The Importance of Diligence in Orthopedic Recapitalization Transactions

04 January 2019 Health Care Law Today Blog
Authors: Donald H. Romano Jana L. Kolarik Roger D. Strode

As noted in previous Health Care Law Today blog posts, we have seen an uptick in private equity recapitalization transactions in orthopedics. We expect this trend to continue, and to pick up pace, as the economy remains robust and the appetite for the most lucrative physician practices increases. When coupled with an increasing maturation of orthopedic practices, the volume of deals is almost certain to increase.

This expected transactional volume likely means increased competition for the larger practices and, thus, larger deals. Competition translates into higher multiples on projected cash flows and higher prices. With this will come increasing scrutiny on issues that have the potential to hamper post-deal cash flows. Orthopedics is one of the few such specialties that lends itself to ancillary income, through ownership of ambulatory surgery, imaging, physical therapy, and durable medical equipment (DME), not to mention arrangements with hospitals involving medical directorships, co-management, etc. These arrangements, while beneficial, also carry regulatory risks that any sophisticated investor will want to understand in an effort to manage downside pressure on post-closing cash flows.

Following is a brief discussion of some common areas that anyone engaged in these transactions should investigate.

Anti-Kickback Issues

The Federal Anti-Kickback Statute (AKS) makes it illegal to knowingly and willfully offer, pay, solicit or receive remuneration, in cash or in kind, in order to induce or reward the referral of business reimbursable under the Federal healthcare programs (e.g., Medicare and Medicaid). The most common AKS risk attendant to orthopedic deals is often found in ambulatory surgery center (ASC) investments by the group or its physicians. We often see private equity investors take substantial stakes in ASCs owned by practices or physicians, thus making the AKS risk something relevant to those investors. In this regard, it is worth noting that the ASC investments generally do not implicate the Stark Law (discussed below) because ASCs are not providing items or services that are considered “designated health services” (DHS) subject to the Stark Law.

Due its breadth, the AKS has a number of “safe harbor” regulations that provide investors with protection from the ambit of the statute so long as the arrangements are structured to meet certain regulatory requirements. These requirements focus on issues such as the types of investors (e.g., physicians or hospitals), whether or not the ASC is an extension of a physician investor’s practice, whether or not the physician borrowed money from the ASC or his or her fellow investors to acquire the investment interest, etc. Complying with the requirements is often uncomplicated, but it is worth noting that the failure to meet one or more requirements, thus failing to meet safe harbor protection, does not render the arrangement illegal but, rather, subject to a more in-depth analysis to determine its risk of being investigated and potentially prosecuted/sanctioned.

Common diligence issues often involve the following questions:

  • Was the physician granted his or her interest in exchange for future referrals?
  • Did the physician pay for his or her interest and, if so, was the payment equivalent to the fair market value of such interest?
  • Did anyone loan the physician the money to acquire the interest, and, if so, whom?
  • Is the physician’s return proportional to his or her percentage ownership interest in the ASC?
  • Does the physician regularly perform procedures that are performed in an ASC, and, if so, what percentage of the physician’s ASC cases are performed in the ASC under consideration?
  • Under what circumstances must the physician sell or surrender his or her ownership interest in the ASC?
  • Is the ASC owned individually by physicians or by a group practice and, if so, are there any owners of the group who do not use the ASC?
  • Does the ASC bill “out of network,” and, if so, are the ASC’s billing and collection practices compliant with relevant state law regarding commercial insurance billing?
  • What sort of arrangements does the ASC have with anesthesia providers, for example do the anesthesiologists bill for their own professional fees or have they subcontracted their services through the ASC or the group, which then bills for them?
  • If the anesthesiologists are subcontracted through the ASC or group, are the fees paid to the anesthesiologists consistent with fair market value?
  • Where the current physician owners are reducing their investment percentage in favor of a private equity investor, is there an earn-out that is arguably based on the volume or value of future business referred by such physicians?

Answers to the above questions, as well as a host of others, will help frame any issues that may be present with respect to an ASC investment in connection with a recapitalization transaction.

Other ASC risks can be present with respect to relationships the group may have with local hospitals through medical directorships, on-call arrangements, co-management agreements and other ancillary arrangements involving imaging services or physical therapy. The problems that are often encountered in these arrangements are those that involve the failure to pay fair market compensation in connection with services provided by the physicians, or the provision of unnecessary or duplicative services.

