When financial institutions fail to conduct the right kind of due diligence prior to financing the purchase of a health care entity, bad things can happen. Too often, banks focus their due diligence too narrowly, missing red flags that may result in over-estimation of value.

Here are some key points to think about when planning and doing due diligence.

Know the Business

Health care entities are special creatures in the market. They are highly regulated delivery systems, dependent on government, private and/or third party payers. They expose lenders to layers of risk that can go undetected when due diligence is conducted superficially. Due diligence of a health care entity should dig into a company to find out how it works, where its strengths lie, and what weaknesses it has. Inquire about and understand the nature of the health care services delivered. Ask that the services be specifically described. Identify the local labor pool available and quantify labor resources and costs – key elements for a health care provider.  Understand the payer mix to determine how the business is reimbursed, what the reimbursement and payment sources are, and how reliant the business is upon each source.  Understand the market economy and the up or downward trends that are present. 

Know Its Reputation

Health care entities, especially those that engage in medical specialties, rely heavily upon referrals from consumers and professionals. A bad or marginal reputation will not be transformed magically into a good reputation because a health care entity has a new owner. Indentify and check referral sources to understand the reputation of the entity being sold. Often in smaller or closely held businesses, the owner is the source of the reputation.  When the business is sold and the former owner is gone, referral sources may diminish, resulting in deteriorating occupancy rates. 

Understand the Assumption of Risk

A seller that receives reimbursement from Medicare has been assigned a Medicare number. When the business is sold, the Medicare number attaches to the new owner, unless the new owner applies for and receives a new number from the Centers for Medicare and Medicaid Services (CMS). Application for a new number can add time and contingencies to transactions. When the buyer assumes the seller’s provider number, the buyer assumes the record of compliance violations and the sanctions and fines that accompany the number, and CMS will pursue the new owner (i.e., the holder of the provider number) for a remedy. CMS will not chase the seller. Indemnification provision in lending agreements provide little solace in the face of a CMS enforcement onslaught. If compliance problems are identified in the due diligence process, discussions with regulators may be required to understand the severity of the problem and the impact the problem may have upon the business. Negotiations with the regulators may not be out of the question. 

Determine Its Billing and Revenue Projection Accuracy

Projected revenues are sometimes overstated because accountants who prepare statements relied upon by lenders may not take into account the collectability of accounts receivable. Revenue projections and the collectability of claims submitted to payers are influenced by a number of factors. First, the amount billed may not be the amount third party payers have contracted to pay. Second, projected revenues may not adequately take into account collection and bad debt histories. Third, claims may be submitted with a high degree of inaccuracy, resulting in denials or substantial delays in payment, effecting in turn estimates of per-day revenues – an especially important factor in the valuation of nursing homes and long term care centers. Due diligence is required to determine what discounts the health care entity has agreed to and how that might effect projected revenues; whether projected collections have been overstated and bad debt has been understated, and if the claims submitted have a history of being incorrect. 

Identify Building and Licensing Issues

In many states, change of ownership of certain health care entities requires re-licensure. The licensing process may bring to light the fact that the facility is in noncompliance with code but has received waivers from the state that release the seller from the requirement to repair and upgrade or that grant a delay.  Waivers sometimes are not transferrable upon sale, resulting in nasty surprises for the new owner or lender when confronted with unanticipated but mandated costs during the re-licensing process. A review of the existing license along with waivers and exceptions related to building code requirements will minimize this risk.