In addition, the profile of physician practices has changed significantly. A large percentage of physicians are now employed by hospital-based systems or large groups affiliated with such systems (such as medical foundations), eliminating the needs for capital and infrastructure support that drove physicians to seek refuge with PPMs in the 1990s. In addition, after a period in which some physician organizations, principally large independent practice associations (IPAs), collapsed due to their inability to deliver value to their physician members, large multi-specialty groups are reasserting themselves in the marketplace, and this is creating pressure on solo and small practices which are unable to adapt to required technological innovations, the shift to value based purchasing for physician services and the re-emergence of risk-based compensation systems in markets which abandoned such systems in the past.
Many of the current models for large physician organizations are showing signs of instability.1 Physician-hospital affiliation models created years ago and modeled on the then current, primarily fee-for-service reimbursement models have not shown the ability to adapt to changing circumstances and shifts in the means by which medical services are being delivered, including the emphasis on population health management. While large physician organizations have more capital resources than their smaller peers, their ability to continue to grow and remain relevant players in the marketplace is fundamentally constrained by laws which restrict ownership and limit physician organizations from assuming risk for the services of other providers.2 As a consequence they are seeking new sources of capital (other than hospital systems) and partners that can provide the means to expand service offerings and support practice improvement initiatives.
This article will provide an introduction to private equity (PE) firms which are entering the market to acquire physician and ancillary services provider organizations, explore the nature of the deals being proposed to physician organizations and identify a number of important considerations and common deal terms which characterize PE transactions with physician organizations, reflecting the expectations and investment perspective of these firms. While much of the discussion will focus on acquisitions of physician organizations or practice assets, it is equally applicable to joint venture transactions to create new organizations to be engaged in risk contracting or population health management.
Enter the PE Firms
PE firms3 have appeared in the fractured marketplace described above, presenting an alternative for physicians and groups.4 These organizations have raised large pools of capital for investment in physician services and allied businesses, lured by the $600 billion marketplace,5 and their investments in provider services in recent years are substantial.6
Many of the PE firms are market sector agnostic, e.g. physician services as opposed to diagnostic services, as they are focused on deals promising absolute financial return to their investors and healthcare investments in general have provided better returns over the past few years than comparable investments in other industry sectors.7 In addition, they may lack a meaningful pedigree in the delivery of healthcare services, which on the one hand means they may be naïve as to the environment in which physician organizations operate, but also that they are not limited in their imagination by traditional tropes and are not burdened by regulatory constraints which affect hospitals. Since they are not providers of care they are willing to be more concrete in their support for clinical independence of their physician partners, within the confines of financial performance parameters established in their models.
As noted, private equity investors are primarily motivated by absolute return on invested capital. The managers of these funds rely on outside investors for capital and are aggressive users of debt to magnify their returns. Since they typically are compensated based on a formula that includes a two percent annual return, based on invested funds and 20 percent of gains on the disposition of investments,8 they must achieve significant returns to satisfy the expectations of their investors and this fuels an appetite for debt, particularly in the current low interest rate environment. In addition, the managers enhance returns by rotation of their investments, typically within time horizons of five to seven years.9 This is a stark contrast to hospital-physician deals which, in the author’s experience, are typically premised on extremely long partnership periods (20 years or more) and means that physicians involved in PE deals need to be prepared for prospective change in their PE partners relatively frequently. A benefit for physicians in these deals is that they are offered an equity upside from future transactions (which is generally not available in hospital deals), and if the PE firm offers a significant increase in scale by rolling up a number of specialty practices, prospective gains which are substantially higher than the physicians would realize from the sale of just their practices.
The need for returns influences the types of deals that are attractive to PE investors. They tend to be interested in practices which are readily scalable due to similar services offerings, those which make use of relatively capital intensive technology (e.g., ophthalmology practices which use lasers and dermatology practices offering Mohs surgery), and those for which they forecast stable to increasing levels of reimbursement in the investment horizon.10 They are also interested in reimbursement schemes (such as managed Medicaid) in which there is opportunity in managing risk through improved practice performance, even if the reimbursement rates are below those offered for private pay or Medicare services. As a consequence the targets for their acquisitions may vary from year to year.
