The U.S. healthcare system has recently experienced events that would ordinarily cause those considering private equity investments in the industry to be hesitant to do so. A new Administration, uncertainty regarding the status of the Patient Protection and Affordable Care Act (PPACA), consolidation in the provider and payor world and changes in reimbursement would seem to all be material in making investments in the healthcare sector. However, these considerations, which may be red flags to some, appear to be opportunities to others. While there has been a slight drop-off in healthcare merger and acquisition activity, private equity investment in the healthcare sector continues to be significant across areas of the spectrum. This activity is not limited to hospitals and physician practices. Significant investment continues to flow into ancillary providers. These ancillary providers supplement the care provided by hospitals and physician practices or provide products or services utilized by those providing direct patient care. For purposes of this review, all such ancillary providers are considered ancillary healthcare providers.
Why Does Private Equity View Healthcare Investment Favorably?
Despite the uncertainties tied to the healthcare industry, the total value of private equity investment in 2016 reached its highest level since 2007.1 Investors continue to view the healthcare industry as a safe haven from economic volatility.2 The value of disclosed transactions involving private equity was $36.4 billion on a global basis.3 This investment activity was across all major sectors of the healthcare industry, with significant activity involving those referred to as “healthcare-light companies.” 4 This classification encompasses those in the healthcare industry that are usually not directly impacted by changes in reimbursement.5 This industry positioning allows for those entities to benefit from market forces, causing growth in healthcare without being detrimentally impacted by some of the regulatory risk.6 Many types of ancillary providers fit within that category.
North America healthcare investment experienced a tumultuous 2016 in light of the competition for choice asset targets, political uncertainty and aggressive valuations but still witnessed a total deal value of $28.4 billion.7 The focus away from those companies overly affected by regulatory and reimbursement concerns fueled much of this activity. Interestingly, nine of the top ten healthcare deals globally involved U.S. assets with 40 percent of those transactions involving European buyers.8
Niche Ancillary Provider Investment Areas
The healthcare industry has certain niche ancillary providers that are of particular interest to the private investment community. These ancillary providers include healthcare IT and electronic health record (EHR) vendors, laboratories, behavioral health, urgent care, revenue cycle management, and management companies offering business services to dental and anesthesia providers.9 The reason these areas are of heightened interest is three-fold.10 First, some ancillary provider segments of the marketplace are experiencing high profits which are not expected to last for a significant period due to pending regulatory or payor action or market saturation. Second, the products and services of these ancillary providers may be in high demand in patient care so profits are reasonable and explainable. Third, these providers often offer profitable ancillary products or services to a primary business line such as laboratory services in a physician office.
Those ancillary providers who have seen significant investor interest but which have recently experienced less activity include medical devices, ambulatory surgery centers and specialty pharmacies.11 While these three areas still maintain solid returns, each has issues that may make them less attractive than the other highlighted ancillary providers.12 These concerns do not necessarily mean that any of the three would not be an attractive industry for investment purposes. Rather, market attention has simply shifted to new areas that appear to have greater potential from a financial aspect or in light of market conditions dictated by the government or payors.