In addition, the past decade saw the advent of the formation of medical device resellers by physicians. Physicians have formed companies to buy so-called “physician preference items,” such as screws, pins, spinal devices, partial or whole replacement joints, etc., from the manufacturer and then re-sell them to the hospital. If not structured properly, these transactions can present AKS risks and have come under scrutiny by the United States Senate Finance Committee (which has jurisdiction over the Federal health care programs) and certain hospital purchasers.

Other issues can arise in the event the group has sold a service line, such as physical therapy or imaging, to an independent service provider that has embedded itself in the practice, often through co-location, and is providing the practice with the same services the practice previously provided to itself.  These arrangements can raise issues of whether or not the purchase price paid to the physician group was for a legitimate, freestanding business or simply for the captive referrals of the group, to be enjoyed by the service provider.

Stark Law Issues

The Stark Law is a federal anti-referral statute that prohibits certain referrals by a physician of DHS to any entity with which the physician has a financial relationship whether through ownership of the entity or a compensation arrangement with the entity. The entity is also prohibited from billing Medicare or, in some cases, Medicaid for such referrals.  This broad prohibition, however, has a number of exceptions that allow for such referrals so long as the exception is fully met. The most common DHS, in the context of orthopedics, are imaging services, physical therapy services, DME, and orthotics.

The Stark Law is of concern to investors because a physician’s referrals for DHS to his or her own group practice can implicate the law, specifically when the practice owns and bills for services such as imaging, physical therapy, DME and orthotics.  Violations of the Stark Law can render referrals to the practice illegal and can negate the practice’s billings to Medicare and Medicaid (because they are not payable if billed in violation of the Stark Law), requiring repayment to the Centers for Medicare & Medicaid Services (CMS) along with possible penalties and fines. In addition, the practice can find itself in violation of the Federal False Claims or Civil Monetary Penalties Acts, which carry their own fairly harsh penalties.

To avoid these penalties, and to determine whether or not the group under consideration is at risk for violations of the Stark Law, one must work their way through a number of issues. The in-office ancillary services exception protects referrals of most ancillaries (excepting most DME) within a group practice, regardless of whether the referral comes from an owner or an employed/contracted physician.  However, in order to take advantage of this exception, the group must meet all of the components of Stark’s definition of “group practice,” including its rules on how the group may compensate its physicians. Because of the potentially disastrous consequences of a group not meeting the definition of “group practice” and thereby not being able to use the in-office ancillary services exception, we often advise that referrals by bona fide employed, non-owner physicians, meet the “employment exception,” and that referrals from independent contractor physicians meet the exception for personal service arrangements. Note that the requirements of the definition of “group practice” and the various exceptions are well beyond the scope of this discussion, but should be discussed, in depth, with counsel knowledgeable with them.

The foregoing pertains to referrals for ancillaries within the group; however, because orthopedic physicians often perform cases in a hospital setting, it is also important to review arrangements the group has with any of its hospital partners. This is primarily because inpatient and outpatient hospital services referred by physicians and billed to Medicare are also considered DHS under the Stark Law. Since the Stark Law considers a “compensation arrangement” to be a direct or indirect financial relationship implicating the Stark Law, common arrangements between orthopedic physicians or their groups and a hospital can create a “direct compensation arrangement” or “indirect compensation arrangement” between a referring doctor and the hospital. Thus, arrangements such as space or equipment rental arrangements, medical directorships, on-call arrangements, co-management arrangements, and joint ventures between a hospital and a group (or its physicians) involving imaging, physical therapy or DME can implicate the Stark Law with respect to referrals by the group or its physicians. Often there are exceptions that can be used to protect the arrangements, but the analysis can be complicated, especially as to whether compensation paid by a group to one of its physicians creates an “indirect compensation arrangement” with a hospital.

Billing and Coding Issues

It is common (and highly recommended) for acquirers to undertake audits of the coding and billing practices of acquired groups. Persistent mistakes in coding and the billing of procedures or services can affect the quality of a practice’s earnings, to say nothing of invoking compliance risks which may not otherwise surface until after the deal has closed. Common errors in orthopedic practices can include billing for physician assistants, i.e., billing their services as “incident to” the physician service without the proper supervision, and incorrect levels of supervision over in-office ancillary services such as imaging or physical therapy. We often recommend that a practice consider its own billing and coding audit before pricing the deal to ensure against surprises after a letter of intent is signed, at which point the parties are likely to find themselves engaged in discussions regarding price concessions.

Summary

The likely volume of orthopedic deals has the potential to create pricing competition resulting in robust multiples. This pricing environment will put pressure on the review of potential legal risks. Groups and investors considering a transaction are well advised to work through the above issues to confirm the quality of the group’s earnings and avoid unpleasant surprises following the close of any transaction.

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