Identifying, Measuring and Incorporating Risk Factors into Assessment Valuation — Part II

In part one of our two-part series about ambulatory surgery center (ASC) risk factors, we summarized the state of the current ASC marketplace and determined that appropriately measuring risk associated with the ownership of physician-owned minority ASC equity units requires diligence and a unique perspective. The ASC market is almost saturated — there are currently more than 5,000 ASCs, with more under development — creating staggering competition for a limited number of physicians. This dynamic has increased the likelihood of unpredictable events involving ASC profitability. Failure to properly assess and measure risk in this environment could lead to an incorrect assessment of ASC value.

Part two of our series focuses on identifying, measuring and incorporating relevant risk factors into an assessment. We also explain the current problems in ASC valuations performed today, review major risk-factor categories for individual ASCs that ultimately define value, and provide an example that illustrates the quantitative function of measuring and properly incorporating these risks into a valuation analysis.

Current Valuation Problems

The majority of ASC valuations performed today rely too heavily on metrics of previous performance, making the critical assumption that the future will resemble the past. The value of a business, however, should focus on its future cash-generating potential. Any valuation analysis that doesn’t is inherently incorrect. Historical operations are important in that they help predict future performance. Estimating future ASC performance and incorporating the appropriate risk factors to the pro forma cash flow is fundamental to conducting an ASC fair-market value analysis.

Summary of Risk Factors

Four main categories of risk factors affect a fair-market value analysis of an ASC (Make sure to solicit input from ASC management and the appropriate physicians to determine the relative importance of each):

1. Market risk factors. Analyze the local outpatient surgery market, including any and all ASC and hospital outpatient surgery competition, to determine whether strategic initiatives instituted by those facilities will affect case volume of the subject ASC. Pay special attention to ASCs or hospitals offering shares to physicians, especially those just outside the physician ownership non-compete area. The greater the number of uncommitted physicians in the market, the greater the chances the subject ASC will find new, productive shareholders. However, uncommitted physicians could also signal an increased risk of new competition.
   In addition to analyzing competing facilities, attempt to discern which partners (if any) will most likely exit and compete with the subject ASC. This is potentially hard information to glean because physician partners planning to leave will likely not reveal their intent. Determine this dynamic by measuring physician satisfaction within the ASC. Look at current and historic financial performance and distributions of the subject ASC, the ability of each physician to obtain optimal time slots for surgery, and the level of physician ownership in proportion to relative contribution.
   The best safeguards to prevent a physician from exiting are well-managed partnerships that include healthy, frequent and open communication. In most cases, facilities that create a forum for physicians to address their concerns greatly mitigate the risk of those doctors exiting and becoming competition.
2. Physician ownership risk factors. The physician partnership ownership profile is critical to the success of an ASC. Retirement, health issues, sabbaticals, physician conflict and other expected or unanticipated events all affect case volume. ASC partners may also simultaneously own interests in other ASCs or specialty hospitals. It is important to understand how these factors influence future physician behavior.
   The effects of older physicians either cutting back their hours or retiring are fairly predictable, particularly when these physicians state their intentions. Physicians often plan retirement years in advance and are not afraid to say so. Less predictable are the high-volume physicians who sporadically decrease case load because of a desire to pursue other interests.
   Analyze with caution those high-volume physicians who don’t have partial ownership in the ASC and who are not currently on track to buy in to the partnership. Consider the cash flow related to these physicians “at risk.” This is especially true in markets with low barriers to entry and significant ASC and hospital competition.
3. Payor risk factors. The case mix of a center largely determines its reliance on commercial or government payors, and therefore, the center’s profitability. For facilities that rely heavily on non-governmental payors, assess the percentage of volume concentration by payor. Reliance on one or two payors increases the risk for future reimbursement declines and subsequent serious financial ramifications.
   If the center performs a large percentage of out-of-network cases, consider “at risk” any revenue from those cases. Concentration and reliance on a few payors affect the risk of a reimbursement impact on future profitability.
4. Physical risk factors. Don’t overestimate the importance of an ASC’s physical attributes. Some of the most profitable and well-run ASCs operate in older and smaller facilities with inexpensive finishing and not-so-great aesthetics. However, in the long run, location and convenience are important. A facility located far away from where the physician partners or the patients live will eventually hit a ceiling in terms of its ability to grow.
   Analyze evidence of deferred maintenance on building and equipment. This may signify that the ASC will eventually require large capital expenditures that will negatively affect cash flow. The best-managed ASCs invest in maintenance and state-of-the-art equipment as necessary.

Risk Quantification

When performing a valuation analysis, it is important to transform qualitative risks to a quantitative analysis. An example of a quantitative risk scoring system is shown on page 19. However, the illustrated scoring system works only if the subject ASC can be compared against the risk profile of comparable ASCs. Prepare the chart with significant management input.

After calculating the score, determine center risk on a relative basis. An ASC with a higher score compared to other facilities with similar characteristics will yield a lower valuation, all other factors being equal.

Conclusion

Determining the value of an ASC is as much of an art as it is a science and the process requires a thorough understanding of an ASC’s relative risk factors. Overstating value by not properly identifying and considering risk will lead to share offerings that incoming physicians may perceive as too high and an inability to entice new physicians necessary to sustaining the venture.

Part Two of our series focused on the identifying, measuring and incorporating relevant risk factors into the assessment of value of an ASC. We also explained the current problems in ASC valuations today. As the example above left illustrates, a proper assessment and incorporation of business risk into an ASC valuation is the only optimal method to ensure appropriate value of physician equity units.

Elliott Jeter, CFA, CPA/ABV, is a partner in the healthcare valuation and consulting firm of VMG Health. He can be reached elliottj@vmghealth.com. Jon O‘Sullivan, CPA, is a senior partner in the healthcare valuation and consulting firm of VMG Health. He can be reached at osullivan@vmghealth.com.