Converting Ambulatory Surgery Centers:

Converting Ambulatory Surgery Centers:
A Roadmap to a Successful Project

By David Woodrum, Joe Zasa, and Keith Korenchuk

Throughout the country, many operators of hospital-owned ambulatory surgery centers (ASCs) have found their centers to be less than profitable, with often a decreasing market share and reduced profitability. Yet the operation of an ASC with the right support and incentives can create an opportunity for hospitals to grow market share, increase overall profitability and provide an additional source of revenue for many hospital systems that are facing increasing financial pressures. This article outlines the considerations, both business and legal, in the conversion of a hospital-owned ASC into one that is jointly owned by the hospital and community physicians.

An early step in the conversion process is to assess from a business perspective the ongoing operations of the existing ASC and to determine which areas of operational improvement a joint venture can facilitate. To undertake this process, a review of the financial statements, patient mix and physician medical staff is in order. After this initial review is undertaken, a strategic conversion plan can be developed that will lay out the development milestones for the conversion.

The first step in the conversion process is to determine the likely scope of services for a converted facility, and the likely targets for physician involvement. With preliminary assumptions being made with respect to physician involvement, number of cases, and mix of cases, a pro-forma financial statement can be established that can provide a quick overview on the financial feasibility of the project. This financial feasibility would include not only revenues, but also expense projections, including operational and capital expenses for modernization of the site, site relocation, and other necessary redesign work.

A second development milestone is to determine the core set of physician leaders that will help facilitate, organize, and ultimately negotiate the relationship with the hospital. Hospitals that engage in the process should identify a physician leadership group with which they can work collaborately to achieve the goals of the conversion. This physician group should be expected to meet quite often in the development process to work through design and other business issues associated with the development of the project. These physicians also can act as a sounding board with respect to the levels of potential interest for physician investment and the size of that investment.

By creating a mechanism to allow the development work to proceed on a conversion, a hospital, along with the physician working committee, can establish a framework to move forward on the development of the converted ASC. Key issues such as ownership structure, percentage of ownership by the physician group and the hospital, the amount of capital needed to be raised, the willingness of physicians to enter into personal guarantees to secure debt, and the governance of the overall organization must be considered in the conversion process.

Equally as important in the conversion process is a realistic assessment of the value of the existing facility. The valuation of the existing facility is a critical piece for it will establish the baseline contribution that the hospital will make to the venture. From a regulatory perspective, as well as from a business perspective, valuations of businesses such as ASCs must be accomplished through a third-party appraisal. This third-party appraisal will undertake an assessment of the enterprise value of the ASC. This valuation is typically expressed in three different ways, arriving at a composite valuation based upon the expert opinion of the valuation company. For an ASC, these three valuation methodologies include:

The first uses comparable values of other facilities. Under this mechanism, the valuation company will review available sales of comparable facilities and a value for the existing facility based upon what “comparable sales” there are in the market place.

The second method of valuation involves an assessment of what it would take to build a facility from inception. This process would estimate what a development would cost for acquisition of the land, costs of construction, occupation of the space and all up-fitting that would be required for the facility.

The third method of valuation relies upon a discountered cash flow analysis. This discountered cash flow expresses what a willing investor would be willing to pay upfront for the opportunity to enjoy the cash flow associated with a business during the life of the investment.

This methodology utilizes well established valuation processes for small closely held businesses and includes an assessment of revenues minus expenses and a determination of the free cash available on an after-tax basis. This process will result in a cash flow over a five-year period and a residual value. These amounts are discounted using an appropriate discount rate to arrive at the valuation in present value terms.

Once this valuation process is complete from the business perspective, the hospital and the physicians will know the cost of entry for the physicians and can structure the development of the ASC conversion on that basis.

Other critical items to be considered in the development process from a business perspective include facility up-fitting, operational enhancements, and the ability to convert the facility on a fast-track basis, typically within a four- to six-month timeframe.

From the legal perspective, a number of significant issues must be considered in the development process, some of them focusing on the business process at hand for creating a business transaction, while others focus on the regulatory requirements and compliance considerations confronted when physicians and hospitals do business together. From a business-law perspective, critical issues such as the type of entity that will operate the facility must first be determined. Typically this entity is a pass-through entity, often a limited liability company, which can then be owned by both physicians and the hospital.

The issues that need to be considered in the formation of the entity include how the physicians and hospitals will make decisions together, and what reserved powers a hospital may need to retain to participate in the transaction. These reserved powers often depend upon the nature of the hospital entity itself. For many tax-exempt organizations, necessary residual powers include decisions regarding charity care and protection of nonprofit status.