Preliminary Considerations; Meeting the PE Firm
PE firms may approach what they believe to be an attractive group without regard to existing relationships or commitments the group may have.11 If the physician group is already party to a management or services arrangement with a hospital or system, its leadership must consider the degree to which it has freedom to discuss a potential transaction with a third party. It may be that the physician group is only bound to joint contracting in a limited sphere of payment arrangements, leaving it with the right to pursue other opportunities on its own initiative. The group may have certain exit rights from its current arrangement, or believe that its hospital partner has not fulfilled its obligations with respect to investment in practice assets, management infrastructure or negotiation of managed care arrangements. Before initiating discussions with a PE firm, the group must carefully explore the extent of its commitments and devise a strategy, including communication and transition plans that will permit it to seek a new partner. In addition, knowledge of its obligations may inform the negotiation of terms with a PE firm that will include funds to exercise buyout or other rights necessary to terminate its contracts and move on to a new relationship.
Unlike negotiations with hospitals over joint ventures or affiliations, in which physicians and groups often enter based on significant historic relationships, preliminary meetings with a PE firm must be approached with regard to the firm’s expectations and experience. The PE firm may bring some expertise from other transactions into the discussions, but it will not have the same orientation toward delivery of care as would a hospital or another provider group. Rather, the PE firm will be much more focused on financial aspects of a transaction, since it does not directly benefit from clinical integration — unless it is acquiring multiple practices in a specialty area and is looking to gain market share for competitive and contracting purposes. Hence the ability of the group to demonstrate predictable future earnings will be an important consideration, both in determining price and in evaluating the feasibility of financing the transaction. Since most physician groups distribute substantially all of their earnings to their owners and do not have audited financials, physicians who negotiate with a PE firm must be prepared to see their financials “reconstructed’ (with caps on physician income) to reflect profitability at the entity level — either the group itself, in states where that is permitted, or through a management enterprise jointly owned by the physicians and the PE firm. In addition, the PE firm will expect to have an outside accounting firm perform what is called a “quality of earnings” or QoE, analysis to test the historical accounting practices of the group and develop a forecast of likely future earnings. It may also retain a consulting firm that can provide an assessment of prospective changes in federal or state law and policy that will affect reimbursement for the group’s services in the future. Finally, the PE firm may have certain baseline expectations concerning physician work commitments and revenue generation to support its financial models and the capital structure of the deal.
The PE firm will want to enter into a non-disclosure agreement very promptly and get authority to do preliminary financial testing to determine whether a deal makes sense without being committed to complete the transaction. To get there it may issue a preliminary “expression of interest” with a proposed purchase price and other key terms. It is important for the group to understand that such a document is not binding, and will be highly qualified, leaving the PE firm with substantial opportunity to renegotiate terms or walk away from the deal.12
The Letter of Intent
After the PE firm has conducted its preliminary investigation, it will make a decision on whether to present a letter of intent (LOI) for the acquisition. While the LOI will be characterized as “non-binding,” unlike the expression of interest the LOI will include relatively definitive terms, including price and structure of a proposed transaction as well as a requirement that the group negotiate exclusively with the PE firm. In addition, the LOI will set out more detailed requirements for due diligence, conditions precedent to the obligations to complete the transaction and termination rights. It is important that the group be well advised on what are typical (or in the jargon of dealmakers, “market”) terms in the LOI, to avoid a situation in which the group is tied up negotiating an inferior transaction and unable to seek better terms. In one case with which the author is familiar, the PE firm’s LOI was exclusive for a set period of time, but did not include a right of the group to terminate, creating an ambiguous situation where, several months after the LOI was signed, it was not at all clear whether the PE firm was intent on proceeding, but the group was at potential risk for entertaining other offers.
In some instances, the group may wish to propose a “fiduciary out” term, which allows the group to terminate negotiations during an exclusivity period if it receives an unsolicited offer that it deems superior to the pending offer from the PE firm. The rationale is that the board of the group cannot truly exercise its fiduciary duty to the owners of the group if it cannot seek the best price and terms for a deal. If the PE firm is amenable to such a provision, it will typically require either the ability to match the other offer or to receive a “break up” fee (which may be two to five percent of the value of the transaction), to compensate it for the time and expense associated with its investigation of the deal. These types of protections for the PE bidder will tend to discourage competing offers from being made at all, and the group should not seek a fiduciary out unless it is reasonably sure that competitors are likely to approach it without being invited to submit a bid.
