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Physician/Hospital Collaboration and Competition in Southern California

November 14, 2007

Eric ThemmSenior Vice PresidentMedical Development Specialists, Inc.

Topics For Discussion

1. Southern California Overview

2. Current Trends and Drivers of Physician/Hospital Collaboration

3. Approach to Evaluating/Considering Strategic Options

4. Case Studies

5. Takeaways

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3

MDS: Active Areas of Work

Troubled Hospital Assistance

Strategic Planning With Financial Overlay and Risk Analysis: Strategic Response Regarding Physician Strategy for Hospitals and Systems

Affiliation/Joint Venture Development and Implementation

Valuation and Fairness Opinions (JVs, ED Call, Directorships, etc.)

Foundation Model – 1206L

Physician Needs (Shortages, Retirements, Part-timers)

Major Trends in Southern California

Ongoing challenges with escalating costs – operating, building, labor and living – Very expensive place to do business

Difficult reimbursement and payor mix challenges (uninsured, Medi-Cal)

LA County in crisis (e.g. MLK closure, ED backlogs). Private hospitals being affected (e.g. Downey, Centinela). Several in financial distress. More closures expected.

Hospital systems divesting (e.g. Tenet, CHW). Physician groups (e.g. Prime) are buying.

Highly competitive market with fragmented market share and challenges maintaining centers of excellence

4

Major Trends in Southern California

Proliferation of freestanding outpatient centers. Saturation and oversupply in some sub-regions.

– Pace of new center development has slowed– BBA has affected imaging– Ownership restructuring occurring with hospitals offered a bigger piece

of the pie in some instances

Physician group consolidation/growth and increase in

market share. Physician market share increasing on O/P side.

Difficult for hospitals to recruit doctors. Kaiser-Permanente and large groups securing a high percentage of new recruits.

5

California Age Shift

Source: OSHPD Annual Utilization Report of Hospitals 6

0

20

40

60

80

100

120

140

160

180

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Inpatient Admissions per 1,000 Persons1981 - 2004

Source: The Lewin Group analysis of American Hospital Association Annual Survey data, 1981 – 2004, for community hospitals and US Census Bureau: State and County QuickFacts, 2004 population estimate data derived from Population Estimates, 2000 Census of Population and Housing

Per

Thousa

nd

7

Total Inpatient Days in Community Hospitals1981 - 2004

100

120

140

160

180

200

220

240

260

280

300

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Source: The Lewin Group analysis of American Hospital Association Annual Survey data, 1981 – 2004, for community hospitals.

Per

Thousa

nd

8

9

Percentage Share of Inpatient vs. Outpatient Surgeries 1981 - 2004

0%

20%

40%

60%

80%

100%

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Source: The Lewin Group analysis of American Hospital Association Annual Survey data, 1981 – 2004, for community hospitals

OutpatientSurgeries

InpatientSurgeries

10

Outpatient Surgical Market Share

1998 2003 2005

Source: FASA

Number of Freestanding Ambulatory Care Surgery Centers

2,4252,754 2,864

3,508 3,5703,836

4,601

5,095

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

1996 1998 2000 2001 2002 2003 2004 2005

Source: Verispan11

Further I/P Shifting to O/P Setting

Strong growth of ASCs projected for the next 5+ years

Other centers of excellence inevitable (Radiation Therapy, Cath Labs, Retail Mini-Clinics)

Lower cost setting and technology advances will continue to shift services to the ambulatory setting

Healthcare consumerism will increase the demand for care in settings that favor customer-focused services such as more flexible hours of operation (evening and weekend hours) and ease of access (close to home, easy parking, quick turnaround times)

12

Consumerism : Healthcare the Patient’s Way

Private Rooms

Convenient Access

Documented Quality

13

Quality Expectations and Transparency

AHRQ Indicators:

Prevention, Inpatient, Pediatric, Patient Safety

This site includes ratings for clinical care, patient safety, and patient experience for the 210 hospitals in California that have chosen to participate in this important voluntary project.

CalHospitalCompare.org

In August 2006, President Bush signed an Executive Order to help increase health care transparency by encouraging the adoption of health information technology standards, the provision of options that promote quality and efficiency in health, and that pricing and quality information be made publicly available

Hospital Compare has quality measures on how often hospitals provide some of the recommended care to get the best results for most patients

Organizations working with IHI in many areas, including programs such as IMPACT Learning and Innovation Communities; initiatives such as Pursuing Perfection, Transforming Care at the Bedside, and the Safer Patients Initiative; IHI's global projects; and the work of IHI's Strategic Partners.

