Key Valuation Issues for Healthcare Leadership

Key Valuation Issues for Healthcare Leadership Don Barbo, Managing Director, VMG Health Thomas A. Warrington, Jr., CVA, Managing Director, VMG Health Bartt B. Warner, CVA, Manager, VMG Health

Trends in Business Valuations 2

Market Observations 3

Healthcare Transaction Activity 4

2009 2010 2011 2012 2013 2014 2015 2016 Number of Deals Announced Healthcare Services Transactions 1000 900 800 Number of deals vs. $ value of deals Spike in 2015 deal value driven by managed care megadeals $200 $180 $160 700 600 500 400 300 200 $140 $120 $100 $80 $60 $40 $ Value ($ billions) 100 $20 0 $0 Number of Deals Total $ Value of Deals ($ billions) Source: Irving Levin Associates: The Health Care M&A Report Fourth Quarter 2016 (2015, 2014, 2013, 2012, 2011, 2010, and 2009) 5

2016 Healthcare Services Transactions by Sector By Transaction Volume Other 22% Behavioral Health Care 4% Home Health and Hospice 6% Hospitals 10% Rehab 4% Physician Mediacal Groups 11% Managed Care 2% Long-Term Care 37% Labs, MRI & Dialysis 5% Source: Irving Levin Associates. Health Care M&A Report Q4 2016 and Q2 2016 6

2016 Healthcare Services Transactions by Sector By Transaction Volume [CATEGORY NAME] [VALUE] [CATEGORY NAME] [VALUE] [CATEGORY NAME] [VALUE] [CATEGORY NAME] [VALUE] [CATEGORY NAME] [VALUE] Source: Irving Levin Associates. Health Care M&A Report Q4 2016 and Q2 2016 7

What is driving the increase in transaction activity? Transaction Drivers: Consolidation among health systems has been increasing in recent years, despite heightened regulatory scrutiny When considering hospital transactions: Hospital deals fueled by sell-offs from publics; Community Health Systems and Tenet FTC challenges have blocked some prominent hospital mergers in 2016 Market and regulatory forces can make it difficult for health systems to go it alone Unknown regulatory changes regarding the ACA Reimbursement pressures from payers Credit outlook for the sector is poor, and health systems often lack access to much-needed capital Technology and value-based-care investment requirements are significant Few health systems have differentiated themselves enough to make themselves invaluable to stakeholders and differentiate from competitors 8

Healthcare Industry Performance S&P 500 Market indices, VMG Healthcare Services Index Total Enterprise Value / EBITDA: Source: CAPIQ 9

Transaction Multiples Hospitals 2008 (pre-aca era) through January 1, 2017: Source: CAPIQ Source: CAPIQ 10

Looking Ahead 11

Primer on Health Reform and its Impact on the Valuation of Healthcare Entities 12

Overview of Health Reform What are the objectives of reform? Increase access: provide healthcare coverage for the millions of uninsured Americans Improve Quality: improve quality of care and patient safety Lower Costs: reduce overall healthcare costs 13

Reform Measures Impacting Valuations Metric Who Is Impacted? Quantifying the Impact Sustainable Growth Rate Physicians Repealed in April 2015 replaced with fixed 0.5% annual increases through 2019 Value-Based Payment Modifier Physician Quality Reporting System Meaningful Use payments Physicians Physicians Physicians, hospitals Bonus payments: 3% increase in Medicare payments Penalties: 1% decrease (initially) in Medicare payments Began in 2015 for groups of >100, sunsets after 2017 Penalties: 1% decrease (initially) in Medicare payments Began in 2015, sunsets after 2017 Penalties: 1% decrease (initially) in Medicare payments Penalty phase began in 2015, sunsets after 2017 Chronic Care Coordination Payments Physicians Payments of $42 per patient Value-Based Purchasing Hospitals Penalties: 2% reduction Medicare payments if benchmarks are not achieved, additional 1% reductions for hospitalacquired conditions, up to 3% reductions for preventable readmissions 14

Reform Measures Impacting Valuations Metric Who Is Impacted? Quantifying the Impact Exchange enrollment and Medicaid expansion Bundled payments for care improvement initiative Hospital market basket update Disproportionate share hospital payments Restrictions on physician-owned hospitals Medical device excise tax Physicians, hospitals Physicians, hospitals Hospitals Hospitals Physicians, hospitals Hospitals, medical device companies Extremely difficult to quantify. For providers in states with a lot of new coverage, this will have a positive impact. Difficult to quantify at this point In 2015 0.2% decrease in CMS payments, increases to 0.75% decrease in 2017 Difficult to quantify at this point Impact difficult to quantify increases demand for shares of hospitals which have physician ownership 2.3% tax on devices, expected to be passed on to hospitals. Impacts many of their supplies, total impact difficult to quantify. 15

