“History does not repeat itself, but it rhymes,” according to a popular proverb misattributed to Mark Twain. Healthcare trends tend to be cyclical, and the 1990s trend of publicly traded physician practice management (PPM) companies infusing investor capital into medical practices has returned from oblivion in the form of private equity (PE) transactions. Like the ill-fated PPMs, PE deals offer physicians cash up front and ownership in management companies that are designed to be sold in the future at a profit, and like PPMs, PE deals claim to be in a position to consolidate physician groups to achieve greater profitability. The results may not be in for a few years, but PE firms hope to avoid falling prey to the mistakes which led to the meteoric rise and fall of the PPM industry.
For the last two decades or more, medical practices have been targeted by health systems and other investors who desired the economic benefits that could result from capturing the stream of patients controlled in large part by physicians. A Physician Practice Benchmark Survey published by the American Medical Association (AMA) reported: “2016 was the first year in which less than half of practicing physicians (47.1 percent) had an ownership stake in their practice. With this report a new milestone has been reached – 2018 marked the first year in which there were fewer physician owners (45.9 percent) than employees (47.4 percent).” The AMA’s survey noted that more than half of the shift toward employment occurred between 2012 and 2014, and that the trend has slowed considerably thereafter. Nevertheless, employment models remain attractive to physicians. The increasing cost of IT and other capital, the complexity of the reimbursement and regulatory environment, and the clinical focus and aversion to management tasks prevalent among younger physicians continues to fuel this trend.
The term “private equity” refers to non-publicly traded funds that directly invest in private companies, or that engage in buyouts of public companies. In contrast, the most prominent PPM companies in the 1990s were public. PE firms are typically organized as limited partnerships in which investors, including pension funds and other large institutional players, contribute capital as limited partners and the fund organizers manage the company as general partners. The manager/general partner charges a management fee based on a percentage of the investments under management. Acquired companies become part of the fund’s portfolio. Portfolio companies are then positioned for subsequent resale at a profit to larger purchasers.
Transactions involving professional practices face additional regulatory barriers. In Pennsylvania, as in many states, generally only licensed physicians can own a medical practice itself. (There are exceptions that allow certain other licensed healthcare professionals to incorporate with physicians). This restriction, known as the “Corporate Practice of Medicine” doctrine, prevents PE companies from acquiring direct ownership in a medical practice. One option is for the PE company to acquire the practice through a “friendly” or “captive” physician-owned entity such as a professional corporation whose physician-owner is part of the acquiring company’s executive team. The more common workaround is for a PE firm to form a management company, sometimes called a Management Service Organization (MSO), that takes on the responsibilities of providing space, equipment, staffing, recruiting, billing, collection, day-to-day management and third-party payor contracting, in exchange for a management fee paid out of the practice’s collections. The physicians may be offered an equity stake in the MSO to share in its revenues and ideally to cash in for a sizeable return when the MSO is sold. Just like the PPMs of the ’90s, right? Not quite – today’s buyers have learned some lessons from the failures of their predecessors.
Subspecialty practices, particularly ophthalmology practices, were among the first targets for private equity. Hospital-based practices, including radiology, anesthesiology, pathology and emergency medicine, followed the first wave, along with gastroenterology, otolaryngology and orthopedics. These service lines have the potential for ancillary income – lab services, diagnostic testing, therapy and ambulatory surgery centers. Purchasers also find practices who focus on elective procedures and/or self-pay patients such as infertility, dermatology and dentistry to be attractive, and are beginning to acquire primary care practices with an eye toward capturing new sources of revenue from population management/accountable care payment models.
One reason the 1990s PPMs failed was that they purchased practices at premium prices due to bidding wars, and then continued to pay the selling physicians compensation packages comparable to what they earned as private owners. The math simply didn’t work. The presumption was that with infusion of professional management and IT solutions, and the elusive “economies of scale,” costs would be brought down and enough additional profits would be generated to satisfy MSOs, physicians and investors alike. In fact, the PPMs quickly learned that many physician-owned practices had been managed as well as possible given that every dollar not spent went straight to the owners’ paychecks, so there was little if any additional profit to be squeezed. Layers of middle management added costs but did not produce the anticipated returns. It turned out that management functions were not readily scaled-up and centralized. Hospital and health system purchasers could rationalize losses on acquired practices because they could make up the difference on admissions and facility fees captured through practice ownership (the “elephant in the room” that could never be acknowledged), but PPMs could not do so. The next stop for many PPMs was Bankruptcy Court.
How do today’s buyers hope to avoid a similar fate, particularly considering that their investors often expect annual returns of 20% or more? First, purchasers have become more realistic about purchase prices and their relationship to the compensation of selling physicians. Prices for practice assets are frequently determined by multiples of earnings before interest, tax, depreciation and amortization (EBITDA), not the market-driven valuations of the past that frequently assumed unrealistic growth. However, those multiples have been increasing in the recent years, so one element of the PPM history may be in fact repeating. The higher the EBITDA multiple, the less money will be available for physician compensation after the transaction, which may present internal conflicts among the older and younger members of a group. Importantly, the first seller in a market often can command a better price than others in the same specialty, because the PE firm can use that practice as the platform from which it will attract more physicians. Those later-acquired practices are sometimes referred to as “bolt-ons.”
Selling physicians may see their salaries initially reduced, but may be rewarded instead with actual ownership, stock options, profit-sharing or “phantom” equity that reflects the financial performance of the buyer. The goal is to more clearly align the incentives of the physicians with those of the management team, a feature often missing from the previous PPM arrangements. Many PE firms claim that they will maintain a hands-off approach to clinical decision-making so that the physicians remain in control of medical matters, and in fact, state regulators may intervene if they do not honor those promises. For example, the New York Court of Appeals ruled in June 2019 that an insurer could withhold payments to practices who have ceded excessive control to MSOs and were thereby operating in violation of the state’s corporate practice of medicine rules.
As owners in the MSO entity, the physicians can participate in a “second bite of the apple” if and when that MSO is sold by the PE fund to a new owner. From the PE investor perspective, the goal is to grow and consolidate practices so that they are more attractive to a larger PE purchaser, then “flip” them for a profit, generally within three to seven years. Physicians are understandably wary that new owners may not be as responsive to their goals, or potentially bring a more top-down management style that limits their autonomy. Physicians need experienced counsel to guide them through negotiating the initial sale and management documents to protect them from overreaching by the next owners.
Some factors to consider before entertaining a PE transaction
- What are the goals of the physicians in the group? Are they aligned? Are there age disparities among the physicians which pit older physicians looking for favorable cash-out terms against younger physicians with more years ahead to practice? What about the non-owner physicians of the group – will they be fairly compensated going forward, and if they leave, how easily can they be replaced?
- Do the economics work? How confident are you in the financial projections presented that show your compensation and your anticipated returns through the MSO? Are they based on realistic assumptions? Remember, you may know your market better than a national company thinks they do. What is your personal horizon and is there an acceptable exit strategy? How much are you depending on future distributions or sale from profits that may never materialize?
- Who will control key decisions after closing? What role will the selling physicians retain? Can your group be combined with other groups that are later acquired by the PE firm, and if so, how will that impact the dynamics of your practice? Will you have any say in the selection of newly recruited physicians?
- How much will you still control medical decisions? Will your new capital partner force you to change your use of midlevels/physician extenders? Will they pressure you to see more patients in less time, or to order services you do not feel are necessary? Who will ultimately control coding, and if a payor demands a large refund, will they back you up?
- As always, make sure you seek experienced counsel before making any binding commitments. Due diligence and carefully crafted agreements can help avoid seller’s remorse later on.