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15

Leveling the Playing Field

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What We Are Seeing: Physician Side

Struggles with cost escalation & growing administrative burdens of practice management

Shortage of PCPs (especially IMs) and growth of hospitalist models

Continuing and growing participation in JVs – ASC, surgical hospitals, MOBs. Desire to supplement income and have more autonomy

Erosion of solo practitioner model

Quality of life/lifestyle = key for younger physicians

Desire for state-of-the-art technology

Increase in employment & participation in integrated models

Hospital Industry Dilemma

Historical inpatient focus achieved at the expense of developing an outpatient core competency

Lack of focus and expertise (jack of all trades, master of none) created an opening for single-specialty niche providers

Focused factories have provided a more efficient, service-oriented alternative

Hospitals have been slow to respond and embrace the changing landscape

Physicians view hospitals as IP operators and they have little confidence in their OP expertise

Dependence on external OP center operators to facilitate JV deals and manage centers

17

Common Hospital Strategic Questions

What outpatient services should we focus on?

Is it too late to develop a freestanding ambulatory surgery center? Imaging center? How can we recapture the market?

Should we cannibalize our own services in order to offer a physician joint venture?

Should we develop a satellite office building/ambulatory center? What services should we offer in a satellite center?

How creative can we get with joint ventures in order to anchor our specialists?

What should we do about specialty hospitals?

How do we prevent our best physicians from being our competitors?

18

The Hospital of the Future

Much greater dependence on dedicated OP Centers of Excellence (Focused Factories) competing on service, convenience and quality of care

Smaller IP acute setting surrounded by a portfolio of OP centers/services (e.g. Cancer Center, Cardiac and Vascular Center, Urgent Care Center)

As the portfolio of services grows and becomes more decentralized, providers must create an information-enabled environment to integrate care

Many of these centers will be JV’s requiring operating expertise and discipline

19

GAC Hospital Value Proposition?

What’s the hospital’s value proposition if they’re not developing/managing the center?

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“Because of improvements in medical science, big hospitals are not needed for most treatments. You still need them for transplants, high-end oncology and very complex cardio thoracic operations, but that’s less than 10-15% of what is provided by hospitals. The rest of it can be provided by short-stay or outpatient facilities. We can do things a whole lot cheaper because we have fewer expenses and because we are a lot more efficient.”

»James Thomas, CEO of Cirrus Health, “Traditional hospital feeling the squeeze from doctor-owned specialty clinics,” Los Angeles Times, 7/25/07. (In reference to a pending orthopedic hospital partnership)

Hospital-MD Joint-Venture Imperative

Defensive Strategy: Creating joint-ventures to keep physicians from branching out independently. Partner or lose the business.

21

“Everybody wants to create outpatient buildings that tether physicians to the hospital. They’re operationally more efficient. They provide a more-satisfying patient experience. They protect – or grow – market share. And they establish more harmonious relationships with doctors.”

» Hospital Executive, “Now Entering the Outpatient Zone,” Modern Healthcare, 8/06.

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Physician/Hospital Relations?

2323 23

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What are Physician Alignment Options?

– Service Line co–management– Service Line co-marketing– Service Line Clinical Services– 1206D– Gain Sharing– Straight and Per Click– Joint Ventures– 1206L– Employment (not CA)

Low Risk

Investment

High Risk

Investment

26

ASC Case Study

Hospital System in California – 2 regional hospitals within 8 miles

Affiliated, high volume surgical group interested in ASC

Hospital concerned about losing group. Better to have part of something than all of nothing.