The healthcare IT and EHR space, or what is recently been referred to as the “Digital Health” space, has seen the market mature where the number of market participants has narrowed significantly.13 This reduction in providers fosters incentivizing those remaining to outpace competition by creating and offering advances in technology. The result of such activity makes for an attractive market. Also, the various governmental and payor efforts to create and utilize common information platforms in the delivery of care will continue to create a market for these products and the underlying support services they have to offer. Significant private equity transactions in the second quarter of 2017 include Modernizing Medicine, which provides EHRs for specialists; it raised $231 million, increasing its total funding to $318 million.14
Laboratories continue to be appealing to investors, since their services are necessary in the delivery of care by hospitals and medical practices and are a basic component in the national effort to provide preventive care and coordinate care among providers.15 There have been several recent highly publicized private equity transactions in the laboratory area.16 However, there has been significant enforcement activity involving fraudulent billing, unneeded services performed and kickback schemes between laboratories and other providers.17
In addition, laboratories that utilize management and distribution companies to create a financial arrangement with a referral source rather than the provider having an investment in the laboratory may be subject to additional regulatory scrutiny. The laboratory will establish a management or distribution company and will offer providers, commonly those who refer business to the laboratory, the opportunity to invest in the company. The general concept of a management or distribution company may fit within certain safeguards and be lawful, but the use of this business model has pushed the boundaries. For instance, a laboratory may pay the management or distribution company for questionably needed services or amounts that may exceed fair market value for services performed. There are also instances where the laboratory has established multiple management or distribution companies and offered investment opportunities to small groups of physicians. The company will then provide management and distribution services related to the laboratory’s business associated with the investors. However, this type of arrangement usually reveals no business purpose for a laboratory to have multiple management companies performing the same service and the investor physicians commonly receive distributions that may be similar to their referral patterns. The Department of Health and Human Services’ Office of Inspector General (OIG) remains sensitive to management arrangements that involve companies with physician investors that are providing products and services to ancillary providers that the physician investor may refer to and in turn benefit from the management fees derived from such referrals.18
Behavioral health and substance abuse treatment operations have seen a significant increase in investor attention. The attractiveness of this ancillary area is due to the increased demand for their services in conjunction with limitations on the ability of payors to utilize more onerous standards when determining reimbursement for such services than those used for pure medical services.19 Additionally, governmental regulation requiring behavioral health payor coverage and significant revenue and profit margins are other driving forces that have caused this area to be appealing for the past five years.20 Indications are that such drivers will continue to create a positive effect on this segment’s outlook.
The urgent care market encompasses more than just neighborhood urgent care centers. Investments in this area include CVS’ Minute Clinic, free-standing emergency departments and specialty urgent care, such as orthopedic-specific urgent care facilities.21 Since 2008, approximately $3 billion has been invested in this industry with speculation of continued activity in this area occurring through 2019 and beyond.22 A recent transaction involving the majority acquisition by a private equity firm of a majority stake in the 68-unit CityMD urgent care chain is an example of such activity.23
Revenue Cycle Management
One may not believe that revenue cycle management (RCM) providers are ancillary providers in the healthcare world. However, the core business of these providers pertains to the fundamental issue encountered by all healthcare providers: efficient tracking, billing and collecting of revenue. RCM is more than just billing and collecting services. It may be as complex as the administrative department of an enterprise that handles all financial aspects of operations, performs analytics and offers revenue solutions, or as simple as providing software that may be used to perform such functions.24 With the variety of RCM services, its market is expected to grow at a 26.5 percent compounded growth rate through 2018.25 Private equity has been instrumental in expanding RCM operations through internal growth as well as acquisitions of smaller targets to shore up end-to-end RCM service offerings.26
Practice management companies, such as in dentistry and anesthesia, have been attractive to private equity groups. Similar to RCM providers, these companies provide a valuable tool in navigating the business aspects of healthcare. From the mid-2000s to 2015, more than 25 private equity firms committed significant investment in dental practice management companies, with some of the larger companies in this space achieving annual revenues in excess of $100 million.27 Similar projected growth continues to make this an appealing ancillary provider even in spite of a 2013 Senate committee investigation that concluded some dental practices should be excluded from Medicaid due to questionable practices.28 Recently a private equity group committed $25 million to fund the organization of a dental practice management start-up.29
Anesthesia practice management companies have exploded onto the market in the past few years, and private equity has taken notice.30 Anesthesia practice management services allow for platforms that are scalable without the need to incur high cost since anesthesia services are primarily located at facilities such as hospitals and surgery centers.31 It is not a capital-intensive venture to expand anesthesia operations because they generally do not require significant space, equipment or staffing. This allows for a much more profitable type of medical practice that will in turn generate revenue for the management company.
