John M. Harris
Karin Chernoff Kaplan
Many physicians have become disenchanted with joint ventures, creating opportunities for hospitals; but it’s important to keep the physicians engaged.
At a Glance
- Strong hospitals and health systems should be on the lookout for opportunities today to acquire physician businesses at depressed fair market values.
- In some instances, an outright purchase of physicians’ interest in a physician-hospital joint venture may be preferable; in others, the hospital may benefit more from simply increasing its interest in the venture.
- A critical part of the strategy should be taking steps to ensure the physicians remain engaged, including addressing physicians’ income goals and need for control.
It seems like only yesterday that physicians were clamoring for hospitals to partner with them on joint ventures. Many hospitals found themselves being dragged reluctantly into a joint-venture ambulatory facility—an ambulatory surgery center (ASC) or an imaging center, or radiation oncology, endoscopy, or some other service. In some instances, the venture could even take the form of a surgical specialty hospital.
Hospitals went along with these deals chiefly for two reasons: because they saw that half of a pie is better than no pie, or because they realized that if they didn’t do it, one of their competitors would or the physicians might bring in an outside partner.
But in the current economic environment, joint ventures, as well as some physician-owned independent businesses, have become less attractive to physicians. (See the sidebar “What’s Driving the Trend?” following this article.)
If your organization has been party to a physician-hospital joint venture, you may already have noticed this change of heart among the physicians involved. It’s possible the physicians have asked you to consider buying them out. It may be a good idea to do so, but it also may be in your best interest to offer to purchase a larger interest or a controlling interest in the existing entity—thereby keeping the physicians in it, albeit in a diluted fashion.
Savvy organizations should be on the lookout for such opportunities. And when an opportunity presents itself, they should ask many of the same questions they asked when they entered a joint venture in the first place:
- Will the business succeed in the current market?
- If we don’t buy the business, will a competitor acquire it and damage our competitive position?
- Can the facility be converted to a hospital outpatient department (HOPD), improving revenue and possibly meeting a facility space need?
But there’s also a twist today—one that requires an important additional question: How should the deal be structured to keep the physicians interested in the success of the business, even after they are no longer owners?
Be Ready—and Circumspect
Stronger hospitals and health systems should be ready to step in, taking advantage of physicians’ desire to sell and the organization’s ability to meet their needs. An important caveat is that, as with all transactions with physicians, any deals would need to be at fair market value—in this instance, a depressed value.
As a joint venture partner, it is easier to know when an ambulatory business is shifting from profitability and when physicians may want to sell. It is less obvious for an independent physician-owned business. Be on the alert for the signs that an opportunity may exist, as it is important to identify opportunities before the physicians seek help from a competitor.
Being ready to act on such opportunities may require setting aside some of the limited capital resources available to your healthcare organization in these tight credit markets for just such an opportunity. As credit markets ease, these resources can be bolstered by partnering with third parties that want to finance and own the facility. Such partners can stretch limited capital resources by moving the debt associated with the facility off the hospital’s books. For example, a hospital may want to partner with a real estate investment trust or developer to own the land and/or real estate and lease it back to the venture.
If neither of these approaches is viable, you may need to let the market play out. You may see the value of your ownership stake in a joint venture decline significantly. Or you may see your competitors seek to step in. Nonetheless, the best strategy may sometimes be to allow an independent business or joint venture to fold. It is important to keep this option in mind as the financial modeling is pursued.
Be careful, as well, to seize the opportunity without rattling the physicians’ egos or triggering the competitive radar. Putting the word out that your door is open and maintaining trust by preserving confidentiality are two key factors for success in pursuing these opportunities.
Assess Strategic Fit
To identify how a potential opportunity fits with your strategy, you should ask five key questions:
- Is the service part of a priority clinical service or in support of it?
- Does the business enhance the hospital’s geographic market position?
- How serious would it be if a competitor acquired this business?
- Would the business be likely to close if your hospital does not acquire it? What would be the implications for the hospital?
- What does the fine print in the joint venture agreement or other related legal documents say about transactions in these relatively extreme circumstances?
Purchasing physician-owned businesses will often align with your hospital’s interests. Depending on the licensing and structure of the new entity, you may recapture the technical revenue that was split with physicians in joint ventures or completely lost to physicians as competitors. Further, buying an existing business could help you avoid future capital investments on your hospital’s campus.
