Due to heightened legal and regulatory scrutiny related to healthcare transactions, the issuance of commercial reasonableness opinions is a growing area of focus for professional advisors and consultants in the healthcare industry. As discussed in the first installment of this three-part Health Capital Topics series on commercial reasonableness, there is no single, universally accepted definition of commercial reasonableness. However, guidance for its interpretation can be gleaned from: (1) the Internal Revenue Code (IRC); (2) Treasury Regulations; (3) other Internal Revenue Service (IRS) publications and pronouncements related to reasonable compensation; (4) Office of Inspector General (OIG) Advisory Opinions and pronouncements; (5) Federal Anti-Kickback Regulations; (6) the U.S. Public Health Code; and, (7) pertinent case law.1 As discussed in the second installment of this series, the key components of a commercial reasonableness analysis (CR analysis) include both a consideration of the qualitative factors that affect the commercial reasonableness opinion, as well as a quantitative analysis of the elements of the anticipated transaction in the aggregate.2 This is the third and final article in the three-part Health Capital Topics series on commercial reasonableness, and addresses the quantitative components of a defensible CR analysis in today’s increasingly scrutinized healthcare marketplace.
Rendering a commercial reasonableness opinion requires that a specific set of core competencies be mastered by the valuation analyst apart from, but related to, the more traditional knowledge base, skill set, and experience required in rendering Fair Market Value (FMV) opinions related to the appraisal of the enterprises, assets, and/or services being transacted.3 For example, when opining as to the FMV of an individual discrete subject property interest, a valuation analyst may use an income approach, which generally involves the following steps:4
Projecting the future net economic benefit accruing to the owner of the subject property interest;
Determining the risk adjusted required rate of return associated with the projected future net economic benefit arising from ownership or control of the subject property interest;
Discounting the projected future net economic benefit related to the subject property interest back to the valuation date; and,
Summing all discounted future net economic benefit related to the subject property interest to determine a value as of the valuation date.
The post-transaction financial feasibility analysis used in assessing the quantitative factors of an anticipated transaction is similar to the income approach in that it considers projected future net economic benefit streams, and an assessment of the risk related to the probability of realizing those benefits streams. However, a CR analysis differs from a FMV opinion in that it considers:
“All consideration to be paid by purchasers and lessees to sellers and lessors,”5
in the aggregate
, when projecting future net economic benefit,
not just the net economic benefits arising from the individual discrete
subject property interests comprising the anticipated transaction;
The aggregate projected net economic benefits
of ownership or control accruing to a particular buyer
, which may include any “unique synergies the … particular buyer would realize as a result of acquiring the asset,”6
not the aggregate projected net economic benefits
accruing to the universe
of typical buyers, sellers, owners, and investors; and,
An economic cost/benefit analysis
(e.g., payback period, net present value,
and internal rate of return
) to determine whether the anticipated transaction makes “commercial sense”
for a particular buyer
, not just a single estimate or range of monetary values
for the universe
of buyers, sellers, owners, and investors.7
The distinctions between a CR analysis and a FMV opinion discussed above, may lead to different underlying assumption being utilized in a CR analysis, including the following:
Projecting future net economic benefits inclusive of the factors available to a particular buyer that may not be available under the FMV assumption of a universe of buyers, sellers, owners, and investors, e.g.:
Revenue synergies, e.g., increases in reimbursement yield which may result from a hospital converting a free-standing physician practice, which bills Ancillary Service and Technical Component (ASTC) services to Medicare under the Medicare Physician Fee Schedule (MPFS) on a non-facility basis using Current Procedural Terminology (CPT) codes, to a Hospital Outpatient Department (HOPD), which bills ASTC services to Medicare under the HOPD Prospective Payment System (PPS) using ambulatory payment classification (APC) codes;
Operating expense synergies, e.g., the historical operating expense burdens associated with the target entity’s billing staff may be reduced due to the redundancy and reduplication in the services that an acquirer may already provide; and,
Capital expenses synergies, e.g., the fixed costs per patient related to an electronic health records (EHR) system may be reduced due to an increase in EHR utilization resulting from the anticipated transaction; and,
Determining the risk adjusted required rate of return for a particular buyer inclusive of factors that may not be available under the FMV assumption of a universe of buyers, sellers, owners, and investors, such as:
Operating risk reductions
, e.g., decreases in risk which may result from a diverse, multispecialty integrated health system acquiring a focused, single specialty free-standing physician practice;8
Financial risk reductions
, e.g., a large integrated health system may enjoy greater access to capital and, thus, a lower cost of capital than a small free-standing physician practice.9
It should be noted that valuation analyst must take care to avoid double counting when considering the various net economic benefit synergies and risk synergies described above. For example, if the valuation analyst projects a reduction in the target entity’s billing staff, then he may wish to consider increasing the operating risk return to reflect the additional risk required to attain the projected billing staff levels.
