Learnings from Recent Physician Practice Private Equity Transactions

05 December 2022 Health Care Law Today Blog
Author(s): Roger D. Strode

As deal lawyers we, at Foley, continue to see high volumes of health care private equity (PE) backed platform transactions. While the number of deals in the space is down, year over year, the industry is still on pace to reach almost 800 health care deals this year. In this regard, physician practice recapitalization deals appear particularly robust.

Like all transactions involving health care, deal terms in PE-backed transactions remain fluid and changing. Purchase price payment terms, the handling of rollover equity, and the use of representations and warranties insurance, are a few examples that continue to evolve. Below are some observations with respect to those items from recent transactions.

Purchase Price Payment Terms

While traditional “earn-outs” have always proved difficult to implement in physician recapitalization transactions due to regulatory concerns, we have seen an increased number of contingent or deferred payment terms from private equity sponsors. The contingent payments were initially, a product of the COVID-19 Pandemic when there was an inability to rely on patient volumes during the Pandemic to project post-closing patient volumes.

While we’ve seen a reduction in the above types of purchase price payments, we have seen set, deferred payments as incentives to keep physicians engaged in the practice post-closing. If a physician does leave before a deferred purchase price payment is made, they will forfeit their right to that payment. In most cases, those physicians who remain will share the forfeited payment. This means that while the payment is “contingent” on a physician-by-physician basis, it is not contingent as to the group.

These deferred payments do raise several business issues that are better addressed when the deferred payment structure is proposed. First, many physician groups may insist that interest be paid on those deferred amounts. It should be noted that if interest is not paid on those amounts, the Internal Revenue Code (Code) will impute interest on such amounts and recharacterize a portion of each payment as interest, taxable at ordinary income rates, rather than at capital gain rates, thus increasing the cost of the transaction to the selling practice. Finally, most groups will elect to use “installment sale” treatment under the Code, deferring taxation on the installments until the money is received, which may also involve the payment of interest on the deferred taxes. All of these can be significant to the selling practice and should be considered when negotiating the purchase price and its payment terms.

Rollover Equity

Rollover equity (i.e., equity in the management services organization (MSO) or its parent entity) is often an important feature in these transactions. Physicians often receive not only cash as purchase price but equity in the MSO. This equity can, generally, range from 10-40% of the total enterprise value of the acquired practice. Rollover serves several purposes: First, it is a tax-deferred way to allow the physician practice owners to reinvest in the enterprise, and second, it incentivizes them to remain engaged in, and grow, the larger organization. Given the foregoing, it is important for the physician owners of rollover equity to participate in a later sale of the platform MSO, especially since that sale is sold to the physicians as the “second bite at the apple” with the hope that it is a significant multiple of the original investment.

While not a recent advent, it is becoming a more common requirement that physicians must “re-roll” a percentage of their equity in a later sale of the platform MSO. The business justification for this requirement is that it is easier to convince a prospective purchaser of the platform to purchase and to pay a higher multiple of earnings if the physician investors remain engaged as owners.

The question then become that of how much must the physician investors be required to re-roll.   We’ve seen buyers demand that physicians be required to re-roll up to 100% of their equity. Such an approach doesn’t seem particularly practical as it would limit the ability of physicians to enjoy the benefits of growth of enterprise value while saddling them with new covenants not to compete, new employment agreements, vesting requirements, etc. At a minimum, we see physicians being allowed to sell rollover units equal to their initial value, but normally see some sort of cap on the amount of rollover there will be required to retain and that cap memorialized in the governing documents of the MSO (or its parent). Thus, when the PE sponsor sells, the physicians will be allowed to sell, at least, up to any pre-agreed upon cap.

In addition to the above, rollover equity is often subject to restrictions on transfer and potential forfeiture upon certain events pursuant to which the physician leaves the practice.

Representations and Warranty Insurance

A development that arose several years ago, and has continued to evolve is the use, by the parties to recapitalization transactions, of so-called representations and warranties insurance (RWI). This insurance is designed to protect the buyer from breaches of representations and warranties and help limit the selling practice, and its physicians, from claims for damages arising from those breaches. Not every deal is large enough to justify RWI, but when appropriate it can be a powerful tool for both purchasers (as an incentive to selling practices) and sellers (to limit exposure).

These policies generally provide coverage up to 10-15% of total enterprise value, so that a $100,000,000 deal will provide for $10-$15MM of coverage. They, like all policies, contain a deductible, which is usually 1% of enterprise value, so in the case above the deductible would  $1MM. The deductible is generally split between the purchaser and selling practice with the practice agreeing to escrow its portion of the deductible. Except in certain circumstances, such as fraud or certain excluded liabilities, it is not uncommon for the parties to agree that the selling practice’s exposure for breaches of representations and warranties be limited to the escrowed deductible, which the purchaser is allowed to access first. Following that, the purchaser would absorb its portion of the deductible and then proceed against the policy for amounts in excess of the deductible. Savvy sellers insist that even if the RWI insurer refuses to pay on the policy, the selling practice’s liability remains capped at its escrowed portion of the deductible.

Obviously, there is a lot of negotiation that can go on between purchaser, seller and insurer but the above is a generally reliable construct as to how RWI is used in today’s transactions.

* * *           

Health care private equity transaction volume remains high and shows no real signs of slowing. While there are many complex aspects of these deals, sophisticated purchasers and sellers are well counseled to focus on the various business and legal issues highlighted above.

We have the resources to help you navigate the important legal considerations related to business operations and industry-specific issues. Please reach out to the authors, your Foley relationship partner, or our Health Care Practice Group with any questions.

This blog is made available by Foley & Lardner LLP (“Foley” or “the Firm”) for informational purposes only. It is not meant to convey the Firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Any opinions expressed in this article do not necessarily reflect the views of Foley & Lardner LLP, its partners, or its clients. Accordingly, do not act upon this information without seeking counsel from a licensed attorney. This blog is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Communicating with Foley through this website by email, blog post, or otherwise, does not create an attorney-client relationship for any legal matter. Therefore, any communication or material you transmit to Foley through this blog, whether by email, blog post or any other manner, will not be treated as confidential or proprietary. The information on this blog is published “AS IS” and is not guaranteed to be complete, accurate, and or up-to-date. Foley makes no representations or warranties of any kind, express or implied, as to the operation or content of the site. Foley expressly disclaims all other guarantees, warranties, conditions and representations of any kind, either express or implied, whether arising under any statute, law, commercial use or otherwise, including implied warranties of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Foley or any of its partners, officers, employees, agents or affiliates be liable, directly or indirectly, under any theory of law (contract, tort, negligence or otherwise), to you or anyone else, for any claims, losses or damages, direct, indirect special, incidental, punitive or consequential, resulting from or occasioned by the creation, use of or reliance on this site (including information and other content) or any third party websites or the information, resources or material accessed through any such websites. In some jurisdictions, the contents of this blog may be considered Attorney Advertising. If applicable, please note that prior results do not guarantee a similar outcome. Photographs are for dramatization purposes only and may include models. Likenesses do not necessarily imply current client, partnership or employee status.