Full hospital ownership of the acquired facility will also give you the control to more rationally divide volume between the hospital facilities. Assuming the facility license can be converted to an HOPD, dividing the volume is easier in this case, as the decision is not complicated by having to share revenue in a joint venture if the volume is shifted there. After an acquisition, the facilities are of equal importance and value, and decisions about what procedures to perform where can be based on the best rational allocation of services.
In some instances, it may be better to purchase a larger interest or a controlling interest in the existing entity, and keep the existing physician owners partially invested. This strategy results in less control than with an outright purchase, but it may be preferable where there’s a concern about keeping the physicians engaged.
Finally, buying back independent businesses may permit you to regain market share that was lost to physician competitors.
Factors to Consider When Choosing an Approach
Different factors will determine your best approach moving forward. Purchasing the entire entity is probably the best option when the physicians clearly want out, the facility can be converted to an HOPD, the purchase fits the hospital’s strategy, and/or physicians can be retained in operations management roles. By contrast, increasing ownership share may be preferable where the physicians want to reduce exposure and/or the hospital can resyndicate the venture to engage additional physicians. And you should probably opt not to invest if your hospital has little or no ownership interest, and if there is little threat of a competitor acquiring the venture for strategic advantage—and you therefore could expect to get the volume by default.
Structural Considerations
When considering how to structure the deal for the greatest likelihood of success, start by revisiting why the physicians wanted to develop and own the business in the first place. The usual reasons are the desire for control or additional income, but ego satisfaction may also have played a role.
You should assess the degree to which these goals are currently being met, and how well physicians, by selling their ownership of the business, can continue to meet these goals. The physicians—particularly those who invest in an ASC—typically want control so they can both enhance their professional practice income and perform services when it suits their schedule. But it is important not to forget pride of ownership as a motivating factor.
Structuring the deal to meet these physician goals is the key to ensuring the physicians will remain committed to the success of the business. The specific structural issues of concern will depend on whether you have opted for an outright purchase, an increased ownership share, or some other option. Here’s a brief overview of key points to consider for different approaches.
Outright Purchases
Physician income goals are perhaps the primary concern in an outright purchase of an entire joint venture. A number of options are available that involve paying physicians for legitimate services that they are contracted to provide. Each of these options requires careful analysis to ensure the hospital complies with Stark, anti-kickback, and IRS regulations related to the fair market value of the arrangement.
Medical directorships. There are often roles for medical directors in these facilities, ranging from overall medical direction to serving on an operations committee. Although these part-time medical directorships will not provide significant sources of income, they can facilitate the former owner’s continued involvement with the business and provide the physician with a steady payment for his or her services.
Professional service agreements (PSAs). Where appropriate, particularly in an imaging center, consider whether it makes sense to enter into a PSA with the radiologists. With such an agreement, the hospital can bill for the technical and professional portion of the services and pay the radiologists a predetermined amount based on either a fee schedule or a percentage of collections. The PSA payments must be made at fair market value.
Although a PSA does not make sense in all situations, it can provide certain advantages to both the hospital and the physicians. Consider, for example, that to survive, an imaging center needs high-quality radiologists and service stability. Paying the radiologists on the basis of collections gives them a level of security that, in turn, transfers to the hospital. Moreover, by paying the radiologists a percentage of net collections or on a predetermined fee schedule, you can eliminate the risk of service disruptions due to difficulties the radiologists might encounter with certain payers with which your hospital has contracts. And by bringing about greater integration between the hospital and the radiologists, a PSA helps produce a closer working relationship and increased likelihood for stability.
Management services agreements. Under a management services agreement, the hospital pays the physician (or his or her practice) for certain administrative services—including, for example, center management, billing and collections, and quality management. These services, of course, would be separate and distinct from services provided under a medical director agreement and would also need to be paid at fair market value.
The approaches described above can provide more than just an income opportunity for the physicians and a means to gain their assistance in operating the business. They also create a fair amount of operational control for the physicians.
Specifically with respect to the issue of physicians’ desire for control, forming an operations committee is another way to ensure the physicians’ involvement. Physicians in most joint venture or physician-owned entities are already accustomed to serving on such committees, making them ready models for continued physician involvement. You may need to reduce the scope of authority of these committees, but retaining the organizational structure can simplify the transition, allowing the physicians to say, “So this committee will operate like before? Great.”
