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The Future of Private Equity Firms and Investing in Healthcare

Posted by Erick Cutler, CPA on Feb 22, 2017 9:21:18 AM

Every investment is a quantified unit of belief. This is how investors demonstrate their belief in the viability and profitability of a business. Private equity firms are frequently the financial matchmakers in this arrangement. They secure funding from individual investors, organizations and institutions that are willing to stake their wealth on the success of a business venture.

The big news in the world of private equity is investment in healthcare businesses, especially in the field of dermatology. In a report by Health Care M&A News, investment in healthcare businesses soared up to $563.1 billion in 2015. Dermatology practices were one of the niche investment areas that saw the strongest growth over the past year. This trend has attracted both physicians looking for more reliable financial backing and private equity firms seeking better returns.

Why Dermatology Has Attracted Investment

Numerous factors contribute to the attractiveness of dermatology practices as investment platforms. Dermatology remains a highly fragmented market, and the multi-site, multi-unit structure of group practices is ideal for pursuing buy-and-build strategies. Elective, cash pay, ancillary services in cosmetic dermatology allow for direct-to-consumer marketing, while medical dermatology provides a solid foundation for recurring cash flows. Practice branding lends well to physician transition, unlike other medical specialties where the practice goodwill resides predominantly with the physicians. Scale is key, not only in terms of geographic reach but also in the number of providers. Achieving a certain level of scale affords the ability to bring pathology lab services in-house and provide additional ancillary services and products.

Although the high profitability of dermatology practices has been the big draw for private equity firms, there is also a growing interest for top performers in the primary care field. Some hospital systems are going through private equity firms to buy a stake in physician groups. This builds their existing provider networks and puts the hospitals in a better position for the future when their revenues are likely to be based on the health of their patient populations. By investing in the right primary care practices, hospitals also automatically gain experience in managed-care contracting with public and private insurance companies.

Considerations before the Deal

There are many factors that must come under close scrutiny prior to a capitalization deal, such as:

The Structure of the Deal

One of the main barriers to investment in medical practices has been state laws that ban the “corporate practice of medicine.” Those laws generally state that corporations and partnerships that are not physicians are prohibited from offering medical services. These non-medical businesses cannot contract with a physician to provide medical services. This is meant to protect doctors from unfair competition and protect consumers from unqualified medical providers.

To make sure financing deals do not violate these laws, the private equity firms normally create a management company that is jointly owned by the deal sponsor and the physician owners of the original practice. The assets of the practice are then transferred to the management company, which hires the office staff.

Meanwhile, the physicians, nurses and other clinicians will still be employed by the original practice. All of the services required to run the practice, as long as they are non-clinical in nature, are controlled by the management company. This is paid for at a fair market value and it is usually the same as the practice’s profits after salaries and related expenses. All of the profits and cash flow in the management company is parceled out based on equity ownership percentages.

Long-Term Valuation of the Practice

Valuation has proven to be an extremely complex and controversial step in the deal-making process. One of the reasons for that is all the volatility in the industry. Physicians have been attracted to seeking out equity financing due to rising healthcare costs and stagnant reimbursements. Those same forces make it hard to put a value on a business for the long term. Some practices have seen valuation multiples that are more than 12 times the total of their EBTIDA (earnings before taxes, interest, depreciation and amortization) over the past year.

The three main valuation approaches are based on:

  • Income – where a single value is assigned to projections of future cash flows.
  • Market – where the practice is in comparison to the value of similar practices that have recently been sold. It tends to offer little insight due to the difficulty of comparing unique businesses.
  • Cost – where the analysts try to assign the costs of what it would take to recreate the business using the assets minus the liabilities.

Due Diligence and Compliance

In the due diligence phase, private equity firms often search for errors and non-compliance issues that can seriously compromise the value of the business. Investors will press for indemnity limits or escrow holdbacks until the errors are corrected. Some of the typical areas for concern include improper coding, over-billing, extenders and inadequate documentation of office practices.

The Essentials of Healthcare Investing

In the past few years, there has been a surge in investments in dermatology offices and primary care practices led by private equity firms. This intense interest from investors looks like it is only beginning as large healthcare providers consolidate and prepare for a more volatile market in the very near future.

Goldin Peiser & Peiser has years of experience working with medical practices of all sizes and specialties from inception to sale. Contact the professionals at GPP for advice on how to structure the sale of your practice.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.

Topics: Medical, Healthcare