Healthcare M&A Due Diligence and Financial Reporting

Healthcare M&A Due Diligence and Financial Reporting AICPA National Healthcare Industry Conference Las Vegas, NV November 6, 2014 Presented by: Ronald D. Finkelstein, CPA/ABV MBAF, LLC rfinkelstein@mbafcpa.com Colin McDermott, CFA,CPA/ABV VMG Health ColinM@vmghealth.com

Ronald Finkelstein Ronald D. Finkelstein, CPA/ABV, is the Principal-in-charge of the Healthcare Services Group at Morrison, Brown, Argiz & Farra, LLC. Ron s 25 years of healthcare practice focuses on assurance related merger and acquisition transactions and joint ventures serving medical groups, HMO s, home health providers, ASC and IDTF entities. Ron has counseled clients on clinical integration, Medicare & Medicaid reimbursement; Stark-related matters; physician incentive arrangements and valuation of healthcare provider businesses. He has extensive experience with healthcare-related forensic and litigation matters and has served as an expert witness for various healthcare providers in cases involving breach of contract, valuation matters, fraud investigation, partnership dispute and shareholder actions. Ron is a frequent speaker on physician provider related topics, a contributing author to the BVR/AHLA Guide to Healthcare Valuation and is a member of the AICPA Health Care Expert Panel. Ronald D. Finkelstein, CPA/ABV Healthcare Principal (954) 760-9000 rfinkelstein@mbafcpa.com American Institute of CPAs

Colin McDermott Colin McDermott, CFA, CPA/ABV is a Senior Manager with VMG Health and is based in the Dallas office. He specializes in providing financial, valuation and transaction advisory services to clients in the health care industry. His clients have included hospitals, hospital systems, ambulatory surgery centers, imaging centers, laboratories, physician groups and other healthcare entities. Colin McDermott VMG Health Senior Manager, CFA, CPA/ABV (972) 616-7808 ColinM@vmghealth.com 2515 McKinney Avenue Suite 1500 Dallas, TX 75201 www.vmghealth.com Mr. McDermott has assisted numerous non-profit and for-profit clients with valuation analyses related to ASC 805 Business Combinations (formerly SFAS 141R) and has issued valuation opinions on the fair value of intellectual property and other intangible assets acquired as a result of the acquisition of acute care hospitals, ambulatory surgery centers, rehabilitation hospitals and multi-specialty physician groups. Additionally, Mr. McDermott has assisted numerous health care clients with their annual impairment testing process as required by ASC 350 Intangible-Goodwill and Other (formerly SFAS 142). American Institute of CPAs

Disclaimer The views expressed in this session are the views of the presenters and do not necessarily represent positions of the Financial Accounting Standards Board, AICPA or any other authoritative entity. American Institute of CPAs

M&A Due Diligence American Institute of CPAs

M&A Transaction Life Cycle

Source: HFMA Value Project Report, June 2014

2013 vs 2012 Health Care Services Mergers & Acquisitions By Sector Source: Health Care M&A News March 2014

Accounting Due Diligence Observations Common to find cash, modified cash or tax basis financial reporting. Overstatement of revenue and accounts receivable due to thirdparty billing and reimbursement issues is typical. Other revenue issues are common, such as deferred revenues and multiple deliverables. Health care technology: Billing and accounting systems are not integrated. Hospitals: Impact on recurring revenue of revised payor contracts, Medicaid funding and non-procedural revenue (e.g., EHR incentives) Pharmaceuticals, drugs and labs: Revenue being reported at gross billing. Inaccurate inventory reporting and reimbursement concerns are common.

Accounting Due Diligence Observations (continued) Durable medical equipment: Review accuracy of coding. How is the target pursuing accounts receivable for private pay, deductibles and copays? Medical devices: Supplier contract issues are common such as volume thresholds, exclusivity, related ownership issues and absence of formal signed agreements. Discounted pricing offered below Medicare and Medicaid rates is typical. Physician practices: Review physician-owned business requirements and resulting managed service agreements. Billing and coding issues are common. Evaluate compensation structuring. Medical billing: Review contract assignability. Deferred revenue and tiered recognition based on level of effort tiers is common. Assess senior management and employee turnover.

