Following a record year of U.S. healthcare deal volume in 2020, healthcare-focused investors are continuing to aggressively pursue acquisitions in the physician practice space. Physician-owners interested in seeking strategic partners to pursue their strategic objectives for their practices and liquidity for their partners must consider many factors. We’ve broken down several considerations below, with a focus on transaction preparation and alternative transaction structures.
Successful physicians have built impressive reputations in the communities they serve, and sometimes even nationally and internationally, depending on the specialty. It’s ultimately the physicians who create value in a physician practice and, for this reason, an investor will expect (or even require) the selling physicians to remain with the practice for a minimum of three to five years. Physicians must understand this requirement and prepare their practices for a transaction process accordingly.
Once a physician practice owner or owners have made the momentous decision to pursue a transaction, they must confer with all of their partners to ensure goals are aligned. Physician partner alignment may be the most important consideration of pre-sale preparation, as internal practice dynamics have the potential to make or break a deal. Often, younger partners, who are further from retirement, may be less interested in a sale and will need to be kept appraised of the strategic goals for the practice, as well as the interests of older partners who may be closer to retirement. Younger physicians should be incentivized by the operational efficiencies, near-term liquidity, and potential for increased equity value in aligning with a financial partner. Additionally, admitting new partners to the practice prior to a sale will dilute the equity value of the partner group, as well as potentially introducing different viewpoints on a transaction altogether. Therefore, all partners should be aligned on the strategic direction and goals of their practice, prior to commencing a process to find an outside investor.
In a similar vein, physician partners will need to consider various items related to any non-partner or employed physicians. This includes reviewing how much-employed physicians are producing for the practice, as well as determining what incentives are (or can be) put into place to keep them aligned through the transaction process, including a path to ownership. Employed physicians are often the future of the practice and represent part of the growth opportunity an investor is buying into. Accordingly, it is important to keep them motivated through various operational and financial incentives to keep interests aligned. If employed physicians were previously incentivized through a path-to-practice partnership, this does not necessarily disappear when the practice is sold. It will be important to discuss this when evaluating potential investors and educate the employed physician on their new career potential accordingly.
After the partners have agreed to pursue a transaction and the employed physicians have been considered, it will be useful to review (and potentially amend) the practice’s operating agreement. This will serve to recognize, avoid, or potentially eliminate legal challenges that may arise during a transaction process. In particular, understanding if any partners, payors, affiliated practices, or health systems can block a transaction or create any issues for the practice’s strategic goals will be an important pre-sale consideration. Prior to starting down the path towards a transaction, physician-owners may want to amend their operating agreements to limit the number of parties or external factors that could block a transaction to facilitate a smooth sale of the practice.
In preparing for a transaction, physician partners must consider the potential transaction structures that may be proposed. The transaction structure will likely determine how much an investor will pay for the practice, as well as create the post-transaction physician compensation model. Additionally, this structure will serve as the basis for physician reinvestment and relative ownership in their practice going forward. The most common buyers for specialty physician practices are currently private equity firms. Private equity firms will partner with the practices and bring administrative expertise, growth capital, and allow for physicians to achieve a liquidity event while continuing to retain additional upside. To facilitate a transaction, the private equity firms will form a managed services organization (MSO) and seek to partner with practice as a “platform” or “add-on” investment (to an existing platform) depending on factors including the size and sophistication of the practice. An MSO is essentially a legal entity that acquires all operating assets of a physician practice and handles all non-medical business and administrative functions, in exchange for an agreed-upon management fee for its ongoing services. The MSO structure is the mechanism that enables non-physician investors to participate in the business of physician practice management while maintaining compliance with the corporate practice of medicine laws.
Whether the practice is treated as a platform investment or as an add-on to an existing MSO will influence valuation, as platform investments typically command higher valuations. While practice level valuations are important, it is also important to understand that the individual proceeds from a sale will likely be based a physician’s production, in addition to their individual equity ownership. Higher producing physicians often realize higher incremental proceeds than their lower producing partners. Prior to a transaction, physician compensation is typically based on both their net collections and profitability of the practice. Post-transaction, investors will likely propose a market-based, percent of collections compensation model that keeps physicians incentivized to grow their individual productivity while maintaining the investor’s ability to attract new physician partners to the practice. The difference between the pro-forma compensation vs. historical compensation represents the amount the physicians can “monetize” as part of the transaction. For example, if a physician is earning $1 million pre-transaction, the new structure might allow for that physician to earn $600,000 post-transaction at similar production levels. The result of this discount to current income is the creation of $400,000 of profit attributable to that physician, which will then be monetized at a multiple in the transaction.
In addition to valuation, another way to maximize the individual proceeds from a transaction is by limiting the amount of taxes in the sale. This can be accomplished through the introduction of personal goodwill, which is viewed as an asset that is owned by a physician (not the practice itself) and represents the value of the physician’s personal productivity, reputation, expertise, and relationships. Attributing a portion of the proceeds to personal goodwill may reduce the overall tax liability associated with a sale as a portion could be treated as long-term capital gains, rather than as ordinary income.
Physician-led practices pursuing growth initiatives or retirement planning will oftentimes need a strategic partner with access to capital to accomplish these objectives. Private equity firms have over $1 trillion of capital ready to be invested and are more active than ever in partnering with specialty physician practices (see our previous article “Trends in Physician Practice Management” for more explanation on what is driving this consolidation). Having the right advisors by your side can make all the difference in finding the right partner and executing a successful transaction. Before moving forward in a potential transaction, physician practices should consult with their advisors to execute on the pre-sale preparation and understand the potential transaction structures to ensure a smooth and positive outcome for all stakeholders.