EVALUATING INVESTMENT OPPORTUNITIES FOR

AMBULATORY PROJECTS

                                                        by Robert L. Chiffelle

In today's competitive business environment, physicians have many opportunities for joint-venture investments in for profit, privately owned medical businesses. Most often, these businesses are centered around the medical procedures done by the physicians in hospital-based facilities. The objective is to move the physician's current hospital-based procedures to an independent outpatient center in which he or she has an ownership interest.

This article will review the issues involved in such an investment, and set forth a framework for evaluating the opportunity. It will describe a "typical" opportunity modeled on an ambulatory surgery center (ASC) project, and show how to identify areas of concern to the potential investor. It is not intended to substitute for an independent evaluation by an experienced accounting, consulting and/or legal firm, which is recommended prior to entering into any binding agreement.

Management Companies as Developers

The most common forms of investment opportunities are (1) ambulatory surgery centers, (2) free-standing imaging centers, and (3) mobile diagnostic or treatment equipment. All types are frequently offered to "qualified" physicians by management companies, many of whom are owned by out-of-state corporations. These companies bring expertise in the business development, construction and operation of such projects, and are able to bring together groups of physicians as investors in a short time frame. Physicians who are offered an opportunity to join such a business venture are generally those who will contribute to its profitability, such as general surgeons or ophthalmologists in an ASC project. In most cases, the management company serves as a catalyst for investment, and owns anywhere from 20% to 50% of the venture. The remainder is owned by the investor physicians, who purchase ownership "shares" at a defined value. This ranges from as low as $5,000 per share to $60,000 and higher. The value of each "share" is generally set as a fraction of the start-up cost of the project not covered by a loan. Most individual shares represent two percent of the total capitalization.

The management company will attempt to put together the physician investors in a short time frame, usually within two weeks after first contacting them. Often this involves "high pressure" salesmanship, and the physician investor can expect to be provided with a standard package of documents and complex financial projections with a very short time in which to conduct an evaluation.

Common Elements of an Investment Opportunity

Use of a "standard" model for the project Formation of a Limited Liability Company (LLC) Up front equity investment Management company fees Investor at risk for capital shortages Investor liable to the lending institution for outstanding debt Powers of the managing company In a typical venture, the management company will put forth a "standard" model which it feels will be the most effective vehicle for the project. The financial projections will be built upon this model. The investors and the management company will jointly form a Limited Liability Company (LLC) as a vehicle to own and operate the project. The investors will be required to contribute their equity share immediately upon signing the LLC Operating Agreement, which is the key document setting forth the rights, responsibilities and powers of the investors and the management company.

Management companies generally will require (1) an "Origination Fee" averaging $25,000, (2) a "Development Fee" averaging $250,000, (3) an ongoing "Management Fee" averaging 5.0% of collections, and (4) a management contract for the first two years of operation.

Generally overlooked is the fact the Operating Agreement will require all investors to be at risk for additional (unanticipated) capital in proportion to their ownership shares in the LLC. In addition, the lending institution (bank) that finances the project will also hold investors individually liable for outstanding debt in amounts averaging 150% of their ownership share of the LLC, in the event of failure of the business.

The Operating Agreement usually reserves the powers of management to the management company, and gives them the right to call for the expulsion of an investor for specified reasons. There should always be specific language dealing with expulsion and how the shareholder is compensated for the value of his share.

Evaluating Financial Projections

Use of Medicare ASC Payment Groups to model reimbursement Inclusion of all expenses, including downtime due to licensing delays Realistic financing Rates

A key element in evaluating the business opportunity is an assessment of the accuracy of the financial projections. Common problems include (1) overstatement of revenues, (2) understatement of expenses, and (3) unrealistic timetables for achieving profitability.

A good example for evaluating reimbursement projections involves ambulatory surgical centers. In the current managed care environment, most health plans utilize the Medicare "ASC Payment Group" system for determining facility fee reimbursement. All Medicare - covered ambulatory procedures are classified into nine (9) groups, with year 2000 Maricopa County facility fees ranging from $335 for the lowest group to $1,345 for the highest group. These fees include all services except physician professional service, certain implants and durable medical equipment. Health plans generally pay a percentage of this amount, with the most common rates being in the range of 90% of the appropriate group.

In order to evaluate the accuracy of the projections, the investor should match the CPT codes of the most commonly done procedures with the appropriate Medicare group and multiply this by the expected reimbursement rate for the community. The average reimbursement rate should be compared to the projection put forth by the management company to determine the accuracy of the projections.

Often management companies make projections based on billed charges figures available from the state health department, and then adjust these by using a "national" collection rate. This can result in a misleading projection, as collection rates vary considerably by location, depending on the degree of managed care penetration in the market. It is not unusual to see revenue projections overstated by as much as 40% when local conditions are not taken into account.

In Arizona, roughly 90% of patients are covered by some form of managed health care program. The number of patients in the "self pay" category is quite small, with the notable exception of cosmetic surgery and Ophthalmology (RK) patients. Financial projections should recognize this, and develop revenue projections using the Medicare payment groups.

Delays - License, Managed Care Contracts and Accreditation

All expenses, including those associated with "downtime" waiting for state licensure and delays in signing contracts with managed care plans, should be included in the financial projections. Commonly made errors reflect the assumptions that (1) a facility can become licensed immediately upon completion of construction, (2) that it can immediately secure managed care contracts, and/or (3) that it can be quickly accredited by a quality-assurance organization.

A facility will get an occupancy permit at the completion of construction, but must wait until it is licensed before patients can be treated. Delays of four months are not unusual for license inspections; during this time, the facility must pay fixed expenses and may not serve patients until the inspection is satisfactorily completed.

