1. Uncovering the Gem: Hidden Elements in ASC Valuation
Presented by
Lorin E. Patterson, JD, Partner, Reed Smith LLP
Todd J. Mello, ASA, AVA, MBA, Principal, HealthCare Appraisers

2. Presentation Outline Regulatory Considerations
Practical Considerations
Valuation Framework & Issues Specific to ASCs
Factors Affecting Value
Selection and Application of Appropriate Valuation Methodologies
Other Relevant Issues (Partnership Life Cycle; Impact of Changes in Reimbursement; Minority Interest and related discounts; Industry Multiples)
Managing the Valuation Process

3. Regulatory Considerations
Cardinal Rule: In healthcare ventures, ALL relationships MUST be conducted on FAIR MARKET VALUE terms.
Adherence provides participants the best protection against possible liability under Federal and State anti-kickback statutes and other applicable laws.
“Kickbacks” can include any form of remuneration, including overpayments or underpayments for interests in physician-owned ASCs.

4. Regulatory Considerations
Risk Scenarios: Surgery Center grappling with the “Price of Success.”
Years of successful operations result in prohibitively high unit prices making recruiting additional investors difficult.
Unreasonably low price or easy terms offered to “heavy hitter” physician investors.
The “spread” between FMV value and price offered could be a kickback.

5. Regulatory Considerations
Risk Scenarios
Hospital anxious to maintain market share and appease groups of specialists overpays for share in existing ASC or offers to provide services or benefits (e.g., below FMV rent) to the venture on non-FMV terms.
Again, “spread” between FMV and actual terms could be deemed a kickback to procure referrals.
Real world example: Advisory Opinion (6/19/2007). OIG issues unfavorable opinion where Hospital buys units in ASC directly from orthopedic surgeon at possibly inflated prices.

6. Practical Considerations
When validating FMV, a third-party appraisal by an experienced third-party appraiser will be the best means of procuring protection.
Not necessarily required.
Keep in mind that businesses are being valued – not referrals.

7. Practical Considerations
Occasions where third-party valuations may be appropriate or necessary:
Combination between two existing healthcare ventures.
“Out of the ordinary course” sale of interests in existing ASC to group practice, corporate partner or hospital.
Commencement of service or other relationships between referral sources.

8. Practical Considerations
“Out of the ordinary course” buyouts of participants in existing healthcare ventures.
The commencement of a re-syndication by an existing ASC to a number of physician investors.

9. Practical Considerations
Occasions when obtaining an appraisal may not be necessary:
In connection with the raising of capital by a newly formed healthcare venture (value of interests will be speculative).
True arms-length negotiations between participants of a healthcare venture.
Buyouts of existing participants where means of valuation is set forth within the governing documents (e.g., through the use of a formula).

10. Valuation Framework What is the ownership interest being valued?
What is the purpose of the valuation?
Pending transaction (e.g., a physician buy in/out or a transaction with an ASC company)
Compliance with federal ASC safe harbors and IRS private inurement issues
Shareholder disputes/litigation
What is the standard of value?
Fair Market Value (“FMV”)
Fair Value
Investment Value
What is the premise of value?
Going concern
Liquidation

11. Definition of FMV
IRS Definition: In Revenue Ruling the Internal Revenue Service defines fair market value as “the amount at which property would change hands between a willing seller and a willing buyer when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and when both have reasonable knowledge of the relevant facts.”
CMS Definition: “the value in arm's-length transactions, consistent with the general market value. “General market value” means the price that an asset would bring, as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset.” Usually, the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition.”

12. Valuation Issues Specific to ASCs
Physician ownership makeup or lack thereof is critical
Physician risk is the most important risk factor in ASC valuation
Value related to distributions (i.e., dividends) as compared to capital appreciation – much higher liquidity built into investment
Divestiture typically required upon retirement, relocation, and inactivity – buyout typically formulaic or fair market value
Importance of restrictive covenants
Numerous regulatory hurdles – anti kickback statutes and potentially private inurement regulations
Publicly traded corporations are generally not relevant comparisons
Sales of similarly sized blocks of stock often not comparable
In valuing entity, important to understand uniqueness of industry

13. TWO PRIMARY DRIVERS OF ASC SHAREHOLDER VALUE
Primary Factors Affecting Value
TWO PRIMARY DRIVERS OF ASC SHAREHOLDER VALUE
Future Cash Flow available to shareholders (Distributions)
Volatility or Risk associated with future cash flow
There are a multitude of variables that impact the assessment of risk and the projection of future cash flow.
The value of a business is not based upon historical earnings but rather future earnings!
Historical earnings are only relevant to the extent they help predict future earnings. Future earnings in a surgery center partnership can be very volatile!
Proper partnership management can reduce volatility.