State Adoption of Medicaid Expansion January 1, 2017 16

Looking Ahead Key: 17

Looking Ahead Key: 18

Regulatory Overview: Health System and Physician Transactions Stark Anti-Kickback Statute False Claims Act IRS Private Benefit / Private Inurement Civil Monetary Penalties Other 19

Overview of FMV: Health System and Physician Transactions Stark Law Fair market value means the value in arm s-length transactions, consistent with 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, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of the acquisition of the asset or at the time of the service agreement. (42 C.F.R. 411.351) Commercial Reasonableness In the preamble to the Stark Phase II interim final rule, CMS gave a definition to commercially reasonable as "an arrangement will be considered 'commercially reasonable' in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential designated health services ("DHS") referrals." (69 Fed. Reg. (Mar. 26, 2004), p. 16093.00) IRS Revenue Ruling 59-60 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. (IRS Rev Ruling 59-60) Anti-Kickback Statute The federal Anti-Kickback Statute ( Anti-Kickback Statute ) is a criminal statute that prohibits the exchange (or offer to exchange), of anything of value, in an effort to induce (or reward) the referral of federal health care program business. See 42 U.S.C. 1320a-7b. 20

Healthcare Litigation Engagements: Industry Trends Major cases and Settlements Tuomey Healthcare System Halifax Hospital Medical Center Adventist Health System Commercial Reasonableness Increasing trends and drivers of trends Increased False Claims Act enforcement More aggressive merger review by the FTC Data breach litigation in the spotlight Payer-provider disputes Anti-trust litigation OIG Concerns 21

Healthcare Litigation Engagements: Industry Trends Qui Tam / Whistleblower disputes Fair Market Value Commercial Reasonableness Breach of Contract Lost Profits Diminution of Value Non-compete Disputes Shareholder disputes Marital Divorce Other 22

Trends in Physician Compensation 23

Compensation Arrangement Types & Trends Administrative Services Call Coverage Co-management (fixed + variable) Subsidy P4P, Bundled, HEIP, IDN, & ACO Payment models PSA Model ($/WRVU + expenses) Professional/ technical splits Clinical Services Billing and Collection Management/IT Development Medical Director AMCs Tier 1,2,3 (Sunshine Provision) Telemedicine Hub to spoke Hub to provider System to Vendor 1 Regulatory Scrutiny 2 Internal processes for setting compensation 3 P4P newest challenges for determining FMV 24

Top 3 Trends in 2016 1 Increased regulatory scrutiny Huge surge in Qui Tam suits physicians, compliance officers, etc Federal funding for fraud and abuse investigations growing Numerous and material settlements over past several years (Tuomey, Citizens, Halifax, Bradford, Lexington, etc ) Personal accountability now a real thing 2 New processes to streamline physician compensation Save time Save money Increase compliance 3 New types of arrangements APM, P4P, ACO, IDN Government and commercial payors continue to introduce payment models at a rapid rate. Market data and regulatory guidelines for these payments scarce Waivers conflict with Stark and only cover some deals FFS plus P4P how to ensure its OK? 25

Recent Health Care Fraud Efforts Why? For every $1 spent on healthcare fraud related investigations, government recovers $6.10 2016 stats: Strike force teams in 9 areas targeting local doctors and large companies have resulted in 2,185 indictments and nearly $2 billion in recoveries DOJ recovered $4.76 billion in FCA cases, 25% more than 2015 June 2016 DOJ and HHS reports landmark charging 301 individuals for false billing of $900 million Yates memo and OIG alerts warn individuals are at risk criminally and financially 26

Physician Compensation Compliance and FMV Basics 27

The Three C s of Physician Compensation Consistent with Fair Market Value Is the compensation within Fair Market Value? Compliant with the Laws and Regulations Does the compensation arrangement comply with the healthcare laws and regulations and not based on the volume or value of the physician s referrals? Commercially Reasonable Is the compensation commercially reasonable? 28

The Three C s for Valuations Cost importance Compliance risk tolerance Convenience speed, need for assistance 29

Internal Processes for Setting Physician Compensation Many health systems have a partially or fully automated opinion process primarily for traditional arrangements which remain at the forefront of scrutiny Medical Director On-call Coverage Clinical Compensation Options for determining and documenting FMV Verify all arrangements internally Split between internal process and outsourcing higher risk arrangements Verify all externally Not all health systems are structured alike, FMV process differs based upon: Risk tolerance (may change with leadership as well as external market forces) where are thresholds, 75th ok? Health system s approach to physician agreements (consistent -> each unique) Structure of physician alignment team and decision process Team dedicated to physician compensation Legal, business development, compliance, or facility-level decisions Decentralized or centralized opinion requests 30