When performing a cost/benefit analysis for a particular buyer, a valuation analyst may also wish to consider the value metrics, which result from the application of one or more of the following analytical methods, to serve as a basis for a commercial reasonableness opinion related to an
Net present value (NPV) analysis
, which examines the total expected risk-adjusted future net economic benefits
(e.g., present value of the future net cash flows) arising from the total initial economic expense burdens
(e.g., initial cash outlays);10
Internal rate of return (IRR) analysis,
which contrasts an organization’s risk adjusted required rate of return
(or hurdle rate) against the discount rate
that, when applied to the expected future net economic benefits
of the subject property interest, results in a zero net present value;11
Average accounting return (AAR) analysis
, which determines the average of the net income
arising from the assets or services to be acquired in the anticipated transaction for each discrete accounting period
, divided by the book value of those subject property interest(s) acquired for each of the corresponding accounting periods
Discounted payback period analysis
, which is similar to a payback period analysis,
calculates the number of discrete periods “…until the sum of the discounted cash flow is equal to the initial investment;”13
Payback period analysis
which calculates the number of discrete periods necessary for “the cumulative forecasted [undiscounted] cash flow [to] equal the initial investment.”14
Each of the value metrics, which results from the cost/benefit analyses described above, should be considered within the context of the qualitative factors of the CR analysis.15 This is especially true when the cost/benefit analysis reflects a financial loss, as a transaction may still be commercially reasonable after the non-monetary benefits that may arise from the anticipated transaction are taken into consideration. For example, the benefits produced by a transaction that results in an expansion into new geographic areas and/or new service lines or an improvement in the access to technology and/or innovation may provide substantial evidence of a prudent business decision, i.e., commercial reasonableness.16
In today’s healthcare delivery system, hospitals have an expanded scope of responsibility to be the integrators and coordinators of care for their market service areas, often serving as the only and last resort of critical care in the health and well-being of their communities. In these instances, non-profit, tax-exempt entities may enter into prudent, sensible business transactions to create a social benefit “in furtherance of [their] charitable purpose,” which may necessitate an integration support payment that results in a financial loss.17
Mastering the foundational principles for a CR analysis – including accurately understanding the definitions of commercial reasonableness, as well as the differences between a FMV opinion and a CR analysis – is essential before an analyst renders a commercial reasonableness opinion on behalf of a client.18 In an era of increasing regulatory scrutiny and growing healthcare transaction volume, proper consideration of the threshold of commercial reasonableness, within the qualitative and quantitative aspects of a CR analysis, can increase the defensibility of an opinion that the proposed transaction is in regulatory compliance, including whether the anticipated transaction takes into consideration “value or volume of referrals.” 19 In addition, a transaction that is financially feasible under the quantitative analysis may not necessarily be commercially reasonable. The analyst should also perform a qualitative analysis as part of the determination of commercial reasonableness.
This article concludes the three-part series on the development of a commercial reasonableness opinion, which discussed the: (1) Definitions Related to the Threshold of Commercial Reasonableness; (2) The Qualitative Analysis Related to the Threshold of Commercial Reasonableness; and, (3) The Quantitative Analysis Related to the Threshold of Commercial Reasonableness.
