A well-run and well-prepared practice can be very attractive to private equity investors
In recent years, there has been a tremendous growth in the number of physician practice transactions with private equity across multiple specialties. In fact, 2021 saw the highest number of deals in this sector, fueled in part by low interest rates, pent-up volume from the 2020 COVID backlog and a fear of change in the capital gains tax rates from a change to the Biden Administration. In our view, valuations during this time were at an all-time high and added more fuel to deal volume. A change in macroeconomic factors in the latter part of 2022 and into 2023, has impacted deal volume, but valuations remain strong despite these changes. This article discusses these recent valuation trends and our predictions for 2023.
Consolidation in the physician practice management space began over 30 years ago with the trend being catalyzed by the ‘roll-ups’ of the 1990s.While the concept was widely celebrated, most roll-ups ultimately failed as promises to unify practices by providing business support never materialized. Despite these early failures, private equity investors eventually tried a management services organization (MSO) model designed to provide non-clinical, administrative support services to acquired physician practices. This model proved effective and investors achieved widespread success across specialties like dental, dermatology, and veterinary from the early 2000s through the mid-2010s. The success of private equity investors in these sectors prompted many physicians to eventually take notice and explore ways to participate in the opportunity. The model evolved from an all-cash buy-out to a partnership framework, where doctors retain some equity (or roll-over equity) as part of the transaction consideration.
As the partnership model gained momentum during the mid-to-late 2010s, private equity investors began entering into other unconsolidated medical specialties like urology, ophthalmology, gastroenterology, ENT and allergy, orthopedics and cardiology.From 2015 to 2019, transaction volume for physician practices increased over 25% year-over-year. However, the impact of COVID-19 caused transaction volume to plateau in 2020 with the U.S. government mandating temporary closures of physician practices for all non-emergent procedures. As the world paused, so did the M&A volume. This pause created massive pent-up demand by private equity investors needing to deploy a large amount of amassed capital into health care companies.
Once practices reopened after the height of the pandemic, we observed private equity investors flood the market resulting in a resurgence of M&A activity. Sellers were the net beneficiaries as the supply-demand imbalance drove transaction multiples well beyond previous all-time high levels.Transaction volume nearly doubled from already historic levels in 2019 and 2020. Robust transaction volume continued from 2021 into early 2022, fueled by record low borrowing costs, demand from private equity ready to deploy capital into health care companies, and the impending fear of changes to the federal tax code.
During this time, a new cadre of investors entered the consolidation frenzy. New entrants included large national and multi-national pharmacies (Walgreens and CVS), payors (United Healthcare, Aetna), global retailers (Walmart and Dollar General), and even Amazon, via its acquisition of One Medical. In 2023, physician groups are once again the net beneficiaries of evolving dynamics in health care and now have a variety of alternatives to consider for potential partnerships.
Prevailing Market Conditions
While we observed private valuation multiples in 2021 and 2022 eclipse previous record levels, the broader U.S. economy experienced rapid inflation with rates exceeding 9% by the end of Q2 2022. The Federal Reserve intervened by drastically raising rates to mitigate inflation, resulting in a near doubling of borrowing costs over just a few months. In response, we observed the syndicated loan market temporarily pause its lending to large platforms in Q4, carrying over to Q1 2023.
Fast forward to 2023, large recapitalizations are on hold until later in the year, and consolidators are focused on integrating recent acquisitions while also pursuing organic growth initiatives to drive value creation. This internal focus benefits the consolidators operationally and financially - through business improvement, system conversion and integration, compliance and unification of processes and protocols to name a few. With stronger platforms and optimized practices, these companies will likely be more attractive to future buyers.
For these reasons, we believe 2023 is shaping up to be the “Year of the Add-On”, where private equity-backed consolidator platforms are focusing on small and medium sized acquisitions in lieu of pursuing their own platform recapitalizations. This aligns with buyer sentiment now focusing on companies that have demonstrated organic growth and value creation at the practice level, a completed integration of the practices (EHR and PMS) and a unification of systems, processes, and protocols. Quality add-on acquisitions are now the focus of these buyers.
Key Considerations for Independent Physician Practices
Due to the high-cost debt environment, we have observed private transaction multiples decrease by one to two-plus turns of EBITDA. Despite this, we believe M&A demand remains robust and the fundamentals behind consolidation remain. However, we are observing buyers being more discerning on the financial performance for selling practices. Specifically, buyers are evaluating and underwriting reported EBITDA with a higher level of scrutiny around adjustments, add-backs and pro-formas that, previously, were widely accepted. Buyers are dissecting every EBITDA component to thoroughly evaluate the viability - de novo maturation, ramping of new physicians, ramping from growth initiatives, projected savings from renegotiated contracts, compliance with health care laws, etc.
Buyers have reverted to traditional corporate finance fundamentals to evaluate acquisition opportunities. In our experience, higher multiples are paid for practices with a demonstrated history of organic growth, consistent financial results, and opportunities to attain future growth (both organic and inorganic). It is important to remember that each physician practice is unique and not all EBITDA is evaluated equally. Key value drivers for physician practices include size and scale, clinical reputation, level of professionalization of the MSO or non-clinical functions, historical and prospective growth, geographic and/or strategic alignment, pipeline of M&A opportunities, existing payer contracts, and compliant relationships with referral sources, etc.
In our opinion, physician practices are in the enviable position of having available a variety of potential capital partners while valuation multiples are at robust levels. Therefore, we recommend practices considering exploring strategic alternatives should start preparing as early as possible and get their “house in order” by conducting a comprehensive internal evaluation of their own operations, financials, and legal compliance to identify areas of improvement and potential risks. A thorough due diligence process can be laborious, so advanced preparation for conversations is critical. Further, having time to engage with third party advisers across investment banking, legal, regulatory, accounting/quality of earnings, real estate, tax, and wealth management can best position the practice to achieve their goals and objectives. We believe these advisors can help identify potential strategic partners and provide guidance on valuation and transaction structuring. In this environment, preparation is key to ensuring receipt of the highest valuations and the smoothest, cost-effective transaction process.
Rich Blann is the managing director in DC Advisory's global health care team.
Anjana D. Patel, JD, is a member of Epstein, Becker, Green.