Last week we published an article discussing the nuances of investing in a healthcare business with heavy “out-of-network” reimbursement. We get a lot of questions from funds and lenders on this topic as such investments involve very specific regulatory and business risks.

Here is the article, which originally appeared on Law360. It is written by Geoff C. Cockrell, Amber McGraw Walsh and Barton C. Walker, McGuireWoods LLP, and Tammy Hill, McGladrey LLP.

For several years, industry observers have been predicting the demise of out-of-network business models, yet they still survive. For some providers in certain specialties and certain geographies, a predominantly out-of-network business model works well and can be a positive way of setting that provider apart from its peers. But for other providers, such a model poses challenges for sustainability.

If you are thinking about investing in an “out-of-network” provider business, how do you assess the magnitude and probability of the unique risks associated with such a business model for a particular target? It can be difficult. To begin to understand the risks, you need to first understand the dynamics of the relationship.

An out-of-network health care provider business is one where a significant amount of the revenue is generated from commercial insurers with whom the health care provider does not have a contract. An example might be a dermatology practice whose patients generally have insurance coverage but the practice does not have a contract with most dominant insurance companies.

This can be a significant difference. The practice may have a standard rate structure that is three to four times higher than the in-network contract rates. Without a negotiated rate in place with insurers, the providers default to their “usual and customary” charges. Some practices bill on an out-of-network basis while they are pursuing participation agreements with payors. Others have chosen to adopt out-of-network as an ongoing business strategy.

In some markets, payors have narrowed the provider networks or have ceased enrolling new providers altogether. This can present a dilemma for providers. Although the practice might desire to go “in-network” in order to gain access to the broader patient base of the payor, there may be strong economic incentives to remain out of network and attempt to collect the higher billed charges.

Payors, of course, would prefer that their patients utilize in-network providers with whom they have prearranged rates. Among other nudges to push patients toward in-network providers, payors usually require a much higher copay (perhaps 40 percent out-of-network vs. 20 percent in-network).

As a working example for this article, let us consider a procedure that has a $5,000 standard out-of-network rate and a $1,500 contracted in-network rate — this wide of a distinction is not atypical. The patient has a 40 percent ($2,000) copay on the out-of-network service and a 20 percent ($300) copay on the in-network service.

Payor Levers

Copay Challenges. Staying with the example above, there are a couple of areas where things can get sticky. You can see how a provider would prefer to remain out of network even if the patient was unable to pay the 40 percent copay because the $3,000 payor portion for out of network is more than the entire $1,500 in-network payment. That dynamic creates an economic incentive for a provider to charge out-of-network rates while letting the patients slide on the out-of-network copay and creates suspicion on the part of payors that out-of-network providers are doing exactly that.

Not surprisingly, we have seen a significant uptick in cases brought by insurers alleging that providers are waiving or inappropriately reducing the patient copay in order to induce the out-of-network patients. On the other hand, there is no requirement that a provider sign an in-network contract with any particular payor. Further, most providers are not unscrupulous and handle the patient copay obligation in a fair and professional manner.

Increasing Patient In-Network Inducements and Out-of-Network Pain. Another way that payors can exert pressure is by adding to the in-network incentives and out-of-network disincentives. For example, payors have been increasing the patient portion of out-of-network charges. This obviously puts pressure on the copay challenges noted above.

On the incentive side, payors can reduce or eliminate the patient copay for certain types of in-network services like urgent care visits. While these measures have always been present for out-of-network businesses, the pressure is steadily increasing and is arguably compounded by more employers moving to plans with higher deductibles.

Administrative Burdens. Whether making reimbursement payments directly to the patient (increasing collection risk for the provider) or slower claims processing, payors have the ability to make the life of an out-of-network provider difficult. With payments made directly to patients, providers can have serious problems collecting from the patient. Note that many states have clear assignment of benefits rules that payors (and providers) must obey. Payors are also beginning to more aggressively deny offset payments where they perceive overpayments or abusive practices to be occurring.

Influencing Out-of-Network Referrals. Payors have also become better at influencing out-of-network referrals. While payors have different levers to affect this, the significance to an investor is that out-of-network businesses rely on referrals from in-network physicians and as a result could face pressure on those referral streams.

Assessment of Risk Variables and Mitigants

The issue for a buyer is that you are likely paying seven to 10 times trailing earnings before interest, taxes, depreciation, and amortization (EBITDA) for this business (maybe more) and it is imperative that you understand the probability that some portion of historical cash flow may be at risk going forward and understand the magnitude of that risk.

This requires a clear understanding of both the magnitude of the risk and probability that such risk will be realized. Magnitude and probability, in turn, fluctuates on a number of variables that can mitigate or aggravate such risk. The following items are intended to be a brief introduction to the factors that should be considered by an investor.

Percentage of Revenue and EBITDA. Obviously, the greater the percentage of business that is out of network, the greater the magnitude of potential risk. It should be noted, however, that even moderate percentages of out-of-network revenue can represent much higher percentages of EBITDA on account of the significantly higher margin of out-of-network business.