As noted, the LOI is still non-binding, except for provisions related to confidentiality of information exchanged, the obligation to negotiate in good faith toward definitive agreements, termination rights, and in some cases remedies for a breach of the LOI. As a result, it is important that the group have a sense of whether the PE firm is truly serious about the deal or is just kicking the tires. In many instances it is useful to perform “reverse due diligence” on the PE firm to learn about its track record in closing deals and possibly to interview physicians with whom the PE firm has worked in the past. As important as the terms of the deal are going in, it may be far more important for the group to have an understanding of how it may be treated by the PE firm after the closing — for example, will the PE firm be faithful to key understandings or does it say whatever is necessary to get the deal signed and then become a bad partner? Will it respect bargains about governance and truly involve the group in key decisions or just pursue its own agenda? Will it be committed to making the partnership successful, or will its attention be focused on the next deal? The answers to these types of questions should play an important role in proceeding with a PE firm.
Traditional hospital-physician affiliation models involve the acquisition of practice assets coupled with a long term provider agreement, the purpose for which is to bond the physician group to the hospital or health system. Physicians will realize some gain on the initial sale and benefit (hopefully) from a compensation package which will afford some protection from market pressures and alliance with provider system that remains relevant to payors in the future. In the case of non-profit hospitals and health systems there are regulatory limits (such as the Anti-Kickback and Stark laws) on the amounts that can be paid to acquire assets and in compensation going forward, in addition to charitable trust concerns and the inability to afford physicians a continuing equity role in the enterprise. For-profit hospitals do not face the latter constraints and can create true joint ventures with physician equity participation, but must still contend with patient referral concerns and fair market value considerations in structuring the financial relationship with physicians.
In contrast, PE firms do not typically face these types of hurdles. Since they are not providers, and generally are focusing on a relatively narrow silo of services, they are usually not concerned with anti-kickback issues with respect to the acquisition of assets or compensation to physicians, although they are disciplined by (some would say) the harsher mistress of financial performance. Rather than being unable or unwilling to offer an equity upside to physicians, PE firms typically require that sellers retain 20 percent of the equity in the acquisition vehicle, so that the physicians have “skin in the game” and to reduce capital investment in the acquisition phase. Physicians need to be concerned about two issues in this regard — the first being what rights they may have to sell the 20 percent “strip” in the future, and second, ensuring that it represents a meaningful stake in the future if the PE-backed enterprise grows. Typically, the physicians will be required to sell their interest into a transaction the PE firm negotiates, a so-called “drag along” obligation, and may be able to participate electively in a potential sale, a “tag along” right, but they typically do not have the right to require the PE firm to buy them out in the future or to sell their equity to a third party.
In addition, an important point of negotiation is the equity rights the physicians will have, if any, in a parent entity which owns the practice acquisition vehicle. Having a right to convert subsidiary equity into parent equity more closely aligns the physicians with the ultimate financial interests of the PE firm, rather than potentially being limited to owning a piece of an entity that serves their practice alone, or a small universe of local practices, and consequently may reduce the risk of holding the equity investment over the longer term. Conversion rights, if offered at all, will be heavily negotiated by the PE firm, since granting them to physicians prospectively dilutes returns for the PE sponsor and its investors.
Depending on the relative sophistication of the physician group and its financial history, there may be significant negotiation about how the purchase price is to be paid. PE firms may try to set a high price to attract interest from the physicians, but minimize front-end capital outlays by making certain elements of the purchase price contingent, whether on post-closing adjustments based on audits of profits or working capital, or through “earnout” arrangements where additional payments are tied to attainment of financial performance targets by the management vehicle after closing. These bits of financial engineering can have significant implications for the actual proceeds physicians can expect to receive in a transaction, as well as the value of the equity interest they retain. In a more perverse situation, the physicians may discover that they are ultimately paying themselves by providing all of the financial returns that generate future contingent payments. It is important that the group have counsel and other advisors who are familiar with these types of arrangements and can analyze the risk and reward associated with different payment models.
Physicians also need to be aware that PE firms will be more aggressive than hospitals in implementing IT systems and financial reporting infrastructure, and are more likely to require changes from the platforms the physicians may be using with hospitals. Often the PE firm will see such systems as drivers of profitability through decreasing operational costs. On a related note, the PE firm will be focused intently on revenue enhancement through careful attention to coding for services, prompt billing and aggressive collection practices, and this can be disruptive to physicians, as it represents changes in the way they have typically conducted their business. There will likely be a loss of collegiality and understanding of certain practices which are viewed by the PE firm as inefficient.
In addition, in situations where the basic agreement anticipates management of the physician group or a complex contracting strategy, the PE firm will insist on a fairly iron-clad long term provider agreement. Unlike the rationale for such arrangements with hospitals — insuring long term loyalty — the PE firm is seeking to lock in a revenue stream that will facilitate the sale of the enterprise in a relatively short time frame. Consequently, financial terms in the provider agreement need to be reasonably acceptable into the future and include downside protection against changing reimbursement patterns, since physicians will not have a right to terminate, say in the event of a sale of the management enterprise or a financial restructuring by the PE firm.
