Executive Session: Gary Herschman on private equity investment in healthcare

Gary Herschman, JD, member, Epstein Becker & Green, P.C., has the pulse of what is happening in the interests of private equity investors in medical groups and the advantages, as well as disadvantages, for groups looking for capital investment.

Q. What do you see happening with physician transactions in recent years?

A. Over the past three to five years, there’s been a 20% to 30% per year increase in the number of physician groups that enter into major strategic transactions. We're seeing that trend because practicing medicine and all aspects of healthcare right now are extremely complex, and physicians are being pressed more than ever to provide high-quality, cost-efficient care and to participate in population health, value-based payment programs, care coordination, etc. … It takes a lot out of them. They’re looking to join bigger organizations that have professional corporate infrastructures in place, as well as more capital to invest in expanding functions to help them succeed in this transforming marketplace. 

Q. Why would private equity be interested in taking their money or their investors' money and putting it into a medical group?

A. Private equity firms are looking for ways to make phenomenal returns. They are looking to get a three- to five-times return on their cash in anywhere between three to seven years. I would say five years on average, but there have been several private equity companies that have developed platforms in certain physician specialties and have exited those investments after just three years or less.

Q. What would a private equity firm do for a medical group that a hospital would not? 

A. What a private equity firm would do is make you more efficient and make your practice more profitable. That means investing in infrastructure, advanced EHR, data analytics, care coordination capabilities and also benefiting substantially from economies of scale in all of these capabilities, as well as practice expansion. This means expanding into new ancillary services, adding ancillary service locations, adding practice locations through organic growth or through acquiring other practices so that you could potentially double or triple the practice, all on the same corporate infrastructure and capital resources.

Q. If you have an initial investment in the practice and part of that is rolled over as equity and some of it is retained — as paid to the doctors or current owners — what happens with the rest of the dollars?

A. As a simple example, let’s look at a $10-million practice valuation, although most groups are valued much higher. In this instance, the physician owners would get 70% in cash, which comes to them mostly as capital gains, a favorable tax treatment. The $3 million that is not given to them in cash is provided as rollover equity and is going to grow in value. Therefore, if the private equity firm receives five-times return on its investment, then that $3 million in rollover equity could turn into $15 million in three to seven years. If shareholders of newly acquired practices in the same specialty are also provided rollover equity, then there likely will be some dilution of the platform’s ownership percentage, but as the pie gets bigger as the platform’s EBITDA (earnings before interest, taxes, depreciation and amortization) or profitability increases, so does the multiple and, in turn, the valuation of the enterprise.

Q. Could you explain more about EBITDA?

A. Some financial advisors describe it generally as excess cash flow of a practice. The value of a practice general is reached by taking its adjusted EBITDA and applying a multiple (e.g., 8-12). The multiple varies depending on the type of specialty, the size of the group, extent of its ancillaries, the experience of its executive/management team and many other strategic factors.

The way that EBITDA primarily is created in a medical practice is through normalizing the salary of the shareholder doctors. When their income gets normalized to a lower number, but one that’s still market compensation for a physician of their specialty and experience, the difference between that amount and what they earned as an owner — when they profited on employed physicians and nonphysician providers and ancillaries — goes into EBITDA. For example, if a doctor was making $800,000 a year and her salary were to be normalized down to $500,000 annually, the extra $300,000 is considered EBITDA. If there are 10 doctors with a similar situation, then you have $3 million of EBITDA right there. There are other adjustments that can increase a practice’s EBITDA too, such as one-time (non-recurring) expenses and ramping up of new offices or ancillary services.

From an investment banker’s perspective, they’re investing in the best practices where the doctors are earning much higher than market compensation as an indication of the value of that practice.

Although it’s not always followed, one of the rules of thumb is that the normalization of the shareholder physicians’ compensation is between 30% to 40% of the collections “off their back” for their personally performed professional services. If their services yield $1.2 million of collections, it would be normalized down to roughly one-third, or $400,000.

Q. What is in it for the shareholders?

A. Risk: The healthcare industry is transforming and it’s directly impacting physician practices, their revenues and profits. It’s becoming harder and harder to compete and there’s uncertainty as to the future challenges of private practices… [this is] taking some of that risk off the table.

