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    Gary W. Herschman
    Gary W. Herschman, JD
    Jeff Swearingen
    Jeff Swearingen

    It seems like every week or two there are announcements in industry newsletters and publications about physician groups entering into major transactions – either with hospital systems, large regional medical groups, national physician companies, or private-equity funded groups focused on specialty practices.  This transaction activity has increased substantially over the last few years (see Figure 1 below) with no end in sight to this upward trend – and it’s important that physician groups and their executives understand four key questions: 

    • What is spurring this increased activity?
    • How are medical groups “valued” in these transactions?
    • How are these transactions structured; and
    • What are the pros & cons of these options vs. doing nothing and “maintaining the status quo”?

    Figure 1: Number of physician practice transactions from 2016 to 2018

    Healthcare Transformation

    A panel of experienced financial and legal professionals will be addressing these questions in great detail during a session on the morning of March 4, 2019 at MGMA’s Financial Conference in Las Vegas. This article contains an “executive summary” of these topics as a preview to that presentation.
    It’s hard to deny that transformation is well underway in the healthcare industry, as evidenced by substantial consolidation among hospitals and other providers, a changing reimbursement landscape shifting to value-based payment programs, increased focus on providing care in lower cost outpatient settings, and the greater need for investments in advanced electronic medical records, data analytics, and care coordination capabilities. These changes are impacting the operations, strategy and profitability of physician groups across the country – and there is little doubt that larger, well-capitalized organizations, with seasoned corporate executives and more robust infrastructure, are best positioned to be successful in this changing industry environment.

    In sum, the shifting healthcare landscape has created substantial uncertainty regarding how a medical group’s operations, revenues and profitability will look in 3-5 years. Thus, physician groups that are both realistic (with regard to industry changes underway) and sophisticated with respect to how to best position themselves for the future, should be exploring the following potential strategic options (see Figure 2 below as well):

    1. A major transaction (purchase or other “alignment”) with a large hospital/healthcare system in the region

    2. A sale to, or merger into, a much larger regional multi-specialty or single-specialty medical group

    3. A sale/restructuring transaction with a private-equity (“PE”) backed company focused on their physician specialty

    4. “Maintaining the status quo” – essentially, passing on any of the three possible options above, but continuing to implement (and revise as necessary) the group’s strategic business plan (likely involving capital investments in growth and other enhanced capabilities)

    Figure 2: Future risk/reward of selling a business vs. maintaining the status quo

    Strategic Options

    There are various pros and cons to each of the potential options listed above, which can be assessed based on the following general factors:

    1. Ability to “monetize” the value of the practice in several respects:
      1. “Realistic” valuation of the practice that was built over many years by the physicians, based on market factors, and practice’s “Adjusted EBITDA” (as described further below), weighed against “normalization” (reduction) of physician annual compensation
        1. Short-term cash payment upon transaction closing, which allows all owners to “take some chips off the table”, to hedge against future uncertainty while bringing in additional infrastructure to grow the practice
        2. Interim cash payments upon future “liquidity events” – usually after substantial growth in the company and greatly enhanced value – involving new/additional financial investors


    1. Ability to maintain control over daily clinical decisions (most relevant to a PE transaction)


    1. Benefits of enhanced revenues and market share based on:
      1. Strategic advantages of professional practice management by seasoned executives
      2. Strategic advantages of greater capital to invest in practice growth, advanced EMR/data analytics, care management staff, etc.
      3. Benefits of economies of scale from experienced corporate infrastructure (finance, billing, credentialing, HR function, etc.), capital investments and group purchasing (health benefits, malpractice insurance, equipment, supplies, etc.)
      4. Benefits of more effective negotiation of value-based reimbursement and other innovative payor arrangements


    Market Valuations

    In several (but not all) of the strategic options listed above, market valuations of a physician practice are based on a variety of factors, such as:

    • A multiple of the practice’s “adjusted EBITDA” (described in more detail below)
    • Number and ages of physicians and midlevel providers, and diversity of services & subspecialties
    • Number of offices and geographic reach & diversity
    • The extent and sophistication of the practice’s corporate infrastructure (e.g., CEO, Administrator, CFO, HR director, Billing Department, etc.)
    • Number of “ancillary” services operated by the practice, for example:  pathology, imaging,   ASC, infusion, therapy, DME, etc.
    • “In-Network” status with key payors in the region, and diversification of revenue sources
    • The terms of other major “revenue-generating” contracts and strategic relationships – with a focus on future sustainability
    • Various other dynamics in the local competitive marketplace


