Healthcare Advisor: Top Transaction Issues Commonly Uncovered During Healthcare Due Diligence

November 30, 2015 by Cole Powell, CPA, CGMA, FHFMA

The following scenario is a familiar one in today’s ever-consolidating healthcare industry: A hospital system or private equity group identifies a potential candidate to acquire. A letter of intent is drafted and then sent to the owners of the practice, healthcare entity or hospital detailing the interest in an acquisition. The owners like the offer and make the decision to sell their business to the buyers.

Taking a Closer Look, Before You Leap

Obviously, a considerable number of steps will need to be bridged before a letter of interest becomes a signed deal. Due diligence serves as a roadmap that examines a broad spectrum of considerations which will help to shape the particulars of the finalized deal. Due diligence can also reveal circumstances within the seller’s operation that may cause the transaction to be delayed or cancelled altogether.

A due diligence team engages in a fact-finding mission. The team members are essentially historians researching the seller. The information discovered throughout key areas within the business will provide pieces of the puzzle that will assist both parties in determining whether or not the transaction is a good fit.

Due diligence generally does not result in opinions on the discoveries the team makes. Due diligence reports the facts and then presents those findings to the sellers. It is important to note that the scope of due diligence in healthcare is not limited to one group of issues. In addition to the day-to-day activities reviewed by a team of professionals well versed in healthcare, due diligence typically involves lawyers, as well as experts researching various aspects of the seller’s business or changing financial conditions both external and internal. Any of these professionals reviewing a proposed transaction could raise red flags on a deal.

The execution of a thorough due diligence process for healthcare transactions has the potential to reveal issues that must be addressed by the seller and by the buyer. While not all issues discovered will lead to one (or both) walking away from the sale, the issues found by the due diligence team can impact the structure and the final sale price of the deal, which must be both commercially reasonable and of fair market value.

Looking Out for Common Transaction Issues

In an effort to assist parties who are considering an acquisition, we have identified a number of important considerations from which issues arise during due diligence. For potential sellers, our list can provide insights into issues that could require attention. For potential buyers, our list can serve as a road map for finding the facts necessary to determine the ultimate viability of a proposed transaction. The list is not complete but focuses on some of the most common financial issues impacting transactions. In several of the items listed, review by an attorney is needed and it is strongly suggested that both parties be represented by attorneys with healthcare transaction experience.

Regulatory compliance issues: In the process of due diligence, one of the key areas of focus is compliance with regulations. This is true whether the buyer will assume the seller’s provider number or not. There are a range of issues in the area of compliance that could delay a transaction or cause the buyer to walk away. Regulatory hurdles can arise as the result of a coding violation or a whistleblower claim. Compliance issues can materialize during due diligence on a variety of fronts. Stark, the anti-kickback statues, HIPAA and coding involving Medicare and Medicaid are a few of the many areas in which a potential sale can be impeded because of regulatory concerns. If regulatory compliance issues are identified, the seller will likely need to dedicate significant time and money addressing each circumstance discovered. The sellers would also be obligated to cover the costs of any fines or penalties (unless otherwise directed in the final transaction).

Valuation: Typically, there is a time gap from the point at which the deal is first negotiated and when due diligence is performed. The first step in a possible transaction begins with an indication of interest or a letter of intent. From there, due diligence is engaged, any issues are identified and findings are released. The gap of time from the letter of intent to the beginning of due diligence can vary. It can range from two to three weeks to two or three months or possibly even longer. The timeframe depends on how fast the two parties are willing to move. During this period of time, there can be changes in the business or changes in the healthcare trends related to the business – all of which can impact the valuation.

In some instances, there have been potential sales in which the value comes out as being less than what it was thought to be at the time of the negotiations. Many times, it can depend on how the seller’s operation is valued. For example, many private equity or corporate acquirers prefer to use a market driven approach calculating the purchase price by multiplying Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) a specific number of times. There is no industry standard multiple for a valuation in healthcare acquisitions as it varies by niche, changes in the space and what is ‘hot’ and what is ‘not’. EBITDA is also a variable that is often adjusted by the seller for varying reasons. Traditional valuation techniques such as those required by the American Society of Appraisers, the Institute of Business Appraisers, and the American Institute of Certified Public Accountants often provide a methodical and credible approach to testing valuations determined using a market driven approach.

Financial Statement Errors: In any potential transaction, the parties can encounter unanticipated or explained errors in the sellers’ financial statements during the trailing 12-month period (TTM). While the errors found could include an allowance account not properly stated on an interim or annual basis, there are other surprises that can be revealed during due diligence. For instance, if there is a major error within the accounts receivable valuation, it could significantly impact the purchase price. The most frequent errors discovered in financial statements during due diligence are systematic in nature and, as a result, can involve large amounts of money. Sometimes, errors are explainable. Other times, the discovery of an error creates a significant issue that must be addressed by the buyer and seller. In some circumstances, there can be other issues on the buyers’ side of the deal that may be used as an offset for a substantial error in the seller’s financial statements – underlining the importance of the due diligence process.

