Last year, we outlined reasons on why having an appraisal review completed may be a prudent step in the transaction process.  Healthcare transaction activity during the last year has continued at a rapid pace, with buyers and sellers becoming increasingly aware of the resources available to them in ensuring a fair and equitable transaction is consummated.  As a result, we have experienced an increased demand from our clients for appraisal review services.  An appraisal review may be a wise choice in a variety of circumstances, such as when a seller is unable to fully interpret an appraisal the purchaser completed, or when negotiations have stalled as a result of a purchaser and seller having completed separate appraisals with widely different results.  We have also been engaged to complete appraisal reviews when both the buy-side and sell-side of a transaction agree to jointly engage an appraiser, whose resulting work product was skeptically viewed by one or both of the engaging parties.  As a follow-up to our article from last year, we have outlined some recent outcomes that have resulted from our appraisal reviews over the last year.

We completed an appraisal review of a diagnostic imaging center that was completed by an internationally renowned accounting and consulting firm.  In their application of the Market Approach, three of the five comparable public companies that were selected by the firm were Fresenius, LabCorp, and Quest Diagnostics.  Fresenius, an international firm that is headquartered in Germany, is focused on the provision of dialysis services and associated equipment and consumables, while LabCorp and Quest Diagnostics are focused on providing outsourced clinical diagnostic testing through the use of blood samples and urinalysis (among others).  These entities are not comparable to a diagnostic imaging center, which not only provides very different services, but has also been facing a much different trend in payor reimbursement in recent years.

The Income Approach prepared by this firm modeled several expenses that were applicable to that of the post-transaction hospital purchaser.  Included was a hospital corporate overhead allocation, which substantially reduced the resulting cash flows that were utilized in the discounted cash flow analysis.  As the imaging center was performing on a standalone basis without the need for these expenses, including these expenses resulted in a standard of value that was not applicable to the scope of work – investment value instead of fair market value (“FMV”).  The FMV standard requires an appraiser to model the cash flows of a hypothetical purchaser – not a specific purchaser (i.e., a hospital).

Lastly, this firm did not take the time to understand the entity they were appraising.  The imaging center expense structure had been sharing staff with a related radiology professional practice that had common ownership.  The imaging center expense structure had also been reporting certain physician-related benefit expenses.  Adjustments were necessary to move expenses related to the physician practice off the expense structure of the diagnostic imaging center, which resulted in a sizeable increase to the imaging center’s operating margin.

We completed an appraisal review of a medical group that was completed by a national healthcare valuation firm.  While the appraisal did not include a report narrative, the valuation exhibits were very detailed, containing 70 pages of data analysis and valuation modeling.  Despite this level of detail, some basic addition and subtraction math errors resulted in EBITDA being understated by nearly 100 percent.  This materially affected the value of an entity which was already valued at tens of millions of dollars, before consideration of this adjustment.

We conducted a separate appraisal review of a medical group that was completed by a national healthcare valuation firm, in which the firm misapplied the excess earnings method in determining normalized physician compensation.  The firm utilized benchmark data in their analysis which had such a small sample size of respondents and great variance in the data year-over-year, that generating a statistically significant conclusion from this data was impossible.

FMV Pitfall: Most healthcare appraisals are complex valuation assignments.  Mistakes that seem small may have large repercussions on the conclusion of fair market value.  The extra cost and time associated with completing an appraisal review should be viewed as a smart investment in ensuring that multimillion-dollar transactions are being completed at the correct value.

Author: Matthew J. Muller, ASA and Nicholas Janiga, ASA

An often overlooked or disregarded aspect of the appraisal process is appraisal review. The American Society of Appraisers, which awards the Accredited Senior Appraiser (“ASA”) designation for disciplines such as Business Valuation and Machinery and Technical Specialties, holds those with the ASA designation to a certain set of professional standards – the Uniform Standards of Professional Practice (“USPAP”). USPAP, which is published through the Appraisal Standards Board, also publishes standards regarding appraisal review. USPAP defines appraisal review as “the act or process of developing and communicating an opinion about the quality of another appraiser’s work that was performed as part of an appraisal or appraisal review assignment.” The scope of an appraisal review can vary, with the subject of an appraisal review assignment containing all or part of a report, workfile, or a combination of these. When relying on an appraisal, it is important to consider whether having an appraisal review completed is prudent.

