The introduction of healthcare reform in the United States will make uncertainty a fact of life for physicians and hospitals over the next several years. As a result of heightened uncertainty and risk, orthopaedic surgeons may seek to sell their practices to hospitals or establish joint ventures. But before making that decision, orthopaedic surgeons should pay special attention to the current regulatory environment and understand the fundamental drivers that determine the value of their practices.

Historical perspective
During the early 1990s, healthcare transactions were propelled by health system consolidation, the growth of the physician practice management industry, capitated payment models, and the Clinton Administration’s proposed healthcare reform. From 1993 to 1995, the number of hospital-owned physician practices tripled.

The failure of Clinton’s legislation and numerous poorly structured deals with high, guaranteed salaries for physicians eventually prompted many hospitals to divest themselves of physician practices. To attract and increase access to patients, health systems then turned to strategic joint ventures (such as surgical or specialty hospitals and ambulatory surgical centers [ASCs]) with ancillary service providers. More referrals, more patients, and more procedures quickly became the health-system mantra; the joint venture model served this strategy.

The passage of the Health Information Technology for Economic and Clinical Health (HITECH) Act in 2009 and the Patient Protection and Affordable Care Act in 2010 accelerated a shift back to the integrated healthcare delivery model and hospital-employed physicians. By 2010, about 32 percent of all physicians were hospital employed.

In selling their practices to hospitals, physicians typically receive a fixed-base salary with volume-based incentives and reduced risk over the independent practice of medicine. Integrated delivery models enable hospitals to broaden their referral bases, increase referrals to their ancillary facilities, and mitigate risk through shared savings and quality payment arrangements.

To better understand the current environment for mergers and acquisitions of orthopaedic practices, it is important to evaluate how reform will affect the volume trends and operations of both ASCs and orthopaedic practices.

The market for ASCs
After a 10-year period of substantial ASC development growth, development of new ASCs has declined substantially. This has not, however, dampened the interest in existing ASCs. In a recent investor conference call, Chris Holden, CEO of AmSurg, a leader in the development, management, and operation of outpatient surgery centers, commented that “[our] merger and acquisitions pipeline is very robust. Today, there are more than 2,000 centers we would evaluate in the prospecting pool.”

Hospitals and ASC managers continue to acquire ASCs. With their low cost of care and high quality of service, ASCs are still a fantastic opportunity for both physicians and hospitals. As hospitals continue to buy primary care referral sources from surgeons across the country, however, ASCs are facing greater pressure to compete with hospitals to maintain high volumes.

Due to their low costs, freestanding ASCs are reimbursed by Medicare at approximately 56 percent of hospital outpatient department rates. This gap could possibly narrow, as the Office of the Inspector General recently stated that it would study the reimbursement gap and determine if any disparity exists. Assuming that the reimbursement gap narrows, investments in freestanding ASCs may become more popular for physicians and hospitals.

Regulatory overview
Under federal Stark and Anti-Kickback laws, physicians who fail to comply with fair market value standards could face fines ranging from $15,000 to $100,000. “Fair market value” is defined as “the price, expressed in terms of cash equivalents, at which a property would change hands between a hypothetical willing-and-able buyer and a hypothetical willing-and-able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy nor to sell, and when both have reasonable knowledge of the relevant facts.”

The following three approaches are generally used to value a business’s fair market value:

• Cost (asset) approach—The cost approach takes into consideration the cost of replicating a comparable asset, security, or service with the same level of utility. This approach is typically used when an entity has either historical losses or nominal projected cash flows.
• Market approach—The market approach estimates value by comparing the value of similar assets, securities, or services traded in a free and open market to the subject asset, security, or service. This approach is rarely used to value a physician practice, because few direct market comparables are available.
• Income approach—The income approach discounts the projected future cash flows of a business based on forecasts of revenues and expenses. Several assumptions can affect an income approach valuation, including future capital expenditures, working capital requirements, and post-transaction physician compensation.

Value drivers
Key value drivers associated with orthopaedic practices are listed in Table 1.

Patient population—Hospital buyers often seek higher acuity patient populations to drive referrals of complex inpatient surgical procedures. Equally important is a practice’s mix of payers; physician practices with strong commercial population bases generally command higher valuations.

Physician characteristics—Physicians looking to sell their practices must be keenly aware of both local and national physician compensation trends. When negotiating post-transaction salary, physicians must be aware that higher post-transaction compensation agreements can decrease a practice’s valuation. Along with compensation, a physician’s capacity to generate additional volume can affect the value of a practice.

Practice characteristics—Orthopaedic practices that operate within a specialty (such as spine or sports medicine) often receive higher valuations than orthopaedic generalists because they generate higher revenues and volumes. Specialty groups are not only attractive to patients with specific orthopaedic needs, but also to hospitals seeking to drive referrals.

Practice ancillaries—Imaging centers and physical therapy facilities can be attractive add-ons to potential buyers of orthopaedic practices. These ancillaries, however, pose difficult questions for sellers of orthopaedic practices, who must decide whether to sell the totality of the practice or just parts of it. Individually carving out ancillaries from a practice may add value to the transaction, depending on the ancillaries’ referral mix, management structure, and operating efficiency.

Tangible and intangible assets—Hospitals typically acquire all of a practice’s nonpersonal inventory, fixed assets, and intangible assets, while physicians typically retain working capital (less inventory) and personal fixed assets. Tangible assets involved in a transaction usually include working capital (cash, inventory, and accounts receivable) and fixed assets. Under fair market value, physicians may receive value for the cost to recreate certain components of a practice, including the value of the practice’s phone line and costs to recreate patient medical charts and to hire and train a nonphysician workforce. Physician practices may also receive value for trade names and covenants not to compete.

Final thoughts
Although fee-for-service continues to dominate the payer landscape, bundled payment models, quality incentive contracts, and other capitated payment schemes continue to gain popularity and will be necessary to drive down healthcare costs. Hospitals are anticipating these changes by building integrated delivery systems through the acquisition of physician practices and freestanding ancillary businesses. Uncertainty over payment models will be further affected by a looming physician shortage, rising costs, and an aging population.

Private-public healthcare models may present opportunities for physicians wishing to remain independent. Therefore, a valuation of an orthopaedic practice must consider all of the risk and reward elements in order to produce a reasonable conclusion.

Greg Koonsman, CFA, is a senior partner and founder of VMG Health, a valuation and transaction advisory firm, who specializes in working with healthcare clients. He can be reached at gregk@vmghealth.com