Feasibility process to identify options, select optimal model and frame project (financials, structure, timeline)

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Hospital Business Options (ASC)

1. Hospital Joint Ventures the ASC with Qualified Surgeons: Hospital and surgeons own and operate the ASC

2. Hospital, Surgeons and For Profit ASC Company Form Joint Venture: Hospital, surgeons and third party management company invest in ownership. Outside for-profit ASC company provides management

3. Hospital owns and operates the ASC under the Hospital License: Hospital operates the ASC without physician investors (Eliminated as an Option)

4. Surgeons form an Operating Company to Manage the Hospital ASC: Hospital owns the ASC which is operated under the hospital license. Operating company is formed as a physician venture in order to manage the ASC for the hospital

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Option 1: Hospital Joint Ventures the ASC with Qualified Physicians

Hospital501(c)(3)

51%+ ownership

Ownership Surgeons

49% or less

Terms – Free standing ASC owned and operated by a limited liability

corporation– Qualified physicians must have a third of their income from

surgery– Ownership percentages must be based on the investment

amount, not the volume of surgeries or procedures

Freestanding ASC

• Space and Equipment

• Operations and

Management

Ownership

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Option 1: Hospital Joint Ventures the ASC with Qualified Physicians

Description Free standing ASC through a limited liability company joint venture formed between Hospital and qualified physicians. Joint venture operates the ASC and profits are divided according to investment/ownership percentages.

Pros– Involves interested group of surgeons in ownership of the ASC avoiding

physician start up of separate venture or loss of volume to other competing ASCs

– Opportunity to attract Group physicians and patients– Physician ownership involvement can lead to better efficiencies and

cost effectiveness

Cons– Profitability would be greatly reduced from Hospital’s historical

performance with resulting losses for all investors– Management/performance by physician/hospital joint venture may not

be as effective as an experienced for profit company- leading to investor disappointment

31

Option 2: Hospital, Surgeons and For Profit ASC Company Form JV

Hospital ASC

ManagementCompany

ASCManagement

Company

VRC

Terms – Percentage ownership split between physicians, hospital and

management company (e.g. 40%/40%/20%)– Negotiated management fees with for profit company– Profits distributed according to investment/ownership percentages

Joint Venture

•Space•Personnel•Equipment

SurgeonsSurgeons

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Option 2: Hospital, Surgeons and For Profit ASC Company Form JV

DescriptionFree standing ASC through a limited liability company joint venture formed between Hospital, qualified surgeons and for profit ASC company. Outside for profit company operates the ASC and profits are divided according to investment/ownership percentages.

Pros– Involves interested surgeons in ownership of the ASC

preventing loss of volume to other competing ASCs – Opportunity to attract physicians and patients– Outside management and physician ownership involvement

can lead to better efficiencies and cost effectivenessCons

– Profitability would be greatly reduced from Hospital’s historical performance with resulting losses for all investors

33

Option 3: Physician Owned Operating Company Manages Hospital ASC

Hospital ASC

Surgeons

Terms – ASC location within 250 yards of hospital buildings– Physicians establish operating company to provide services

at FMV to hospital owned ASC – Ownership interest and profits based on investment

Ownership

Agreement for

management

of Hospital Outpatient

ASC

Physician Owed

Operating Company

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Option 3: Physician Owned Operating Company Manages Hospital ASC

DescriptionASC is run as a hospital outpatient department and managed by an operating company created by qualified surgeons. Joint venture services provided at fair market value and profits are divided according to investment/ownership percentages.

Pros– HOPD reimbursement is greater than freestanding rates– Involves interested surgeons in the operating company ownership preventing

loss of volume to other competing ASCs – Opportunity to attract physicians and patients– Physician ownership involvement can lead to better efficiencies and cost

effectiveness– Profitability for Hospital could be about half of historical performance based on

prior contribution margin comparisons– Retains flexibility to operate as hospital department if physicians elect not to

invest– Allows management operations, personnel policies similar to for profit company

Cons– Certain legal issues and restrictions:

» Limited distance from hospital (Medicare issue: 250 yards)» Separate building address (union contract issue)

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Key Volume and Financial Assumptions

Volume: new versus cannibalize– By service line– FFS vs MC

Volume assumption by physician

Major capital requirements

Expenses – staffing, supplies, purchased services, etc.