Not surprisingly, termination rights are also heavily negotiated. The PE firm will want exits in situations where its financial projections are upset by material changes in regulations or reimbursement rules or where the physicians fail to meet basic productivity targets. They will resist termination rights in favor of physicians and groups in situations where the PE firm has failed to achieve market share or growth targets. Rights to terminate for breach will be very limited. Neither side should be looking for, or expect, a near term exit. In addition, the deal terms need to address the disposition of assets in the management enterprise on termination. Unlike the typical hospital-physician relationship, in which physician practice assets have little value to the hospital, the PE firm may have a strong interest in certain assets that support its management of other groups, and the physicians need to contemplate how they might replace the systems for maintaining medical records and which support billing and financial reporting in the event that the PE firm is unwilling to sell them to the physician group on termination.
Another important consideration is governance rights. While the PE firm may offer the physicians parity in board representation, it may insist on tie-break rights on key issues that affect financial performance and provide only limited “reserved powers” to the physician representatives on the board. In addition, managers appointed by the PE firm will typically have fairly broad discretion in business operations. The physicians should expect control over clinical matters, but even in this area, the PE firm may want a voice in clinical decisions that affect revenues and profitability, to the extent this is not limited by laws governing the professional practice of medicine. In addition, as is the case with equity interests, the physicians need to appreciate whether their governance rights are limited to the subsidiary which acquired their practice or includes representation in a parent entity, which may be charged with making decisions that affect the subsidiary based on regional, or even national, considerations.
Finally, the parties need to consider the issues of capital investment. Physician groups are chronically short of capital and one factor that PE firms emphasize in pitching for deals is their ability to provide resources for better practice support. The key question is whether the PE firm will deliver on its promises and meet the expectations of the physician group, which may also turn on a meeting of the parties’ minds about common expectations. Physicians should expect that future capital decisions by the PE firm will be based on fairly hard-edged financial metrics and need to become familiar with terms like “hurdle rates”13 for investments. This is in stark contrast to historical relationships they might have with a hospital, where the hospital may be motivated to make capital investments for political or other non-financial reasons.
The Transaction Process
Traditional hospital-physician transactions are often idiosyncratic, with terms negotiated to suit the particular local situation and influenced by personal relationships between the principals. In many cases the parties may even choose common legal counsel in an effort to save expense and limit contentious negotiation. In contrast, physicians should expect the PE acquirer to come to the table armed with very specific transactional norms in mind and detailed reasoning behind its negotiation strategies. It may demand use of its form deal documents and entertain only limited changes. Physicians are well advised to retain knowledgeable transaction advisors, both to assess the reasonableness of proposed terms and provide a context for the group to appreciate the consequences of the transaction as well as to negotiate favorable terms based on prior experience. Counsel can play a valuable role in shaping physician expectations concerning the outcome of negotiations as well as helping the group deal with transactional customs such as disclosures and due diligence investigation, which form the basis for representations the group will need to make in definitive agreements.
The decision to enter into a purchase contract dramatically increases the liability of the parties; they are no longer in a situation in which they can easily walk away from the deal without consequence. The purchase agreement is a binding contract and must be treated with seriousness, as it contains all of the specific terms of the transaction. A discussion of the key elements common to these documents follows.
Representations and warranties will comprise a substantial share of the base acquisition or joint venture documentation, and physicians must appreciate subtleties in what they are promising about the business being sold. Breach of representations and warranties implicates contractual remedies, so it is very customary to negotiate limitations on the extent of representations, for example the extent of the representation is based on the actual knowledge of key physicians in the group (rather than being absolute) or limited to matters that are “material” (those for which a misrepresentation would have a substantial impact on the acquired practice). In addition, there are customarily time limits on the duration of the representations, after which the acquiring entity has assumed the risks of a state of affairs inconsistent with the representation. In this area it is also important to have advisors with experience in negotiating representations and prepared to propose customary limitations to protect the physicians’ interests.
The representations generally tie into provisions which require the physicians to indemnify the acquiring firm if certain events occur after the closing. The indemnity language may require that the physicians actually assume the defense of the acquisition entity or, alternatively, pay for any expenses or damages incurred. The obligations may also be affected by the availability of insurance to cover losses, obviating the need for indemnification by the selling physician organization. As with the representations, it is important for the physicians to understand customary terms for indemnification, for example capping exposure to a percentage of the purchase price, or requiring that the damages exceed a negotiated threshold before the obligation is triggered. It is also important that there be time limits on the assertion of any claim for indemnity to provide certainty as to the extent to which the physicians may be exposed.
