Valuation Strategies for Unwinding "Bad Deal" in Physician Acquisitions
Background
All industries which undergo a period of rapid consolidation eventually undergo a period of de-consolidation. Particularly in the case of hospitals, many of the acquisitions of physician practices have failed to achieve the expected financial results. In deed, many have been abysmal failures. Hospitals desiring to unwind these transactions generally hope to do so without creating ill will amongst the affected physicians, being concerned about the loss of admissions and ancillaries in addition to the inability to meet obligations under managed care contracts. On the regulatory side, hospitals need to be concerned with Stark and Fraud and Abuse issues. If the hospital is exempt, it must also be concerned with inurement and intermediate sanctions. This situation affords a valuation consultant an opportunity to use knowledge of the various classes of physician practice assets to develop an unwind transaction that meets the fair market value standard.
Both parties to an unwind need to be concerned with fair market value today, particularly if it is less than the appraised value when the original transaction took place. Although the original appraisal will certainly have relevance to a regulator in the event of an audit or other review, the determination of fair market value is made at a given point in time. "The willing buyer and the willing seller are hypothetical persons, rather than specific individuals or entities, and the characteristics of these hypothetical persons are not necessarily the same as the personal characteristics of the actual seller or a particular buyer." ... "Fair market value is determined as of the valuation date and no knowledge of unforeseeable future events which may have affected the value is given to the hypothetical persons." (Tax Court Judge Laro, Pabst Brewing Company v. Commissioner, TCM 1996-506).
If an acquisition is performing badly (as is presumably the case if an unwind is being sought) this likely indicates a higher risk premium for the practice than was previously used, all other things being equal. In turn, this would indicate a lower value. Similarly, if revenue growth forecast is the original valuation has not materialized, this would also indicate a lower value.
What classes of assets are likely to have value in such a situation? Going concern, workforce-in-place, fixed asset and working capital value are likely to be preset, even in an unprofitable practice. (Note that a DCF model will typically include the value of net working capital, which the seller will typically retain.) Also relevant from the acquirer's standpoint is the value of any covenant not to compete obtained from the physicians (assuming it is enforceable), and any offsetting liability represented by the employment contract.
How much should physicians be willing to pay to repurchase their practice? A hypothetical buyer will pay no more than the cost of replicating the subject practice. The appraised value of going concern, workforce-in-place, and fixed assets (using a "where is, as is" standard) is a reasonable measure of what might be paid, bearing in mind that the physicians will have to "purchase" this in a start-up of a new practice. Physicians confronted with starting a 'new' practice may find it less expensive to stay where they are.
Professional vs. practice goodwill
"Goodwill" is often defined as the excess earning power of a business not attributable to tangible assets. Goodwill is actually a misnomer, as the individual components of intangible value generally exist and can be separately measured. The portion of excess earning power which attaches to the individual is commonly referred to as personal or professional goodwill, and the remainder may be referred to as practice or business goodwill. It is the transfer to the acquirer of the professional goodwill that the covenant not to compete is designed to ensure. Absent the covenant, it would not be possible for the acquirer to obtain the benefit it had bargained for.
The recent Tax Court Memorandum case Norwalk vs. Commissioner (TCM 1998-279) illustrates this point. It is of particular note because it is reported at a time when many transaction involving goodwill are likely to be the subject of regulatory proceedings. The Court, citing MacDonald v. Commissioner, (3 TC 727), stated "We find no authority which holds that an individual's personal ability is part of the assets of a corporation by which he is employed where, as in the instant case, the corporation does not have a right by contract or otherwise to the future services of the individual." The Norwalk case explicitly states that personal goodwill is not transferable in the absence of a covenant not to compete. Inclusion of such a covenant between the buyer and the selling corporation and physicians is presumably the norm, but in several states, e.g., Massachusetts, Arkansas, and Alabama, the enforceability of such a covenant is either questionable or moot. In Florida, such a covenant is only enforceable if irreparable harm can be shown. In North Carolina, a covenant is more likely to be enforced against a selling shareholder than against an employee-physician of the seller.
It is incumbent upon the valuator to first determine if a covenant is enforceable and then to measure its value in the context of the unwind transaction. This, in turn, implies a need to separate professional goodwill from the other components of intangible value, or practice goodwill.
Measuring the liability associated with an employment contract
A frequent desire of a hospital is to make the unwind as financially painless as possible for the physicians. Given the limitations on achieving this goal inherent in the fair market value standard, what uncommon issues are present in properly performing such as valuation. Physicians may have a long-term employment contract with the hospital guaranteeing a certain base salary, plus an incentive for reaching certain performance targets. For the following discussion, assume that the performance targets are not being met (predictably) and that the base salary guarantees apply. Assume that the P&L for the practice appears as follows and that the physician has a five year contract with three years to run. The discount rate is assumed to be 18%.
| Revenue | 300,000 |
| Operating Expenses | 240,000 |
| Income before Physician Compensation | 60,000 |
| Physician Compensation | 150,000 |
| Net Loss | (90,000) |
|---|---|
| Present Value | (195,685) |
Certainly the hospital can justify on an economic basis treating the employment contract obligation as a liability attaching to the practice assets.
