All indications appear to point toward a robust market for health care mergers and acquisitions (M&A) in the coming year. Inflation — finally — appears to be easing. With that, we may continue to see interest rate cuts from the Federal Reserve. The incoming Administration is bringing with it renewed optimism among business leaders regarding the United States economy. The new Presidential administration may tamp down Federal attempts at health care reforms, such as national bans on covenants not to compete and scrutiny of private equity investments in provider organizations. The same may be said for similar state-led initiatives, though that is less certain. With these winds at the country’s back, those involved in health care transactions could experience a very busy 2025.
This renewed vigor will bring with it challenges to physician practices deciding whether and how to approach the M&A marketplace. Large, profitable provider groups with strong management are likely to be approached regularly by investors interested in acquisitions and recapitalization transactions. These approaches bring with them a host of issues and questions that well-counseled physician practices must consider, including (i) the pros and cons of engaging in a transaction with a private equity investor, (ii) understanding what is necessary to prepare for any such transaction, and (iii) the material business and legal issues that arise in these deals.
Pros and Cons of Private Equity Transactions
The obvious attraction for a physician group considering a sale or recapitalization transaction with a private equity sponsor is the purchase price the group will receive. In most instances, the price practice group owners are likely to receive in a transaction will be substantially greater than what each owner would otherwise receive from the group upon his or her retirement or other exit from the practice. Although purchase price multiples are not currently at tall-time highs, they are still robust and are likely to increase as the cost of debt decreases.
The purchase price in these deals is generally paid with a combination of cash and so-called “rollover” equity in the newly recapitalized practice (structured through the use of a management services organization (MSO)). This rollover equity is generally held by the rollover investors so long as the private equity sponsor maintains its investment in the recapitalized practice. The equity, or at least a majority of it, is sold by the rollover investors when the private equity fund owner exits its investment. The hope is that the equity in the recapitalized practice ends up being worth substantially more than when it was issued. In addition to the above, the cash and equity should be taxed at capital gains rates, rather than as ordinary income.
However, not all medical groups, and not all physician members of these groups, consider private equity transactions attractive. Certain types of practices have been less receptive to private equity investment than others. Orthopedic and spine surgery groups are often less attracted to outside investment given their ability to leverage their practices with ancillary services such as ambulatory surgery centers, imaging, physical therapy, and durable medical equipment. These ancillary services help keep revenues and incomes strong and allow these groups to maintain their independence. However — with the exception of the “mega” groups — this resistance has begun to weaken. In addition, there can sometimes be a split of opinion between older members of physician groups and younger members as to whether a sale to a private equity firm is beneficial.
There can be several reasons for this, the first of which is that older physicians are often the most highly compensated and likely will enjoy a greater percentage of the purchase price and rollover equity in the transaction than younger doctors. Moreover, and maybe equally as important, older physicians are less likely to stay with the practice much beyond the secondary exit and the sale of their rollover equity, while younger physicians could spend most of their careers working with and for private equity or other financial investors. Such a scenario may not have been what they envisioned during medical school and training.
Preparation for a Transaction
It is important for a physician group to prepare should it desire to engage in a transaction with a financial investor. This preparation includes everything from gaining broad support within the group, to choosing advisors, to readying the practice to undergo the business and legal scrutiny that comes along with a deal that involves sophisticated investors.
Broad support from the group’s owners and other important physician stakeholders is key to a successful transaction. If there is dissension or disagreement, the group could lose physicians who are not interested in being part of the deal, thus degrading the value of the group. Moreover, even if unhappy physicians stay, getting critical deal points negotiated becomes more complicated. It is important that the group is fully behind the idea of entering into a transaction. Any sponsor will want the same.
Choosing good advisors is key. The idea of an expensive investment banker or a large, national firm may be somewhat daunting, but the benefits of sophisticated advisors can far outweigh the costs. Strong investment bankers will inject a dose of valuable reality into the conversation and can be invaluable in selecting the right private equity partner. The best bankers tend to have relationships with the best sponsors and those relationships lend credibility to the target group and the process. Moreover, good bankers know how to “make a market” in order to drive higher values than the practice could alone. Attorneys are equally important. There may be a tendency to want to use legacy counsel, but that can lead to a less than optimal result if traditional counsel does not understand how these transactions are structured and what the “market” is for terms and conditions between buyers and sellers. Most private equity groups will have the benefit of strong, national counsel and the target group should as well. Good counsel will help with tax planning and strategy, which is often critical, identifying compliance issues before they are discovered by the acquiror (or a whistleblower), working through employment agreements and restrictive covenants, and advising selling owners in connection with their receipt and holding of rollover equity.
Getting the practice in shape to transact cannot be understated. It is not unusual to find that practices have regulatory and compliance issues no matter how careful they have been, especially given the complexity of Federal and state fraud and abuse laws, such as the Stark Law and the Anti-Kickback Statute. This lapse in compliance is almost always unintentional and, in certain instances may have been “blessed” by third-party consultants or outside legal counsel. If compliance issues are not discovered until the diligence process, they can lead to devaluation of the practice. For example, we have seen situations where a practice has long had a method of billing or accounting for particular procedures or arrangements that, during the course of diligence, have been found to be incorrect or in violation of applicable law. At times, the fix to the issue has a negative effect on earnings, thus resulting in a lowering of the purchase price. For example: assume that the purchase price for a target practice is nine to 10 times earnings before interest, taxes, depreciation, and amortization (EBITDA), the loss of $1 of EBITDA is the loss of $9-10 of value in the transaction. Thus, it is important to understand if any such issues exist before price negotiations begin and try to put a more positive focus on the issue, its resolution, and how the practice can backfill any gaps in earnings. We always tell our clients, “Once you negotiate price, the deal never gets any better for the seller.” In extreme scenarios, a serious regulatory concern can completely derail a deal. It is better to learn of any such issues early.