    Key Financial Matters

    The aforementioned factors all contribute to determining what a practice is worth, but the most important factors in calculating valuation are key financial matters. Strong revenue growth is crucial, as is the ability to demonstrate high-quality, recurring revenue. On the profitability side, high margins and ability to control costs over time will be scrutinized, which leads us to the most important factor alluded to above – “adjusted EBITDA”. This metric, which stands for adjusted Earnings Before Interest, Taxes, Depreciation and Amortization, has the following attributes:


    • It is calculated as revenue less cost of services and overhead expenses (but excluding interest, taxes, depreciation and amortization expenses)
    • In the context of the sale of a physician practice, adjusted EBITDA is more frequently thought of as the incremental increase in pre-tax cash flow through a variety of means, including the following:
      • Reduction of seller compensation to market/replacement rate
      • Decreased billing and collections cost to market rate
      • Improvement in billing and coding (as long as verifiable)
      • Reduction of rent to “market” rate
      • Potential “add-backs” for one-time expenses, such as relating to a major non-recurring cost or litigation. Additionally, adjustments can come in the form of revenue growth investments currently in place but for which a practice is not yet realizing the full revenue potential

    Let’s look at an example that applies the concept of applying a multiple to a practice’s adjusted
    EBITDA in order to provide a valuation for a hypothetical physician practice:

    Figure 3: Illustrative proceeds per partner from a sale of a physician practice

    Figure 4: Breakeven analysis comparing maintaining the status quo vs. selling 100% of the business
    Figures 3 and 4 above depict an illustrative scenario of how the sale of 100% of a physician practice today will yield the same cumulative after-tax proceeds as keeping the business for 13.6 years (“maintaining the status quo”), subject to the following assumptions:

    • Average partner gross earnings of $600,000 (status quo) reduced to a market rate physician salary of $400,000
    • Illustrative sale multiple of 10.0x on the partner compensation reduction (or EBITDA)
    • Transaction-related and tax expenses of $480,000 (5% of transaction value for legal, accounting and advisory fees and majority of proceeds at 20% tax rate)

    After-tax proceeds

    After-tax proceeds from sale are invested and earning a conservative return, while partner earnings at status quo ($600,000) are assumed to grow steadily, but are taxed at higher “ordinary income” rates. Notably, other related factors that are not reflected in this illustration are:

    1. The lower “market rate” salary in a PE transaction commonly includes productivity bonuses, which can result in increased overall compensation;
    1. the assumption of continued compensation from the current group at the same level (and/or with steady increases) may not be realistic in light of downward trends in reimbursement, especially for groups that are not fully prepared for value-based payment initiatives; and
    2. if a PE investor is involved, this does not reflect additional proceeds that physicians who own “rollover equity” may receive upon a “second bite” transaction a few years down the road.

    Strategic Transaction

    This example helps offer insight into what selling a practice might yield for physician shareholders as opposed to keeping full ownership of the business. That said, before deciding to “maintain the status quo” or to proceed with a major transaction, practices should explore all of the various strategic options that may be available to them so that they understand the key details, pros and cons of each option, and can make a fully informed decision on what (if anything) to do.
    If a physician group elects to pursue a strategic transaction, it is highly advisable to:

    1. Hire external counsel and investment banking advisors to help prepare the practice for a transaction;
    2. Get its “house in order” well in advance of a courtship by ensuring billing, compliance and other operational functions are robust and appropriate – and making any beneficial changes – to be prepared for comprehensive due diligence to be conducted by a potential partner/investor; and
    3. Conduct stringent “reverse due diligence” on any prospective partner/investor, in regards to experience with physician organizations, financial wherewithal, prior investment success, overall organizational “culture” (including site visits and privately meeting with physicians who partnered with them over a year ago), and approach to both day-to-day operations and future growth and investments.
    Jeff Swearingen

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    Jeff Swearingen

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