Quality of Earnings Study - Key Considerations A quality of earnings study is not an audit What gives earnings quality? EBITDA vs. other earnings metrics Isolating the earnings Effect of net working capital Seller s adjustments

Quality of Earnings Study - Key Considerations (continued) Contingent consideration Due diligence adjustments Pro forma adjustments Concentrations and operational risks Run rate study Related party analysis Debt and debt-like terms

Financial Statement Audits vs Quality of Earnings Analysis (continued)

Quality of Earnings ($ In thousands) FY11 FY12 FY13 Operating income $ 1,514 $ 1,802 $ 1,951 Depreciation and amortization expense 541 547 555 EBITDA, as reported 2,055 2,349 2,506 Management adjustments: Extraordinary professional fees 227 87 103 EBITDA, as adjusted by management 2,282 2,436 2,609 Due diligence adjustments: Non recurring 52 16 215 Accounting related (249) (105) (330) Run rate related 4,377 4,380 4,560 Subtotal 4,180 4,241 4,445 EBITDA, after due diligence adjustments $ 6,462 $ 6,727 $ 7,054 As a % of net sales: EBITDA, as reported 4.9% 5.8% 6.3% EBITDA, as adjusted by management 5.4% 6.1% 6.5% EBITDA, after due diligence adjustments 15.4% 16.7% 17.6% Source: Audited FS, Internal management reports and M&A analysis

Healthcare Combinations Post-Transaction Financial Reporting Implications

The Deal is Done; Now What?

Accounting Guidance Financial Accounting Standards Board ( FASB ) Accounting Standards Codification ( ASC ) ASC 820 ASC 805 ASC 958 Fair Value Measurements and Disclosures Business Combinations Not-for-Profit Entities

ASC 820, Fair Value Measurement and Disclosures Fair Value The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Key Concepts: Based on price to sell an asset or transfer a liability Market participant-based measurement Highest and best use (nonfinancial assets) Standard valuation techniques As of a specific date

ASC 820, Fair Value Hierarchy Input Level Level 1 Level 2 Level 3 Description Quoted prices in active markets for identical assets or liabilities Significant other observable inputs Significant unobservable inputs Examples Active exchange-traded equity securities Listed derivatives Most U.S. Government and Agency securities Restrictive stock Infrequently traded corporate or municipal bonds Pricing models with observable inputs (interest rate and currency swaps) Pricing models which are correlated with market data Management estimates of market participant behavior Private equity investment Long-dated or complex derivatives ASC 820-10-35

ASC 805, Business Combinations - Overview Business Combination A transaction or other event in which an acquiring entity obtains control of one or more businesses Key Concepts: Use of Acquisition Method Determining the fair value of all consideration transferred measured at the acquisition date; Recognizing as of the acquisition date, the fair value of the identifiable assets acquired and liabilities assumed; and Recognizing goodwill or, in the case of a bargain purchase, a gain at fair value as of the acquisition date.

ASC 805, Business Combinations - Example Theory Normal Working Capital Tangible Fixed Assets Intangible Assets = Interest Bearing Debt Stockholder's Equity Example Determination of Business Enterprise Value: Normal Working Capital Current Assets 60,000,000 Current Liabilties (20,000,000) Normal Working Capital 40,000,000 Allocation of Business Enterprise Value: Tangible Fixed Assets 50,000,000 Cash Paid $150,000,000 Intangible Assets Liabilities Assumed Identifiable Intangible Assets 30,000,000 Current maturities of LTD 5,000,000 Goodwill 60,000,000 Long-term debt 25,000,000 Intangible Assets 90,000,000 Total Liabilities Assumed 30,000,000 Business Enterprise Value $180,000,000 Purchase Price $180,000,000