Finally, to address the question of ego satisfaction, consider retaining the name of the business or some element of the identity related to the physician ownership. Such gestures can go a long way toward maintaining physician goodwill and ongoing support, as most physicians would prefer that their sale of ownership not be broadcast to their patients.
Leasing Rather than Purchasing
In some instances, it may make more sense to lease from the physician owners, rather than buy them out. The lease could involve just the real estate (if the physicians own and want to keep it), the equipment, or the entire business.
A physician owner can generate cash flow from assets that have been fully depreciated and/or from the debt on those assets that is fully amortized. For example, if there is no real business to sell in an ailing physician-owned business, you can simply “take over” control of the business, while allowing the physicians (the physician-owned LLC) to retain ownership of the fixed assets and subsequently lease the equipment and improvements that they own to the hospital. The lease will be priced to reflect “refurbished” equipment plus any tenant improvements.
The physicians will do well in this scenario because the lease pricing (at fair market value) will reflect a “prudent lessor” capital structure, and the physicians’ LLC capital structure will represent a higher equity percentage (their debt being fully or near fully amortized). Thus, the lease payment (even one that’s relatively low reflecting the “refurbished” nature of the equipment) will represent pure cash flow to the LLC/physicians.
Regarding physicians’ desire for control and ego satisfaction, the same approaches should be considered with a leasing situation as with an outright purchase—that is, forming an operations committee and retaining some element of the physician’s identity in the new business.
Increased Ownership Share
As an alternative to a straight asset purchase of the joint venture, you could consider purchasing some physician equity and resyndicating the deal. For example, an ASC developed by a small group of surgeons to the exclusion of others may be facing hard times today. Rather than just buying all of the assets of such an ASC at a depressed price, you could purchase equity in the existing entity (also at a reduced price), thereby diluting the original owners’ stake and providing them with cash. You then could resell shares through a secondary offering to new physicians who had originally been excluded.
Advantages to this approach over a complete purchase by the hospital include:
- The opportunity to bring in new blood and revitalize the operations
- Avoidance of the need to relicense
- Preservation of the physician governance element (which can be restructured under the new arrangement to accommodate the preferences of the “new blood” physicians if necessary)
- Preservation of physician engagement
Run the Numbers
It should be fairly simple to develop a financial model to estimate the value of an opportunity, given that there will be financial results of an ongoing business. If the licensing is changed to an HOPD, then revenue would increase to the extent that HOPDs are entitled to receive higher Medicare payments than most freestanding facilities. However, the ability to convert a freestanding facility to an HOPD depends on several factors:
- Medicare criteria for a hospital outpatient department
- State certificate or determination of need laws
- State licensing laws and construction standards
- Location within prescribed distance from hospital campus
Project Volumes
The difficulty in estimating financial results arises in predicting service demand and volumes, which depend on whether current physician owners continue to prefer the facility after they are no longer investors and whether additional physicians will begin using it. Much will depend on the structure of the deal transaction and the role of the former physician owners in the ongoing management of the facility (discussed previously).
Depending on the deal structure, you may have reason to feel more or less confident that volumes will remain at the same levels or improve. Given this uncertainty regarding volumes, it is usually best to model three scenarios that reflect different deal structures and management arrangements, and the likely volumes in each.
Historical volumes in the business and the market should be considered where relevant. Can you gain more market share? Or can you bring in, as additional users, new physicians who were reluctant to use the facility when it was owned by other physicians? Talk to your physicians, both owners and nonowners, to find out how you need to provide services in order to attract their volume. Finally, check that the volume you estimate on this basis results in a market share that you believe is achievable.
Anticipate Revenues and Cost-Efficiencies
When evaluating the upside potential of buying the business, you should consider the potential reimbursement impact. With a change in status to an HOPD (assuming regulatory hurdles have been met) comes a change in reimbursement levels.