Other

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Example 5 Year Volume Summary

DETAILS 2005 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

Number of FFS Patients (1)ENT 213 224 235 247 259 272 Gynecology 232 244 256 269 282 296 Neurosurgery 2 2 2 2 2 3 Ophthalmology 1,087 1,141 1,198 1,258 1,321 1,387 Orthopaedic Surgery 417 438 460 483 507 532 Plastic Surgery 118 124 130 137 143 151 Podiatry 29 30 32 34 35 37 Surgery, General 162 170 179 188 197 207 Surgery, General Vascular 115 121 127 133 140 147 Surgery, Podiatric 17 18 19 20 21 22 Surgery, Urology 122 128 135 141 148 156

Colonoscopy 944 991 1,041 1,093 1,147 1,205 Sigmoidoscopy 38 40 42 44 46 48 GI 877 921 967 1,015 1,066 1,119 Total FFS Patients 4,373 4,592 4,821 5,062 5,315 5,581

Number of Hospital HMO PatientsOphthalmology 286 300 315 331 348 365 Orthopaedic Surgery 298 313 329 345 362 380 Surgery, General 158 166 174 183 192 202

GI 548 575 575 575 575 575 Total Hospital HMO Patients 1,290 1,355 1,393 1,434 1,477 1,522

Total Patients 5,663 5,946 6,215 6,497 6,793 7,104

ASC

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Option 35 Year Profit and Loss Summary (Example)

PROFIT & LOSS YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

Number of FFS Patients (1) 4,592 4,821 5,062 5,315 5,581 Number of Hospital HMO Patients 1,355 1,393 1,434 1,477 1,522

Revenue 9,168,947$ 9,612,011$ 10,079,684$ 10,569,483$ 11,012,068$ Direct Expenses (1,608,930) (1,720,185) (1,838,747) (1,964,877) (2,091,213)

Gross Profit 7,560,017$ 7,891,826$ 8,240,937$ 8,604,606$ 8,920,855$ Operating Expenses (2) (5,688,796) (5,919,352) (6,105,784) (6,279,652) (6,453,019)

Operating Profit/(Loss) 1,871,221$ 1,972,474$ 2,135,153$ 2,324,954$ 2,467,836$ Net Interest (3) 41,037 129,031 223,960 325,611 434,252

Profit/(Losss) Before Tax 1,912,258$ 2,101,505$ 2,359,113$ 2,650,565$ 2,902,087$

% 20.9% 21.9% 23.4% 25.1% 26.4%

Average Revenue Per Patient 1,542$ 1,547$ 1,552$ 1,556$ 1,550$

(1) Includes both Hospital and Group(2) Includes depreciation on $10.8m in CAPEX and TI(3) Assumes no debt. Any leasing or bank loan facilities will have to be accounted for.

Outcome

Hospital and physicians selected model

Potential short-term financial loss projected for Hospital but far less than probable outcome of physician exodus

Long-term partnership solidified (expectation)

12-15 month timeline to implement38

Surgical Hospital Case Study

Highly attractive and competitive market in CA

30 orthopedic surgeons in 3 groups looking for ownership in a surgical hospital

Physicians anxious and aggressive

Two hospital competitors looking to beat each other to market

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JV Expectations

Improved Quality– Stronger peer review– Increased peer pressure

» O.R. start times» Discharge times» Physician behavior» Core measure improvement» Care standardization» Utilization management

Improved Cost– Increased involvement in

capital decisions– Product standardization– Formulary control

Operations Impact– Employee turnover– Employee satisfaction– Length of stay improvement– Service line development

Win/Win

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Overview/Key Planning Assumptions

Dedicated, separately licensed orthopedic specialty hospital located on campus.

Approximately 60,000 square feet (dedicated use) with 4 O.R.s (5th shelled) and 32 private rooms.

Joint venture between Hospital and key orthopedic physicians. Estimate 30+ active physician users.

Spine/joint focus. Non-orthopedic services not envisioned at this time.

1,500 cases projected in year 1, growing to 2,500 within 3 years.

2 year window/timeline to complete project (facility operational in June of 2009).

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Orthopedic Hospital Development Timeline and Staging

4242

Services: In-House Versus Contracted

Service Location Comments

Administration Probably not in building Not required to be in building proper

Anatomical Laboratory Contracted with Hospital

Anesthesia In-house Pre-op and PACU capabilities

Blood Bank Contracted with Hospital

Central Sterile Supply In-house Adjacent to O.R.s

Clinical Laboratory Contracted w/ In-house (draw station)

180 square feet needed Clinical lab services and

equipment needed for “routine” lab work such as urinalysis, complete blood counts, blood typing and other tests as needed

Dietary Contracted on site; emergency food capabilities only

Provided at main hospital

Emergency None Provided at main hospital

Isolation Room In-house A private room shall be available for any patient in need of physical separation

I/P Surgery In-house 4 O.R.s (600+ sq. ft.)