ASC 805, Business Combinations Acquired Assets Order of Purchase Price Allocation: 1 st Tangible Assets Net Working Capital Property, Plant, & Equipment 2 nd Identifiable Intangible Assets Trade Name Certificate of Need Non-Compete, Etc. 3 rd Goodwill Purchase Price > FV Record Goodwill Purchase Price < FV Bargain Purchase or Contribution Purchase Price = FV No Goodwill

Business Combinations - Not-for-Profits In January of 2010, FASB issued Accounting Standards Update No. 2010-07, which recodified FASB Statement 164 to ASC 958-805. Purpose: Key Provisions: Improve the relevance, representational faithfulness, and comparability of the information that a not-for-profit entity provides in its financial reports about a combination with one or more other not-for-profit activities. Guidance to determining type of combination o Merger or Acquisition Requires Carryover Method for mergers Requires the Acquisition Method for acquisitions Determines the acquirer of the combining entities Amends ASC 350, Goodwill and Other Intangible Assets, to make it fully applicable to not-for-profit entities

Not-for-Profit Transaction Trends Continued Consolidation Of the 2,100 standalone hospitals, many are expected to consolidate Not-for-profit health systems have been active consolidators ~5,000 Hospitals in USA 2,894 (58%) Not-for-profit 1,068 (21%) For-Profit 1,037 (21%) Government ~2,100 (40%) Stand-Alone 1,040 (49%) Not-for-profit 280 (13%) For-Profit 800 (38%) Government

ASC 805 Business Combinations - Intangible Assets Recognized intangible value if one of the two criteria are met: Contractual-Legal Criterion: Separability Criterion: An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights. An intangible asset shall be recognized as an asset apart from goodwill if it is separable; that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged.

Intangible Assets Growing percentage of the S&P 500 s market capitalization attributable to intangible assets 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1975 1985 1995 2005 2010 Tangible Assets Intangible Assets

Common Healthcare Intangible Assets Asset Description Valuation Approach (Method) Insight Certificate of Need (CON)/ Medicare Licenses Cost (Replacement Cost) Valued based on the cost associated with recreating the asset Based on employee s time and wages needed to recreate the asset, third party costs, and other applicable fees Technology/ Software Cost (Replacement Cost) Used for proprietary software/ technology only Based on employee time to develop the software/ technology Technology/Software Income (Relief from Royalty) Apply royalty rate to revenue attributable to the technology/ software Use the estimated remaining useful life on the patent expiration Trained Workforce Cost (Replacement Cost) Based on expenses related to recruiting new employees Considers lost productivity assumptions in first month of employment Is not considered an identifiable intangible asset, and is only included in Goodwill Non-Compete Income (With-Without) Value of Non-Compete = CFs w/ Asset- CFs w/o Asset Cash Flows w/o Asset driven by revenue loss due to: o Competition o Probability of competition Trade Name Income (Relief from Royalty) Apply royalty rate to revenue attributable to Trade Name Life should be based on the intended time period that the name will be used possibly indefinite Customer Relationships Income (Excess Earnings) Residual earnings after subtracting expected returns on tangible and intangible assets from total earnings Check for reasonableness

Intangibles Example - Trade Name Projections Terminal Year 1 Year 2 Year Total Net Operating Revenue 100,000 103,000 106,090 Total Estimated Royalty Fee 1.00% 1,000 1,030 1,061 Pre-Tax Relief From Royalty 1,000 1,030 1,061 Tax Rate 35.0% 350 361 371 After-Tax Royalty 650 670 690 Terminal Value 5,747 0.5 1.5 2.5 Present Value Factor 15.0% 0.9325 0.8109 0.7051 Present Value of Cash Flows 606 543 4,052 Sum of Present Values 1,149 Present Value of Terminal 4,052 Fair Value of Trade Name (Prior to TAB) 5,201 Tax Amortization Benefit (TAB) 891 Fair Value of Trade Name (Rounded) 6,000

