Who Will be on Your Team? Acquiring a Physician Practice Requires Multi-Faceted Due Diligence

A combination of economic, regulatory and competitive market forces is transforming the healthcare industry. Hospitals and physicians are no longer solely compensated for the volume of sick patients they treat. Rather, new financial incentives encourage providers to work together to improve health outcomes and keep patients well. As providers join forces to deliver the preventive care that payors are emphasizing today, there has been an uptick in hospital and physician practice integration. Nearly 75 percent of the physicians in a recent PwC survey said they are already in financial relationships with hospitals, and more than half say they want to become closer. [1] 

This interest in working together is not unprecedented. In the 1990s, hospitals rushed to absorb physician practices in an effort to expand and maximize reimbursement. This experiment ultimately failed when reimbursement models proved not to be as beneficial to hospitals as they had hoped. Hospitals ultimately divested their practices, and the tenuous trust between hospitals and physicians eroded.

Today's healthcare landscape is once again making integration attractive to hospitals and physician practices. But this time the motivation for integration goes beyond maximizing profits. Enhancing quality of care is a key focus, since new payment schemes have created financial incentives for improved clinical outcomes. Many hospitals believe new care delivery and payment models — including accountable care organizations, bundled payments and value-based payments — are the inevitable wave of the future, making convergence with physician groups part of the solution. The more integrated the care delivery, the thinking goes, the better chance there is of effectively and efficiently managing patient outcomes.

By owning a physician group through purchase — one form of hospital-physician integration — hospitals can team with physicians to drive down medical costs and ultimately be more profitable. But purchasing a physician practice does not always pay dividends. Every deal has some risk and should be examined carefully.

Successful buyers have tailored a robust due diligence process that addresses financial and legal considerations. But other factors such as governance, human resources, compliance and information technology are also key valuation considerations that should not be overlooked. All of these factors should influence a buyer's financial model and ultimately determine if acquiring a physician group fits into a hospital's overall growth strategy.

With that in mind, hospital management teams should answer eight important due diligence questions before making a physician practice transaction:

1. What type of practice is it? Acquiring a practice must be viewed as a strategic decision that takes into account the mission of a prospective practice, its service offerings and its compatibility with the acquiring hospital or health system. A hospital's evaluation of a transaction should go beyond financial considerations and also consider how clinical outcomes and continuity of care will improve. Hospitals should ask themselves: Does this group of physicians apply the appropriate care to the appropriate patients in the appropriate venue? Is patient satisfaction measured and taken into account? Do physicians follow evidence-based guidelines? Do physicians work in silos or as part of a coordinated care team?

2. How can I bridge a practice's historical financial performance to its forecasted results? Most buyers perform financial due diligence to analyze the company's historical "quality of earnings." This analysis assesses the impact of non-recurring items and non-operating costs and revenues and ultimately should help the buyer form an opinion of the sustainability of revenue and earnings. Common diligence procedures also analyze trends in revenue and margins by specialty. Once past performance is analyzed, it is used to bridge the historical performance to management's forecast. Prospective buyers should ask themselves: Is this forecast achievable based on the historical results? Has the financial model considered the expected decline in Medicare rates? 

3. What are the practice's working capital requirements? A buyer should understand the current working capital needs of a prospective practice by analyzing its historical trends. The overall cash cycle should also be assessed. How long does it take to convert a medical procedure into cash? How much of the actual gross billing can actually be collected? Some physician groups may also own an insurance plan requiring that certain cash levels are maintained for state solvency requirements. Capital expenditures should also be evaluated. Capital investments related to physical locations for urgent care centers, ambulatory centers and information technology — especially EHRs — will be necessary for physician groups to compete in the new marketplace. In fact, the need for capital investment may be one of the reasons a physician group is inclined to sell. 