The purchase agreement may also contain specific promises concerning matters to be addressed by one or both parties as conditions precedent to closing, in situations where there is a gap period between signing the purchase agreement and the closing date. These “covenants” can include securing governmental or third-party consents where required to complete the deal; addressing employment matters, such as assisting the purchaser in hiring key personnel or transitioning employee benefit plans; restrictions on the pre-closing conduct of the business; protection of the confidentiality of deal terms; and limits on the ability of the selling physicians to compete with the acquiring entity in certain lines of business in the future.
Finally, the purchase agreement will contain certain terms that are described as “boiler plate” and which seldom attract attention from businesspeople negotiating a deal, as they address somewhat mundane issues such as governing law and whether singular terms refer to the plural as well. Nonetheless, some of these often-neglected provisions can become significant to the parties in the future — for example, the right of the PE firm to assign its interests to another entity or the manner in which disputes between the parties are to be resolved. Competent advisors will recognize the importance of such terms and at the least focus the attention of the physicians on the potential consequences of certain choices.
Once the transaction is closed, the parties must now accommodate themselves to coexistence based on the terms of the agreements they have negotiated. Early decisions on the conduct of the business will test whether the governance arrangements mirror the expectations of both sides and provide for a solid working relationship. As the management of the new enterprise begins to dig into operational details it may discover problems which implicate the accuracy of representations, such as the existence of an undisclosed claim or non-compliance with a key license, and the parties must determine how to address the situation — either by working cooperatively to solve the problem or seeking recourse to the contractual terms they have negotiated. It is perhaps only at this time that the physicians may appreciate the importance of the representations and covenants they agreed to. Operational decisions that may be left to management under the key agreements can be escalated to the governing board if, for example, physicians become dissatisfied with policies concerning support personnel, creating tension concerning the appropriate roles of management and the board.
Over the longer term, compensation arrangements will be subject to contractual adjustments, and this will be tested against the parties’ expectations. Physicians may become dissatisfied and seek to leave the group, creating potential issues with exit strategies and possibly with maintaining sufficient practice revenues to support the management structure.14 At some point the PE firm will reach the point at which it seeks to roll over its investment to raise cash for distribution to its investors, or to find new acquisition targets with better returns, but keep the physician group bound to provider or other agreements to assure that it has a salable asset. This will prompt discussions with the physician owners concerning the future course of the business, including the willingness of the physicians to work with a potential new partner or alternatively to exercise rights to reacquire the business. While these issues should properly be addressed in the negotiation of the purchase agreements, even the best advisors have limited foresight as to issues that may emerge, particularly if the PE firm is inexperienced in operating the business or the physicians were not well advised on their undertakings.
The transactional documents may also contemplate a potential breakup of the deal in certain events — for example, if the entity is unable to meet agreed upon targets for revenues or profitability, or changes in law or regulation jeopardize the viability of the organization. Some recent transactions involve the creation of joint venture entities that will be risk bearing organizations, contracting with health plans to provide a wide range of services for a global capitation payment. This is an area in which state laws in many instances are undeveloped or developing, and the transaction structure chosen by the parties may not be in compliance with changing requirements. Changes in law may require additional capital commitments or expenses associated with licensure, which were not contemplated by the parties and may be beyond their capabilities. Negotiation of exit provisions (as noted above) is often difficult and distasteful to the parties; who wants to contemplate divorce on the precipice of marriage? Nonetheless, having certain plans against future events built into the relationship at the outset may create a basis for resolution and the avoidance of disputes. The working relationship developed between the parties may be critical in how they address potentially unforeseen circumstances that force reconsideration of the basic deal.
The recent interest of PE firms in acquiring provider organizations has created new opportunities for physicians and introduced an element of disruption into the traditional relationships between physicians and hospitals. The access to capital and ability to innovate afforded by PE firms may create new models for service delivery that better address the reimbursement profiles of the future, with increasing bundles, value based payments and true risk arrangements. While deals with PE firms may be superficially attractive to certain physicians, completion of deals can be quite challenging given the ways in which the expectations of PE firms differ from well-trod ground that underlies the provider deals negotiated in the past. As a consequence, it is important that physician organizations take the time to understand the new players in the market and seek out counsel and other advisors who can be effective in evaluating and documenting potential deals.