As deal lawyers we, at Foley, continue to see high volumes of health care private equity (PE) backed platform transactions. While the number of deals in the space is down, year over year, the industry is still on pace to reach almost 800 health care deals this year. In this regard, physician practice recapitalization deals appear particularly robust.
Like all transactions involving health care, deal terms in PE-backed transactions remain fluid and changing. Purchase price payment terms, the handling of rollover equity, and the use of representations and warranties insurance, are a few examples that continue to evolve. Below are some observations with respect to those items from recent transactions.
Purchase Price Payment Terms
While traditional “earn-outs” have always proved difficult to implement in physician recapitalization transactions due to regulatory concerns, we have seen an increased number of contingent or deferred payment terms from private equity sponsors. The contingent payments were initially, a product of the COVID-19 Pandemic when there was an inability to rely on patient volumes during the Pandemic to project post-closing patient volumes.
While we've seen a reduction in the above types of purchase price payments, we have seen set, deferred payments as incentives to keep physicians engaged in the practice post-closing. If a physician does leave before a deferred purchase price payment is made, they will forfeit their right to that payment. In most cases, those physicians who remain will share the forfeited payment. This means that while the payment is “contingent” on a physician-by-physician basis, it is not contingent as to the group.
These deferred payments do raise several business issues that are better addressed when the deferred payment structure is proposed. First, many physician groups may insist that interest be paid on those deferred amounts. It should be noted that if interest is not paid on those amounts, the Internal Revenue Code (Code) will impute interest on such amounts and recharacterize a portion of each payment as interest, taxable at ordinary income rates, rather than at capital gain rates, thus increasing the cost of the transaction to the selling practice. Finally, most groups will elect to use “installment sale” treatment under the Code, deferring taxation on the installments until the money is received, which may also involve the payment of interest on the deferred taxes. All of these can be significant to the selling practice and should be considered when negotiating the purchase price and its payment terms.
Rollover equity (i.e., equity in the management services organization (MSO) or its parent entity) is often an important feature in these transactions. Physicians often receive not only cash as purchase price but equity in the MSO. This equity can, generally, range from 10-40% of the total enterprise value of the acquired practice. Rollover serves several purposes: First, it is a tax-deferred way to allow the physician practice owners to reinvest in the enterprise, and second, it incentivizes them to remain engaged in, and grow, the larger organization. Given the foregoing, it is important for the physician owners of rollover equity to participate in a later sale of the platform MSO, especially since that sale is sold to the physicians as the “second bite at the apple” with the hope that it is a significant multiple of the original investment.
While not a recent advent, it is becoming a more common requirement that physicians must “re-roll” a percentage of their equity in a later sale of the platform MSO. The business justification for this requirement is that it is easier to convince a prospective purchaser of the platform to purchase and to pay a higher multiple of earnings if the physician investors remain engaged as owners.
The question then become that of how much must the physician investors be required to re-roll. We've seen buyers demand that physicians be required to re-roll up to 100% of their equity. Such an approach doesn't seem particularly practical as it would limit the ability of physicians to enjoy the benefits of growth of enterprise value while saddling them with new covenants not to compete, new employment agreements, vesting requirements, etc. At a minimum, we see physicians being allowed to sell rollover units equal to their initial value, but normally see some sort of cap on the amount of rollover there will be required to retain and that cap memorialized in the governing documents of the MSO (or its parent). Thus, when the PE sponsor sells, the physicians will be allowed to sell, at least, up to any pre-agreed upon cap.
In addition to the above, rollover equity is often subject to restrictions on transfer and potential forfeiture upon certain events pursuant to which the physician leaves the practice.
Representations and Warranty Insurance
A development that arose several years ago, and has continued to evolve is the use, by the parties to recapitalization transactions, of so-called representations and warranties insurance (RWI). This insurance is designed to protect the buyer from breaches of representations and warranties and help limit the selling practice, and its physicians, from claims for damages arising from those breaches. Not every deal is large enough to justify RWI, but when appropriate it can be a powerful tool for both purchasers (as an incentive to selling practices) and sellers (to limit exposure).
These policies generally provide coverage up to 10-15% of total enterprise value, so that a $100,000,000 deal will provide for $10-$15MM of coverage. They, like all policies, contain a deductible, which is usually 1% of enterprise value, so in the case above the deductible would $1MM. The deductible is generally split between the purchaser and selling practice with the practice agreeing to escrow its portion of the deductible. Except in certain circumstances, such as fraud or certain excluded liabilities, it is not uncommon for the parties to agree that the selling practice's exposure for breaches of representations and warranties be limited to the escrowed deductible, which the purchaser is allowed to access first. Following that, the purchaser would absorb its portion of the deductible and then proceed against the policy for amounts in excess of the deductible. Savvy sellers insist that even if the RWI insurer refuses to pay on the policy, the selling practice's liability remains capped at its escrowed portion of the deductible.
Obviously, there is a lot of negotiation that can go on between purchaser, seller and insurer but the above is a generally reliable construct as to how RWI is used in today's transactions.
Health care private equity transaction volume remains high and shows no real signs of slowing. While there are many complex aspects of these deals, sophisticated purchasers and sellers are well counseled to focus on the various business and legal issues highlighted above.
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