As their medical practices returned to near-normal operations recently, more than two years after COVID-19 restrictions were first imposed by the Centers for Disease Control and Prevention (CDC), some practice owners found themselves taking stock of their livelihoods and future prospects. The pandemic caused many of them — including physician groups and health systems — to conclude that the status quo is unsustainable and that other options therefore must be considered.
The solution for many independent physician practices has been to pursue acquisition by a health system or large practice. Another viable alternative for practices and health systems, however, is to partner with PE investors.
Private equity deals in healthcare trending upward
According to Bain & Company, a leading consultancy headquartered in Boston, the number of PE deals in the healthcare sector is skyrocketing.a Bain found that PE investors closed 515 deals with an aggregate value of $151 billion in 2021. These numbers dwarf the 380 deals worth $66 billion that closed in 2020. It remains to be seen whether end-of-year numbers for 2022 will be adversely affected by recent spikes in interest rates and other unfavorable economic factors, but there is no doubt that the PE investment model is here to stay.
This model therefore warrants due consideration not only from physicians and prospective investors looking to expand their portfolios, but also from health system executives looking to grow their businesses through acquisition and provider employment. Following are the three key issues that providers and provider organizations should consider as they explore potential partnerships with PE investors.
Private equity (PE) penetration into 6 physician specialties, 2019
|Total physicians practicing in specialty
|Number of physicians working in PE-acquired practices
|Percentage of physicians within specialty working in PE-acquired practices
|All six specialties
1 How PE investors are making their investments pay off
Many physicians are leery about the prospect of having their practices run by owners whose primary motivation is financial. The specter of shortened visit times, increased billing rates and superfluous testing keeps many providers on the sidelines. These concerns have been borne out in studies.
But these concerns do not apply to all PE investors. Scrupulous investors are adopting a more holistic, longer-term view, with an eye to generating profits by creating efficiencies, realizing economies of scale, increasing bargaining leverage with payers and improving care models.
They also truly believe that their contributions of money and expertise can create win-win arrangements for investors, providers and patients. For example, a PE firm may have the financial wherewithal to equip a small medical practice with a state-of-the-art electronic medical records and billing system that improves revenue capture, speeds the delivery of test results to patients and reduces labor costs. Moreover, a PE firm may have the expertise, tools and desire to take over certain aspects of running the healthcare business that were never the provider owners’ forte or passion.
As a result, in the best-case scenarios, the PE firms can take over managing the business, leaving the provider owners to do what they do best, which is to practice medicine.
2 How to structure the deal between the PE investors and provider owner
Although many variations exist, most partnerships between PE investors and provider owners involve a bifurcation of the businesses’ activities into management functions and clinical functions. This division is driven in part by the practical reality that PE investors are usually business people, not healthcare providers. But it is also driven by the legal reality that many states limit the ability of nonphysicians to own or control physician practices, to employ physicians or to share physicians’ professional fee income. Oregon law, for example, provides that a non-licensee owner of a professional corporation “may not direct or control the professional judgment of a licensee who is practicing within the professional corporation.”
The PE investors get paid for their management services in a few different ways.
They charge management fees to the provider owners. These fees are usually billed in flat, monthly amounts, rather than as percentages of revenues, to minimize concerns about fee splitting and improper incentives.
They ensure that their management services company has at its disposal the sticks and carrots needed to manage provider performance effectively. Providers who are failing to meet established practice standards can find themselves increasingly marginalized or even looking for new jobs. (Indeed, the desire to part ways with a colleague who is disruptive or has different priorities can be a primary motivator for providers to consider PE partnership and third-party management in the first place.)
They look to glean future benefits from a successful relationship. PE investors reserve a claim to future gains that result from the enhanced profitability their management services may help generate.
In return for ceding managerial control and agreeing to continue to work for their new PE partners for a set number of years, provider owners usually get generous, upfront payments that are based on some multiple of the practice’s earnings before interest, taxes, depreciation and amortization (EBITDA) margin. They also usually get some promise of a future windfall if and when the practice is resold to a downstream PE firm.
3 Potential pitfalls for providers from PE deals
Among their other priorities, PE investors are out to make money. One of the first ways they can accomplish this goal is by purchasing practices at bargain prices. Provider owners should educate themselves not only on the amounts of revenue their practices are generating, but also on the multiples that are being used in comparable deals being pursued by PE investors to calculate purchase prices. One source suggests that the initial payments made to provider owners in PE deals can equal as much as 12 times a practice’s EBITDA. Spending the time and money to obtain an independent appraisal in this context may prove worthwhile.
Another detail provider owners should closely consider is the length and geographical scope of any noncompete clause in the partnership contract or any associated employment agreement. In general, courts do not like noncompete clauses. Where a noncompete clause is deemed too restrictive or inequitable, a court may decide not to grant an employer’s request for enforcement. Suffice it to say, provider owners who are asked to enter into constrictive noncompete clauses should consult with their legal counsel before signing away their rights.
Provider owners should also get as much information as they can about the management practices and expectations of their potential partners. The provider owners may be reassured by having a provision in the partnership agreement that gives them the express right to participate in certain decisions affecting the practice. But they might find their window for renegotiation has closed by the time they become aware of the true costs of the control they have ceded. Again, an ounce of prevention, such as taking the time to have legal counsel review such provisions of the partnership agreement, may be worth a pound of cure.
Finally, provider owners should familiarize themselves with applicable laws and regulations on corporate ownership and control, patient referral and fee splitting. Many of these rules, such as the Stark Law, the Anti-Kickback Statute and IRS restrictions, apply nationwide. Other rules, though, are state-specific. This fact can create challenges and questions not only for provider owners but also for PE investors who are generally familiar with the structures and risks of healthcare deals but may lack a nuanced understanding of local restrictions and market dynamics.
The key is for each side of the transaction to have in its corner the state-licensed attorneys, accountants, appraisers and other specialists needed to ensure that its interests are adequately protected and promoted.
The guiding principle for a successful partnership
COVID-19 brought home for many provider organizations the conflicting challenges of operating a medical practice. Independent practice owners must juggle their business-related responsibilities of marketing, staffing, billing, and paying the utility bills, as well as their patient-related responsibilities of providing high-quality and personalized care. The result can be long hours at work, mounting stress, and, in some cases, dropped balls. Partnering with PE investors to obtain support on the business side is therefore an attractive solution. But these alliances should not be entered into lightly.
Vetting potential partners on their commitment to promoting high-quality patient care is critical. Absent that commitment, a PE-associated medical practice has little hope of enduring, let alone thriving. The immediate sense of relief that provider owners derive from having business and management support will quickly be overshadowed by feelings of dissatisfaction and regret if patient care suffers. The best PE collaborators are the ones who understand that happy patients lead to happy providers and, ultimately, successful partnerships.
a. Jain, N., et al., Healthcare private equity market 2021: The year in review, Bain & Company, March 16, 2022.