Intangibles Example - Certificate of Need (CON) 1. Employee Costs Position Total Hourly Hours Total CFO $150.00 4 $600 VP Finance Ops $100.00 125 $12,500 Other $50.00 200 $10,000 Total $22,500 2. Third Party Costs Legal $100,000 Consultant $30,000 Architect $10,000 Total $140,000 3. Certificate of Need Fees Application Fee $10,000 Miscleanous Fee 10,000 Total $20,000 Certification of Need Value Replacement Cost 1. Employee Costs $22,500 2. Third Party Costs $140,000 3. Certificate of Need Fees 20,000 Replacement Cost $182,500 Less: Taxes @ 35.0% Costs Avoided, After Tax 118,625 Tax Amortization Benefit $20,331 Fair Value of CON (Rounded) $139,000

Intangibles Example - Non-Compete Footnotes Projections Year 1 Year 2 Year 3 Year 4 Year 5 Total Net Operating Revenue 99,500 100,000 101,500 103,023 104,568 106,136 Growth % 0.5% 1.5% 1.5% 1.5% 1.5% Without Non-Compete Revenue Lost to Competition 20,000 20,300 20,605 20,914 21,227 Revenue Lost to Competition (%) 1 20% 20% 20% 20% 20% x Probability of Competition 2 40% 40% 40% 40% 40% Adjusted Revenue 99,500 92,000 93,380 94,781 96,202 97,645 Growth % (7.5%) 1.5% 1.5% 1.5% 1.5% Adjusted Cash Flows to Invested Capital 15,545 14,879 15,102 15,329 15,559 Partial Year Adjustment 1.00 1.00 1.00 1.00 1.00 Periods Discounting 0.50 1.50 2.50 3.50 4.50 Present Value Factor (mid-point convention) 15.0% 0.933 0.811 0.705 0.613 0.533 Present Value of Cash Flows 14,496 12,065 10,649 9,399 8,295 Net Present Value (With Non-Compete) 86,281 Less: Net Present Value (Without Non-Compete) 54,903 Fair Value of Non-Compete Agreement (Prior to TAB) 31,378 Tax Amortization Benefit 5,378 Fair Value of Non-Compete Agreement (Rounded) 37,000 Footnotes 1 &2 are assumptions determined by Management

Recent Notable Transactions - Sheridan $ in Millions Determination of Business Enterprise Value: Property, Plant, & Equipment Book Value 29,784,000 Fair Value 29,784,000 Write-Up 0.0% Management believes that the carrying value of property and equipment approximates fair value. Allocation of Business Enterprise Value: Working Capital Current Assets 306 Current Liabilties (128) Cash Paid $2,159 Working Capital 178 Other Tangible Fixed Assets 30 AmSurg Shares $343 Noncontrolling interests $27 Other Assets 15 Total Other $370 Intangible Assets Liabilities Assumed Identifiable Intangible Assets (1) 1,168 Deferred Income Tax $408 Goodwill 1,606 Other L-T Liabilities $61 Intangible Assets 2,774 Total Liabilities Assumed $468 Business Enterprise Value 2,997 Purchase Price $2,997 Footnotes: (1) Intangible assets will principally relate to noncompete agreements and customer relationships with hospitals and are expected to have a useful life of approximately three to 25 years. AmSurg Corp. Acquires Sheridan Holdings, Inc. on May 29, 2014

Recent Notable Transactions - Vanguard $ in Millions Determination of Business Enterprise Value: Tenet Healthcare Corp Acquires Vanguard Health Systems on October 1, 2013 Business Enterprise Value $5,360 Purchase Price Purchase Price Allocation $5,360 Property, Plant, & Equipment Book Value 2,325,000 Fair Value 3,074,000 Write-Up 32.2% Allocation of Business Enterprise Value: Working Capital Current Assets 1,054 Current Liabilties (1,012) Cash Paid $1,301 Working Capital 42 Other Tangible Fixed Assets 3,074 Noncontrolling interests 7 Redeemable noncontrolling interests 165 Other Assets 200 Total Other 172 Intangible Assets Liabilities Assumed Identifiable Intangible Assets 108 Current maturities of LTD 161 Goodwill 1,936 Long-term debt 3,726 Intangible Assets 2,044 Total Liabilities Assumed 3,887 Goodwill, 36.1% Other intangible assets, 2.0% Net working capital, 0.8% Other assets, 3.7% Property and equipment, 57.4%