Why Has Private Equity Increased Its Focus on Ancillary Providers?
There are several reasons why ancillary providers have experienced increased investment activity by private equity compared to physician practices. First, hospital acquisition of physician practices has increased, so physician practices do not necessarily need to seek private equity to fund aspects of the practice. Rather, the health systems may acquire a physician practice and provide the funding necessary to expand it and its capabilities, a function ordinarily served by private equity. Second, the prohibition against the corporate practice of medicine doctrine32 restricts private equity from investing in physician practices. In those states that follow this doctrine, it limits the ability of a private equity firm to invest in physician practices since a non-licensed person would be an owner in or control a medical practice. Finally, ancillary providers have experienced substantial revenue growth due to PPACA’s expansion of the need for such services through incentivizing preventive medicine and quality of care measures that rely upon ancillary providers and their services.
The availability of capital from private equity has been of significant value in the various ancillary markets. The opportunity for increased access to funding allows local or regional providers to expand the markets where they offer services. It may also provide funding for new equipment or personnel or the ability to move into other complementary ancillary services. By providing avenues for funding, private equity enables the ancillary providers to be more independent and not reliant on health systems as a funding source by being acquired or entering joint venture arrangements. Ultimately, new sources of capital that ancillary providers may access havebeen a “win-win-win” for all involved. It allows the ancillary provider a different source of capital from that it has traditionally utilized through health systems and physicians. The private equity firms are able to invest in healthcare and obtain significant positive return on investment through a focused healthcare vehicle. Non-ancillary providers and their patients have additional, and more advanced, opportunities from those ancillary providers that have expanded their operations, either through geographic footprint or services offered, which may lead to better care.
Private equity investment in ancillary healthcare entities will continue to thrive even with the uncertainty in the U.S. healthcare system. Ancillary providers that have made a niche in the industry addressing product and service lines necessary to comply with governmental and payor requirements are popular investment vehicles since they are needed by those who provide medical services. Those that provide value-added services, especially without incurring significant cost in doing so, have been particularly attractive to private equity. Many of these ancillary providers were spawned out of the need to bring additional expertise to the healthcare provider in the delivery of care. Continued evolution of further ancillary providers that identify additional niches will be those whom private equity will continue to seek out for investment purposes.
Patrick D. Souter is Of Counsel with the law firm of Gray Reed & McGraw, LLP in Dallas, Texas where he is a member of the Healthcare, Corporate and Securities Practice Groups. Mr. Souter’s practice focuses on transactional, administrative, regulatory and antitrust matters for healthcare providers and suppliers. His representation includes organizational and operational issues with specific emphasis on the areas of fraud and abuse, licensure, reimbursement and compliance. He is an Adjunct Professor at Baylor University School of Law in Waco, Texas where he teaches Healthcare Law, Healthcare Fraud and Abuse and Regulation of Healthcare Professionals. He is also an Adjunct Professor in the MBA Program at the Baylor University Hankamer School of Business Robbins Institute for Health Policy and Leadership where he teaches Healthcare Law and Ethics, Healthcare Law: Applications & Strategies and Business Law: Applications and Strategies. He may be reached at firstname.lastname@example.org.
Kara Murphy, Nirad Jain, Joshua Weisbrod, Franz-Robert Klingan, Vikram Kapur, Justin Doshi and Jeff Haxer, Global Healthcare Private Equity and Corporate M&A Report 2017, Bain and Company, April 19, 2017, p. 1, available at http://www.bain.de/en/Images/REPORT_Healthcare_Private_Equity_and_Corporate_M%26A.PDF.
Kara Murphy and Nirad Jain, How Private Equity Picks Healthcare Winners, Forbes, June 20, 2017,p. 1, available at https://www.forbes.com/sites/baininsights/2017/06/20/how-private-equity-picks-healthcare-winners/#59a472ed1249.
Global Healthcare Private Equity and Corporate M&A Report 2017 at 3.
Id. at 1.
Id. at 12.