For ASCs, the implementation of payment policy changes in 2008 that set ASC payment rates for most procedures at 67 percent of the amounts paid to HOPDs mostly standardized the payment differentials between HOPDs and ASCs. The new rates phase in over a four-year period. CMS will adjust ASC payments each year to reflect changes in technology and resources used in performing procedures. In 2010 and beyond, the ASC conversion factor will increase by an amount equal to the U.S. consumer price index (CPI) for urban consumers. The APC payments for HOPDs will be inflated based on a difference methodology. Therefore, the payment differential between ASCs and HOPDs will change over time due to different conversion factor update methods and separate budget-neutrality adjustments for recalibration of the relative weights.
Finally, you should not only quantify the revenue impact, but also carefully consider whether you can operate the business as efficiently as the physician owners did. Conventional wisdom has it that hospitals are generally not as efficient as physicians at providing outpatient care. Some hospital inefficiencies can be avoided simply because the joint-venture facility has the benefit of being designed for outpatient care with necessary resources arranged in a compact space. Also, low variation in case types, which the facility is likely accustomed to seeing, can keep turnover times low—a key measure of efficiency for
physicians.
In addition, there may be potential economies of scale in purchasing. For example, the hospital may be able to do the billing at a lower cost.
In any event, any hospital would be hard pressed to operate such a facility as efficiently as the physician owners. And it is this reality, in particular, that underscores the value of entering a management services agreement with the previous physician owners. As an alternative, a professional management company can also offer an increased assurance that the HOPD will be operated effectively as a freestanding facility.
You should not only consider the impact of a change in ownership on operating expenses, but also be prepared for the possibility that you might need to inject significantly more capital than you originally thought. Physician-owned entities often defer capital expenditures. If cash flow was falling off a cliff, the physicians would have probably avoided the capital upgrades that normally would be necessary to remain competitive.
An Eye for Value
Hospitals may find more physicians knocking on their door to buy out joint ventures and physician-owned businesses. But you should also be on the lookout for such opportunities. If one comes your way, then with an eye for good value and a thoughtful approach to structuring the transaction to ensure continued physician engagement, you have a good chance of significantly improving your organization’s market position.
John M. Harris is a principal, DGA Partners, Bala Cynwyd, Pa., and a member of HFMA’s Philadelphia Metropolitan Chapter (JHarris@dgapartners.com).
Karin Chernoff Kaplan, AVA, is a director, DGA Partners, Bala Cynwyd, Pa., and a member of HFMA’s New Jersey Chapter (kkaplan@dgapartners.com).
What’s Driving the Trend?
Clearly, the economic downturn is presenting strong hospitals and health systems with opportunities to acquire physician businesses, often at depressed fair market values. These opportunities are emerging largely as a consequence of reduced volumes and reimbursement pressures.
Reduced volumes will reduce profitability. There’s no question that the economy is having an impact on consumer healthcare decision-making. A recent American Hospital Association survey indicates that 38 percent of hospitals are experiencing declines in admissions and 31 percent are experiencing declines in elective procedures (Report on the Economic Crisis: Initial Impact on Hospitals, November 2008). In certain regions of the country, ASCs and imaging centers are facing significant volume reductions as well, since many services at these facilities are elective.a As volume reductions push profits down, physicians may sour on owning this type of business. They may want to cash out to shore up their personal finances or to reduce the risk level of their portfolio of investments.
Reimbursement pressures exacerbate the impact. Changes in the payment landscape are adding to the pressure on profits for physician businesses. For example, recent changes to Medicare’s reimbursement system significantly reduced the profitability of many ASCs as payments for certain gastroenterology procedures were reduced 5 percent in 2008 and another 7 percent in 2009. Imaging centers experienced significant reimbursement hits in 2007 as a result of the Deficit Reduction Act, which capped technical reimbursement at the lesser of the physician fee schedule or the hospital outpatient rate. The net impact was a 12 percent reduction in Medicare expenditures for imaging services from 2006 to 2007.b And there is speculation that additional cuts related to imaging are looming.
Compounding the impact of Medicare changes, commercial payers are consolidating in some markets, gaining leverage that allows them to push down rates, as well. Thinning margins combined with volume losses can be expected to have a significant impact on a physician-owned business’s profitability.
a. Taylor, M., “Economy, Medicare Rules Hit Surgery Centers,” Indiana Economic Digest, Jan. 5, 2009.
b. Medicare: Trends in Fees, Utilization, and Expenditures for Imaging Services Before and After Implementation of the Deficit Reduction Act of 2005, Government Accountability Office, September 2008.