The seller will want to pay particular attention to revenues, expenses, assets and liabilities that are NOT being acquired by the buyer.

EBITDA Adjustments: While the financial components for EBITA are well defined, it is possible to identify items in the financial statements that do not necessarily need to be counted against the seller. Credit can be given to the sellers’ legitimate reasons that are often identified during due diligence. For instance, if there is an accounting error, it could impact EBITDA one way or another. There are also one-time items which could have an impact on EBIDTA. An example here could be a lawsuit settlement or a lump-sum payment from a big payor – like a Blue Cross. The seller sometimes sees these items as revenue or income that can increase EBITDA and thereby increase the purchase price. The buyer may see these as one-time, non-recurring items that overstate EBITDA and the resulting purchase price.

One-time expense items can usually help a seller because they can be excluded from EBITDA. In some of the smaller deals, there can be seller discretionary costs, including running all your travel, family and business, through the company. This could include cell phone contracts and expenses for family members on the payroll. If these expenses are not legitimate business expenses, these discretionary costs can be added up and eliminated.

In addition to the exclusions, there can also be other adjustments that can impact EBITDA. One such example could be that of the seller’s launch of a new service line or offering during the trailing twelve month period used to establish EBITDA. The new service line would then need to be annualized, potentially pulling the earnings into or out of the valuation, depending on the assets being acquired, because of the potential impact going forward.

Buyer synergies with personnel and the duplication of positions can also have an impact on go forward EBITDA. It goes to reason that an organization would not need two chief financial officers, for instance. It also goes to reason that removing duplications through the elimination of commonly-shared positions will free up cash for the combined organization. Buyer synergies in commonly shared areas – beyond personnel – are identified as part of the due diligence process.

The detailed review of the seller’s operations can also yield opportunities for buyer adjustments – a set of circumstances in which the buyer is giving the seller credit for something the buyer is bringing to the table that the seller was not able to do. In most instances, the buyers have a desire to buy that is as great as or greater than the seller wants to sell. The two parties can trade off with many of issues identified during due diligence with the identification of synergies. The positives and negatives discovered on both sides can help to cancel each other out and allow a deal to move forward. In fact in many instances, synergies can help to provide negotiation point that can directly the purchase price or the purchase decision.

Real Estate Assignment: The issue of real estate assignment can be a factor when there is a third-party landlord, or property owner, who holds the rights to seller’s location(s). An example of this circumstance would be a seller has 10 different locations and each lease says it’s non-assignable or only assignable with permission by the lessor. The parties in the transaction would need to go to the landlord and inform the landlord that the business is being sold to the buyer. Taking this example a bit further, there could be a situation where there’s only six months left on the lease and the buyer could take the opportunity to renegotiate the deal. Landlords typically do not want to lose a good tenant, but negotiations with a third party, including possible changes and updates to the existing leased facility, could impede progress of the transaction. In some cases, the landlord can derail or significantly delay a transaction.

Physician Provider Numbers with Payors: With some payors, it’s hard to get new provider numbers. If the acquitting entity doesn’t already have provider numbers set up with the payors, then cash flows may be delayed, reduced or eliminated.. It’s also possible that the seller may have patients that are part of network, such as an independent physician association, not currently available to the buyer. In the case of a buyer not having a relationship with a network, the buyers might ask the physicians to keep their provider numbers or contracts. In these situations, it often means that the buyer will have to keep an entity going – like an affiliate with the sellers’ provider numbers. Conversely, if the buyer has a provider number established, the doctors can come over as employees and use their provider numbers – depending on whether or not it’s a corporate practice of medicine state. Provider numbers can create some deal complexities and present cash flow hurdles – particularly if new provider numbers must be obtained. Given that the process to secure provider numbers can take time, it’s an issue that could potentially have an impact on cash flow for months.

Physician Resistance: Doctors in a practice or hospital setting can sometimes provide the largest resistance to a transaction by not wanting to be a part of the acquiring entity. There are any number of reasons for this potential roadblock, including a previous bad experience with the buyer’s management group. It’s possible that the owner of the practice wants to sell as part of an exit strategy, but the doctors in the practice like their lifestyle, hours, and the current set-up with patients. A doctor in a seller’s practice might have questions about the quality of care provided by the buyer. There’s no question that the physicians involved from the sellers’ side have the power to quash a potential deal. In these cases, negotiations between the buyers and the doctors slated to join the acquiring entity are key to the transaction going forward.

