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John D. Fanburg, JD, is the managing member of brach Eichler LLC and chairman of the firm’s health law practice group.
Physicians owners must understand their motivations for selling and those of the potential purchaser for buying.
Private equity funding is offering independent physicians opportunities to monetize their medical practices in numbers both startling and enticing.
In light of healthcare reform, reimbursement reductions, the ongoing political debate regarding healthcare and how to pay for it, medical practices are being offered opportunities to monetize their medical practices in numbers both startling and enticing. Whereas healthcare systems were the primary buyer just a few years ago, private equity has changed the acquisition landscape over the last several years. Significant recent acquisitions have occurred in the specialties of orthopedics, gastroenterology, and ophthalmology.
Almost all transactions are based upon a multiple of the practice’s “EBITDA.” EBITDA is a measure of a company’s operating performance and is defined as earnings before interest, tax, depreciation, and amortization. The higher the multiple, the less the post-transaction compensation for the provision of professional medical services will be. So, depending upon the relative ages of the physicians in the practice, even though the payment at closing may be deemed “high,” the practice must assess how the future compensation and loss of autonomy and independence may, in fact, make the deal less attractive. For example, younger physicians with more years left to practice may find these deals less attractive.
Private equity firms purchase practices with the goal of merging numerous small specialty practices into one large practice that can expand the range of patient services and leverage greater purchasing and negotiating power to spread the cost of IT upgrades or management investments over a larger revenue base. To grow efficiently, these firms will approach and negotiate with dozens or even hundreds of target physician practices at one time, with only 1 to 5 percent of targets actually being acquired.
To assure that best terms are achieved or, if necessary, negotiations are terminated appropriately and efficiently, it is imperative that physicians owners understand their motivations for selling and those of the potential purchaser for buying.
Is the transaction right for the practice?
There are many reasons why practice owners may want to sell. Healthcare economics are uncertain; competition with large multi-specialty groups and hospitals is increasing; IT and other infrastructure investments are large, and financing often requires personal guarantees by the partners; and payers are increasingly reducing reimbursement. A merger or acquisition could result in cash to the owners, professional management of their practice, superior infrastructure, and greater negotiating power with third-party payers.
Before entering negotiations, the owners must be on the same page. Smart, analytical, and seasoned physicians may feel that it is best to simply invite a potential purchaser to their office to negotiate a transaction. Such an approach may not be prudent. The issues involved, including valuation, operational issues, governance, and legal and regulatory issues, are complex and outside the normal range of activity and experience of many physicians. Merger and acquisition (M&A) specialists should be hired or contracted to run the acquisition program, providing an expertise that most physician do not have and limiting the distractionfrom running the practice and caring for patients.
Physician owners must also understand that as employees in the new model, they will no longer be compensated as partners of the practice, but instead will be retained as fixed-salaried employees for a certain period of time or based on "relative value units." But while they may not be able to generate the same level of compensation that they had earned in their own private practice, they also no longer need to worry about slow years and fluctuating revenue. This stability and security is often welcomed by risk-averse and risk-seeking physicians alike, particularly in an economic climate where reimbursement rates are continually reduced by private and government payors.Another benefit is that employed physicians are not responsible for the overhead associated with running a private practice. Their only concern is maintaining their patient relationships and providing high-quality, cost-effective care.
However, physicians who once controlled every aspect of their practice soon learn that, as employees, they have very little say over management and decision-making. While some aspects of control are negotiable terms in the transaction, selling a practice may still require an adjustment period for physicians who have grown their practices from the ground up. It is not always an easy transition from owner to employee.
Determining valuation from the purchaser perspective
While a hospital or another privately held physician group may take into account community relations, professional expertise, and certain other goodwill considerations when buying a practice, private equity acquisitions are typically driven by the valuation of the target practice and the financial return the transaction will provide to its investors. From the purchaser's standpoint, there are three critical points of analysis, which are often intertwined, that help determine if they will complete a transaction and what they want to pay for the physician practice: quality of earnings, synergy, and scalability.
Quality of earnings focuses on how likely it is that the target practice's profits will continue after its acquisition. Factors affecting quality of earnings include whether the target group has long-term referral arrangements in place, dominates its geographic market, and expects third-party payer reimbursement to increase.
Synergy revolves around the degree to which costs and expenses can be eliminated, or revenues increased, in the target practice through a merger with the purchaser. Potential purchasers will analyze how administrative costs can be reduced, medical malpractice rates improved, and if a stronger negotiating position will impact reimbursements from third-party payers.
Scalability addresses whether or not the revenues of the target practice will escrow due to its acquisition by the institutionally financed practice group. For example, potential purchasers will analyze whether the transaction would increase the likelihood of the target practice acquiring additional local practices, obtaining new contracts, opening additional office locations, offering a wider range of services, or retaining more referrals.
If the stars align, a purchaser will be able to cut the target practice's costs, improve reimbursement, and increase revenue. If all of these things occur, the purchaser is in a position to pay more for the practice in the form of cash, salaries, bonuses, and stock. Often, however, the stars do not align and a valuation compromise must be reached.
It is also important to understand that, after a transaction is closed, if profits do not meet an institutional buyer's requirements, cost-cutting measures may be taken in an attempt to maintain a financial return on the investment. A buyer may not be as sensitive to non-financial issues as the physician owners were, nor will they be sentimental toward former partners or staff in seeking their financial goals.
Carefully assess the regulatory framework
Besides the valuation issues pervasive in these transactions, physican owners should also be aware of the applicable regulatory issues. It is common for publicly traded or venture-capital-backed physician practice groups to enter into management services agreements with third parties that provide a host of services to their entire organization, such as billing and collection, staffing and maintenance, and general administrative services. Because such management companies are often owned in part by non-physician entities or individuals, physicians should be careful not to run afoul of the corporate practice of medicine rules and fee-splitting prohibitions in certain states.
Entering into an agreement to sell to a private equity firm is not an easy decision to make, nor one that should be undertaken without careful reflection and analysis. Understanding the nuances of such transactions, particularly the valuation and regulatory considerations that drive them, are critical to negotiating favorable terms and getting back to what matters - practicing good medicine.
John D. Fanburg is managing member and chair of the Healthcare Law Practice at Brach Eichler LLC, a law firm in Roseland, New Jersey. He has more than 30 years of experience in health and hospital law, with an emphasis on corporate, transactional, and regulatory matters. He can be reached at 973-403-3107 or firstname.lastname@example.org.