With the “Silver Tsunami” rapidly approaching, national healthcare spending is projected to reach $6.2 trillion by 2028.¹ Considering the impact of the COVID-19 pandemic on telehealth, home health and the behavioral health industry, it is no wonder that more and more financiers are looking to expand their lending capabilities to the healthcare sector. However, before doing so, lenders must understand that resorting to their customary financial and legal diligence checklist will not suffice. Although lenders certainly must conduct customary financial and legal diligence, given both the federal and state regulatory oversight of the healthcare sector, they also must undertake specialized healthcare diligence as well.

Failing to understand how a company operates within its regulatory framework or whether it is in compliance with its regulators early in the process could delay closing significantly or, worse yet, stop it from happening at all. Although it would be impossible to detail all the federal and state laws and regulations applicable to healthcare related companies and the potential diligence issues that could arise in a healthcare financing, this article offers an approach for lenders to perform efficient diligence on healthcare companies in connection with a lending transaction.

The Need for Specialized Diligence

The first step toward successfully completing diligence of a healthcare finance transaction is to recognize that specialized diligence must be undertaken. Asking these simple questions will reveal whether healthcare related regulatory oversight is implicated:

• Does the borrower provide a medical service or product?
• Does the borrower regularly do business with a medical service provider or a medical product manufacturer or distributor?
• Does the borrower obtain payment for its services or products from a private health insurance company or a government reimbursement program?

If the answer to any of these questions is yes, then it will be important to understand how the company is regulated and what those regulations may mean for the company’s financial performance, the proposed collateral pool and, in some instances, the transaction structure itself. Consultation with healthcare finance and regulatory specialists will be essential. Keep in mind that the scope of diligence needed will vary based upon the type of healthcare company involved and whether the transaction involves asset-based, cash flow or real estate lending.

Which Regulations Apply?

As mentioned before, both federal and state governments extensively regulate the healthcare sector, and it would be impossible to cover all of the healthcare related laws in this article. However, whether a borrower engages in life sciences, biotechnology, pharmaceuticals, medical devices, or is a hospital, skilled nursing facility or other provider, it is certain that some or all of its business will be regulated.

The most common regulations implicated by most healthcare businesses are the Federal Anti-Kickback Statute, the Federal Physician Self-Referral Law (Stark Law), HIPPA, the False Claims Act and the Corporate Practice of Medicine just to name a few. However, which regulations are applicable will depend on which type of provider the company is and whether the provider participates in a government reimbursement program. Consequently, consulting healthcare finance and regulatory specialists is critical. Once the applicable regulations are determined, the due diligence request may be tailored to focus on whether any of the regulations affect:

• The structure of the lending transaction
• The collateral pool
• A borrower’s financial performance, especially if the borrower is out of compliance with the regulations

For example, if the borrower is an anesthesiology center owned by a private equity sponsor, then state corporate practice of medicine laws (which vary from state to state and may restrict or prohibit an entity that is not licensed to practice medicine from owning and operating a medical practice) may affect how the lending transaction is structured. When it comes to a borrower’s financial projections, a lender will want to know whether there are any impediments to the projected performance. For example, if the borrower is a pharmaceutical company, it would be important to know whether the borrower has recently received any FDA warning letters that could potentially impact the company’s ability to manufacture and distribute pharmaceuticals or if it has failed to obtain FDA approval for a new product.

Accordingly, at the outset, before the diligence request is even drafted, a lender should ask a few crucial questions of the borrower regarding its compliance with regulations. These initial questions will facilitate an efficient and appropriate approach to the diligence process. Again, these questions will depend on the company’s business, with examples including:

• Is the company currently negotiating or subject to a Corporate Integrity Agreement related to non-compliance of regulations?
• Is the company currently negotiating a settlement for a material overpayment with a third-party payor such as Medicare?
• Is the company aware of any whistleblower suits filed against it?
• Is the company subject to any civil monetary penalties resulting from the failure to comply with regulations?

Asking these types of questions early in the process will avoid surprises later and enable a lender to evaluate associated risks.

How is the Borrower Paid?

One of the initial questions in every secured lending transaction is: What is the collateral and who owns the collateral? Answering this question in a healthcare finance transaction may not be as straightforward as in other financing arrangements.

First, the types of payors a healthcare company contracts with may vary. Typically, healthcare providers will receive a mix of payments from government reimbursement programs (such as Medicare and Medicaid), commercial insurance companies and patients themselves (which is known as self-pay).

Second, the entity controlling the receivables may not be the ultimate owner of the receivables. With respect to Medicare/Medicaid payments, these payments may only be made to a provider that is licensed and maintains the provider contract with Medicare/Medicaid. So, using the anesthesiology group example again, while a management company running an anesthesiology group may “control” these receivables, it is not the “owner” of the receivables because only the licensed anesthesiologist/provider is entitled to payments from Medicare/Medicaid.

Third, providers participating in government reimbursement programs may receive additional compensation through programs other than traditional Medicare/Medicaid, including quality assurance fees for hospitals or enhanced reimbursement for skilled nursing facilities via participation in an upper payment limit program (UPL). If so, a lender will need to understand how and to whom these payments are made as well as what would happen to a borrower’s financial performance if the payments were delayed for any reason, if the borrower were no longer entitled to participate in the program, or if the program was eliminated.

The CARES Act, specifically the CARES Act Provider Relief Fund and Medicare Accelerated Payments Program, adds to this complexity. Consequently, lenders also should inquire about both general federal aid and healthcare focused aid, including:

• Has the provider received any grant money from the federal government through the Provider Relief Fund Program? Has the provider complied with the required reporting for the grant?
• Has the provider received any advance payments of its Medicare billings and how does it intend to repay those funds?
• Has the provider deferred any payroll taxes and how does it intend to eventually catch up on these payments?
• Has the provider obtained any Paycheck Protection Program loans and has the provider complied with the rules for forgiveness?

Once a lender understands the support the borrower has obtained as well as its anticipated impact on future cash flows, the next step will be to determine how this support should be treated in accordance with loan documentation covenants and, in particular, any financial covenant definitions.

Lastly, and in particular with a new presidential administration, lenders must be aware of any federal government policy changes and legislative investigations that might impact a borrower’s source of repayment, such as Medicare and Medicaid reimbursement cuts or legislation regarding drug pricing.

There is no doubt that there are unique considerations for healthcare finance deals. Asking questions focused on the key areas outlined in this article early and conducting specialized healthcare diligence along with customary financial and legal diligence will pave the way for a more efficient and tailored diligence process and, ultimately, a smoother execution.

1. NHE Fact Sheet, CMS Medicare and Medicaid.

Stacy Hopkins is of counsel at Paul Hastings. Her finance and restructuring practice focuses on commercial finance and creditors’ rights. She advises clients on structuring, negotiating and documenting cash flow and asset-based transactions across all lifecycles of a loan. Prior to rejoining Paul Hastings, Hopkins served as senior vice president in the healthcare finance group at Wells Fargo Commercial Capital.