Scott Becker, Brooke Murphy, Geoff Cockrell, Bart Walker and Amber Walsh, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, Becker’s Hospital Review, April 11, 2016, available at https://www.beckershospitalreview.com/white-papers/private-equity-in-healthcare-a-review-of-15-niche-investment-areas.html.
Id. at Introduction.
Id. at II. Investment Areas: 4. Medical Devices; 8. Ambulatory Surgery Centers; and 14. Specialty Pharmacy.
The impacts on private equity interest in each of these ancillary services are the result of varying market-driven forces that may make each less attractive to those in search of a private equity opportunity. The medical device industry, while highly concentrated with a limited number of major participants on a national level, has a high degree of market fragmentation on the local level. Ambulatory surgery centers still produce profitable financial results but the industry itself has not recently witnessed significant overall growth. Specialty pharmacies have more risk due to the possibility of significant swings in revenue.
Id. at Section 2. Healthcare IT and EHR.
81 Digital Health Funding Deals from Q2 2017, MobiHealthNews, July 7, 2017, available at http://www.mobihealthnews.com/content/81-digital-health-funding-deals-q2-2017.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 3. Laboratory Businesses.
Amber Walsh, Paul Kiehl and Bart Walker, Lab Services Market Remains Ripe For Private Equity, Law360, May 4, 2017, available at https://www.law360.com/articles/920293/lab-services-market-remains-ripe-for-private-equity.
See New York Doctor Sentenced To 33 Months In Prison For Role In Test-Referral Scheme With New Jersey Clinical Lab, Department of Justice, U.S. Attorney’s Office, New Jersey Division, November 8, 2017, available at https://www.justice.gov/usao-nj/pr/new-york-doctor-sentenced-33-months-prison-role-test-referral-scheme-new-jersey-clinical; See also Drug Testing Company to Pay $5 Million Civil Money Penalty Settlement, Office of Inspector General, Department of Health and Human Services Press Release, February 12, 2014, available at https://oig.hhs.gov/newsroom/news-releases/2014/drug-cmp.asp ;
OIG Advisory Opinion No. 11-15, available at https://oig.hhs.gov/fraud/docs/advisoryopinions/2011/AdvOpn11-15.pdf.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 5. Behavioral Health.
Deborah Balshem, Behavioral Health Continues To Attract Private Equity Investors, Forbes, July 6, 2017, available at https://www.forbes.com/sites/mergermarket/2017/07/06/behavioral-health-continues-to-attract-private-equity-investors/#20e4f8d06210.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 6. Urgent Care.
Dave Barkholz, Private Equity Firm Warburg Pincus Buys Majority of Urgent-Care Chain CityMD, Modern Healthcare, April 18, 2017, available at http://www.modernhealthcare.com/article/20170418/NEWS/170419866.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 13. Revenue Cycle Management.
Brooke Murphy, 7 Thoughts on Private Equity in RCM, Becker’s Hospital CFO Report, March 18, 2016, available at https://www.beckershospitalreview.com/finance/7-thoughts-on-private-equity-in-rcm.html.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 7.Dental Practice Management.
Private Equity Firm Invests $25M In Ohio Startup DSO, GroupDentistryNow, March 8, 2017, available at https://groupdentistrynow.com/private-equity-firm-invests-25m-in-ohio-startup-dso/.
Becker, et al, Private Equity in Healthcare – A Review of 15 Niche Investment Areas, supra at Section 12. Anesthesia Practice Management.
Amber Walsh, Top Physician Specialties For PE Investment, Law360, June 2, 2014, available at https://www.law360.com/articles/541918/top-physician-specialties-for-pe-investment.
Generally, the prohibition against the corporate practice of medicine doctrine prohibits a layperson from controlling a physician in the delivery of medical services, owning or controlling an entity that provides medical services or participating in revenue derived from such services. The rationale is that the physician should be free to provide care to the patient as needed and not be impacted by commercial or business purposes.