Private equity (PE) remains very active in purchasing physicians' private practices, but when acquisition activity is as high as it is now, practice owners have a number of cards to play in negotiating the best deal possible.
Whether it be a primary care office, oncology practice, anesthesiology group, or any other healthcare provider, PE buyers are eager to acquire the consistent cash flows and growth potential these businesses can provide their investors. In fact, healthcare saw more than 300 PE deals in 2019 totaling more than $78 billion – the highest values ever recorded, according to findings from Bain and Company. These trends are nothing new, as PE activity in healthcare has been steadily increasing for nearly a decade. Despite COVID-19, S&P Global intelligence is showing a similar trajectory in the first half of 2020, with more than $31 billion in transactions already taking place.
Selling to PE firms comes with unique benefits to the healthcare provider, as we've outlined in a previous advisory. Doing so often removes administrative burden from physicians and allows them to focus on what they do best – practicing medicine. PE investment also gives practices the capital to modernize or upgrade, which benefits patients and can create economies of scale.
When a private practice decides to sell to a private equity firm, there are a number of points to take into consideration when negotiating the term sheet and definitive agreements. 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 considerations every practice owner must keep in mind when negotiating a transaction:
- Understand the value of the business: PE firms are buying more than just the physical assets or the brand name of the practice. They're purchasing future revenue prospects, contracts, and potential intellectual property or proprietary processes. Owners must understand that the value of their business is far greater than its physical assets or current annual income. Doing so will help them negotiate a fair purchase price. Depending on the size of the practice, the sellers may be well advised to engage their own appraisal of the business.
- Negotiate a purchase price: PE firms tend to base their purchase price on a multiple of EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization. Depending on the practice's specialty, there are typical industry standards when it comes to the multiples paid by buyers. Understanding the market rate for your type of practice is critical when negotiating a final sale price.
- Outline exactly what is included in the sale: Medical practices are not monolithic businesses. Even a relatively simple office-based practice may be comprised of several business units or asset classes. These can range from patient accounts receivable, medical office buildings, intangible assets and new business opportunities. Physicians must decide and clearly outline what to include in the sale, and what to retain, for example trade receivables.
- Iron out how the PE firm will pay for the assets: There are many forms of payment used to fund an acquisition. PE firms typically leverage equity, debt, or a combination of the two when making acquisitions. Each option has various implications for the selling partners, and it's critical to understand the differences between these financing options.
- Decide if the buyer will acquire a controlling interest: PE firms require the ability to act decisively when managing the portfolio of companies the fund has invested in. Normally, this takes the form of a majority interest in the business. However, some PE firms accomplish this through a substantial yet minority interest in a company. Some PE firms are satisfied with (or may actually prefer) having a minority stake in a business if that helps maintain the entrepreneurial spirit of its original owners. The selling partners must decide how much of their business they wish to retain and have open conversations with the purchasing firm about their options.
- Determine if a representative from the PE firm will serve on the board of directors: A PE firm's representation among the directors and officers of the portfolio company depends on whether the investment is in the medical practice or a derivative thereof, such as a joint venture. If a new entity is formed to consolidate multiple practices or to form a new business (such as a population health management company, for example), it is more likely that the PE firm will require significant representation on the board and key officer positions. In addition to the right to appoint directors or board observers, a PE firm may seek representation on the company's audit and remuneration committees.
- Negotiate whether existing management will stay in place and have representation on PE/Affiliate Board: Although the existing leadership of a physician practice may be an important component of its business value, it is by no means certain that a PE firm will leave management unchanged during the term of its investment. Even if the PE firm has a minority position in a company, it may demand "step-in" rights to allow it to take control of the business if it is performing poorly. Several scenarios can trigger such action, including breaches of financial covenants in financing arrangements, failure to meet specified financial thresholds, material breaches of the shareholders' agreement, and more. Selling parties must examine these clauses closely to ensure their interests are maintained. Just as important, practice leadership should consider requesting to have a representative serve on the PE affiliate board or the board of the affiliated PE management services organization (MSO) that will be assuming the management operations of the practice post sale.
- Establish capital support from the PE firm: The financial structure of a PE investment will depend on whether the deal is an asset purchase or a share purchase. The current value of the business is the starting point for all price negotiations. However, PE firms are adept at determining a company's "enterprise value," which assumes how it will perform after the infusion of capital and management resources. PE firms must also be able to determine how to make the deal "financeable," by pricing in the risk factors associated with increased borrowing. PE deals may utilize a variety of debt instruments depending upon market conditions and the particular nature of the business, and it is critical for the selling physicians to understand the implications of doing so.
- Determine the impact on physician compensation and benefits: In most medical practices, physician compensation and benefits are the largest components of the organization's budget. No medical group would have an interest in a deal that risks diminishing physician compensation. Considering a PE firm's main goal is to grow the business, any increased margins must be derived elsewhere. That being said, a medical practice's compensation plan could be out of step with the current economic market, and a PE firm may suggest ways to redesign the plan, like reallocating the compensation pool, to improve the group's overall performance.
- Set profit distributions to the physicians: While the PE fund's investors may be content waiting to receive the return on their investment upon exit, most physicians are looking to see a return more quickly. 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.
- Negotiate restrictive covenants and non-compete agreements: Depending on the purpose of the PE investment, it's not unusual for physicians to be restricted to providing only professional services that are aligned with the PE investors' interests. The enforceability of covenants not to compete is primarily a matter of state law. Where such covenants may be enforced against a physician, attention must be paid to the scope of the geographic restriction both during and after the term of the physician's employment. Sellers should expect non-compete covenants separately in connection with the sale of the business and, if any of the sellers stay on, non-compete restrictions as part of individual employment agreements. The courts are more agreeable with permitting longer restrictive time periods and larger geographic areas in connection with the sale of a business than it might otherwise permit in connection with employment arrangements.
- Think ahead by setting and negotiating exit rights: Since PE firms normally buy businesses to sell them in a relatively short period of time, they place very high importance on their exit rights. PE firms typically expect to have restrictions on transfer, put and call options, drag-along rights, and tag-along rights within their buy-sell or shareholders' agreement. Firms with a minority investment may also expect to have dividend preferences over other classes of equity, conversion rights and anti-dilution protections. For example, a tag-along right might vest gradually over a period of time intended to keep the selling physicians actively engaged in the practice during that period of time. However, if the PE firm were to sell its interests in the business enterprise sooner than the physicians would otherwise qualify as 100% vested, selling physicians should negotiate that their interest nevertheless becomes automatically wholly vested at any time the PE sells all, or part, of its interest.
Engaging experienced counsel
With so much to keep track of, navigating the intricacies of a PE transaction requires the close attention that an experienced team of attorneys can bring to the table. In most cases, this is the first and only transaction of this type that a physician will be engaged in during their careers, and they are selling an asset they may have spent decades building. Not the same can be said of PE firms. This is what they do routinely, and they are sophisticated in their interactions and negotiations. At Buchanan, we're well versed in this process and have helped a wide range of physician practices. Retaining expert legal counsel who can guide sellers through the process and eventual structuring, negotiation and documentation of the transaction is an important step in ensuring the best possible outcome for all stakeholders.
This article was originally featured in MedPage Today.
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