Critical Business and Legal Issues
Although the business and legal issues attendant to a private equity recapitalization are many and varied, a few stand out, such as taxes, deal and execution risk, and rollover equity.
The tax treatment of the transaction is of critical importance to its success Almost every deal is structured to ensure that the purchase price is not treated as ordinary income and is taxed at capital gains rates, and the receipt of rollover equity is received on a tax deferred basis. The tax status of the target practice and the manner in which purchase price is allocated among the owner physicians can have significant impact on the tax consequences of the deal. For example, it is common for physician practices to be organized as Subchapter S corporations under the Internal Revenue Code. Although fairly tax efficient, Subchapter S corporation structures offer certain complications and require the holding of rollover equity in certain ways to avoid untoward tax consequences. In the off chance that the target practice is taxed as a Subchapter C corporation, tax treatment becomes increasingly complicated and often requires certain special circumstances to avoid being very costly from a tax perspective. In addition to the above, it is not uncommon for practice owners to reallocate purchase price in a manner that is reflective of productivity and the value each physician brings to the transaction, rather than according to relative ownership percentages each holds in the acquired practice. These purchase price reallocations can have differing tax consequences to the owner physicians and need to be carefully thought through and planned for.
Execution and deal risk are real and need to be planned for. Execution risk can come from many angles, be it compliance risk, failure to choose the right advisors, poor tax planning, or a lack of buy-in from important stakeholders. Another area of common concern is a failure to consider the various consents and approvals that are necessary to close the deal. State and Federal approvals are easy to determine, as are material contract approvals. What is often overlooked are the consents or approvals the practice may need to seek from joint venture partners who may have a say in whether or not certain parts of the deal can proceed. For example, it is common for practices to own interests in joint ventures, such as ambulatory surgery centers, with local hospitals or third parties. These ventures may have terms that prohibit the physician practice from selling all or part of its interest therein without the prior approval of their partner(s). In these instances, we have seen groups overestimate their leverage with their JV partners or the JV partners’ willingness to consent to a transaction. In these instances, we advise groups to confront these issues early as the failure to receive the needed consent(s) may have deleterious effects on deal value or can derail the deal altogether.
Deal risk usually arises in the form of post-closing indemnification exposure for breaches of representations and warranties. Limiting exposure to such claims, can be managed several ways, the most common of which has become the use of representation and warranty insurance (RWI). RWI has become increasingly prevalent in transactions as it often gives buyers a leg up on other bidders when offered during negotiations. Under typical RWI deals, a seller’s exposure for post-closing claims is often limited to one-half (1/2) of the deductible under the policy. This amount is often placed in escrow and becomes the only source of indemnification available to the buyer from the seller. Moreover, we are beginning to see so-called “walk away” deals when RWI is used where the seller has no exposure for post-closing claims (unless any such claims are known before closing), and the RWI policy is the only method of indemnification available to the buyer. RWI policies can reduce overall legal costs in negotiating and executing a deal because counsel may be less likely to “nitpick” over representations and warranties (although counsel to the RWI insurer is going to want market representations and warranties). Another way to reduce post-closing exposure is to ensure that seller’s counsel understands current market terms related to indemnification, such as survival periods, baskets, and caps. Capping exposure at some percentage of purchase price is the most effective way of limiting exposure in non-RWI deals. Most importantly, whether a deal is an RWI deal or a non-RWI deal, consider negotiating these terms as part of any letter of intent and use the auction process to get the best terms possible from an indemnification perspective. Moreover, sellers need to ensure that they are as candid as possible with their counsel to ensure that any issues that can impact indemnification are disclosed or otherwise negotiated to avoid unwanted “gotchas” post-closing.
As noted above, purchase price is usually bifurcated between cash and rollover equity in the recapitalized practice (generally structured through a MSO). In larger deals, this rollover equity can constitute up to 40% of the value of the recapitalized practice and, thus, is an important component of the transaction. There is generally an expectation, and a hope, that any rollover equity that is received grows in value and can be cashed in upon an exit. Thus, keeping that rollover equity is important. Care must be taken to limit the instances when and if rollover equity is forfeited and/or can be repurchased, making sure that the holder has the right to cause a buyer of the practice to acquire it upon a subsequent exit and understanding how much equity, if any, must be “re-rolled” upon such subsequent exit. As we have recommended above, we would advise that these terms be negotiated early in the process, including at the letter of intent stage.
Conclusion
Deal volume appears to be on the upswing, and it is likely that this volume will include physician practice recapitalization transactions. These transactions are complex and need to be carefully considered and structured in order to maximize the benefits of the deals to the participants. Careful preparation and execution are keys to success in these instances. Foley is here to help you address the short and long-term impacts in the wake of regulatory changes. We have the resources to help you navigate these and other important legal considerations related to business operations and industry-specific issues. Please reach out to the authors, your Foley relationship partner, or to our Health Care & Life Sciences Sector with any questions.
