Recalibrating Priorities

In addition to the size and volume of investments in the healthcare industry, PE deals are happening faster than ever before. According to PitchBook, many industries, including the healthcare industry, are experiencing competition so intense that some deals are closing within a matter of days in an attempt to appease sellers.  The conveniences of Zoom and other virtual programs have assisted dealmakers in doing so.  Too many investors and a significant amount of capital with too few assets are pushing the supply and demand envelope more than ever before.  Behavioral health providers, for example, are an industry segment that has experienced “runaway valuation growth” due to “attractive margins, secular tailwinds, and a paucity of available targets.”

The more PE firms funnel dry powder into the healthcare sector at this unprecedented pace, however, the more they risk heightened exposure to the uniquely treacherous legal and regulatory landscape in which they are investing.  Today, both whistleblowers and the government are turning their attention both to PE firms’ portfolio companies and to PE firms themselves.  History indicates that government enforcement efforts will follow private investment and government reimbursement dollars.  In their eagerness to take advantage of the current investment landscape, PE firms and their portfolio companies must be careful not to sacrifice due diligence efforts under an increasingly watchful eye on the regulatory and legal side.  If PE firms are to avoid an enforcement collision of great magnitude, they must strongly consider how to limit liability under laws like the False Claims Act, which can lead to massive, almost draconian exposure due to its provisions allowing for both treble damages and statutory penalties for each false claim submitted to the government.

Private Equity’s Role in the Healthcare Sector

PE has become a huge player in the healthcare sector over the last decade — yet not everyone has welcomed its presence with open arms.  PE can fuel growth and support innovation.  It can help small healthcare companies scale up quickly — in some cases, creating an entirely new market for those firms and their customers.  PE firms can provide more than just capital, too.  They can help portfolio companies grow through business advice, hiring, contacts, diagnostics, systems development, and more.  They can, some would argue, improve management, compliance, and insurance reimbursement rates.

In the last decade, PE firms “have put greater focus on adding personnel able to improve the operating performance of portfolio companies.”  With respect to the healthcare industry specifically, PE firms are infusing capital to address consolidation and care coordination concerns while also providing management and business resources that allow physicians greater autonomy and fewer conflicts as compared to a relationship with a health system or larger independent physician practice. All of these effects can and do contribute to significant, positive advancements and improved patient outcomes in healthcare.

Despite those numerous benefits, however, some believe PE’s role in the healthcare industry is misplaced because its profit-driven focus is contrary to the ultimate goal of providing the best patient care possible.  A May 2021 white paper, published by experts at UC Berkeley and the American Antitrust Institute, concluded that “when the fundamental characteristics of the PE business model are combined with the unique structure of the United States healthcare market, the results are potentially catastrophic for healthcare providers, consumers, and the stability of the healthcare supply chain.”

According to those same experts, the very nature of the PE firm is geared toward generating short-term profits, which results in unsustainable business practices and pushes the limits of health and safety regulations.  Profit-based healthcare, they say, threatens patients’ trust in their doctors, and can lead to lost jobs, the destruction of previously-successful businesses, lost lives, and more expensive, lower quality healthcare.    

Regardless of one’s view, both sides should be mindful that the healthcare industry is built upon a complex web of laws and regulations designed to protect patients from the misalignment of interest that can result from profit-driven healthcare.  The False Claims Act is one such tool — and an extremely powerful one at that.  Today, it is being used with greater force than ever before against PE firms’ portfolio companies and PE firms themselves.

The Interaction of the False Claims Act and PE Firms in Healthcare

The False Claims Act is a federal law that permits private persons (also known as “whistleblowers” or “relators”) to file qui tam lawsuits on behalf of the federal government.  The government can intervene in the lawsuit and assume responsibility for the litigation, or can leave the whistleblower to litigate the case on his or her own.  The False Claims Act imposes civil liability for, among other things, knowingly presenting a false claim to the government or knowingly making a false record or statement to the government in connection with a claim.  Many states have similar counterpart laws related to state government healthcare programs.