In addition, the facility must secure managed care contracts. This requires that it have a license, and for ASCs, that it go through each individual health plan's accreditation process for a facility contract. For ASCs, facility fees are paid separately from professional fees. The fact that a physician has a professional services contract with a health plan does not mean that a facility contract will be granted; this depends on the market-driven needs of the plan.

While much of the facility accreditation work can be completed during the time the facility is waiting for the license to be issued, a contract will not be effective prior to the completion of the licensing process.

Many health plans require an ambulatory facility to be accredited by a national organization, such as the Joint Commission for the Accreditation of Healthcare Organizations (JCAHO), before signing a contract. This accreditation costs somewhere between $7,000 to $10,000, and requires 4 - 6 months to complete. This will add additional cost to the projection, and may cause additional delay in securing contracts for those plans that require accreditation.

The waiting time for a license, managed care contracts and accreditation must be factored into the financial projections, as costs incurred during the delay must be funded either with a line of credit or from individual investors.

Financial Benchmarks for the Cost of Capital

A common error in financial projections relates to the use of unrealistic or dated financing assumptions. Most major lending institutions use market-based guidelines to set interest rates, and many are owned by national corporations. Their rates tend to be very comparable among similar projects, and rough "benchmarks" can be listed for evaluation purposes.

For example, most lending institutions will finance a maximum of 75% of the assessed valuation of the project. This is determined by an independent appraisal commissioned by the lender, who makes an evaluation based on the "highest and best use" of the property and assets of the project. In many cases, the appraisal may not be as high as the investors would like, and in such cases the amount financed may be substantially less than 75% of the total project cost. Within the general context of a financing package, four types of loans are encountered for the "typical" project:

Interim Construction Loan - a one-year loan to cover the initial construction. Typical rates are prime plus 1.0%, plus a 1.0% loan origination fee. For example, for a hypothetical construction loan of $1,000,000, with a market based prime rate of 9.5%, the interest rate would be 10.5%, and the loan origination fee would be $10,000.

Permanent Loan - this loan "takes over" when the construction loan expires, is generally amortized over 20 years, but has a provision for a "call" at 7 years. Rates are most often set based on either (1) the prime rate, or (2) the yield of 7 or 10-year U.S. Treasury Bills plus a certain number of "basis points," with 100 basis points equaling one percent. For example, if the 7-year U.S. Treasury Bill yield was 6.5% and the basis points put forth by the lending institution were 300, the interest rate would be (6.5 + 3.0) 9.5%.

Equipment Loan - this is a separate loan to cover the cost of fixed and moveable equipment, and is generally for 5 years. The most common rates are prime + 1.0%. Line of Credit - this is intended to cover operating deficits during the start-up period, and can be structured in several different ways. Most commonly, it requires interest-only payments for a period of time, at the rate of prime plus 1.0%. Lending institutions may limit the time the principal is outstanding, or may permit this to convert to a short-term loan similar to the Equipment Loan.

Project Development Issues

Assuming no delays in land acquisition, the process of constructing an ambulatory center generally takes 15 - 20 months, depending on the size and complexity of the project:

Architectural Design 5 - 6 months City Approval and Bid Process 2 - 4 months Construction Time 8 - 10 months

The state of Arizona is fortunate to have an abundance of well-qualified and highly experienced medical project architects and contractors. These individuals know local and national construction codes relating to ambulatory centers, and are capable of completing projects in the minimum time.

No architect or project manager can appreciably speed up or circumvent the regulatory or licensing processes. A frequently-made assertion by management companies is they have an out-of-state architect that knows how to construct these centers, and can speed them through the regulatory processes faster than local architects or managers. Statements such as these are misleading, and should serve as a "red flag" to the potential investor to evaluate the other assumptions put forth in the project for accuracy.

Assessing the Competition

Potential investors need a clear idea of the effect that competing facilities may have on the project. For example, hospitals and/or other surgery centers in the immediate service area may adopt a strategy of lowering prices to managed care plans in order to counter the effect of a new ambulatory center. This will have a detrimental effect on the ability of the project to secure managed care contracts at the projected prices. The investment offering should contain a section dealing with competition, and account for the possible downside risks associated with the project.

Identifying Investor Risks

The physician investor should carefully and deliberately evaluate the project within a reasonable time frame (a minimum of 2 - 4 weeks), and seek answers to the following questions:

1. Is there a limit on capital call liability? Are all capital liabilities clearly identified?

2. Are the financial projections accurate? Do they take into account current marketplace conditions, and accurately portray the mix of payors? How is revenue modeled?

3. Are the up-front fees clearly listed? Are they in line with market norms? Does the value of the management company expertise exceed these costs?

4. Are the time frames for the project accurate?

5. Has a realistic appraisal been made of the competition and its capabilities?

6. Is this a project that requires a national management company, or could it be better done using local talent to avoid the initial development and ongoing management fees?

Summary

Physicians considering investing in an ambulatory project should carefully evaluate the opportunities and risks of the project. This includes a careful examination of the assumptions and financial projections upon which it is marketed. They should ensure that actual marketplace data and rates are utilized, and that all risks are clearly disclosed. Enough time should be accorded to conduct a "due diligence" study; in most instances this will require a minimum of two weeks. Potential investors should closely examine all promises put forth regarding performance, particularly those that appear to fall outside of the generally accepted benchmarks for project development.

Robert L. Chiffelle is a consultant with Wolfe Consulting Group in Phoenix, Arizona. He specializes in managed care and business development activities.