Developing a Conversion Package

T he importance of assuring that the value of charitable assets has been maintained and that the health needs of a community will continue to be met after conversion is reflected in the increased involvement of state Attorneys General in the review of hospital conversions.

It is possible for hospitals to use covenants in conversion agreements as a mechanism to guarantee continuation of important community benefits. While the Carolinas case studies showed no significant violation of such contractual agreements, governing board members must consider how an agreement will be monitored and enforced over time. In general, for-profit conversions appear to result in a reasonable price paid for a hospital. This section discusses all of these important issues. WHAT IS THE HOSPITAL'S VALUE?
The assets of a not-for-profit hospitals subject to transfer in a conversion are the result of years of government subsidy and tax benefits--including exemptions from state and federal corporate income taxes, state property taxes, and the benefit of tax-exempt donations—as well as donations of time and money by members of the community. Similarly, county-owned hospitals have been built and maintained by the taxes paid and tax-exempt financing from a particular county. By definition, if a not-for-profit hospital is undervalued when sold to a for-profit chain, then individual stockholders and hospital management, rather than the community, will benefit from the long-term investment in the facility. Thus, fair valuation is critical.

Therefore, in the interest of fairly reimbursing the community for its history of commitment to a county or not-for-profit facility, determining the value of the hospital is tremendously important. This is especially true given the ability of an Attorney General to review a conversion based on the use of due care by the hospital governing board. Such a review may assess whether a hospital board's due care requirement has been met, for example, through the use of an impartial expert third party to conduct the valuation.

How is a Fair Price Determined?
There are several schools of thought on how to value the assets of a hospital for conversion purposes, and hospitals may utilize one or more of these in their conversion process. Because of the difficulties in accurately assessing the value of not-for-profit and county hospitals (given the many community benefits they provide), many sellers rely upon the market approach to ensure a fair price. To obtain competitive bids, either a Request for Proposals (RFP) is used to obtain offers from independent bidders or bids are obtained by having a proposal "shopped" privately among prospective buyers using a consultant. This competitive process is aimed at encouraging prospective purchasers to offer a fair price. A bidding process, especially if combined with public disclosure, can help overcome the fear that the purchaser could get a bargain price due to an informational advantage or because financial details remain secret.

* 4 of the 14 hospitals studied by GAO used an RFP and 9 others considered several potential partners before selecting one from which a bid was solicited. 7 of the 14 hospitals received more than one bid.5

An RFP may elicit mixed arrangements that span the conversion continuum (e.g. proposals for the lease or joint venture with the hospital), rather than just a straight cash sale. Because offers may contain non-economic intangible considerations such as mission and quality of care, the market approach may actually be limited in its ability to set an accurate price for the hospital. Instead, the chief benefit of the market approach is its ability to bring a variety of offers to the table, which may be very helpful for a board not completely convinced that it wants to divest itself 100 percent of the hospital.

In addition to the market approach, a hospital's value also may be determined through an objective third party appraisal, typically completed by an outside financial consultant (Table 10). Regardless of whether the final price is negotiated with a single purchaser or results from a bidding process, hospital decisionmakers typically obtain some estimate of the hospital's value during the conversion process, either to serve as the basis for subsequent negotiations (e.g., through a formal valuation or appraisal) or as reassurance that a proposed price is fair (through a fairness opinion). Most hospitals rely on outside experts to provide these valuation estimates, including major accounting firms, consultants or appraisal companies that specialize in this area. The cost to obtain such estimates varies widely based on the size and complexity of the transaction.

* 13 of the 14 hospitals studied by GAO used outside experts to obtain formal hospital valuation estimates; 5 of these also got a fairness opinion (as did the hospital that performed its valuation in-house).

There are three primary methods used to determine a hospital's value: income, market and cost (see next page). The income and market methods are most commonly used. However, some suggest that measures which base values on earnings (e.g., EBITDA multiples) may understate the value of public or not-for-profit hospitals since a for-profit purchaser may no longer need to provide the same level of community benefits. 5, 6

How Are Community Benefits Taken Into Account?
The financial difficulty experienced by hospitals outside of the for-profit sector may be the result of the cost of their community benefits, in addition to a host of other factors such as poor management or unfavorable managed care contracts. If the community benefits provided by these hospitals (e.g., uncompensated care, the maintenance of unprofitable, yet needed services and the high proportion of Medicaid patients) exceeded taxes they might otherwise have paid—this may have resulted in lower profit margins than if they had been for-profit facilities. In addition, assigning a price to a not-for-profit may not reflect the fact that the not-for-profit hospital has not traditionally sought to maximize its profits through the provision of these services.6

To account for possible differences in behavior in the purchase price of a not-for-profit or public hospital, several approaches are possible. One is to determine a one-time flat price based on projecting the net present value of future earnings in the hands of a prospective purchaser. Alternatively, acquisition of a not-for-profit hospital might be structured as a joint venture so that the not-for-profit partner (e.g., a foundation) can benefit from the future financial success of the facility in for-profit hands.

While this latter approach has the potential to maximize the not-for-profit's realization of post-conversion profit, it also keeps the not-for-profit at risk for the hospital's success (albeit less so than before). Moreover, since the value of cash reimbursement and equity must together equal the value of the not-for-profit, this latter approach still does not solve the problem of the amount of cash that should be paid to the not-for-profit for the value of assets it contributes to the joint venture.

Alternative Methods of Calculating Hospital Value5 Income Method. The income method is based on the hospital's actual earnings. A discounted cash-flow analysis makes projections of future cash flows and discounts them to the present to obtain the hospital's value. An earnings analysis calculates the hospital's earnings before interest, taxes, depreciation and amortization (EBITDA) for the preceding 12 months and multiplies this by a factor to estimate the hospital's value. EBITDA multiples vary depending on factors such as debt, age of assets, and market share, but typically range from four to about seven (with lower values used for more financially risky hospitals). Market Method. Two forms of market valuation were also cited in the GAO report: a comparable companies analysis and a precedent transaction analysis. The comparable companies analysis compares the value of a not-for-profit hospital to the value of a for-profit hospital value on the stock market by utilizing EBITDA multiples derived from publicly traded hospital companies. A precedent transaction analysis bases the hospital's value on EBITDA multiples derived from prices recently paid for comparable entities. Cost Method. This method is based on the balance sheet valuation of assets and liabilities. Value is calculated by determining the cost to replace or reproduce an asset, less an allowance to account for physical deterioration or obsolescence. This amount minus the book value of liabilities equals the net value of hospital assets. This method is used to value working capital, real estate and equipment, taking into account the value to a hospital of permits, licenses and managed care contracts.

How Are Intangible Assets Valued?
While the valuation process determines the dollar value of the hospital, those making the conversion decision may want to consider other intangible assets of great value to the community. The following questions help to identify such value:

• Is there another hospital nearby?
• Role of hospital as community employer
• Value of hospital reputation
• Value of hospital as base for volunteerism

Recognizing that "control" has economic implications, converting hospitals may charge a control premium –a certain amount of money paid to a converting hospital for ceding control to the other entity. The amount of a control premium typically is between 30-35 percent. This may be particularly important where partnership and board integration may mask a true change in decisionmaking authority.7

* Control premiums were not a part of the conversion package for any of the case study hospitals in North or South Carolina.