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Private Equity 101

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Private equity (PE) has quietly been reshaping the physician practice landscape for years, but now with increasing deal activity it has become impossible to ignore. As we explore this topic we will address its impact on physicians from various financial and legal angles. In this article we hope to explore the causes of this phenomenon, the implications to physician practices, and different parties involved in the transaction.

What is Private Equity?

PE funds are ultimately just a specific type/source of capital. Investors whether pension funds or high net worth individuals place money in the hands of PE funds for them to invest and turn a profit. These investors are often looking to diversify their assets and earn a decent rate of return on their investments with PE funds.

To achieve that return for their investors PE funds employ a strategy similar to that of house flipping, except they perform the “flip” by buying, fixing, and reselling businesses. For example a PE fund will buy company X, leverage their expertise and economies of scale to make this business more profitable, then sell the new improved company to a larger conglomerate called company Y.  They typically “flip” the new and improved business around the 5-year time horizon though this can be earlier or later depending on the business environment and stated PE funds investment goals.

Why is PE Interested in Medicine?

One of the ways PE can make businesses more profitable is by leveraging economies of scale, the often talked about economics concept that allows Walmart with its size to negotiate better contracts and sourcing on products compared to your local mom-and-pop convenience store.

The private practice world is quite fragmented which allows for increased efficiencies if practices could be grouped together to achieve these economies of scale.

In the physician world dermatology has seen some incredible consolidation due to various PE funds getting involved in the space. Similar trends have been seen among anesthesiology groups with multiple national anesthesia groups emerging. In both cases a larger group allows increased negotiating power to strike better contracts with insurers or hospital systems, which ultimately serves to make the company more profitable.

Another appealing aspect of medical practices is that they are recession resistant professions. Since many investors with PE want steady and diversified returns, targeting the medical profession seems ideal because whether the S&P 500 is up or down, whether we are in bull market or recession, people are still going to see their physician for treatment.

Implications to Physician Practices

Due to the attractive nature of medical practices we’ve discussed, there is a lot of PE fund money that is looking to get involved. They typically get involved in one of two ways (though there are other variations) – (1) a complete buyout of a practice or (2) a majority ownership of the company.

The first option may be appealing to a physician ready to retire in the next few years as it allows her to access some of the value tied up in the practice. In such a transaction, she may receive a lump-sum of money and be asked to stay on for 3 years as a salaried physician of the company (now owned by PE). Typically the amount paid for a complete buyout is lower because the main asset of the company, the physician, is planning an exit. There may be little incentive to see as many patients for the physician because you are salaried, so these purchased often have a performance incentive built in to them.

The second option is appealing to growing practices that need access to added capital to finance organic and inorganic growth.

For a physician practice for instance it may be easy to hire an additional physician to a group to account for increased service demand, but it may be much hard to buy up a competing 10-doctor group, because the latter would require millions of dollars of upfront investment capital. The PE partner would essentially help provide some of the financial knowledge and liquidity needed to make these larger capital purchases.

In exchange for selling a majority stake to a PE fund, a lump-sum payment is also paid based on a multiple of the earnings before interest taxes depreciation and amortization (EBITDA), a form of company earnings. Additionally the physician maintains a minority share of the new entity; thus, they still have “skin in the game” keeping them motivated.  Because the interests of the PE partner and physicians are aligned by the shared ownership structure, often these transactions are considered lower risk by the PE fund, and in turn, allows them to pay a larger multiple.

In both options the lump-sum payment that is made is considered a long-term capital gains. Thus the tax rate of 20% rather than the maximum personal income tax rate of 37% would apply. This provides substantial savings in terms of net after tax income to the selling physician.

However, as Milton Friedman famously claimed, “There is no such thing as a free lunch.” There are significant cons that need to be considered as PE funds take control of the company in either of the models discussed above. While many are not looking to get involved in the day-to-day management of a practice, they most certainly have the right to make changes. Thus, if the company is not hitting its targets, alterations to physician schedules and reduction of staff members to reduce overheads can very easily occur. Indeed, much of the frustration in the dermatology community is that physicians are expected to see more patients with fewer staff, a combination neither good for patients nor doctors.

Who’s Involved?

There are multiple players involved in such transactions. Typically they will include a consultant or investment banker that the practice engages to put the company in the most profitable, but still accurate, light to pitch the sale of the company. Accountants are required to convert practice income, which is typically recorded on a cash basis to an accrual basis so an EBITDA can be determined. Lawyers are involved throughout the process as each of these parties are engaged. Finally PE funds (or other sources of capital) are those that end up bidding on the asset (the practice).

Final Thoughts

While this initial layout of the PE process is simplistic; hopefully it elucidates why PE is involved in medicine, the implications of PE for a practice, and the major players in the process. In future articles we plan to delve into each of these topics to more fully flush out the details.

Summary/Take-Away Points

  1. The phenomenon of PE looking to purchase medical practices is not new, but the pace of acquisitions seems to be increasing.
  2. The type of deal can vary substantially from a total buyout to a partial company sale.
  3. There are numerous players involved in these transactions including investment bankers, accountants, lawyers, and PE funds that all must come together perfectly to complete a deal.
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