Importantly, defendants may be found liable for up to treble damages of the government’s loss, in addition to monetary penalties of approximately $12,000 to $24,000 for every false claim.  Relators, moreover, are encouraged to bring qui tam suits because they stand to earn 15 to 30 percent of the amounts recovered by the government, plus attorneys’ fees.   Virtually every type of actor in the healthcare sector has routinely been the target of qui tam actions in the past.  Although PE firms historically have avoided significant and consistent scrutiny, now they, and not just their portfolio companies, are in danger of being swept into those enforcement efforts.

In June 2020, in a speech to the U.S. Chamber of Commerce’s Institute for Legal Reform, then-Principal Deputy Assistant General Ethan Davis indicated that the Department of Justice (DOJ) was fully willing to hold PE firms liable not only for their portfolio companies’ actions but also what the DOJ may view as the PE firms’ own relevant actions.  Davis stated: “When a private equity firm invests in a company in a highly-regulated space like healthcare or the life sciences, the firm should be aware of the laws and regulations designed to prevent fraud.  Where a private equity firm takes an active role in illegal conduct by the acquired company, it can expose itself” to liability under the False Claims Act.

Enforcement efforts against PE firms are still developing.  The DOJ recently has started intervening in more False Claims Act cases seeking to hold PE firms liable for the improper conduct of their healthcare services portfolio companies.  For example, in September 2019, the DOJ settled a case with PE firm Riordan, Lewis & Haden Inc. (RLH) for its alleged role in a kickback scheme by one of its portfolio compounding pharmacies to pay outside “marketers” to target military members and their families for prescriptions for compounded creams and vitamins, which allegedly were formulated to ensure the highest possible reimbursement from TRICARE.  Specifically, the government alleged marketers paid telemedicine doctors who prescribed the creams and vitamins without seeing the patients, and, in some instances, even speaking to them.  The settlement also resolved allegations that the pharmacy and a marketer paid patients’ copayments and continued to claim reimbursement for prescriptions referred by marketers despite receiving complaints from patients that revealed the prescriptions were generated without patient consent or a valid patient-prescriber relationship.

According to the government, RLH was not merely a passive owner but managed the pharmacy on behalf of its investors and allegedly knew of and agreed to the plan to pay outside marketers to generate the prescriptions and financed the kickback payments to marketers.  The pharmacy and RLH ultimately agreed to pay approximately $21 million to settle the claims, with two of the PE firm’s executives paying approximately $315,000, collectively. 

In November 2020, a pharmaceutical and medical device company paid $10 million to settle allegations that it promoted extracorporeal photopheresis (ECP) systems for unapproved uses in pediatric patients.  As part of the settlement, the Gores Group (TGG), the PE owner of the company, agreed to pay an additional $1.5 million to resolve allegations that the portfolio company continued the alleged improper sales and promotion practices after TGG acquired the company, in part due to sales pressure that TGG applied to the company. 

In July 2021, Alliance Family of Companies LLC, a national electroencephalography (EEG) testing company, paid $13.5 million to resolve allegations related to false claims resulting from kickbacks to referring physicians or that sought payment from the government for work not performed or for which only a lower level of reimbursement was justified.  The PE firm Ancor Holdings LP, a minority owner in Alliance Family, agreed to pay an additional $1.8 million to resolve allegations that it discovered the portfolio company’s alleged wrongdoing during due diligence but failed to take action to stop it. 

In October 2021, H.I.G. Capital agreed to pay $19.95 million in the largest False Claims Act settlement to date involving a PE firm.  The lawsuit alleged that H.I.G.’s portfolio company South Bay Medical Center used unqualified or unlicensed staff to provide mental health services to patients and that it failed to supervise that staff appropriately.  Although the DOJ declined to intervene in the case, the Commonwealth of Massachusetts intervened and pursued damages for claims submitted to the Massachusetts Medicaid program, MassHealth. Two of South Bay Medical’s former executives agreed to pay an additional $5.05 million to resolve the case. 

Interestingly, the settlement came only months after a May 2021 district court decision denying H.I.G.’s and the two executives’ attempts to dismiss the case on summary judgment.  The court found there was sufficient evidence to conclude that H.I.G. could have known of fraudulent conduct at South Bay Medical Center but failed to correct it.  The court pointed out the various times H.I.G.’s members were informed about inadequate supervision at South Bay.  The court also noted that H.I.G.’s members’ majority participation on South Bay’s board of directors meant H.I.G. “had the power to fix the regulatory violations which caused the presentation of false claims but failed to do so.”  This was the first time a False Claims Act case against a PE firm proceeded through discovery and summary judgment before settling.