Compliance Basics Commercially Reasonable An arrangement will be considered commercially reasonable in the absence of referrals if the arrangement would make commercial sense even if there were no potential DHS (designated health services) referrals. (69 Federal Register (March 26, 2004), Page 16093) Pre-cursor to determining FMV Hospital leadership must understand this standard since they will primarily be the individuals who assess CR. Sample P4P considerations: Operational assessment are the quality metrics relevant for the patient population? Physician requirements do physicians impact the metrics being measured and would they be considered stretch goals for the physicians? Financial options are there more viable ways to impact quality (ie: nurse care coordinators)? Counsels role did hospital leadership walk through the business considerations? Valuation firm role is the compensation at FMV? 31

Compliance Basics Commercial Reasonableness Checklist Economic/Financial Reasonableness Operational Reasonableness Physician/Clinical Requirements 1. Consider if the subject arrangement is essential to the operations of the Organization and identify and define the specific purpose of the subject arrangement. 2. Consider if the subject arrangement represents a sensible and prudent business arrangement, excluding the consideration of referrals. 3. Understand how current economic conditions have been considered in relation to the subject arrangement. 4. Ensure that the subject arrangement furthers the strategic and financial goals of the Organization. 5. Determine why alternative models have not been chosen, if applicable, that may result in similar services being offered to the Organization by a provider with similar qualifications at lower costs. 1. Consider the Organization s size, patient population, and patient demand when assessing the need for the services (patient acuity and need warrants services). 2. Consider how the subject arrangement furthers patient care, patient satisfaction, and overall public benefit. 3. Ensure there are safeguards to reduce and eliminate the possibility of fraud, prohibited referrals, waste, or abuse in relation to the subject arrangement. 4. Establish a written agreement containing the material terms of the arrangement. 1. Ensure a physician is required to perform the services. 2. Ensure a physician of a particular specialty is required to perform the services if relying upon an indication of value which represents a specialty specific opinion. 3. Ensure the physician possesses the specialized training, qualifications, and experience required to provide the services. 4. Determine that the duties of the physician under the subject arrangement will not be duplicative of any other duties performed by the Organization s personnel once the arrangement commences. 32

Compliance Basics Fair Market Value Agreements should be carefully constructed Compensation should not be tied to expected or actual referrals. This is important when establishing compensation or when setting mechanism to drive compensation. Carefully construct alternative payment models (gainshare, MSSP, ACO, bundled payments) since often tied to other (non-physician) income streams. Do not determine FMV based on What the hospital next door is paying. Non-comparable services and associated fees (ie: management vs. co-management). Solely on opportunity cost of the physician performing a different service, or their going rate (surgery vs administrative work 33

Compliance Checklist 1 Educate Team on written policies and processes 2 Determine arrangement is Commercially Reasonable Arrangement must make business sense absent considering referrals Hospital leadership must understand this standard since they will primarily be the individuals who assess CR Counsels role did hospital leadership walk through the business considerations? Valuation firm role is the compensation at FMV? 3 Establish FMV for Payments Compensation should not be tied to expected or actual referrals. Do not determine FMV based on What the hospital next door is paying. Non-comparable services and associated fees (ie: management vs. co-management). Carefully construct alternative payment models 4 Monitor arrangements to ensure policies and processes are followed 34

Compliance Checklist Traditional Arrangements Best Practice - internal policies for compliance: 1. A consistent process to determine FMV, including written agreements 2. Internal thresholds with triggers when a 3 rd party appraisal may be needed 3. Monitor to ensure that services were performed 4. Review agreement to verify the need for services still exist Medical Directorships Document services and track time, pay hourly Call coverage understand the burden of call per OIG opinions, caution on surveys Clinical services and employed compensation Benchmark productivity average productivity warrants average compensation Losses in a practice understand reason (safety net hospital, restricted coverage, coordinated care costs) Stacking total dollars and hours make sense? Compensation per WRVU over the median percentile typically warrants additional review Compensation to professional collections over the 75th percentile typically warrants additional review 35

4 Steps to Compliance 1 Educate Team on written policies and processes 2 Determine arrangement is Commercially Reasonable 3 Establish FMV for Payments 4 Monitor arrangements to ensure policies and processes are followed, services are provided 36

Checklist to consider when engaging a valuator 1. Valuation credentials and reputation of the appraiser 2. Valuation experience specific to the healthcare industry and vertical 3. Valuation experience with stark, anti-kickback, and commercial reasonableness 4. The Firm s resources and reputation 5. Independence and Objectivity 6. Quality and turnaround of the appraisal 7. Clear understanding of the contemplated transaction 8. Clear understanding of the scope of services to be performed 9. Understanding of the parties involved, purpose and use of the appraisal 10. Availability of the required information to perform the appraisal 11. Required timing to complete the appraisal and the nature of the deliverable 12. Follow up and support of deliverable 37

