Capital Infusion: Digging Deeper: A Guide to Health Care Regulatory Due Diligence in Private Equity Deals

    9 May 2013


    Investing in the health care industry can be riskier and more complicated than investing in many other industries. Health care providers and suppliers, as well as those companies that interact with them, operate in an intense regulatory environment and are the subject of increased government scrutiny for fraud and abuse and other matters related to compliance. Therefore, any unsuspecting investor that makes a wrong move during the investigative stages of a transaction can find itself in deep water after closing. An investor that seeks regulatory counsel to guide it through the transaction, however, can be in a better position to make informed business decisions. This article highlights key areas in which an investor can expect regulatory counsel to focus its efforts and some of the issues that an investor can expect to encounter along the way.

    Assessing Risks and Liabilities

    During the due diligence phase of a health care transaction, regulatory counsel will closely examine the target provider’s past and current practices to assess the risks and liabilities an investor could face if the transaction closes. Counsel should present a thorough diligence request list to the seller for items such as commercial payer contracts, documentation of enrollment with Federal health care programs, contracts with physician referral sources, lists of referral sources, real property and equipment leases, licenses, audits, information about litigation and government investigations, a summary of any Health Insurance Portability and Accountability Act (“HIPAA”) breaches and enforcement actions, and information about the provider’s internal compliance program.

    The provider’s payer mix often guides regulatory counsel’s review of documents because of its relation to the laws the provider must follow and the severity of the consequences that can result from a violation. Liabilities can be particularly significant when a provider enrolled in Medicare, Medicaid, or TRICARE violates the Stark Law and Anti-Kickback statute. Therefore, regulatory counsel often will focus part of the review in these areas if the target provider is enrolled in one of those Federal health care programs. While this article focuses on those two laws, the violation of other Federal and state laws can create significant liabilities as well.

    The Stark Law prohibits physicians from referring Medicare and Medicaid patients for certain designated health services (“DHS”) to an entity with which the physician or an immediate family member of the physician has a financial relationship, unless an exception applies. The Anti-Kickback statute is a criminal statute that prohibits the exchange (or offer to exchange) of anything of value in an effort to induce or reward the referral of Federal health care business. To evaluate the provider’s compliance with these laws, regulatory counsel should analyze the provider’s financial relationships with physician referral sources, as well as the incentives or inducements that the provider offers or provides to patients in order to generate business. The term “financial relationships” is interpreted broadly and can encompass relationships ranging from employment, professional services, or recruitment agreements between the provider and a physician, to equipment or lease agreements between the provider and an entity in which an immediate family member of a physician has an ownership interest.

    A provider’s compliance with the Stark Law and Anti-Kickback statute should matter to investors for three key reasons:

    • the penalties associated with violations,
    • the impact on future revenue streams, and
    • the effect on purchase price.

    The penalties associated with a violation of these laws can potentially be damaging to a provider. A violation of the Stark Law can result in denial of payment, mandatory refunds of reimbursement money, civil monetary penalties, and/or exclusion from the Federal health care programs. A violation of the Anti-Kickback statute can result in a criminal conviction, civil monetary penalties (which could result in treble damages plus $50,000 per violation), and/or exclusion from the Federal health care programs. Notably, this risk is now present more than ever because of the government’s increased interest in enforcement in these areas. As such, an investor should determine if it wants a provider to resolve any actual violations prior to closing, either by making a repayment for monies owed or by voluntarily disclosing a violation to the government and reaching a settlement agreement, thereby reducing the risk that a new owner will carry this type of liability going forward.

    An investor must also consider what impact these violations might have on the provider’s future revenue stream, one of the most important aspects of a buyout transaction involving leveraged financing. It might be that a provider has been so successful in generating business in the past because it has been offering inducements that violate the Anti-Kickback statute. Even if the investor is able to account for past liabilities, it should be aware that the provider will have to change its practices immediately and should evaluate whether the provider will be able to generate sufficient revenue after closing. If not, the investment might no longer be attractive, or worse, the buyer might not be in a position to service its debt payments.

    Finally, an investor should consider what effect, if any, these liabilities and changes in future practices have on the price it wants to pay to invest in the business. This dovetails with the discussion above related to future cash flows. While a dramatic impact to the cash flows may impact whether an investor wants to proceed with a transaction, it may be the case that an adjustment to the purchase price can be negotiated that will still cause the investment to be attractive to the investor.

