Identifying and Appropriately Measuring Risk in ASC Valuation

Physician-owners of ambulatory surgery centers (ASCs) are concerned with the current valuation of their business for two primary reasons:

• Given the active acquisition market of ASCs by third-party companies, knowing the value of a controlling interest represents an opportunity for physicians to monetize a substantial portion of their investment in the ASC.
• In the case of an ASC interested in adding new physician investors, knowing the value of a minority interest represents an opportunity to add case volume, diversify the physician and specialty base, improve profitability and potentially extend the life of the ASC partnership.

Determining the value of privately-held ASCs can be highly subjective. Because ASC partnership shares are not publicly traded, the values of shares of a given ASC are not readily available. That’s where the valuation multiple, a simple methodology used to figure out the value of an ASC, comes in. This “rule of thumb” is typically based on certain metrics such as total revenue, operating earnings or net income.

Valuation multiples can be useful in the valuation process, but misuse of this tool can lead to inaccurate assessments. The rule of thumb provides a quick estimate of ASC share value, when a detailed valuation is not easily obtainable and a common or “average” set of characteristics exists in the subject ASC. Multiples should not be used in lieu of a full, detailed valuation, for the following reasons:

The simplicity of the valuation multiple methodology means it doesn’t take into account ASCs that vary from the norm. That can result in wildly inaccurate indications of value because the specific financial and risk characteristics of the ASC are not considered.

Multiples of a controlling interest (greater than 50 percent) are typically higher than those of minority interests, and misapplication can lead to inaccurate valuation.

The mature ASC market

The number of ASCs has increased dramatically during the past 15 years. The first ASC appeared on the national landscape in 1972. Today, there are more than 5,000 ASCs owned by physicians, hospitals, surgery center management companies and other, more minor participants in the healthcare services marketplace. In the face of continuing declines in professional reimbursement and the convenience of a specialized setting for the delivery of surgical care, partial ownership in an ASC adds another earning stream for physicians. In many cases, qualified physicians are already active participants in ASC ownership.

That means that in relation to the number of ASCs, there are a low number of available, qualified physicians. Many would argue, therefore, that most local markets have matured and become saturated. Indications of saturation include the following:

• More physicians ownership in multiple ASCs simultaneously
• Cannibalization of physicians from existing ASCs to new facilities
• A myriad of alternative structures designed to attract physician investors
• An explosion in the number of management companies vying for the same market
• Initial stages of consolidation among management companies

The ramifications of market saturation and a high level of competition have been twofold. First, given the high number of ASC management companies vying for the same majority interests in a diminishing pool of ASCs solely owned by physicians, there’s much competition to acquire the existing, high-quality ASCs. This, coupled with the imperative for equity-funded companies to demonstrate earnings growth, has often resulted in aggressive valuations by ASC management companies. As such, while the ASC market is maturing and facing greater risks, the valuations of controlling interests have remained relatively constant.

Secondly, the saturation of ASCs in many markets has resulted in a diminishing pool of prospective physician investors who are not already owners in one or more ASC. Without the ability to add new physician participants/investors who will maintain revenue levels as existing physicians slow down, retire or defect to other centers, an ASC is destined to experience slowly decreasing case volume and profitability over time or suffer a rapid decline as a result of group defections to competing centers.

In addition, the saturation of ASCs in the market has had a profound effect on the valuation of a minority interest (i.e., the sale of a limited number of shares to prospective physician investors). In the past, before market saturation and intense competition for physicians, the forecast for most centers was characterized by continued growth. There were, after all, a limited supply of ASCs and a multitude of physicians who might be interested in participating, either as owners or simply as users of the facility. As a result, a common valuation multiple that incorporated steady growth and low risk, used to be a simple approach to determining value.

However, in a market that has evolved and is characterized by a wide range of risk factors associated with market saturation and competition, catastrophic and unpredictable events are far more likely to negatively affect value.

Any ASC valuation that doesn’t consider all risk factors brought on by an increasingly competitive market is probably overstated and the resulting price of an ASC share is likely priced too high. Significant areas of risk include, but are not limited to:

• Market characteristics
• Payor characteristics
• Physician-ownership profiles
• Physician-utilization profiles
• Facility attributes
• Organizational and legal structure

An overstatement of value resulting from a failure to properly assess and measure risk in the current environment is an unattractive investment for prospective physician investors and a self-fulfilling prophecy towards the slow—or in some cases, rapid—decline in the economics of the subject ASC.

Conclusion

Determining the valuation of an ASC is as much of an art as it is a science. A prerequisite to any valuation analysis is a thorough understanding of the competitive landscape of the national and local markets, and the changes that competition creates. An overstatement of the value of an ASC resulting from not considering risk in current markets will lead to share offerings that incoming physicians perceive as too high and an inability to entice new physicians (who are necessary to sustaining an ongoing venture) to buy in.

The identification, measurement and incorporation of risk factors into an assessment of the valuation of an ASC will be the subject of Part Two of this series.

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