4. Should I assume a practice's debt? In general, it is not advisable for a hospital to assume the debt of a practice it wishes to acquire. However, some debt takes a while to reveal itself. During diligence it is important to identify these "debt-like" items. They are commitments or contingencies that are not recorded on the balance sheet but may require funding post-transaction. Examples include the cash cost of an unfunded pension liability and change in control payments (triggered upon a transaction). If diligence procedures are not created to uncover these, buyers are putting themselves at risk of inheriting financial obligations they may have not known about. For example, a physician group may be self-insured for professional liability claims and the insurance expense may be recorded on the income statement, but the incurred but not reported claims may not be recorded. Once debt-like items are uncovered, the buyer can try to negotiate these obligations away, or at a minimum incorporate the future cash outflows into their financial model.

5. How much should a practice's IT infrastructure be taken into account? A practice's IT infrastructure is a critical asset that should be evaluated during diligence. Buyers should assess a practice's existing IT organizational structure and systems in their entirety to gauge the practice's suitability as a hospital provider. Hospitals should assess the cost of consolidating and implementing the IT systems needed post-transaction. Many times, physician practices will not have invested in interoperability, making it a guaranteed future cost for the hospital. 

6. How should physicians be compensated? Many physician groups are structured as partnerships, making physicians their own bosses. If acquired, they will have to adjust to being employees. Naturally, physicians who are acquired expect to maintain or increase their income under their new employer. Eighty-three percent of physicians who are considering hospital employment said they expect to be paid the same or more than what they are earning when they join a hospital's staff.

Today's physicians are used to being paid on a fee-for-service basis, which lends itself to a volume-driven business. New compensation program designs may bear little resemblance to what physicians have experienced in the past. Patient outcomes will soon outweigh volume as the measure of a physician's productivity. In a world of ACOs, value-based purchasing and bundled payments, physicians will have to change long-entrenched perceptions of how they measure their own professional success. Buyers should evaluate a practice's culture of compensation to determine whether it is open to change.

7. Does the practice have a sound compliance program? Gaining an understanding of a physician group's discipline around coding and compliance is another important step during diligence. If there is no formal compliance program, or if coding practices seem questionable, it may be a serious red flag. Practices should have sound programs in place, including a compliance officer, training and education programs, and auditing and monitoring processes.

Compliance diligence typically overlaps with financial diligence. For example, buyers should analyze the status of Medicare Recovery Audit Contractor audits. Each state has instituted RAC audits to uncover providers' possible improper Medicare payments (both overpayments and underpayments). Most companies have some type of reserve for a potential payback to CMS (a debt-like item).

8. What governance roles should newly acquired physicians assume? There is a legacy of "bad blood" between hospitals and physicians that has caused each to view the other with suspicion over the years. When asked by PwC whether they trust hospitals, 20 percent of physicians said no, and 57 percent said sometimes. Trust must trickle down from the top; leadership should create an environment in which hospital management and physicians can regain the "trust factor." A physician group with no physicians on the acquiring hospital's management team will most likely disrupt the planned integration. More than 90 percent of the physicians surveyed by PwC said that physicians should be involved in hospital governance activities such as serving on boards, being in management and taking part in performance improvements.  Determining how the governance of an acquired entity is going to be structured pre-deal may provide buyers with a competitive edge in a deal process.

As the healthcare industry continues to undergo fundamental change, a well-rounded diligence program is more important than ever when evaluating a physician group for acquisition. While traditional financial and legal diligence is important, buyers should also take into account other variables, such as governance, compliance and IT. These variables can quickly derail an acquisition, and thus are key valuation considerations that should not be overlooked. No deal is perfect, but after robust due diligence, hospitals should know who their new team members are as they work with them to succeed in the ever-changing healthcare environment.  

[1]In 2010, PwC’s Health Research Institute commissioned an online survey of more than 1,000 physicians balanced by age, gender, practice type, and specialty. All of the statistics cited in this article were drawn from that survey.

Mr. Barenbaum is a director in PwC's Healthcare Transaction Services Practice. He can be reached via email at glenn.p.barenbaum@us.pwc.com.

More Articles on Physician Acquisitions:

5 Considerations for Successful Physician Acquisitions
Factors Affecting Orthopedic Surgeon Hospital Employment

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