With the increased transaction activity in the healthcare industry, more accounting, finance, and consulting professionals are preparing healthcare-related appraisals than ever before. Simply having an appraisal completed does not necessarily mean the transaction in question is consistent with fair market value if the price of the transaction is consistent with the value outlined in the appraisal. A notable healthcare example in which a flawed appraisal that was relied upon resulted in a negative outcome for the defendants is US Ex Rel. Singh v. Bradford Regional Medical Center. On many occasions, HealthCare Appraisers, Inc. (“HAI”) has been engaged to review appraisals prepared by another firm. In our appraisal review experience, we have encountered numerous instances of flawed application of valuation theory, and a lack of understanding of the complex healthcare regulatory and case law environment. Examples of items we have uncovered that have many times lead to us uncovering material issues with the appraisal under review we have listed below.

Many professionals preparing appraisals may not be credentialed, and thus the appraisal prepared may not be in accordance with valuation standards widely accepted throughout the business valuation community. Even in instances where a credentialed appraiser is preparing an opinion, certain language referencing these valuation standards may be excluded. This essentially results in an opinion more akin to an ambiguous calculation of value, as the appraiser does not follow a set of widely recognized appraisal standards. This is a situation we have encountered on overly robust valuations that have been reviewed, which conveniently rids the individual preparing the appraisal of having to adhere to his or her valuation standards associated with the credential that is held. Conversely, erroneous assumptions or valuation theory may be applied that could result in a value that is lower than fair market value.

As an example, we at HAI were recently engaged to review a surgery center appraisal in connection with litigation. The appraisal under review was prepared by an individual that did not hold a valuation credential. The report also did not mention any set of appraisal standards that the report adhered to. HAI’s review identified numerous errors in the subject appraisal, including incorrect application of discounts for lack of marketability and lack of control, use of an incorrect income tax rate, and use of unsubstantiated and unrealistic assumptions related to case volume growth, future reimbursement, and long-term growth rate – all of which affected the discounted cash flow analysis that was prepared under the Income Approach. Additionally, the appraiser incorrectly applied the Market Approach, by relying on surgery center transactions that occurred 6 to 18 years prior to the valuation date, many of which were for single-specialty versus multi-specialty surgery centers; a concern as the subject surgery center of the appraisal is multi-specialty. In correcting these errors, HAI prepared a valuation that resulted in the value of the subject center doubling from what was prepared by the opposing appraisal firm.

HealthCare Appraisers has encountered many instances where an appraiser takes a “one size fits all” approach to preparing their appraisals. On one recent appraisal review, we questioned the use of an input the appraiser used, and the response was “this is the same input we have used for the hundreds of valuations we have completed over the last year.” While there will always be items in an appraisal that require appraiser judgement, responses like these indicate that a limited understanding of either valuation theory, the subject entity, the subject industry, or all of these items may be present in an appraisal.

We recently reviewed an appraisal of a cancer center that was prepared by the transaction advisory service line of an internationally renowned accounting firm. The value arrived at resulted in a value of the cancer center of over $1,000,000. Upon review of the discounted cash flow analysis, we observed that the annual depreciation that was projected in connection with the anticipated purchase of a new linear accelerator was erroneously carried into the terminal year. Projecting this depreciation tax shield into perpetuity without offsetting the amount by capital expenditures resulted in an overstated terminal year calculation, and thus, an overstated value under the Income Approach. Correcting for this single calculation resulted in the value decreasing from $1,000,000 to a de minimis value under the firm’s discounted cash flow model.

We have commonly encountered investor-specific assumptions utilized in an appraisal, which do not adhere to the fair market value standard. The fair market value standard requires that only assumptions associated with a hypothetical purchaser be considered. Use of investor specific assumptions typically increase value in a business as compared to the fair market value standard. While these investor specific adjustments may go unnoticed to a casual observer of an appraisal, they will be uncovered during an appraisal review by a healthcare valuation expert. It becomes very apparent that these are appraiser specific assumptions when the appraiser is unable to articulate how other potential purchasers could achieve these investor specific assumptions.

FMV Pitfall: Healthcare professionals obtain business appraisals to ensure their transactions occur in compliance with the healthcare regulatory environment. Unfortunately for these professionals, obtaining an appraisal does not necessarily ensure compliance, as the value determined in the appraisal may or may not have been completed in a manner that is consistent with broadly recognized valuation theory, much less the healthcare regulatory environment. This may leave those involved in the transaction at risk of regulatory scrutiny. By engaging the team at HealthCare Appraisers to complete an appraisal review, you will receive peace of mind knowing that our seasoned healthcare valuation professionals have scrutinized the appraisal that was prepared, and identified any potential issues that might affect the integrity of the conclusions outlined in the appraisal.