Recent Notable Transactions - HMA $ in Millions Determination of Business Enterprise Value: Community Health System Acquires Health Management Associates on January 27, 2014 Allocation of Business Enterprise Value: Working Capital Current Assets 1,299 Current Liabilties (1,467) Working Capital (168) Cash Paid $2,778 Tangible Fixed Assets 3,672 Other Other Assets 146 Noncontrolling interests 355 Shares issued 736 Intangible Assets Contingent value right 16 Identifiable Intangible Assets 93 Total Other 1,107 Goodwill 3,942 Intangible Assets 4,035 Liabilities Assumed 3,800 Purchase Price Allocation Business Enterprise Value $7,685 Purchase Price $7,685 Net working capital, (2.2%) Other assets, 1.9% Property, Plant, & Equipment Book Value 3,591,000 Fair Value 3,672,000 Write-Up 2.3% Goodwill, 51.3% Other intangible assets, 1.2% Property and equipment, 47.8%

One Year Later Impairment Testing

Accounting Guidance Financial Accounting Standards Board ( FASB ) ASC 350 Intangibles Goodwill and Other Accounting Standards Codification ( ASC ) ASC 360 Property, Plant, and Equipment

ASC 350- Goodwill Impairment Test Elective Qualitative Assessment Is it more likely than not that: Fair Value> Carrying Value? Yes No Step 1 Calculate the Fair Value of the Reporting Unit. Is the Fair Value > Carrying Value? No Yes Yes Goodwill Not Impaired Step 2 Calculate the Implied Value of the Goodwill. Is the Implied Value of Goodwill> Book Value? No Goodwill Impaired American Institute of CPAs

ASC 350- Goodwill Impairment Test Goodwill Impaired Book It Income Statement: Impairment Loss Recorded in Continuing Operations Balance Sheet: Goodwill Recorded at Lower Carrying Amount American Institute of CPAs

Private Company Council ( PCC ) Formation U.S. Companies: 28 million Private vs. 14,000 Public Private Companies Issues: Establishment of Blue Ribbon Panel ( BRP ): December 2009 BRP Report: January 2011 FAF Approval: May 2012 PCC on Business Combinations: September 2014 The costs outweighs the benefits of using GAAP for financial reporting. Many Private Companies o Have no reporting requirements other than their annual income tax filings. o Except: A significant number of these companies are required to prepare GAAP financial statements for their lenders, bonding companies, regulators and others AICPA, FAF, & NASBA established BRP o To address how accounting standards can best meet the needs of users of private company financial statements Recommends the creation of a differential framework to enable private company accounting standard setting board to evaluate whether exceptions or modifications of GAAP are needed for private companies The Financial Accounting Foundation (FAF), the parent organization of the Financial Accounting Standards Board (FASB) approved and created the separate accounting standards board for private companies o Private Company Council ( PCC ) Approved a GAAP alternative for private companies Which addressed the Accounting Standards Codification ( ASC ) 350 and ASC 805

Business Combinations - Private Company Update PCC Accounting Standards Update for Business Combinations: 1 st Intangibles Do not have to separately recognize and measure the following intangible assets: o Non-Competition Agreements o Customer-related intangibles not capable of being sold or licensed independently 2 nd Goodwill Amortization 3 rd Goodwill Impairment Binding Election by Private Companies Effective after December 15, 2014 Goodwill would be amortized on a straight-line basis Life would correspond to useful life of primary asset acquired, but not longer than 10 years Impairment on occurrence of a triggering event Impairment at entity or reporting level One Step Test measured as excess of carrying value over fair value

Q & A Ronald D. Finkelstein, CPA/ABV MBAF, LLC (954) 449-6659 rfinkelstein@mbafcpa.com Colin McDermott, CFA,CPA/ABV VMG Health (972) 616-7808 ColinM@vmghealth.com