Healthcare is arguably the most highly regulated industry in the country. For any healthcare valuation, appraisers should have a reasonable understanding of regulations affecting healthcare providers and nonprofit organizations and a grasp of the current changes that Congress and state legislatures may enact. Excerpted from the Guide to Ancillary Healthcare Services Valuation, here are some special considerations to take into account when valuing home healthcare businesses.
Many of the regulations facing providers today were enacted to address years of providers abusing the system and profiting illegally and unethically under government programs, such as Medicare and Medicaid, and private insurance programs.
Today, there are significant fines, penalties, and the possibility of prison for violating federal and state regulations governing the healthcare industry and nonprofit organizations. While enforcement has helped to curb abuses, they still exist.
While appraisers generally are not performing due diligence, it is important for them to do a high level assessment of management’s integrity. Appraisers who understand the home healthcare industry and the associated regulations also understand many of the illegal schemes and can evaluate management’s integrity fairly effectively through benchmarking the company against its peers (looking for anomalies) and interviewing management (looking for inconsistencies).
The risk associated with management’s integrity can impact whether a hypothetical buyer who may not be willing or able to operate the business illegally or unethically can maintain revenue levels and profitability. The appraiser should always require that the organization being valued disclose any and all correspondence and external audit findings that have been obtained from state licensure agencies, Medicare-certifying organizations, Medicare and Medicaid fiscal intermediaries, focused medical review audits and findings, and any past or ongoing notifications from the Office of the Inspector General (OIG) including past or current corporate integrity agreements (CIAs). Other useful tools to test the operational integrity of the organization is whether a compliance plan is in place that is modeled after the OIG’s suggested format as well as internal audit committee reports and findings that would be a component of the compliance plan.
The appraiser’s assessment of management’s integrity may create the need for normalizing adjustments and should have a direct effect on risk-adjusted rates of return used under an income approach as well as judgments the appraiser made using methods under other approaches.
Certificate of need (CON) states
States may restrict or limit new home health businesses though CON legislation. Typically, these states limit CON application to service lines that are “skilled in nature” and heavily dependent on Medicare and Medicaid certification and reimbursement such as home health and hospice. However, some states also have regulations that govern establishment of new “licensed-only” providers that will not be Medicare-certified but will obtain reimbursements from Medicaid.
To start a new home healthcare business in a CON state, you generally need to demonstrate adequate demand and need. Depending on the state, the CON process can be time-consuming and expensive. Generally, home healthcare businesses in CON states will be worth more compared to a similar business in a state without a CON. However, each state’s CON rules may be more or less restrictive, and the appraiser should research the state’s current plan for home healthcare services to determine whether there is opportunity for new businesses to enter the market. Even if the business is no more profitable in the CON state, the lack of new competition will generally reduce risk compared to businesses in non-CON states.
In states where CONs are very restrictive, the CON alone can be worth a significant amount of money, even without an operating business, and, as a result, sometimes CONs are valued independent of the operating business.
Appraisers need to consider the effect on the discount rate when valuing home healthcare businesses in CON states versus non-CON states. When valuing a CON alone (without an operating business), appraisers should generally rely on the income approach (relief from royalty method) or possibly the cost approach, unless comparable transaction data for the CONs in the state are available. If using a relief from royalty method, consider what percentage of the expected operating margin should be allocated to the CON when doing a pretax royalty rate calculation. For example, if agencies are expected to earn 12% in that market, the pretax royalty rate for the CON valuation calculation might be 3% (or 25% of the 12% operating margin, for example) of the forecasted revenues expected if the CON were used in an operating business.
Home healthcare businesses owned by hospitals or nursing homes are unique because they generally will not have their own financial statements or tax returns and will almost never have a balance sheet. They generally only track costs directly applicable to departments or service lines such as home health services (for example, direct supplies, direct compensation, and benefits) but allocate indirect overhead (such as telephone, security, maintenance, rent, utilities, human resource, and information systems) from the parent entity’s total overhead. As a result, operations for provider-owned home healthcare businesses are generally not comparable to stand-alone businesses.
Without objective financial statements (and particularly balance sheets), it is usually impossible to develop meaningful financial ratios and analysis. However, a number of operational benchmarks, such as revenue per visit, average daily census, or visits per employee, can still be developed and compared to industry benchmarks to evaluate the quality of operations.
Another potential problem in valuing a provider-owned home healthcare business is that sometimes it is not motivated by profit. In some cases, the lack of profit motivation may be because home health is not a core part of the overall business and may contribute little to overall operations. In other cases, the business may be viewed solely for its contribution to the parent entity’s mission or as part of a continuum of care. While lack of profitability is not inconsistent with being a nonprofit organization, management sometimes uses its nonprofit mission to rationalize underperformance. Appraisers need to understand that marginal profitability, or even losses in the hands of management, doesn’t necessarily mean these businesses cannot be run profitably in the hands of profit-motivated management.
To value provider-owned businesses, historical and forecasted operations need to be normalized and made comparable to non-provider-owned or stand-alone businesses. Great care must be exercised in doing this to ensure that only controllable costs are adjusted and uncontrollable costs, which may be unique to that marketplace, are not changed. Care must also be exercised to ensure that, under the fair market value standard, adjustments are not unique to a particular buyer.
Appraisers need to develop a reasonable understanding of industry benchmarks for home healthcare businesses to support or evaluate the assumptions that will be necessary to convert the hospital-owned business into a non-hospital-owned business.
Some questions typically asked during these assignments are:
- How much space (square footage) does the business really need?
- Is the rent too high and location too expensive for the needs of the business?
- Is the business sharing management with other departments and how are those costs allocated?
- Are the parent entity’s labor costs and benefits comparable to a non-provider-based business?
- Are there costs and other administrative functions that are only required because they are part of the larger entity (for example, Joint Commission accreditation)?
- How are patients referred for home healthcare services?
How referrals are made to a provider-owned business can have a significant impact on its value—and, of course, referrals are a key regulatory risk area. For example, there is less risk of losing referrals if they come from a variety of physicians as opposed to only physicians employed by or on the staff of the parent entity. While this is a typical risk associated with a concentration of customers, it may be more prevalent for provider-owned businesses. In valuing the business under a fair market value standard, the appraiser should evaluate what would change if the business were not part of, or reliant upon, the parent entity.
Real estate and nonoperating assets
Most home healthcare businesses are not capital-intensive (an exception might be a hospice that has an inpatient or residential facility). As a result, real estate and other nonoperating assets can create special problems in determining value. In particular, cash flows from the operating business often will not provide an adequate return on the real estate and nonoperating assets.
Generally, these assets should be excluded from the value of the operating business and valued separately if they are, in fact, going to be acquired as part of the transaction. These assets should be removed from the balance sheet, and their historical costs should be removed from the income statements. For those assets, such as real estate, that are used in the business, fair market value rent expense (assuming a fair market value standard) should be substituted for the cost of owning and operating the real estate. Fair market value rent for the operating business should be consistent with rents that other home care businesses would pay for only the square footage needed to operate a similar business within the subject company’s market. Fair market value rent could be more or less than rents paid historically or agreed to prospectively.
If the valuation is being done for regulatory purposes, rent that is below or above fair market value is a potential issue that a healthcare attorney familiar with applicable regulations should evaluate.
Valuing home healthcare businesses is not unlike valuing other businesses—it is imperative that appraisers have a significant understanding of their operating characteristics and the industry. To learn more about these special situations that affect home healthcare value, download the complete chapter from Alan B. Simons in BVR’s publication Guide to Ancillary Healthcare Services Valuation.