Due Diligence and Acquisitions: A Review of Common Pitfalls

A regular, although not necessarily routine, exercise that I go through is a re-evaluation of recent acquisitions in the senior housing/long-term care industry to see “how they are doing or performing” post transaction.  Perhaps the primary reason that I do this is my curiosity regarding the effectiveness of the due diligence process and the accuracy of the valuation or economic value proposition created by the acquirer as translated into purchase price.  In short, I’m always curious as to whether the buyer got what he/she/they expected at the anticipated cost (purchase price plus other investments required over the first year or so) he/she/they expected to pay.  As the mechanics and theory behind valuations and due diligence vary between deal to deal (from what I have observed), it is interesting to look at “how things are turning out” once the feeling of accomplishment and the haze of the deal  have passed.

When things don’t go well or aren’t going well at the one year mark, something I find more common in health care transactions (SNFs, Home Care, Hospice, etc.) and less so in Assisted Living or Senior Housing, it nearly always seems to a be a flawed due diligence process that led to an over-estimation of value.  More succinct: Because the due diligence process missed too many issues the price became over-stated as the costs associated with achieving stable operations were under-estimated or the classic, “he/she/they paid too much for what they got”.  Where I notice the largest number of errors occurring during due diligence is when the due diligence is treated as a justification for the purchase price or, a process of validation rather than a process to quantify the economic risks and benefits that are modifiers to the valuation and ultimately, to the negotiated price.  Proof of a what a friend of mine always says; “It doesn’t take a rocket scientist to overpay”.

Separating the issues a bit, valuation is effectively a financial quantification of the relative worth of the business as it stands today, including business/commercial value (cash flow, revenues, expenses, etc.) and tangible and intangible asset value (bricks and mortar, equipment, trademarks, name, etc).  When Buyers capably test the values against their own business models and the available universe of comparable values, the Buyer has established a range of possible purchase price points.  Ideally, within this range lies a number that the Seller will accept or that matches closely, the Seller’s asking price.  At this stage, I would argue that a Buyer should never impute any assumptions on a go-forward basis about “how much” expenses could be lowered or revenues increased to massage an improved value.  A wise Buyer would best assume that upon acquisition, almost all aspects of the business “as is” are set as constant and these same constants are the financial constraints that place the boundaries on the project’s range of values.  This is not to suggest that a pro forma assumption about “go forward” operations that assumes lower debt costs (if applicable), some efficiencies via scale and some reduction in overhead may not be applicable (if in fact they are real and quantifiable).  It is however, a caution based on too many valuations completed at the behest of or by Buyers, that include unrealistic assumptions of census increases, revenue increases, expense reductions, etc., that are hardly quantifiable or even in fact, justified for the particular transaction.  To illustrate: A few years ago I helped an out-of-state buyer get into a particular nursing home transaction (nursing home was for sale).  The buyer owned nursing homes in other locations so the industry was not totally foreign.  The location of the facility was decent but the plant was old and the facility’s reputation marginal.  The asking price had yet to be set “in stone”.  The buyer, accustomed to paying higher prices in other areas, began talking numbers that were far too high for the project, justifying the price with claims of significant improvements in Medicare census and Medicare revenue per day that were unrealistic for the facility (never happened at this location before) and were beyond the norms of the market area.  While I tried to counsel the buyer to be more judicious, the buyer went ahead and acquired the facility.  Within two years, the buyer abandoned the site, having substantially over-paid, never achieving the projections for revenue and census “touted” for the facility. 

Due diligence encompasses the financial valuation but extends the tasks into a level of greater detail that adds or subtracts (creation of debits and credits) from the range of possible values/prices.  In the best of due diligence processes, the methodology also incorporates a review of risks and assists in quantifying costs associated with these risks.  In reality, due diligence should attempt to paint a complete picture of all elements of the transaction, providing final quantification of the price and qualifications to the transaction that must be accounted for by the buyer.  Thought of or approached this way and using the example I presented above, the buyer would never have paid what they paid for the facility and would have realized that achieving a stable, successfully operating SNF in that location would take them years and significant financial and human capital investments.

While buyers tend to approach due diligence and valuation different, each varying upon a theme and using their own methodology and checklists, I’ve found that the problem transactions that I follow each tend to miss one or more of the following elements.  Some of these elements are absolutely critical if the buyer is out-of-state or out of the area and the acquisition represents his/her/their first foray into a given market area.

