Regardless of your political perspective, the impact of the Patient Protection and Affordable Care Act (“PPACA,” and commonly referred to as “health care reform” or “Obamacare”), on a business’s health care costs is something every buyer and owner of businesses should strive to understand. This article briefly summarizes how private equity firms should think about health care reform when looking at acquisition targets and monitoring their portfolio companies and points out some red flags.

For purposes of this article, health care reform has three important mandates, which are currently scheduled to become effective on January 1, 2014.

All citizens should have health care— the “individual mandate.” PPACA mandates that all United States citizens have health care coverage. To that end, PPACA imposes fines on individuals who are not covered. To assist citizens in obtaining coverage, PPACA contemplates that states will set up “exchanges” where coverage may be purchased from participating insurers. In addition, lower-income citizens who purchase coverage through an exchange may be eligible for subsidized premiums.

Employers should continue to be the main source of health care for individuals who work. While there is no requirement that employers provide health care at specific levels, or at all, PPACA imposes fines on employers who do not offer health care to their employees. Specifically, if (1) an employer employs at least 50 full-time equivalent employees during a calendar year and does not offer coverage to all full-time employees and (2) at least one of the employer’s full-time employees receives subsidized insurance on a state exchange, the employer must pay, on a monthly basis, a nondeductible tax of $2,000 per full-time employee per year. For this purpose, a “full-time employee” is an employee who works at least 30 hours per week. So a large penalty could be triggered by only one full-time employee obtaining insurance through a state exchange and receiving a subsidy.

Employer health care should be affordable and provide good value for the money. If an employer offers coverage to its full-time employees but that coverage is not “affordable” and does not provide “minimum value,” the employer must pay a nondeductible tax of $3,000 per year for each full-time employee who obtains coverage on a state exchange and qualifies for the premium subsidy. This tax is also payable on a monthly basis. Note, although this $3,000 penalty tax is higher than the $2,000 penalty tax described above, the $3,000 tax is not applied per full-time employee—it is only applied with respect to each full-time employee who receives subsidized coverage from a state exchange. Coverage will be “affordable” if the employee’s contribution to the health plan for employee-only coverage does not exceed 9.5% of the employee’s household income. “Minimum value” means that the plan must cover at least 60% of the plan’s total allowed costs (e.g., copays, deductibles, coinsurance, etc.) on an actuarial basis (i.e., taking the entire population as a whole) or another method approved by the IRS.

There are two points that should be highlighted with respect to the three health care mandates described above. First, PPACA does not require an employer to offer health insurance at all, as long as the employer is willing to pay the penalty tax. And, it is conceivable that for some employers paying the tax will be cheaper than offering coverage, although to our knowledge no large employer has yet stopped providing coverage. (AT&T made headlines in 2010 when an internal powerpoint presentation surfaced that purported to show that dropping coverage would cost the company $600 million per year in penalty taxes (albeit nondeductible), while providing coverage would cost over $4 billion per year.) Second, the requirements of affordability and minimum value do not require the employer to offer any specific levels of coverage. Thus, it appears that an employer could comply with PPACA by designing a low-cost plan with extremely limited coverages. To our knowledge, no large employer has yet taken this step either.

In light of these mandates, private equity firms should be on the lookout for the following red flags during their diligence review of acquisition targets and in monitoring portfolio companies:

Part-Time Employees. PPACA defines a “full-time” employee as one who works 30 or more hours per week on average, as determined on a monthly basis. Proposed IRS rules would provide that 130 hours in a month is full-time and that full-time status includes up to 160 hours of paid time of for specified periods. For many companies, this definition of “full-time employee” will depart from how the part-time workforce has typically been viewed. Many employers have employees classified as “part-time” who, periodically or on a seasonal basis, work at levels that would be deemed full-time under PPACA. Many employers also do not have computer systems that track hours on this basis with specificity. If an employer classifies employees as part-time but PPACA classifies them as full-time, and one of them obtains subsidized coverage on a state exchange, the penalty tax will be triggered for all full-time employees. However, proposed regulations do offer some relief for seasonal workers hired for only a few months. Compliance with these rules is likely to be both imperative and costly at some acquisition targets and portfolio companies, as a single mistake could trigger a massive penalty tax.

Changes in Projected Employee Costs. We expect that many employers will need to restructure their health plans to provide for more levels of coverage than may have been provided historically. Thus, an employer who previously offered only very expensive coverage (i.e., high employee premiums, or coverage that is simply expensive when compared with employees’ wages) may need to (1) establish more levels of coverage so that lower-wage employees can find an affordable coverage option and (2) bear more of the costs of the coverage so that the plan provides minimum value. Both of these changes are likely to increase health care costs of the employer. This increase is likely to be seen in particular at employers with lots of low-wage workers, as PPACA also phases out annual and lifetime benefit limits between now and 2014. There is some indication that enrollment has already begun to rise because of some of the aspects of health care reform that are currently in effect (e.g., coverage of dependent children until age 26).

Low Historical Employee Uptake. In light of the individual mandate and the very serious question as to how successful the government will be in establishing the state exchanges, it is likely that more employees who have historically opted out of an employer’s coverage will begin to accept the employer’s coverage. This is especially true at employers that adjust their plans to provide for affordable coverage options at minimum value. Thus, diligence and cost projections as to historical trend rates on uptake by employees may need to be closely examined, as future enrollment may be greater than historical enrollment. Another feature of health care reform— required automatic enrollment, which begins in 2014—should further increase employee uptake.

What Peer Companies Are Doing. As noted above, while many employers are discussing dropping coverage or imposing very low-cost alternatives, to our knowledge, no large employer with a national reputation has yet done so. Private equity sponsors should consider whether they want to be “first movers” on these matters, in light of the inevitable negative publicity that would follow. In addition, an employer who does not offer coverage, or who offers low-cost coverage, may be at a competitive disadvantage in recruiting and retaining talent. In this regard, the strategies of competitors should be closely followed. These strategies may include improving coverage; dropping or decreasing coverage and increasing wages; reducing headcount; or increasing headcount but strictly enforcing limitations on hours worked. Because the tax penalties for non-compliance are nondeductible while health care costs and wages generally are deductible, the tax impact of the different strategies would also need to be taken into account.

Maintaining or Losing Grandfathered Status. Certain provisions of health care reform not described in the article, but which nonetheless have an impact on cost, do not apply to “grandfathered” plans. A grandfathered plan is one that was in effect as of March 2010 (when PPACA was enacted) and that is not materially modified after that date. Loss of grandfathered status may occur because of changes that form part of the private equity sponsor’s investment case or because of normal course changes at the portfolio company. However, not all modifications to plans will cause them to lose their grandfathered status.

Consequently, sponsors should take care in understanding whether plans are grandfathered and what the costs associated with loss of grandfathered status may be, as the costs of losing that status would be incremental to the cost of the contemplated plan changes.

In our experience, nearly all employers affected by health care reform have already undertaken studies of the costs of health care reform and available alternatives, either by management or by third party experts. Thus, most targets and portfolio companies are able to speak knowledgably about the potential changes to their businesses now, even though full effectiveness of the matters described in this article is over a year away. Some employers are making only the minimum required changes to their plans, and are putting of any large-scale planning until after the presidential election, although the rationale for waiting is now weaker in light of the recent Supreme Court decision upholding PPACA. For a private equity buyer, paying attention to these lurking costs now is a necessary feature of any diligence process and the related development of the investment case for the acquisition. Private equity sellers should also plan on potential acquirers doing the same with respect to their current portfolio companies.