An interesting question is what the value of the employment contract to the physician is. Arguably, it may not be the same as the liability value to the hospital. A physician may see the relevant approach in several ways. One way would be to measure the difference between what he or se can earn in a hypothetical practice by producing $300,000 in revenue. Assume that this is 40% of revenue, or $120,000. From the physician's standpoint, the excess earnings in the employment contract are $30,000 ($150,000 minus $120,000). What is the relevant discount rate for computing the present value? To an owner/employee of a practice, it may be less than the 18% for the hospital due to a lower perceived risk associated with working for oneself. If we view the physician's decision as a 'purchase to employ another' however, the 18% may be relevant. The present value would be computed as follows:
| Revenue | 300,000 |
| Operating Expenses | 180,000 |
| Income before Physician Compensation | 120,000 |
| Physician Compensation | 150,000 |
| Net Loss | (30,000) |
|---|---|
| Present Value | (65,228) |
This raises (or should raise) the question of whether the operation of the practice by the hospital is that of the hypothetical any willing buyer or whether a normalization adjustment for 'competent management' has to be made. If we assume that competent management would generate a profit before physician compensation of $120,000 (as in the example of the physician buyer) rather than $60,000, the present value would be the same ($65,228).
Which one of these approaches is correct? It is difficult to draw a definitive conclusion. The hypothetical any willing buyer would certainly not assume that the practice would lose $90,000 per year. On the other hand, a "turn around" situation probably involves a very high degree of risk, once the normalization adjustments are made.
Measuring the value of the covenant
One method of valuing a covenant is to use a "with and without" approach. In this method, the valuator prepares a forecast for the practice assuming that the physician continues in the practice (required for the valuation in any event), and one which assumes that the physician leaves the practice and begins a competing practice. This second forecast may, for example, simply be based upon a portion of the profits from the first forecast which the valuator deems to be attributable solely to the presence of the individual physician. The second forecast is subject to a probability factor (determined by the valuator) that the physician will, in fact, commence a competing practice in each of the forecasted years. The discounted present value of the probability-adjusted profits attributable directly to the physician is the value of the covenant. This valuation approach is likely to lead to a very high proportion of the profits being attributable to the individual physician, making the probability assessment a key element in the determination of value. This represents an important use of the valuator's judgment and should be based upon the interview with the physician, and perhaps questions prudently aimed at the question of competing.
In the case of an older physician, the probability may be quite low, whereas in the case of a younger physician, particularly one at mid-career with a substantial patient base, the probability may be much higher. Other factors influencing this decision would include personal net worth, whether or not the physician's spouse works and at what income, and current demands on income for such things as college expenses. Many of these factors are not part of the ordinary questions in a valuation interview and may be difficult if not impossible to ask outright.
If the covenant is deemed definitively not to be enforceable, of course, then it would have no value. If the covenant requires litigation to determine the enforceability and/or the extent thereof, then it may have some value due to the likely reluctance of a physician to bear the burdens of litigation with a larger entity. It is at least arguable that the covenant in this case has a value equal to that of the employment agreement, and that the two cancel each other out for valuation purposes.
Effect on valuation
If the covenant is not enforceable and we accept the argument that the covenant's value at the time of the unwind is equal to the employment contract, then the value of the practice for purposes of resale to the physicians will be equal to the appraised value of practice goodwill, including going concern value and workforce-in-place, plus the appraised value of the fixed assets. All other things being equal, e.g., the discount and cap rates, growth rate and other forecast assumptions used in the original transaction, the resale value would be equal to the transaction date value less professional goodwill.
Assume that the covenant is not enforceable and we conclude that it has no value. The value in this case would be the appraised value of practice goodwill, including going concern value and workforce-in-place, plus the appraised value of the fixed assets, and, arguably, a reduction for the value of the liability associated with the employment contract.
PPM Transactions
These same principles can be applied to the unwind of a transaction with a Physician Practice Management Company. Presently, MedPartners is engaged in selling off the practices it has acquired, primarily in California, the southwest and the southeastern United States. The failure of these acquisitions indicates that the practices are worth substantially less than was paid for them. This should mean that physicians will be able to buy back the practices for substantially less than they were paid, although one can certainly expect that the seller will not readily concede this point. Prospective buyers in this case include both the physician practice units themselves, as well as other PPMs. If other PPMs continue to buy practices, they will be relying, in part, on the earnings potential inherent in acquisition growth, coupled perhaps with the strategic value associated with consolidating the existing PPM practices in even fewer companies. (For a discussion of acquisition growth, see Understanding "Acquisition" and "Same Store" Growth in PPMs )
Conclusion Recent transaction in the physician service sector have been of two generic types: those involving exempt organizations, and those involving Physician Practice Management Companies. With respect to the former, the tax authorities are a significant member of the likely audience for both the original valuation and one done in connection with unwinding the transaction. The standard of value for these unwinds is clearly fair market value. The recent Norwalk case offers valuable insight into potential avenues for reducing the value at which an unwind transaction takes place. (see Goodwill Requires Enforceable Covenant Not To Compete).
PPM transactions, although based in part upon the multiplier effect inherent in taking private earnings into the public equity markets, offer similar valuation issues, as many of the large PPMs divest themselves of their acquired practices. Advisers and valuators do well to focus on the change in the level of risk (as reflected in the discount rate) and earnings growth (as reflected in the capitalization rate) in addition to the different components of intangible value when negotiating on behalf of physicians or other entities seeking to acquire the divested practices.