Capital: Investors/partners are a source of capital to fund a practice’s expansion and its ability gain the capabilities their physicians need to expand and succeed in the changing environment.

The number one reason shareholders should be interested in investment is the ability to monetize the value of their medical practice as one of their assets — part of their wealth, like their home or their retirement plan. Whether they’re late career or mid-career, what will they have when they retire? The truth is that nowadays there are not lucrative buyouts in medical practices — it’s capital account, sometimes capital account plus trailing receivables — but it’s not the “real” value of the practice. If investors are willing to value a practice at $40 million and there are 10 physicians who are equal shareholders, that’s $4 million per doctor. Private equity investment allows them to monetize the value of the practice they built over the years. It allows physicians immediately to take most of this value off the table to hedge against future risk and uncertainty and provides them with a real fair market value buyout of their ongoing minority stake when they retire, if they become disabled, etc.

Q. If a practice were interested in pursuing a strategic affiliation with a private equity firm and the sale of the practice, what should they be thinking about? 

A.  First, they must ensure they’re acting in a compliant way, including coding and billing and documentation. Anybody who’s going to potentially invest or acquire a majority interest is going to conduct a very deep-dive diligence process. To prepare for this in advance, a practice should speak to its accountants and lawyers and bring in consultants to make sure they are squeaky clean, compliance-wise. Second, in addition to an experienced lawyer, they should bring in an investment banker who frequently advises physician groups on strategic transactions to run a competitive process by canvasing the private equity market. Finally, culture is extremely important. The difference between a $60-million valuation and a $58-million valuation is not as important as knowing who your partner is. Narrow down the private equity companies making offers, look at who they are and meet with their management teams. The physicians need to work with their advisors on their own robust reverse diligence of the bidders to make sure they are reasonable and experienced, particularly in physician services.

Q. What else would a physician group be interested in when deciding on a private equity partner?

A. This comes back to culture. Regarding each potential partner (bidder), you should be exploring their approach to business, expansion and operations. To fully vet this, you should go out and talk in-person to other doctors who have partnered with the investor in different specialties in years prior. Where the rubber hits the road is in the reverse diligence. Was it a good marriage? Did they live up to their commitments and your expectations?  Moreover, you should also look at the private equity team’s track record of returns and successful investments in other sectors.

Q. What are the drawbacks?

A. The biggest negatives are not being involved as much or at all in the business of medicine. That’s really going to be passed off to the private equity platform, the administrative services organization function, so there’s going to be less input in that regard. Another negative is that the investor is likely to sell its stake in three to seven years — five years on average — and you’re not going to have any say in that. … From my experience, I don’t think there would be any impact on clinical care and clinical decision-making. The next investor wants to stay aligned with the physicians, and for the physicians to be happy or at least on board.

That second resale does generate additional revenue for the original shareholders who maintained that minority equity share. It’s another liquidity event. If the platform has successfully grown, it’s possible, on that exit, for the physicians to get the same or more than what they received when they sold the majority of their practice. The private equity firm will want to get three- to five-times return on their investment. If they succeed in this objective, then the rollover equity holders also will benefit from that higher valuation and return on investment.

Q. How do you find interested private equity capital?

A. Don’t do it yourself. The first step should be hiring an investment banker who best prepares and positions the practice for a strategic transaction, writes a great summary of the practice and then markets it to the interested investor community who have interest in physician services. That way, it’s a competitive process and you get the most comprehensive-level interest, and that puts you in the best position to get the highest valuation and the largest selection of bidders from which to find a good match.

I recommend interviewing at least three healthcare-focused investment banking firms and engage one of them, along with accountants and attorneys who have done this a lot before. Sometimes physicians think that they’re smart enough to do it themselves, but they’re doing a disservice to themselves and their partners if they don’t bring in a seasoned investment banker, after interviewing and finding the right fit.

Q. Any last comments you would like to make to practice executives?

A. Partnering with a private equity investor is not right for everybody – but don’t come to that conclusion before you become fully informed. Explore what’s out there and get all the key details before you say, “this is not for me” ... you may be surprised. 

—Edited by Kelsey Brading, MGMA content production coordinator