Unsubstantiated or Unreasonable Physician Compensation: Compensation can vary and impact the purchase price.  In non-hospital practices, Physician owners of a practice are usually willing to take less because they are typically receiving a large amount of money at the closing of the sale. If they are going to remain with the larger entity, these doctors are typically going to take less money going forward as employees. However, in many practices, the most important issue is maintaining the current level of compensation in which case a hospital likely does not pay for goodwill.. Meanwhile, the non-owner employees can also create an issue – particularly if there are some professionals who would be considered to be overpaid in their new roles with the buyers when applying fair-market value and commercially reasonable standards. It is critical that the purchase price and compensation structure be treated as two integrate pieces to the same transaction

Information Technology: IT Infrastructure is critical in today’s healthcare industry. The decision to migrate the seller’s information technology activities to the buyer’s IT platform or to maintain the seller’s legacy system is an important consideration. In most instances, the buyer will move the seller to the buyer’s system. The transfer to the buyer’s system will require a commitment of time and training. One exception for maintaining legacy systems following an acquisition would be in the case of the purchase of a hospital or practice to serve as a platform for growth by a private equity group. Typically, private equity groups do not have IT systems for healthcare. Instead, the legacy systems are usually maintained in these types of acquisitions.

Billing Conversion: Among the key questions are these: How will the combined entity bill going forward? Will the seller bill under the legacy system or will the new company facilitate the billing? However these and other questions regarding billing are resolved, the most effective transition strategy are ones that are seamless. Decisions must be made about whether or not the seller or the buyer will retain revenue collected from old accounts receivables outstanding following the transaction’s completion.

Coding Differences and Response by Payors: In any potential transaction, there can be differences in the processing time required for coding and billing. Some sellers, due to a lower volume of accounts, do a better job of billing and coding than the buyers. Additionally, sellers are comparatively small enough that they might run below the radar of the payors as far as the amount and size of claims they submit. At times, the smaller practices have been paid on a timelier basis than a much larger buyer. As part of a larger healthcare provider, following an acquisition, the collection amount and cycle for the seller’s accounts may change. If this information is available pre-acquisition, the buyer can adjust its purchase price and projections, accordingly.

Loss of Significant Referral Sources and Referral Source Issues: With some potential transactions, there could be one party which has a dispute with a key payor. For instance, the seller goes to the buyer and one of the key payors for the buyer is the one payor which the seller is engaged in a dispute. Another referral source issue can arise if the buyer does not have a prior relationship to a referral source and the buyer may not feel the need to stay loyal to them having a significant impact on volumes and revenue post transaction.

Working Capital Settlements: If the current assets and current liabilities are not what they were initially projected to be, then an adjustment may need to be made. If, for example, these totals are less than anticipated, it can cause significant damage to the sale price – potentially cutting millions of dollars from the sale. One of the issues with working capital is that it can often not be properly categorized and it can serve as a surprise as the deal is being worked out. Under these circumstances, it can become a point of contention that can go to court or arbitration. It’s possible to have situations where the working capital numbers were not right at the time the acquisition candidate was identified. (Read our full article “Minimizing Working Capital Disputes in Healthcare Deals.”)

Employee-Related Issues: In addition to potential staff reductions due to the duplication of positions, there are a host of other employee issues, including the following:

  • Working with compensation and benefit structures. Will employee earnings need to be normalized? How will benefit and retirement plans change compared to the sellers’ policies?
  • The question of when to begin communicating with employees about the transaction process. In most deals, the seller prefers to keep the sale and/or the negotiations about a potential sale under the radar. Yet, the parties must address what will be done in the area of training and continuing education and how the new employees will be welcomed into the buyer’s organization.

Examples of Other Possible Issues:

  • Negative Reimbursement Changes: Part of the reality in today’s healthcare market is the fact payors are adjusting their reimbursement rates. A reduction in rates will impact revenues.
  • Anti-Trust Issues: If the buyer and seller are competing in the same market, it can create potential issues related to anti-trust.
  • Background Checks: Along with revealing potential issues regarding personnel, the search might show that smaller companies may not have a Medicare number, for instance.

We Can Help!

A thorough due diligence is the first step toward ensuring that all parties involved in a transaction have the information they need to either complete a deal or to walk away. Due Diligence carefully examines all the key elements that can impact a transaction and it offers precise information enabling decisions to be made. The Elliott Davis Decosimo Healthcare Team features the resources and expertise necessary to provide hospitals and practices with a highly effective due diligence process. To learn more about our approach to due diligence for healthcare, contact your Elliott Davis Decosimo advisor or the Elliott Davis Decosimo healthcare team at 866-417-4059.

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