From an investment point of view, the ownership entity must raise funds from the physician. While the hospital contributes assets, that being its existing surgery center business, the physician is often asked to contribute cash to the venture. The level of participation and ownership must be determined, and the funds must be raised in compliance with the securities law both on a federal and state basis. Often an interest in the ASC conversion will be sold pursuant to an offering that is exempt from registration under both state and federal law. From a securities perspective, it is also necessary to disclose all the relevant facts and risks associated with the investment to the physician investor. This process is often accomplished through the use of a private placement memorandum which outlines the investment terms, describes the business and its plans, and warns the physician investor of the risks associated with the investment.

The other area of legal attention in the development of an ASC conversion is the regulatory area. The primary concerns here are the fraud and abuse laws and the Stark law. From a fraud and abuse perspective, federal and many state laws prohibit getting anything of value in exchange for referrals for care rendered by a facility and covered under Medicare or Medicaid. Accordingly, a basic regulations rule is that as value is exchanged it must be on a fair market value without consideration of the volume or value of referrals. This is one of the primary reasons why a third-party valuation must be undertaken to value the existing ASC business. To the extent that fair market value is received by the hospital for its interest in the facility, the risk of a fraud and abuse violation is reduced.

Physicians must be in a position to also pay fair market value for their investment and to receive fair market value for any services they provide. The fraud and abuse laws are broadly written and broadly interpreted. In an effort to provide some certainty for healthcare providers, the U.S. government through the Office of the Inspector General has issued safe-harbor provisions regarding protection from liability under the fraud and abuse laws. If the requirements of one of the safe harbors are met in the ASC conversion process, the activity will be protected from fraud and abuse risk.

The safe-harbor regulations do have a specific provision regarding ASCs. For those facilities which are jointly owned by a hospital and physicians, a number of requirements must be established to qualify for safe harbor treatment. These requirements include the following: 1) the terms by which an investment interest is offered to a physician must not be related to the previous or expected volume of referrals, service furnished, or amount of business otherwise generated from that physician to the ASC; 2) the ASC or any other investor must not loan funds to or guarantee a loan to a physician if the physician uses any part of the loan to obtain the investment interest in the ASC; 3) the amount of payment to a physician in return for the investment must be directly proportional to the amount of the capital investment of that physician; 4) the ASC and any hospital or physician investor must treat patients receiving medical benefits under any federal healthcare program in a non-discriminatory matter; 5) the ASC may not use space or equipment located in or owned by any hospital investor unless the space or equipment is leased from the hospital in accordance with the lease that otherwise complies with the requirements of the applicable safe harbor under the fraud and abuse safe-harbor regulations; 6) ancillary services for federal healthcare program beneficiaries must be integrally related to the primary procedures performed at the ASC and may not be billed separately to Medicare or other federal healthcare programs; 7) the hospital may not include in its costs report any claim for payment from a federal healthcare program, any costs associated with the ASC and 8) the hospital may not be in a position to make or influence referrals directly or indirectly to any physician or the ASC.

To qualify for the safe harbor, physicians who are investors must meet certain other requirements with respect to their practice. These requirements include: 1) at least one-third of each of the physician investor’s medical practice income from all sources for the previous physical year or previous 12-month period must be derived from the physician’s performance of procedures, and 2) at least one-third of the procedures performed by each physician investor for the previous physical year or previous 12- month period must be performed at the ASC in question. By meeting these requirements, an ASC that is being converted can receive assurance that its investment and operational issues with respect to the ASC qualify for safe-harbor treatment.

From a Stark Law self-referral perspective, ambulatory surgery centers are not a “designated health service.” As the Stark Law prohibits ownership or compensation arrangements of physicians with facilities to which the physician refers for designated health services, the Stark Law does not apply to ASCs. Any ancillary services, however, including laboratory services that are provided at the ASC, must be billed under the composite rate and not separately billed.

Many state laws, however, have similar anti-referral legislation. In any development, a review of the state laws should also be made to determine their applicability. Often under state law, physicians who actually perform the procedures at the ASC must notify their patients in advance that they have an ownership interest in the facility and give those patients the opportunity to seek care elsewhere.

Other important legal issues are also associated with the development of a converted ASC. These include state certificate of need (CON) laws that may be impacted by the conversion, billing requirements, managed care contract assignment from the existing facility and state license laws that impact the change in ownership from a hospital to a converted ASC must be considered.

Although there are a variety of other legal and business challenges associated with the conversion of an ASC, both hospital and physician investors/medical staff members may find the conversion of an existing ASC to be an attractive option. Often the capital expense associated with the start-up of a new facility is minimized, the existing business often already has an established track record, and any management changes and enhancement of the service offerings can be accomplished much more quickly than the start-up of a facility from the inception. Because these facilities already exist and because of the opportunities to increase market share from surrounding areas to these facilities, both hospitals and physicians are finding the ASC conversion process to be attractive.

From a business perspective, careful financial planning and management can insure a conversion that is a success story. From a legal perspective, while there are a variety of issues that must be carefully considered in the conversion process, careful analysis and structuring of a transaction can minimize the risks of both investigation and any regulatory exposure connected with the development, operation and ongoing maintenance of a converted ASC.