Most recently, in March 2022, a California district court unsealed a qui tam complaint alleging violations of the Anti-Kickback Statute against specialty pharmacies and their PE owners. The relator, a former vice president for defendant BioMatrix Specialty Pharmacy, alleged that the specialty pharmacies employed regional care coordinators (RCCs) specifically to recruit hemophilia patients to use the specialty pharmacies’ services.  The relator alleged that the RCCs were improperly compensated based on the number of patients each RCC referred to the pharmacies and the amount of product the referred patient filled through the pharmacies.  With respect to the PE defendants, the relator alleged that the PE owners were aware of the scheme, including participating in board meetings where lucrative “referral source relationships” were discussed.

The DOJ investigated the matter for three and a half years but ultimately declined to intervene.  Although the PE owners were alleged to have been informed about “referral source relationships” generally, the qui tam complaint did not allege more specific knowledge of the purported kickback scheme or more direct management of or participation in the portfolio company’s operations, which may have diminished the DOJ’s interest in the case.  The relator does not intend to pursue his qui tam claims on behalf of the government and filed a notice of voluntary dismissal in April.       

Best Practices: How PE Firms and Their Portfolio Healthcare Companies Can Recalibrate to Accommodate the Increased Enforcement Focus

Despite a slow start in 2022, PE’s investment in the healthcare industry shows no signs of slowing down.  Consequently, PE investors and their portfolio companies must be mindful of the government’s increased enforcement focus and consider ways to protect themselves when considering and executing investments.  Some key factors for investors and their counsel to consider to limit potential False Claims Act exposure include:

• Diligence: PE firms must conduct comprehensive diligence about both the target company and the specific sector in which it operates or will operate.  Investors should make sure that they are aware of past compliance issues or enforcement efforts both specific to the investment and in that sector more generally.  Investors’ due diligence should comport with and reflect the specific risk factors the target company faces in its day-to-day operations.  Depending on the structure of the transaction and its role moving forward, the target company also may be well served to conduct due diligence about the PE investor, including any history of investing in and/or operating healthcare companies.
• Compliance: PE firms and their portfolio companies should maintain effective compliance functions that comport with the Department of Health and Human Services Office of Inspector General’s guidance and that ideally, where practicable given the size and complexity of the organization, are separate from business and financial personnel and have a direct line to the controlling Board or its compliance officer or committee.  The compliance function should be evaluated regularly at the company and Board level and adjusted to address shifting risk factors and government enforcement efforts.  The compliance programs should be supported by an effective “compliance culture” and “tone at the top,” starting with the highest levels of management and the decision makers of the organization, typically the Board and any associated compliance committee, as well as the CEO.  Even where the compliance function is independent, business and financial personnel should receive compliance training as well. 
• Management: Owners should make deliberate and informed decisions about how much direct involvement the PE firm will have in the portfolio company’s operations, as that level of involvement could directly affect the scope of the firm’s exposure.  The extent of ownership’s specific knowledge of the company’s activities and the degree to which ownership actively manages the company’s operations likely will be relevant factors to the government in an enforcement action.  Nonetheless, a PE firm cannot be willfully ignorant of risk factors or compliance issues to avoid exposure.

Conclusion

PE’s investment in the healthcare industry likely will continue to grow.  The history of government healthcare fraud and abuse enforcement efforts teaches that an influx of investment dollars – and the associated reimbursement dollars by the government – leads to increased government scrutiny.  PE firms investing in healthcare companies must make deliberate and informed decisions about how those investments are structured and how the portfolio companies will operate moving forward in order to minimize potential False Claims Act exposure.  To do so, PE firms must stay up to date on healthcare fraud and abuse enforcement efforts generally and on enforcement efforts specific to PE investors.  Although no amount of diligence can foreclose government scrutiny entirely, taking proactive measures to minimize red flags can help not only to reduce exposure but also to short circuit what might otherwise become drawn out and expensive response processes.