Physicians across specialties are facing mounting legal and operational risks at the same time as healthcare systems and private equity investors are hungry to buy practices and take that risk off physicians' hands - at unprecedented valuations.

Forward‑thinking physicians rightfully see the unique opportunity presented by this market, and many are quietly investigating the possibility of selling to private equity firms or health systems. But, while most physicians have a relatively good understanding of what it would be like to work for a hospital, arrangements with PE investors often remain more of a mystery (understandably so). Those considering the possibility of selling to private equity need to understand its history, the current market and what to do next.

What is Private Equity?

Private equity firms pool money from high net worth individuals, pension funds, institutional investors and other accredited investors into "funds" which then invest in privately held businesses. PE firms often field teams of highly experienced analysts and operators who will actively advise the companies they own in order to grow and then sell the company in three to seven years. Because the PE fund must eventually liquidate and return capital to its investors, it is essential to understand each PE fund's "investment horizon" - which can drive whether they view a particular transaction as a short-term or long-term partnership with a business.

According to recent data from Preqin, due to record low interest rates, PE funds are currently sitting on nearly $1.5 trillion in so-called "dry powder," or cash with a mandate to invest and achieve returns. In light of recent projections which estimate that healthcare spending may approach $4 trillion this year alone, PE funds are hungry for opportunities to invest their dry powder in a market which they expect to continue to boom - and to be resistant to recession.

Many PE funds, however, recall the lessons learned in the 1990s, when a similar mandate to invest dry powder in healthcare resulted in overly optimistic valuations and the eventual downfall of eight of the top 10 practice management companies - which once boasted billions of dollars in revenues. In this new, second wave of private equity investment in healthcare, there is greater insistence that healthcare companies develop internal controls and accountability, as well as appropriate incentive programs and equity opportunities to attract and retain the physicians and other providers who are essential to maintaining - and growing - the company's bottom line.

What's Hot Right Now?

At the start of the last decade, private equity interest in healthcare practices focused on urgent care, dermatology, anesthesia, dental and ophthalmology. More recently, however, there has been a surge of interest in orthopedics, urology and gastroenterology. Investors realize that the recent surge of available capital can enable them to facilitate growth in these specialties to larger service areas, as well as provide capital to expand infrastructure to prepare for value-based payments and invest in new ancillary services and technology.

Structuring a PE Deal

The structure of a PE deal can take various forms. Most states do not allow PE funds and other non‑physicians from owning medical practices. As a result, the most common way a PE fund will invest in a practice is by forming a practice management company which will acquire the non-clinical assets of a seller (e.g., equipment and leases) in exchange for a purchase price and the agreement to lease those non-clinical assets back to the practice in exchange for a management fee. When considering one of these transactions, there are numerous factors you need to consider:

• Will the selling physician be required to continue to own the medical practice? If so, what protection will be given to the seller from being named in malpractice or other lawsuits?
• How long is the selling physician required to continue working in the practice? Under what circumstances can he or she be terminated?
• Will the seller have to agree to restrictive covenants such as a non-compete? How long will the non-compete last, and how broad will it be? What happens if things do not work out, and the seller is terminated?
• How much cash will the physician receive at closing, as opposed to some period after closing? How certain is it that the selling physician will actually receive that cash? Who will keep the accounts receivable from work performed before the deal is finalized?
• What are the tax consequences of the transaction to the seller?
• Will the seller have an opportunity to invest alongside the PE fund in the management company? If so, what are the terms of the equity investment?
• How much autonomy will the physician retain over decisions in their practice? Are there advisory committees to ensure that employed physicians' voices are heard?

Comparing the Deals

PE investors typically pay a higher up-front price for physician practices than hospital systems, in part because PE investors are not subject to some of the laws that restrict hospital payments to referring physicians. In the current market, it is not uncommon to see practice valuations as high as 10-12 times EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) for larger group practices - although single-physician practices will rarely see multiples of EBITDA that high.

Post-transaction, physicians should expect to receive compensation based on a percentage of their personal production and, often, a share of practice profits. Although their employment compensation will be less in the short-term than what it was before the transaction, they will have received attractive up-front payments and, hopefully, an additional upside opportunity in the form of equity or bonuses. Because the goal of these transactions is to bring together PE investors' business acumen in professionalizing and scaling the non-medical functions of a platform (e.g., marketing, capital expenditures and buildouts, payor negotiations) with clinically talented physicians, the potential upside for both parties can be significant. Over time, physicians in successful platforms may even see their employment compensation approach pre‑transaction levels - which is on top of their equity upside opportunity.

By comparison, hospitals, which are not allowed to share profits from certain ancillary services (e.g., lab, radiology, drugs), typically pay physicians a set rate per relative value unit. This is less likely to vary with overall practice performance, and so may be a better option for practices with less growth opportunity and lower profit margins. In addition, hospitals with longer operating histories can, depending on one's perspective, assure physicians of either long-term stability and peace of mind, or accumulated red tape and bureaucracy.

In addition to more up-front money and long-term upside opportunity, in some cases, a private equity option may provide physicians more autonomy over the operation of their practice, with potential opportunities to participate in physician committees or business development roles. With greater flexibility, PE platforms are often more receptive to creative ideas.

Going From Here

If you want to further explore a PE opportunity, start by building a team. Reach out to reputable investment bankers and legal, tax and financial advisors with demonstrated experience handling private equity transactions in the healthcare space. Bankers and law firms, in particular, want to help sellers get ready ahead of time because it makes their own lives easier. They will often take calls and meetings off‑the‑clock in exchange for the opportunity to work with those proceeding to a sale. Much like staging a house before a sale, an experienced deal team will help you put your best foot forward before you open the doors to potential bidders.

The opinions expressed in this article are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.

Denise Burke and David Marks are partners with Waller Lansden Dortch & Davis, LLP who provide legal counsel to the healthcare industry. They can be reached at denise.burke@wallerlaw.com and david.marks@wallerlaw.com.