Valuations performed in 2020 may look considerably different than those in 2019. Global financial markets are destabilized due to the Covid-19 pandemic. In the United States, federal, state, and local governments have instituted various public health policies designed to help mitigate the spread of the virus. Many “non-essential” businesses have been shut down, and those that do remain open have seen traffic negatively impacted by stay-at-home orders and social distancing requirements. Forecasting benefit streams and quantifying risk in the current environment present many unique challenges.
In light of COVID-19, elements of business valuations to consider include:
Valuation Date. Valuation professionals should only consider what is known or knowable as of the valuation date when determining the conclusion of value for the subject interest. The timing of the valuation date could have a significant impact on valuations, particularly those for gift and estate taxes, Employee Stock Option Plans (ESOPs), and Buy-Sell Agreements. Given the fluidity of COVID-19 events and the variable responses to the evolving pandemic, determining the date by which COVID-19 is considered a known or knowable event is a grey area. Courts have on occasion relied on subsequent events to guide valuation opinions. In both the Estate of Scanlan and Estate of Jung the Tax Court used transactions that were two years after the valuation date to establish value. In Estate of Cidulka they used a transaction that was four years later.
Discount Rate. The components of the Discount Rate generally include (1) a Risk-Free Rate, (2) an Equity Risk Premium, (3) Small Company Size Premium, and (4) Company Specific Risk. On one hand, current interest rates on treasury bills are at historic lows suggesting that the current Risk-Free Rate of return in the market is significantly lower today than it was a few months ago. On the other hand, few would argue that there is less risk in the market today so discount rates must be higher. In order to fully account for current market conditions it may be necessary to normalize both the Risk-Free Rate and the Equity Risk Premium and adjust the Company Specific Risk to capture the immediate and longer term effects of the pandemic in relation to the specific investment being valued.
Market Comparables. Valuators will need to nuance the Market Approach in coming months as the multiples relied upon in the past may bear little resemblance under COVID-19 economic conditions. If the pandemic proves to be short-lived, then adjustments could be made for its economic impact based on the expectations that growth rates would return to normal in the foreseeable future. If the pandemic persists into 2021, the impact may increase, and valuators would then need to reassess what the new “normal” would look like in terms of growth and risk going forward.
Growth Rate. Many valuation approaches rely on projected growth rates when determining a conclusion of value. The methods used under the Income Approach can be particularly sensitive to changes in the growth rate projected. For example, the projected constant annual growth rate in perpetuity is a key input in both the Capitalization of Earnings Method and the calculation of the terminal value in the Discounted Cash Flow Method. The effects of even small reductions in the growth rate can be amplified if other inputs such as debt and the discount rate increase at the same time. In the United States, the healthcare industry has historically grown faster than the overall economy due to the aging population, the high costs of advanced technology, the third-party reimbursement system, and other factors. Although this still may be the case following the pandemic, the industry faces challenges as patients, providers, and payors try to find their way through in the interim. Will patients limit elective procedures for an extended period? How will providers increase volumes while also taking steps to maximize the safety of their patients and staff? Will these changes become permanent?
HMS Takeaways
Having served clients for nearly three decades, including those affected by Hurricane Katrina, HMS experts have the knowledge to navigate current challenges and assist clients in completing COVID-impacted business valuations. Business valuations going forward will vary depending upon the type of entities involved in the transaction. Hospitals that are financially viable will continue their acquisition activity only if it is critical to their strategic plan, while other less fortunate hospitals may be forced to merge or be acquired. Physician groups will be looking to merge and/or partner with private equity firms or health systems. Operationally, ambulatory surgery centers (ASCs) will look to the reopening with focus on meeting the demand for elective surgeries, while stakeholders will have an eye toward the impact of the pandemic on buy-sell provisions. The level of transaction activity as well as the impact from COVID-19 will be specific to the sector within the healthcare industry.
Should you need transaction advisory services and/or require a healthcare entity business valuation, do not hesitate to reach out to an HMS expert for guidance.