Conclusion 38

More About Don G. DON BARBO, CPA/ABV MANAGING DIRECTOR, VMG HEALTH +1 972 616 7814 Don.Barbo@VMGHealth.com Chateau Plaza 2515 McKinney Avenue Suite 1500 Dallas, Texas 75201 United States MORE ABOUT DON Don Barbo, CPA/ABV is a managing director with VMG Health and is based in the Dallas office. He specializes in healthcare business valuations involving mergers and acquisitions, divestitures, partnership transactions, leasing arrangements, divorces, commercial damages and financial reporting. His extensive healthcare valuation engagements have included the following businesses and services: hospitals, including acute care, long-term care, critical access, and surgical; physician practices, variety of primary care and surgical specialties; physician practices, variety of hospital-based practices (i.e. radiology, pathology, anesthesiology, emergency room); ambulatory surgery centers; diagnostic imaging centers; cardiac catheter labs; pathology and clinical labs; cancer treatment centers; dialysis centers; various contracts between hospitals and physicians, including medical director agreements, on call agreements, lithotripsy service agreements, purchase services agreements; and management services agreements Mr. Barbo has spoken extensively to various legal and valuation organizations and has published articles regarding business valuation issues. He also serves as an expert witness in litigated matters for his clients, including testifying before the U.S. Tax Court. Mr. Barbo has been performing healthcare valuations since 1998. Prior to his valuation career, he served as the chief financial officer for a physician practice management company that provides management services to a variety of physician practices. Before that, he served as the controller/financial officer for various emerging companies. He began his professional career as an auditor with an international accounting firm. Mr. Barbo received a Bachelor of Business Administration in Accounting from Texas Tech University and a Master of Business Administration from Southern Methodist University, Cox School of Business. Mr. Barbo is a licensed Certified Public Accountant (CPA) in the State of Texas. 39

More About Thomas MORE ABOUT THOMAS Thomas Warrington is a managing director in the Professional Service Agreements Division at VMG Health and is based in the Nashville office. He specializes in providing valuation and consulting services for professional service arrangements within the healthcare services industry. Specifically, his areas of expertise are valuations for professional services including call coverage, clinical compensation, physician administrative and executive services and subsidy coverage. THOMAS A. WARRINGTON, JR. CVA MANAGING DIRECTOR, VMG HEALTH +1 615 577 4202 Thomas.Warrington@VMGHealth.com In addition to the Professional Service Agreements Division, Mr. Warrington works in VMG Health s Business Valuation Division where he provides valuation services related to hospitals, specialty/surgical hospitals, ambulatory surgery centers, diagnostic imaging centers, radiation therapy centers and physician practices. Mr. Warrington is a graduate of Tennessee Technological University with an undergraduate degree in Finance. Mr. Warrington is designated as a Certified Valuation Analyst (CVA) and is a member of the National Association of Certified Valuators and Analysts (NACVA). The Pinnacle Building 150 3 rd Avenue South Suite 120 Nashville, Tennessee 37201 United States 40

More About Bartt MORE ABOUT BARTT Bartt B. Warner, CVA is a manager in the Professional Service Agreements Division at VMG Health and is based in the Nashville office. His focus is providing valuation and consulting services for professional services arrangements within the healthcare services industry. He has particular expertise in valuations related to clinical services, on-call coverage, medical director and physician executive services, coverage arrangements, management services and quality initiatives. BARTT B. WARNER. CVA MANAGER, VMG HEALTH +1 615 577 4206 Bartt.Warner@VMGHealth.com The Pinnacle Building 150 3 rd Avenue South Suite 120 Nashville, Tennessee 37201 United States Prior to joining VMG Health, Mr. Warner was a Correspondent Lending Analyst at a privately held mortgage company where he purchased originated mortgages on the secondary market. Mr. Warner started his career at VMG Health in the Business Valuation Division where he provided valuation services related to ambulatory surgical centers, diagnostic imaging centers, single and multi-specialty physician practices, cancer treatment centers, among others. Mr. Warner graduated summa cum laude and holds a Bachelor of Science in Finance with a collateral in Economics from the University of Tennessee at Knoxville. He holds the Certified Valuation Analyst (CVA) designation from The National Association of Certified Valuators and Analysts (NACVA). In addition, he has been published in the NACVA QuickRead, Becker s Hospital Review and is a webinar presenter for the NACVA. In addition, he is a member of NACVA s Think Tank Committee. 41