Payor Concentration. Since out-of-network risk in part tests payor reaction to the out-of-network business, higher payor concentration raises the risk that adverse actions by one or a limited number of payors could have a material impact on the business. A more diversified payor mix lowers that risk. Trends or expectations for payor consolidation should also be considered. In a given geographic market, a merger between payors could significantly change the landscape of a provider’s payor mix.

Actual Rack Rates. Not all out-of-network rates are the same. A very high rack rate puts pressure on a number of elements. It obviously increases the magnitude of cost of signing a contract with the payor. It also increases the payor’s willingness to take more aggressive actions to pressure the provider to sign a contract. Lastly, if the out-of-network rate is above the payor’s notion of “usual and customary” rates, the payor will have other levers to exert pressure on the provider as discussed above.

Very high rack rates obviously help margin but that margin comes at a cost of increased risk. Comparisons of the provider’s OON rates, in-network contractual rates and publicly available UCR rates can be helpful in assessing the risk and sustainability of the provider’s revenue and margins.

Modeled Impact of Going In Network for Key Payors. It would seem obvious, but nothing can replace modeling out the likely impact on the business of going in network even if it is thought that going in network is not a likely scenario.

Changes Over Time and Recent Trend Line. A snapshot of the out-of-network picture (revenue and EBITDA percentages, concentration, etc.) is not as informative as understanding the trend line on these issues. A business that has been moving steadily toward in-network contracts looks different than one that has not. A business that has been slowly moving rack rates up or down in comparison to likely in-network rates raises different concerns than one that has not. It is important to note changes in the service offerings of the providers as well.

In some respects, as payors crackdown on out-of-network abuses of some ancillary services, there can be temptation to replace those services with other business lines. This type of “shell game” is not generally viewed as sustainable. Another situation that is becoming more common is the difficulty for providers in renegotiating expiring in-network contracts. In some cases, the provider may choose to go out of network rather than accept significant reductions in contractual rates. A buyer’s diligence procedures should include obtaining an understanding of current contract negotiations and how the likely changes might impact future top-line revenue and profitability.

Availability of In-Network Contracts. Many payors are moving toward narrower networks in an effort to gain leverage on rate negotiations with providers. In some markets, payors are not looking to expand with new providers. This dynamic can change the analysis of out-of-network risk, but requires highly localized analysis of specific market conditions. Good-faith efforts to attempt to contract with payors (while obeying other applicable out-of-network laws) can be a strong argument in favor of providers.

Evaluation of Billing and Collection Policies. It is imperative in any out-of-network investment that the investor thoroughly reviews the actual billing and collection practices with respect to patient copay obligations and notifying payors of those collection efforts. When there are issues, they are usually not black and white conclusions. Collection practices fall on a spectrum of gray. It is important to understand exactly where a provider’s practices fall on that spectrum.

Evaluation of Methodology Used for Estimating Allowances and Reserves. As part of the above mentioned evaluation of billing and collection policies, it is also important during the due diligence process to understand and evaluate the provider’s methodology for estimating and recording net realizable revenues for OON services.

Most providers use historical experience to estimate the amounts that will ultimately be collected from payors and patients for OON services. However, there is a wide disparity of the level of detail and the predictive quality of the historical experience used. For example, the use of general overall averages for historical collections would likely not be as accurate as the use of detailed historical collection experience for specific payors. Also, market changes and the evolving payor practices described below take some time to be captured in historical averages and can result in understatements of reserves and overstatements of EBITDA.

Evolving Payor Practices. It is a good idea to understand how payors are behaving with respect to out-of-network practices both generally and with respect to specific sectors and states and how that behavior is evolving. Certain jurisdictions (and even certain courtrooms) are hotbeds of litigation. To complicate matters, out-of-court settlements of these types of disputes are often not published.

Specific Payor Posture. It is also a good idea to know how aggressively specific payors in the provider’s payor mix are responding to these issues. Not all payors are reacting in the same manner. Payor concentration certainly ties to this analysis as well.

Any Smoke Already? Has the provider already had run-ins with one or more payors? While payor disputes on this topic are not uncommon, especially with some of the more aggressive payors, it can be an indication of a rougher road to come.

Elasticity of Demand. Some practices enjoy inelastic demand for their services — meaning higher patient copays do not reduce the demand for their services. Smaller components of larger bills and practices where a referring doctor is the more visible component (like an anesthesia group’s charges on a larger surgery) tend to be less affected by the price differential of out-of-network rates. It is unlikely that a patient is making a major surgery decision based on the out-of-network rate of a smaller component of the cost.

Platform vs. Add-On. An add-on acquisition to a larger strategic platform usually has some natural advantages in this analysis. They have much better benchmarking for pricing and collection practices. They also likely have better payor contacts so the thought of going in network might not be as threatening.

It is almost impossible to invest in health care providers and completely avoid out-of-network risk. Understanding the magnitude, probability and trend line of that risk is critical for health care investors. The risk can often be managed or contained through pricing and indemnity in the course of a transaction, but the first step is a clear understanding.

Geoff Cockrell and Amber McGraw Walsh are partners in McGuireWoods’ Chicago office. Barton Walker is a partner in the firm’s Charlotte, North Carolina, office. Tammy Hill is a partner, transactional advisory services, in McGladrey’s Chicago office.