A tremendous amount of capital has been, and continues to be, dedicated by private equity sponsors, and private equity backed companies, toward the recapitalization of physician practices. Here are seven important high-level considerations that may impact your approach to these transactions:
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What is a Recapitalization?
In the context of a physician practice, “recapitalization” is a fancy term for a transaction in which a private equity investor effectively purchases an interest in a physician practice. Due to laws that often prohibit lay ownership of professional medical practices (so-called “corporate practice of medicine” prohibitions), recapitalizations are often structured through the formation of a management company, the majority of which is owned by the private equity investor, with the remainder owned by physicians. The management company acquires substantially all of the “non-clinical” assets of the practice and then contracts to provide all of the non-clinical services required to run the practice. In exchange, the management company receives fees that effectively provide a financial return to the investors. The transaction allows the physicians owners of the practice to monetize a portion of their equity in the practice and to provide new growth capital for the enterprise, often through a combination of equity and debt.
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What Types of Physician Practices are Most Attractive to Private Equity Investors?
In the past several years we’ve seen a great deal of interest in both hospital-based and “retail” medicine practices. For example, anesthesiology and radiology have been regularly acquired by investors, but at lower prices than dermatology and ophthalmology practices, which garner higher prices due to the retail nature of their business models (medical spas, skin rejuvenation, eye glasses, etc.). Recently, we are also seeing a great deal of interest in gastroenterology and orthopedics, no doubt because of the leverage those practices produce through ancillary services such as ambulatory surgery, imaging, physical therapy, and lab.
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How Are These Deals Priced?
Recapitalization transactions are usually priced on a discounted cash flow basis. The prices are then “pressure tested” as a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). We’ve seen multiples approach 14x EBITDA and most who work in this area expect continued increases in valuations at least for the near future. Most importantly, we often see forward-looking EBITDA increased by the physician practice owners through their agreement to decrease their post-transaction compensation to a level roughly equal to 45% of net professional collections.
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What is “Rollover Equity” and How is it Handled?
Rollover equity is the percentage of ownership in the practice that is retained by the physician owners. Depending upon the valuation given to the enterprise, the physician owners may be asked to retain anywhere between 10 and 40 percent of their ownership in the recapitalized entity. Rollover equity is important because when the practice is ultimately sold, there can be substantial appreciation in the retained equity. Given current valuations, some buyers may require physicians to reinvest some portion if their retained equity (i.e., continue to retain) in a subsequent sale, so as to make the subsequent sale attractive to the next buyer.
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Does Tax Play a Big Part in These Deals?
In a word, “YES.” The tax objective is for the cash purchase price received by the physicians to be taxed at capital gain rates and the rollover equity to be received by the physicians on a tax-free basis. Physicians considering a transaction also need to take into account state and local tax consequences as well, as they may differ from federal law and may differ from state to state. Depending upon how the practice has been structured (for example, if the practice is a subchapter S corporation), the deal structure could change dramatically. Finally, depending on how the compensation is allocated amongst the owners, the tax treatment may differ. Needless to say, tax counsel must be consulted in the course of any transaction.
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How Important is Due Diligence?
Extraordinarily important. Buyers spend a great deal of time and money on diligence reviews. They are very concerned with issues related to violations, or alleged violations, of federal and state fraud and abuse laws. Common concerns include errors in billing and coding for procedures such as failure to properly bill for physician extenders, up-coding, and improper use of modifiers. These issues are important for several reasons, but, most importantly because they may affect earnings and have a negative impact on purchase price. Thus, it is important that any practice considering a transaction understand its soft spots and have competent compliance counsel on board.
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Is There a Way for Physicians to Limit their Downside Exposure?
While nothing completely replaces careful pre-transaction diligence, we’ve begun to see increasing reliance, by buyers, on insurance that covers breaches of representations and warranties. Buyers will often purchase this insurance in an effort to make their offer more attractive to sellers. The purchase of this insurance often reduces the level of post-closing indemnity escrows and, further, reduces the caps on indemnity liability. Given the cost of such coverage, however, it is generally only used when the value of the practice is substantial.
These are just a few material issues one must account for when considering the recapitalization of a physician practice. Given the complexity of these transactions, strong legal counsel is advised.
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