14. Factors Affecting Risk of Future Cash Flow
Cash Flow Projection Factors
Case volume, mix, and reimbursement
Expected changes in volume and reimbursement
Opportunities for expansion (rooms, surgeons)
Stability of operating expenses
Risk Assessment Factors
Diversification (e.g., # of surgeons, number & type of specialties, payors)
Size and demographics of physician ownership, appropriate non-competes and ability to attract new investors
Financial leverage, working capital, and on-going capital expenditures
Nature of payor contracts; is there a substantial portion of “out of network?”
Quality and age of facility and equipment
Competent management
Barriers to entry (e.g. CON)

15. Valuation Methodology Selecting the Valuation Approach
Asset-Based Approaches
PURPOSE: Measures the value of an ASC by identifying and individually valuing the ASC’s tangible and intangible assets and liabilities. Based upon the Principle of Substitution; i.e., the premise that a prudent individual will pay no more for a property than he/she would pay to acquire a substitute property with the same utility.
Asset-based approaches are useful when:
The ASC has no expected earnings or other attributes of value whereby an “orderly liquidation value” yields the highest valuation; or
To establish a “floor” of value when using other valuation methods

16. Valuation Methodology Selecting the Valuation Approach
Market Approach
PURPOSE: Measures the value of an ASC by evaluating comparable companies and/or transactions in the marketplace.
Market Valuation Methodologies include:
Guideline Publicly Traded Company Method – generally not applicable
Comparative Transaction Method – depends
Market Approach may be useful if:
Valuing a controlling (as opposed to a minority) interest
Truly comparable entities are available

17. Valuation Methodology Selecting the Valuation Approach
Income Approach
PURPOSE: Measures the value of an ASC by determining the present value of its expected future cash flow stream.
Income Methodologies include:
Capitalization of Earnings
Discounted Cash Flow
Income Approach is useful when:
The ASC is generating significant, normalized cash flow from operations to fund ongoing distributions
When valuing minority interest in cash flowing centers
When the ASC has significant intangible value and when reasonable market comparables are not available

18. Valuation Methodology Decision Tree
ASC
Attributes

19. Other Relevant Valuation Issues
ASC Partnership Life Cycle
Minority vs. Controlling Interest Valuation
Pending Changes in Medicare Reimbursement; potential impact to non-Medicare payors
Industry Consolidation, Valuation, and Competition

20. ASC Partnership Life Cycle

21. ASC Partnership Life Cycle Consequences of Decline Stage
High Staff Turnover
High Volume Physicians Slowing Down
Non-Owner Physicians Disgruntled/ Exiting Facility
Lack of Sufficient Capital to Reinvest in Business
Capital Calls
Deferred Maintenance on Equipment and Building
ASC becomes less attractive to outside physicians

22. ASC Partnership Life Cycle Relationship to Value
Unmanaged Partnerships will Eventually Enter into Decline Stage
Profits Decline Faster than Revenues
ASC Partnerships are difficult to turn around
Quality Governing Documents Assist in Extending the Life Cycle (e.g. divestiture guidelines, restrictive covenants, safe harbor requirements)
Accurate Valuations are Crucial to Sustaining ASC Partnerships
Future Cash Flow and risk are related to life cycle

23. Valuing Minority Interests
Simply stated: Interests providing absolute control (i.e., greater than a 50% interest whereby key aspects of control are not diminished by governing documents or otherwise) are worth more than interests which do not have the same control rights
Control granted by the governing documents (examples on next slide)
Concept of “effective” control – physicians control with their feet
Valuation Guidance: absence of control adjustments in financial projection (preferable approach) or application of minority interest discount (reliance on published studies or other; more difficult to quantify and support)

24. Valuing Minority Interests Matters Subject to Control
Capital Calls
Admission of new investors
Borrowings greater than a certain amount
Acquisition of equipment greater than a certain amount
Selling, assigning or otherwise disposing or encumbering assets
Entering into material contracts
Selling, liquidating, or merging the entity
Changing the core governing documents
Typical ASC ownership agreements are very friendly to the minority shareholder
Note: Physicians display a certain level of control regardless of ownership interest level

25. Additional Valuation Considerations
Medicare reimbursement reasonably “certain” through 2011; additional uncertainty and hence risk related to non-Medicare payors
Despite declining public EBITDA multiples between 2004 and 2006 (see next slide), market multiples for controlling interests remain strong; a 12/06 survey performed by HealthCare Appraisers indicates that 92% of ASC respondents are observing multiples of 6X EBITDA or higher
Multiples paid also driven by private equity transactions (e.g. USPI and Symbion)
Despite continued consolidation within industry, per an August 2007 Market Letter published by Verispan the top 5 outpatient surgery center chains still account only for 10.5% of the market share
Minority interest multiples are based upon the individual center’s facts and circumstances and are more difficult to determine
Market multiples are interesting “rules of thumb” and are easy to calculate; however, do not generally constitute an appropriate method for calculating fair market value

26. Additional Valuation Considerations

27. Managing the Valuation Process
Opposing parties will have inherently conflicting interests during the valuation process.
Adding “structure” will streamline the process significantly.
Avoid “dueling valuations” unless a means of reconciling differences is agreed upon.
Consider joint engagement of a single appraiser selected from a list of qualified appraisers.

28. Managing the Valuation Process
Determine the degree of involvement of both parties in the valuation process.
Both parties may have the right to individually meet with the appraiser and submit factors which they feel are most pertinent.
Both parties may have the right to receive drafts of the appraisal report and comment upon it.
Agreement may be reached as to what price within the range of fair market value in the final report value (e.g., mid-point) will be used in the purchase agreement.

29. Todd J. Mello, ASA, AVA, MBA Principal HealthCare Appraisers, Inc
Todd J. Mello, ASA, AVA, MBA Principal HealthCare Appraisers, Inc. 858 Happy Canyon Road, Suite 240 Castle Rock, CO (303) Lorin E. Patterson, JD, Partner Reed Smith LLP 3110 Fairview Park Drive, Suite 1400 Falls Church, VA (703)