Despite a small dip in the very beginning of 2022, it appears M&A activity in the healthcare sector is roaring back. Now that the worst of the pandemic appears to be behind us, and if recent trends in hospital consolidations and restructuring activities are any indication, it looks like healthcare players and private equity (PE) will continue making deals well into 2022.
For PE buyers, healthcare practices have long been an attractive investment. With the consistent cash flows and growth potential that primary care offices, dental offices, specialty practices and many other healthcare organizations provide, it's no wonder that annual PE deal values in healthcare have tripled since 2010.
However, identifying potential targets to acquire is usually the easy part for PE firms. Most often, the term sheet and definitive agreement negotiation process is the most burdensome aspect of the process. At Buchanan, our attorneys have overseen a plethora of these types of transactions and know the intricacies and best practices when it comes to negotiating a deal. Here are the top 12 questions every PE firm must ask when negotiating the purchase of a physician practice or other healthcare entity.
- What is the true value of the business today? Understandably, purchasing a healthcare practice means more than buying just its physical assets, medical knowledge and brand name. The purchase comes with future revenue prospects, contracts, and potential intellectual property or proprietary processes. How much is that worth and what sort of growth can realistically be forecasted? Is there opportunity for future M&A that current owners may not realize? This is where experience and knowledge can lead to a more advantageous negotiation for PE firms.
- Have any red flags been identified during due diligence? The importance of proper due diligence cannot be overstated when negotiating the purchase of a healthcare practice. Were any irregularities identified in Medicare, Medicaid or insurance coding and reimbursement? Does due diligence reveal any licensing issues or false claims penalties that stand out? Have there been any tax compliance issues in the past that might be cause for concern? While PE firms almost always base purchase prices on a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), other risk factors should, of course, be considered. If the practice's history is a bit messy, it may be worth stepping away.
- What exactly is included in the purchase? Each PE firm has different expectations and desires when it comes to how they want to structure the business after purchasing. This affects what they may want included in the purchase of the practice. Consider that even smaller, office-based practices may be comprised of several business units or asset classes, which can range from patient accounts receivable, medical office buildings, intangible assets, new business opportunities and more. Even whether or not to purchase the physical building that houses the practice should be outlined early in the process. Some physicians may push back on what they want to retain versus sell, but it's important that the deal makes sense for the PE firm, not just today, but in the next three to five years.
- Will payor contracts need to be renegotiated? During due diligence, it's critical to review payor contracts to determine if they are assignable or if they need to be renegotiated. At times, it may make fiscal sense to renegotiate but it can add time to the acquisition process. On the same front, a review of possible antitrust issues is key to avoiding headaches down the line.
- How will the business be structured and is it in a state where the Corporate Practice of Medicine (CPOM) doctrine may apply? Often (but not always), PE firms will set up a separate management company and purchase the practice through that entity, which then employs the physicians and other workers within the business. Yet, that isn't always the case. Sometimes, PE firms find it advantageous to merge the practice into a new entity or healthcare system. However, the CPOM doctrine comes into play in some states, which broadly says that medical services must be provided exclusively by licensed medical professionals and prohibits non-licensed individuals and businesses from employing physicians to provide medical services. With the variations in this law, it's critical to work with legal counsel to ensure the business model is set up correctly and legally.
- How important is it to acquire a controlling interest? When managing a portfolio of companies, PE firms want the ability to act decisively without needing to wait for the input of too many outside parties. Normally, this requires buying a majority interest in the business. However, that isn't always the case. For some PE firms, it may make sense to acquire a substantial yet minority interest in a company when it helps original owners maintain their entrepreneurial spirit and have a greater stake in the business's success. There are upsides and downsides to both options, and the decision typically comes down to how much control is necessary to ensure the business can succeed without interference. Cluing sellers into the benefits of your proposal is critical for physicians who often aren't too familiar with these types of negotiations.
- Will someone from the private equity firm serve on the board of directors? While it's not mandatory that the PE firm has representation on the directors and officers, there are certainly plenty of reasons to do so. If a new entity is being formed to consolidate multiple practices or to form a new business, significant representation on the board and in key officer positions is often necessary. Additionally, having representation on the company's audit and remuneration committees may also make sense, depending on how the practice is being operated before the acquisition.
- Will existing management remain or will they be replaced? In many cases, existing leadership of a physician practice may be an important factor in the value of the business. Still, that does not prohibit a PE firm from negotiating "step-in" rights to allow it to take control of the business if it is performing poorly. Instances where this may be necessary and should be outlined in the terms include breaches of financial covenants in financing arrangements, failure to meet specified financial thresholds, material breaches of the shareholders' agreement and more.
- How much should physician compensation and benefits change, if at all? Understandably, physician compensation and benefits are typically the largest components of a healthcare practice's budget. While proposing to cut physician compensation might end negotiations before they even begin, a medical practice's compensation plan could be out of step with the current economic market and in need of adjusting. Redesigning the plan may be as simple as reallocating the compensation pool to improve the group's overall performance, which may be an easier sell.
- How should profit distributions to the physicians be set? While most PE fund investors are content with waiting to receive the return on their investment upon exit, physicians typically want to see their returns faster. A key point of negotiation will be how and when distributions of newly generated profits will be shared with the physicians. The source of profit distributions will vary depending upon the nature of the business unit in which the PE firm has invested and how that entity affects the profitability of the medical practice. For example, an investment in a management services organization will perform quite differently than an investment in an ancillary business, such as a diagnostic facility. Profit distributions should be set accordingly.
- How will restrictive covenants and non-compete agreements be arranged? In most cases of PE investment in physician practices, physicians are often restricted to providing only professional services that are aligned with the PE investors' interests. However, the enforceability of covenants not to compete is primarily a matter of state law and can vary greatly depending on where the practice is based. Where such covenants may be enforced against a physician, attention must be paid to the scope of the restriction both during and after the term of the physician's employment.
- How should exit rights be structured? Exit rights are supremely important for most PE firms as they often want maximum flexibility to make a deal to sell the business in a relatively short period of time. During the negotiation, high focus should be placed on outlining any restrictions on transfer, put and call options, drag-along rights, and tag-along rights within their buy-sell or shareholders' agreement. Even when acquiring a minority investment, it's important to consider outlining dividend preferences over other classes of equity, conversion rights and anti-dilution protections.
Engaging experienced counsel
Acquiring a physician practice comes with plenty of complexity and potential legal hurdles. From proper due diligence to contracting and more, it requires an experienced team of attorneys to handle. At Buchanan, we're well versed in this process and have helped both PE firms and physician practices during acquisitions. Retaining expert legal counsel who can help firms through structuring, negotiation and documentation of the transaction is an important step in ensuring the deal goes through without an issue.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.