transaction?
A strong due diligence program goes well beyond the review and evaluation of executive bios and compensation matters, which, along with the study of previous purchase agreements, remains a key part of the overall research. It also includes a multi-disciplinary team that includes not only financial and legal experts, but clinical and operational experts as well.
As the focus in the process turns to financial and operational areas, due diligence can serve as a platform to assist in assessing the quality of earnings and the quality of assets and liabilities along with examining working capital. The process is valuable in the identification of overly aggressive accounting policies and the assessment of the adequacy of judgmental accounts, as well as Generally Accepted Accounting Principles.
Along with identifying key business drivers, trends in profitability and significant concentrations of risk, due diligence provides an analysis of cash flows, inclusive of working capital changes and capital expenditures. The process reviews on- and off-balance sheet assets and liabilities, provides an evaluation of management’s forecast and conducts comprehensive discussions with management and their advisors.
Through due diligence, the purchasing party can gain a comprehensive understanding of a target’s operations and its risks, while, at the same time, take note of performance gaps and potential improvement opportunities, including cost reduction and/or revenue enhancement. A comprehensive due diligence process will assess potential carve-out issues and associated costs and provide an initial evaluation of potential synergy opportunities.
The due diligence process involves a variety of analyses that specifically address potential problem areas in a transaction. For instance, coding and billing audits provide verification to the buyer regarding the target’s historical financial information. Thorough due diligence ensures that the target’s revenues are not overstated due to up-coding or erroneous billings. Modification of revenues, either up or down, has a significant impact on the concluded value in the valuation, which can adversely affect the parties involved.
Valuation standards provide that the three primary approaches to value — which are asset, income, and market – be considered during the valuation process. Due diligence can provide information relevant to the identification, existence and risks related to assets and liabilities. These findings may impact the value determined under the asset approach. In the application of the income approach, particularly with a discounted cash flow method where future earnings are forecast, due diligence can identify risk factors related to base-line information, the prospective financial information and the required rates of return. Adjustments to recent earnings identified in the due diligence process will likely impact the market approach, which typically involves applying market-derived multiples to the target’s recent financial metrics.
Due diligence in healthcare transactions can provide buyers with documentation demonstrating the assets being acquired actually exist, the revenues generated are in compliance with the various regulations specific to the healthcare industry and the reported earnings are “quality” earnings appropriate for use when considering market multiples.
Examining the Process of Valuation
Value conclusions should be reasonable and supportable. In some cases, business valuations contain deficiencies which impair the overall credibility of conclusions. In our experience, some of the deficiencies found in business valuation reports include the following:
- Erroneous base year financial information
- Unsubstantiated or unrealistic assumptions in discounted cash flow projections
- Inadequate analysis and understanding of the business and industry
- Inadequate understanding of key operational issues
- Misapplication of valuation methodology
A business valuation that uses the information from an erroneous base year as its source point can be significantly flawed — particularly if that base year impact is projected into the future. For example, consider when a healthcare provider has understated its allowance for contractual amounts or doubtful accounts. This can occur, for example, if the allowance methodology does not properly consider credit balances in accounts receivable. Other sources of erroneous base information include accounts receivable aging analyses that are incorrect, collection rates that are overestimated and payer differences in reimbursement rates that are not properly considered. This kind of bad information may incorrectly report cash flow and profitability, impacting valuation results.
Business valuations require an understanding of the business itself, the industry in which it operates and relevant economic factors. In healthcare, an understanding of the revenue cycle and operational issues specific to the provider type (i.e. imaging center, hospital, specialty physician, nursing home, home health, hospice, diagnostic laboratory, etc.) and its current or anticipated payment rate or methodology changes, is vital to understanding projected net revenues and the risk related to cash flow.
The valuation conclusion for a business interest should represent the valuation expert’s objective consideration of material facts as well as the assumptions and expectations as of the valuation date. At the foundation of the conclusion is the need for realistic assumptions, a thorough analysis of relevant business, industry and economic factors along with use of appropriate valuation methodologies that are properly applied.
Importance of Documentation, Processes & Potential Results for Findings
Quite obviously, the due diligence and valuation processes include obtaining and analyzing documented information. Communication with all parties involved in the transaction regarding the procedures to be performed and the valuation approaches and methods being considered should remain a priority throughout the process.
A quality valuation report will include information on the following:
- Information gathered and analyzed to obtain an understanding of matters that may affect the valuation
- Assumptions and limiting conditions
- Any restriction or limitation on the scope of the valuation analyst’s research
- Work or the data available for analysis
- Basis for using any valuation assumptions
- Valuation approaches and methods considered
- Valuation approaches and methods used (including the rationale and support for their use)
- Information relating to subsequent events considered by the valuation analyst
- Sources of data used
- Other documentation considered relevant
As the trend toward consolidation in the healthcare industry gains further momentum, the role that due diligence and valuation will play in prospective transactions will become even more heightened. When the respective parties come to the table to consider potential deals, the role that accurate and reliable data will play in the ultimate success of any agreement cannot be overstated. Accurate and reliable data is vital to the quality of the conclusion of value in any valuation. The absence of accurate and reliable data — along with the absence of a comprehensive due diligence and valuation process – should serve as an immediate red flag on moving forward with a transaction.
In the wake of recent cases such as Toumey and Mobile Infirmary, a growing discussion has emerged regarding the responsibility of management to understand the valuation professional’s work. The days of simply filing away a completed third-party appraisal without a thorough review are disappearing. With the stakes in today’s market, it takes more than just the “check-the-box” approach.
Parties involved in these types of transactions are paying closer attention to ensure the valuation professional understood the facts and circumstances made available to them for inclusion in the appraisal. For those clients who would like to pursue both a due diligence and valuation process when evaluating a prospective transaction, one strategy to ensure clear communication between the professional teams involved, as well as the buyer and seller, is to consider utilizing a firm that offers both due diligence and valuation services.
We Can Help
The professionals at Elliott Davis Decosimo stand ready to assist healthcare organizations and medical professionals with the intricacies due diligence and valuation. For more information, call 866.417.4059 or visit www.elliottdavis.com/industries/healthcare.