For over a decade, private equity groups have been investing capital in dental practices. Many national dentistry groups have expanded or evolved from some of the largest investments of private equity funds. Often there are a series of such investments and, because there does not yet appear to be market saturation, these types of transactions with dental practices are expected to continue for some time.
For medical practices, private equity investment is a somewhat newer phenomenon. Specialties that are already profitable appear to be the typical target for investment. Among those specialties where private investment has become more prevalent are dental, dermatology, ophthalmology, pain management, orthopedics, urology, gastroenterology, and radiology.
Generally, the goal of the investor is to exit the investment in approximately five years for a substantial return on invested capital. The exit strategy of the private equity group could take one of many forms including initial public offering, sales to a third party or to another private equity firm.
In successful transactions, the medical practices thrive not only financially from the invested capital, but also as a result of the business expertise brought to the venture by the private equity firm. Organizational procedures and operational activities are developed and strengthened to form the building blocks for future growth. Through investment and growth, physician practices are often able to collect more data to document and demonstrate their successes. This can be key to negotiating more lucrative contracts with payors.
Investors with expertise relating to medical practices will be more apt to navigate regulatory challenges and considerations including corporate practice of medicine prohibitions, certificate of need requirements, fee-splitting arrangements, licensing, privacy, Stark and anti-kickback issues. The infusion of funds from private investors typically doesn’t change the structure of the professional entity. The doctors still own and are employed by the professional entity and still make the clinical decisions. The investors generally acquire the group’s management services organization.
The private equity investment, or purchase price, is generally a multiple of EBITDA, i.e. Earnings Before Interest Taxes & Depreciation. In this case, EBITDA is an EBITDA that has been adjusted to “normal,” as compared to actual EBITDA, e.g. removing non-recurring or owner-related items. The multiple to be applied to EBITDA to determine the practice value is a negotiated value. Thus, only the parties to the transaction know the terms that may have resulted in a particular multiple.
A thorough understanding of the compensation structure would be one key to determining an appropriate multiple. A post-transaction objective of the buyer may be to reduce physician compensation to maximize return on the private equity investment. Being able to quantify and ultimately to achieve post-transaction reductions in physicians compensation, the investor is able to gain sufficient insight to maximize return on investment. The investment value that will justify the calculated returns will become evident. As an example, private investment firms generally expect returns in excess of 20% annually on their investments. If there is an additional $100,000 in EBITDA to be achieved through post-transaction physician compensation savings, an additional investment of $500,000 may be deemed appropriate based upon a desired 20% return on a projected 5 year investment.
Ideally, a high multiple yields high value to the owner. There are circumstances, however, where not all of such value passes to the owner. Perhaps a practice has non-owner providers. Some of the enterprise’s value may need to be applied toward retention bonuses for those providers.
A practice that is targeted by private equity generally falls into one of two categories: a platform or an add-on acquisition. A platform may be one or a combination of multiple practices that has some market dominance and established infrastructure. An add-on is a practice that may be attached to a platform that pre-exists. A platform generally commands a higher multiple than an add-on acquisition. If the practice is not a platform, and no platform exists, other factors are determinative. Alternatively, merging back-office functions and increasing influence with payors improves the overall EBITDA of a combined organization.
As with any purchase/sale, it is customary in private equity transactions for there to be various written agreements to address all of the pertinent issues. The asset purchase agreement is the primary document, which is typically preceded or supplemented by such documents as letters of intent, leases, and employment agreements.
The asset purchase agreement addresses the basics of the deal, such as the price and the payment terms. Generally, there is a cash payment and some escrow for potential liabilities. The parties should be careful how the escrow is structured and when it can be accessed. The agreement should be clear as to what is being sold and how the price is allocated to these items. The tax implications of a particular allocation may vary significantly from alternative allocations. The allocation is generally required to be reported by both the buyer and the seller on their respective income tax returns for the year of the transaction. The asset purchase agreement also discloses which party will be responsible for the liabilities, leases and/or contracts of the practice and establishes terms, as applicable, relating to non-competition, representations, and warranties. Early in the process, consider all parties that may be impacted. In practice, the consent of a lessor or obtaining representations and warranties can sometimes hold up a deal.
As noted, private equity transactions are not fading away. On the contrary, investment by private equity has become more prevalent in all types of medical/dental practices and, considering the currently favorable interest rates, is anticipated to continue into the future. Managing profitable practices during times of increasing compliance and regulations and decreasing reimbursements continues to be one of the greatest challenges facing physician practices. Often the plan to meet this challenge involves expanding the patient base, procuring more physicians, or negotiating higher fees. It has not been uncommon for hospital systems and large physician groups to provide the funds for such plans. Increasingly, however, new money from private equity firms is being invested into expanding physician practices.
Please feel free to contact us to discuss your plans for managing profitable practices.
This article contributed by Terri L. Marakos, CPA.