4343

Core Elements of Orthopedic Hospital

Services Offered Within New Facility

ServiceSpecific

Requirements

Estimated Square Footage Comments

Operating Rooms/Recovery/Hold/

PACU/Storage/Work Spaces

4 Built 1 Shelled

13,000 O.R.s (600+ sq. ft. each)

Beds

64 semi-private 32 as private

Rooms already exist and meet/nearly meet code requirements

Minimum space requirements (Title XXII: 110 sq. ft. private; 160 sq. ft. semi-private)

Waiting Areas Main lobby/waiting area

Patient waiting space in main O.R. area

TBD

Imaging CT Digital x-ray Bone densitometer

TBD

PT/OT

Also looked at lab, pharmacy, food service, parking,

etc.

Existing space will be utilized Minimum 300 sq. ft. for occupational

medicine44

Orthopedic Hospital Space Plan

45

Preliminary Start-Up Cost Estimate

46

Item Estimated Cost ($) Comments

Construction/Renovation (New)

Seismic Upgrade

Equipment

Architectural

Legal/Consulting

Other

Total

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Example JV Financial Projections

$000’s

YR 1 YR 2 YR 3 YR 4 YR 5

EBITDA per plan (1) $ 17,120 $ 18,102 $ 19,662 $ 21,270 $ 22,094

Real Estate Lease (4,425) (4,558) (4,695) (4,836) (4,981)

Equipment Lease (5,894) (5,894) (5,894) (5,894) (4,028)

Management Fee (2,308) (2,500) (2,642) (2,791) (2,919)

JV EBITDA $ 4,493 $ 5,150 $ 6,431 $ 7,749 $ 10,166

(1) EBITDA agrees to 3 year Business Plan and Forecast Beyond

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Preliminary Conclusions

60,000 to 65,000 sq. ft. should be adequate for the Orthopedic Hospital. This correlates to 1,875 to 2,031 sq. ft. per bed. The facility does not need to be as large as some freestanding orthopedic hospitals across the country because no ED is needed and other services (e.g. dietary, pharmacy) can be contracted with the main hospital.

32 beds (in private rooms) should be more than adequate in light of projected volume. Flexibility to “ramp up” capacity will ensure that bed availability will not be an issue.

4 O.R.s should be adequate for anticipated volume assuming that capacity in an O.R. is 700 to 1,000 surgeries per year (2,800 to 4,000 total surgeries) depending on the mix of inpatient to outpatient surgeries.

30+ physician users is optimal based on the experience of other surgical hospitals across the country.

There are numerous examples of joint ventured specialty hospital across the country with the ownership “split” varying. For the facilities that we polled, physician ownership ranges from 20% to 50%.

Facility completion should be feasible within 24 months or less.

Preliminary costs for the facility are in the $15-20 million range.

4848

Legal Considerations

Choice of Entity

Structure of JV

Securities laws

Stark Self-Referral Law

Federal Anti-Kickback Statute

Licensure, Provider Agreement

49

Securities Considerations

Private placement memorandum

Accredited investors only

Residents of the state only

45 day offer period– Can be extended at Hospital discretion

Cash only from Physician Investors

Hospital will not loan money to physicians to buy units

50

Partnership Management

Informal process with some financial reporting not enough

Investing in the operational and financial infrastructure necessary to support these free-standing centers

Dedicated, engaged, seasoned specialty care “leaders” to oversee center operations

Monthly partnership financials with quarterly ops review meetings at a minimum

Research variances and prepare explanations for all key financial metrics and drivers (e.g. cash flow, capital calls/distributions, A/R and DSO status, P&L variances)

Strong communication and follow-up

No surprises!

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JV Development: Some Pointers

Transactional experience, resources and skills a must have in order to avoid reinventing the wheel with lots of room for mistakes

Realistic and conservative financial modeling (the model becomes the budget and expectation of the MD partners)

Avoid over-building and over-staffing

Leverage hospital managed care advantage vs. OON reimbursement strategy

Beware of 3rd-parties strong on sales but weak on operations (look for track record and supporting infrastructure)

Open book negotiations critical to establishing physician trust and confidence

Engage center operators in the development process

Speed to market – timely response and constant follow-up

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