As seen in the Westchester County Business Journal and the Fairfield County Business Journal
You and your partners have built a successful medical practice that has served you well in the past; however, you may be considering whether your current model will continue to be successful in the future. Do you have the capital needed to invest in technology, infrastructure and ancillary services? Do you have the data needed to efficiently bill and collect your patient revenue and analyze the productivity of your employed providers? We will explore the characteristics of a couple of options, including a merger/sale to a larger group or hospital system and a sale of a private equity ("PE") group.
Generally, a merger would be an “upstream” transaction of a smaller practice joining a larger practice or a hospital/health system. In all cases, there will be some loss of autonomy, increased accountability for performance of individual physicians and more oversight of day-to-day operations and expenditures. You will experience relief of many administrative responsibilities, a more efficient use of clinical and non-clinical resources (labor and supplies) and improved physician production. Another benefit will be additional resources and talent to build or expand ancillary services to enhance the profitability of the practice.
The practice profile will depend on whether the merger happens with an integrated practice or a more divisional type of arrangement. In single specialty groups, an integrated group practice is more common. In an integrated practice arrangement, your existing group will cease to exist in a relatively short period. The physicians will identify as partners in the merged group, and office operations will follow a common set of rules and procedures so that patients will have the same experience walking into any office
within the practice. Compensation for individual partners would generally be determined under a common income allocation formula.
Divisional mergers are more common in more common in multispecialty groups and allow more autonomy for the joining practices. Divisions would, in many cases, separately compute net income, which would then be shared among the division
partners in a regulatory-compliant manner. Common practice overhead for billing expenses, and practice management salaries and benefits would be allocated to the divisions under an agreed-upon formula.
When a practice merges with another practice or health system, the purchase price will be substantially less than in a PE transaction. In some cases, there won’t be any upfront purchase price, only the promise of increased profits based on more efficient operations, enhanced services and better payor contracts. The merging group is trading off the upfront payment for increased individual partner compensation. As described below, in a PE transaction, the selling partners will see a reduction in their annual compensation, offset to some extent by a higher purchase price, and future profit opportunities in the management company created as part of the PE transaction structure.
In a merger into a hospital system, the hospital will create a “captive PC” that will employ the physicians. Be aware that even the former partners of the old practice will be employees in the hospital’s physician practice entity. Additionally, ancillary services (and profits) are provided by the hospital. In a merger into a larger private practice, the ancillary services (and profits) would remain in the practice.
Unlike when a physician practice sells to a hospital or a larger group practice, selling to private equity often allows physicians to retain ownership and a certain degree of autonomy that an independent and entrepreneurial physician is accustomed to. PE involves a sale transaction that is not constrained by fair market value scrutiny required of hospitals and health systems. PE investors are interested in a practice’s current and future cash flow. A PE investor will only be successful if a practice can significantly increase cash flow through expansion and improvement of non-clinical efficiencies. In a sale to a PE investor, the physician practice entity stays in place and continues to be owned by one or more of the original partners, since in many states (including New York), the corporate practice of medicine prohibits non-physicians from owning a medical practice. The PE investor will also form a management services organization (“MSO”) that will contract to provide all non-clinical services to the practice, such as billing, management, non-clinical labor, etc. These services are delineated in a management services agreement (“MSA”) between the practice and the MSO. It is important that the contracted fees for these services meet fair market value standards to avoid regulatory issues. Generally, PE investors will value and pay a multiple of normalized earnings before interest, taxes, depreciation and amortization (“EBITDA”) for a practice. EBITDA represents the net free cash flow of a practice. The sale price is typically allocated between an up-front cash payment and an equity investment in the MSO. Post-acquisition, the PE financial sponsor and the physicians will own the MSO. In addition, after acquisition of the practice, physician compensation will be reduced to a fair market level, which will provide the cash flow required for the MSO management fee and simultaneously build value in the MSO. Additionally, unlike a sale to a hospital or a larger group practice, physicians, through their equity ownership in the MSO, can continue to participate in the upside of additional sales transactions when the PE investor sells the MSO. A “second bite of the apple” typically occurs within five years of a private equity fund's initial investment.
Typically, the PE investor will be interested in building an initial platform around a single specialty or multi-specialty group with significant ancillary revenue source opportunities, such as oncology and hematology, orthopedics or gastroenterology. After the initial transaction, the newly formed entity will look to acquire other smaller practices to continue to build scale. Those subsequent acquisitions are valued at smaller EBITDA multiples than the initial transaction, but are still attractive to the smaller practices who are looking to join a bigger platform.
Should you choose to merge and/or sell your practice, understanding the dynamics and structural differences between an upstream merger, hospital sale or sale to a PE will help you determine the best path for your practice, your partner group and your patients.