• Economic Location Analysis: Not to be confused with market research principally relying on demographics, this analysis looks deeper into the key economic location elements that are critical to the success or failure of the transaction at the given purchase price.  For example, location analysis would quantify labor resources and costs – key elements for a healthcare provider.  Location analysis would also quantify the strength and depth of referral patterns and the quality of such referrals by desired economic value (payer sources, etc.).  Location analysis also examines the market economy and the up or downward trends that are present.  Too many providers over-estimate the value of a particular location without understanding the economic factors that create or detract from the project’s value.
• Provider Status Assumption Risks: Buyers that are acquiring healthcare projects with existing Medicare business and expecting to assume the former provider’s Medicare number (most common in acquisitions) need to understand that the assumption of the Medicare number brings the assumption of risk.  While it is true that lawyers will create indemnities and warranties that seek to limit the buyer’s assumption of risk, using these clauses to enforce terms when risks are present or encountered is often an expensive and fruitless exercise.  In other words, the seller may no longer exist or as is often the case, will require the buyer to use an expensive legal process to enforce the indemnity and warranty provisions, all while the compliance requirements are inescapable to the current owner. Preferably, although not an expeditious process, buyers should obtain a new provider number and status for the project from CMS, targeted effective on the change of ownership – for Part A and Part B as applicable.  It can be done as I have done it with each of my “former” acquisitions.  By not assuming an existing provider number, the buyer avoids a whole host of issues and compliance problems that may or may not be disclosed or even known by the seller.  CMS, as one would suspect, will only chase the “owner” of the existing provider number when problems arise or are detected and if that is the new owner, regardless of whether the issues pertained to a former operator/owner, the new owner is expected by CMS to be the sole source of remedy.  CMS does not care about the terms of the deal between private parties.
• Billing Risks and Revenue Accuracy: This is a problem area that I see all to frequent.  The buyer relies on the seller’s representation of revenues and does no further testing.  I lost count of how many times buyers relied on accountant prepared or audited statements as being “gospel” only to find upon ownership that the revenues were over-stated.  Why?  First, even during an audit, accountants do not devote sufficient time or have often, sufficient expertise to analyze, the accuracy of the Medicare claims submitted by the seller.  The typical tests are for basic paper-trail elements such as RUGs groups in SNFs matching the billing, matching the revenue postings.  What needs to occur is a much more in-depth, technical review to determine if the Medicare claims that correlate to patients are in fact, correct.  Again, I have seen circumstances where the Medicare revenue per day is grossly incorrect as the seller had no idea how to properly bill Medicare claims.  Last, I rarely see buyers benchmark the revenue and occupancy numbers against area comparables.  Payer mix and revenue per day numbers across the industry tend to fit pretty narrow ranges and when, in any transaction, they are out of this normative range, a red flag should rise.
• Compliance Risks: Another area that I see cause buyers problems time and time again.  Compliance with certification, survey and accreditation standards is a function of past and yet to be.  Acquiring a provider with past problems in these areas requires very careful analysis and discussions with regulatory authorities.  Regulators need to be queried extensively and even, negotiated with when the buyer is acquiring a provider with a record of moderate to serious non-compliance.  Don’t have the discussions or do the additional analysis and assuredly, run into compliance problems that cannot be deemed as “owned” by the prior owner/operator.  Likewise, acquiring a provider with a reasonable or decent history doesn’t mean that the current status of compliance is clean.  Sellers tend to wane on their commitments to compliance the closer the time comes to deal “certainty” or closing.  A fair amount of time may also have passed since the current owner was re-accredited or surveyed.  Complaints may be pending requiring regulatory review.  What is certain is that once the acquisition is complete, regulators/surveyors will descend on the new owner in fairly short order.  Take the time necessary to thoroughly review the past and current status of compliance.
• Market and Reputation Risks: Simply stated: How is the current provider viewed within the market?  New ownership doesn’t mean new perceptions about the quality of the current operation.  If the current operation is viewed marginally or even negatively, a new owner will have a great deal of work ahead to establish an improved or new reputation.  If the business relies heavily on referrals (and most health care provider organizations do), it pays to check referral sources and other common influencers to understand the “market” perception that is in place.
• Environment and Infrastructure Risks: Assuming that acquiring an existing provider means that existing brick and mortar and equipment doesn’t require improvements immediately can be a false assumption.  Existing providers may operate under waivers or as in some states, new ownership necessitates that the entirety of the project be brought to current code with the issue of a new license.  Such is the case in Wisconsin.  A thorough review of the environment and the infrastructure tied to building code requirements, completed by qualified individuals/organizations will minimize this risk.
• Employment Related Risk: Here I am not talking about the legal risks associated with handling employment issues during the closing processes.  The risk that I am talking about occurs when buyers make one of two (or both) assumptions about the quality and stability of existing management personnel and/or, their own management personnel.    The error I see too often made occurs with out-of-state buyers not acquiring sufficient local or area expertise and/or, having enough local support available via contractors (consultants, etc.) to ease the transition.  Each market area and certainly, each state brings forth nuances and issues that require stable management and unique knowledge requirements.  I’ve seen too many new owners underestimate the resources needed and over-estimate the ability of their management to handle new areas and states foreign to them.