Should you have any questions regarding commercial reasonableness opinions, please do not hesitate to contact Health Capital Consultants at (800) FYI – VALU [394-8258], or via email at email@example.com.
“Threshold of Commercial Reasonableness,” Health Capital Topics, Vol. 7, Issue 11, November 2014, http://www.healthcapital.com/hcc/newsletter/11_14/DEFINITIONS.pdf (Accessed 1/12/15).
“Valuing a Business: The Analysis and Appraisal of Closely Held Companies”, By Shannon Pratt and Alina Niculita, 5th Edition, McGraw Hill, 2008, p. 174-182.
“Subpart C: Permissive Exclusions” 42 C.F.R. §1001.952 (2012); “Exclusions from Medicare and Limitations on Medicare Payment” 42 C.F.R. §411.357(d)(1)(iii) (2012); “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services,” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA, Vol. 2, Hoboken, NJ: John Wiley & Sons, Inc., 2014, p. 963.
“BV201: Introduction to Business Valuation”, American Society of Appraisers, 2012, p. 15-16; “Medicare and State Health Care Programs: Fraud and Abuse: Clarifications of the Initial OIG Safe Harbor Provisions and Establishment of Additional Safe Harbor Provisions Under the Anti-Kickback Statute” 64 Federal Register 63526 (11/19/99).
“Medicare Program: Physicians’ Referrals to Healthcare Entities with which They Have Financial Relationships (Phase II)”, 69 Fed. Reg. 16093, (3/26/04).
In general, the greater the diversity of an asset (or portfolio of assets), the lower the risk. For example, see “Investments,” By William Sharpe, 2nd Edition, Englewood Cliffs, NJ: Prentice-Hall, 1981, p. 119-131.
In general, large entities are less risky than smaller entities. For example, see “The Cross-Section of Expected Stock Returns,” By Eugene Fama and Kenneth French, Journal of Finance, Vol. XLVII, No. 2, June 1992, p. 427-465.
“Fundamentals of Corporate Finance,” By Stephen Ross, et al., Second Edition, Boston, MA: Irwin, 1993, p. 220.
“Principles of Corporate Finance,” By Richard Brealey, et al., Ninth Edition, New York, NY: McGraw-Hill Irwin, 2008, p. 122.
For a detailed discussion on the qualitative factors of the CR analysis, see “Threshold of Commercial Reasonableness: The Qualitative Analysis,” Health Capital Topics, Vol. 7, Issue 11, December 2014, http://www.healthcapital.com/hcc/newsletter/12_14/QUALITATIVE.pdf (Accessed 1/12/15); or, “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services,” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, CVA, CM&AA, Vol. 2, Hoboken, NJ: John Wiley & Sons, Inc., 2014, p. 940-963.
See further examples described in Health Capital Consultants, “Threshold of Commercial Reasonableness: The Qualitative Analysis,” December 2014; “Hospital Mergers: Why they Work, Why they Don’t,” By Larry Scanlan, Chicago, IL: Health Forum Inc., 2010, p. 27; “Mergers, Acquisitions, and Corporate Restructurings” By Patrick Gaughan, Hoboken, NJ: John Wiley & Sons, Inc., 2011, p. 14; “Middle Market M&A: Handbook for Investment Banking and Business Consulting,” By Kenneth Marks, Hoboken, NJ: John Wiley & Sons, Inc., 2012, p. 28; “IRS Revenue Ruling 69-545, 1969-2 C.B. 117,” Internal Revenue Service, http://www.irs.gov/pub/irs-tege/rr69-545.pdf (Accessed 1/22/14); “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services,” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, CVA, CM&AA, Vol. 2, Hoboken, NJ: John Wiley & Sons, Inc., 2014, p. 183.
Health Capital Consultants, “Threshold of Commercial Reasonableness”, November 2014.
“Limitation on Certain Physician Referrals” 42 U.S.C. § 1395nn(e) (2012).; Health Capital Consultants, “Threshold of Commercial Reasonableness: The Qualitative Analysis,” December 2014.