    Notifying the Government

    Regulatory counsel will determine the types of government notifications and/or consents that are required in connection with the transaction as part of its due diligence review. This determination involves a close examination of the types of enrollments, state licenses, certificates of need, and accreditation, among other items, that a particular provider has on file.[1] An investor should pay close attention to this process for three key reasons:

    • government notification requirements could impact the way in which an investor should consider structuring the transaction;
    • such notifications could have an impact on the provider’s ability to operate or bill a Federal payer for its services for a set period of time after closing; and
    • such notifications could impact the timing of the closing date.

    At the beginning of the diligence process, regulatory counsel should work with corporate and tax counsel and the investor to determine the most appropriate way to structure the transaction. While the investor should take into account potential liabilities and the tax planning efforts of the parties when it considers whether an asset purchase or stock purchase is preferable, as stated above, government notifications also matter. For instance, the Centers for Medicare and Medicaid Services (“CMS”) often require providers that transfer ownership as part of an asset purchase to apply for a new Medicare number.[2] If a provider transfers ownership as part of a stock purchase, however, CMS might treat the transaction as a “change of information,” rather than a “change of ownership” (commonly referred to as a “CHOW”), and not require the provider to submit a new application. The same could be true for Medicaid, depending upon the state and the type of provider involved. Moreover, state licensing boards might require new licensure applications in connection with a transaction; however, a board might base its decision to require a new application on the level of corporate ownership affected by the transaction rather than on the type of transfer (asset vs. stock) that takes place.

    In the event the chosen transaction structure triggers certain government notifications and/or new applications, the investor should be aware of the impact this decision could have on the provider’s ability to bill a Federal payer for its services or operate after closing. It should also be aware that rules and exceptions to the rules in these areas will vary by state. In the Medicaid context, for example, a provider might be required to hold claims until an application for a new enrollment number is approved. This could result in a short-term depletion of the provider’s revenue stream. In the licensure context, a provider might not be able to operate until its application for a new type of license is approved. Sometimes this interruption in service can be avoided by submitting new applications a significant amount of time prior to closing or by entering into a management agreement with the previous owner after closing, which can allow the new owner to operate under the old owner’s license until the new one is approved. If any of these issues are of significant concern to the investor, it should consider structuring the transaction to mitigate the impact of these requirements.

    The investor should also be aware that a government notification requirement can impact when a transaction will be able to close. Often a buyer must provide agencies with advanced notice of a transaction or obtain certain approvals before a transaction can occur. Therefore, an investor might not be able to move forward as quickly as it expected or planned. To avoid any confusion or surprises, however, regulatory counsel, the investor, and the provider should have a conversation about timing as early in the diligence process as possible.

    By nature, a private equity investor desires to maintain the confidentiality of its own ownership structure, including the financial and personal information of its investors. Unfortunately, in the world of government notifications in health care transactions, maintaining such confidentiality is a challenge. Government agencies such as CMS, State Medicaid agencies, licensing boards, pharmacy boards, and others might require buyers to disclose direct and indirect owners (in some cases those with as little as a five percent ownership interest), as well as other principals, of the provider (after giving effect to the new ownership) in connection with required notifications and/or new applications. Therefore, while the rules vary by agency, an investor should not be surprised if the government requests this type of information, and should undertake to commence the diligence process as soon as possible in order to assess the approvals and notifications that might be required in connection with the transaction.

    The Purchase Agreement as the “Catch-All”

    In an ideal world, regulatory counsel will learn about every aspect of a provider’s business during the due diligence process. In reality, however, regulatory counsel will be dealing with imperfect information and will have the chance to review only the documents that the seller is willing to provide. The purchase agreement serves as one means for counsel and the investor to try to level the playing field with the seller. As such, regardless of how the transaction is structured, the purchase agreement should require the seller to make detailed and far-reaching representations about compliance with health care laws. Additionally, the purchase agreement should hold the seller accountable for making any false statements relating to those representations and for any health care liabilities that regulatory counsel was unable to identify during due diligence in order to best ensure that the investor will have adequate recourse against the seller if any liabilities or “surprises” come to light after closing.


    While health care deals can be intimidating to unfamiliar investors and often involve unexpected developments along the way, the process can be smooth if the investor learns to expect anything. By staying in front of the issues that are bound to arise, regulatory counsel can be in a position to timely and successfully navigate the investor through the regulatory minefield and successfully close on a timely basis, while at the same time reducing risk for the investor.

    [1] This scope of this review will vary by provider type.

    [2] It is important to confirm that this general rule applies to the particular provider type involved in this transaction.