With the much-anticipated release of the Small Business Administration (SBA) Interim Final Rule on affiliation under the Paycheck Protection Program (PPP) late on April 3, those waiting with bated breath for any clarification on the affiliation rules applicable to private equity-backed physician practice management companies were left empty-handed.
The Interim Final Rule made clear that the affiliation rules in place for traditional SBA loans would also apply to PPP loans. For now, at least, there will be no relaxation of the affiliation rules (other than for businesses receiving financial assistance from a Small Business Investment Company) for private equity firms and their portfolio companies in the healthcare sector.
What does this mean for physician practice management companies?
For management services organizations (MSOs) in which a private equity sponsor either owns a majority stake or owns a minority stake but has significant negative control rights, the MSO will likely be deemed to be an affiliate of the private equity fund and its other controlled portfolio companies. The result is that once combined with its affiliates, the MSO will be unlikely to meet the SBA size standards to qualify as an eligible small business under the PPP (i.e., 500 or fewer employees).
The exception to this is where the MSO has an SBIC fund investor, in which case a broad waiver of all affiliation rules applies to the management company. It is also possible if the MSO is in a new fund with no other or few investments that the portfolio company aggregation will be limited to that fund, but this would require a facts and circumstances analysis based on the common ownership and control of the general partnerships.
What about managed physician practices?
It is possible in certain MSO models to have physician practices that are decoupled from the management company such that a physician practice may independently qualify for PPP funding. This may be more likely in states with very strict corporate practice of medicine prohibitions that prevent the management company from having in place stringent financial or operational controls. However, in structures where the management company holds strong control rights – such as controls over the removal and replacement of physician-owners, the payment of dividends and distributions, determining compensation for practice employees, hiring and firing practice employees, changes in the practice’s strategic direction, encumbering assets, purchasing equipment or making capital expenditures, incurring debt, making changes to the budget or bringing or defending a lawsuit – the practice could be deemed an affiliate of the management company.
Even where affiliated with the MSO, however, if the platform is otherwise eligible for a PPP loan (i.e., they have an SBIC fund investor or fewer than 500 aggregate employees), it may make sense for the practice(s) and MSO to apply separately to avoid confusion or complications around multiple payrolls flowing through a single PPP application, so long as there is no duplication of payroll cost for purposes of the applications.
It is important to note that independent contractors do not count towards the 500 employee test for determining PPP loan eligibility. Independent contractors are treated as separate businesses that may apply for their own PPP loans directly (assuming they otherwise meet the applicable eligibility criteria). To the extent that a physician practice contracts with physicians on a bona fide independent contractor basis, this may provide an opportunity for the practice to work with these physicians to obtain their own PPP loans, which could help relieve pressure on the practice.
SBA Affiliation Rules
SBA regulations outline several different tests for affiliation, any of which being a sufficient basis to find an affiliate relationship exists. (For purposes of PPP loans, the affiliation rules can be found at 13 C.F.R. § 121.301(f).) This analysis will necessarily need to be undertaken on a case-by-case basis, but assuming the physician practice is owned by one or more “friendly” physicians (and not by the MSO or another corporate affiliate of the MSO), in most cases the most relevant tests for determining whether a managed physician practice is affiliated with its MSO under SBA affiliation rules likely will be those that evaluate management control and the totality of the circumstances.
Affiliation Based on Management
The practice will be deemed to be an affiliate of the MSO if at least one of the following criteria are met:
- The officers who control the management of the practice also control the management of the MSO (e., officers in common).
- The same person or entity controls the board of directors or management of both the practice and the MSO (e., directors in common, or the ability of a private equity sponsor to control board composition of both entities).
- The MSO exerts sufficient control over the management of the practice through a management agreement.
Because of corporate practice of medicine restrictions on who may serve as directors and officers, the third factor is likely to be determinative in most MSO models. A key inquiry when evaluating a management agreement will be whether the practice maintains “meaningful oversight” of the MSO’s management activities relating to the practice; if the management agreement provides for “meaningful oversight” by the practice, SBA guidance suggests that the practice may not be deemed to be an affiliate of the MSO by virtue of the management agreement.
To maintain “meaningful oversight,” the practice must be involved in decisions made concerning the operation of the practice, and the management agreement must provide for the practice to approve the annual operating budget, approve capital expenditures or operating expenses over a significant dollar threshold, have control over its bank accounts, and have oversight over the employees operating the practice (who must be employees of the practice). (See also B&L, LLC d/b/a Orange Grove Med. Specialties, P.A., SBA No. 4279 (S.B.A. 1997), discussed below).
Affiliation Based on Totality of the Circumstances
The SBA may consider all connections between the practice and the MSO to determine whether affiliation exists based on the totality of the circumstances, even if the MSO does not exert sufficient control over the management of the practice to meet the management-based test above.
Factors likely to be considered by the SBA in determining whether affiliation exists between the practice and the MSO include the right of the MSO to dictate or block certain operational and other management decisions (such as compensation and other personnel matters, entering into material contracts, changes in the practice’s strategic direction), the scope of the services provided by the MSO (including any involvement in clinical functions or clinical staffing), the duration of the management arrangement, and the level of control exerted by the MSO over the ownership of the practice. Other factors that the SBA could consider in a totality of the circumstances analysis include the sharing of resources, equipment, locations or employees between the practice and the MSO, or between the practice and other practices managed by the MSO; the provision of loan guaranties; other financial or managerial support between the practice and the MSO; and the inclusion of the practice in the MSO’s consolidated financial statements.
Orange Grove Case
The SBA affiliation rules do not specifically address managed physician practices, but one published decision of the SBA Office of Hearings and Appeals (OHA) provides some guidance as to how the SBA would evaluate affiliation in MSO structures (B&L, LLC d/b/a Orange Grove Med. Specialties, P.A., SBA No. 4279 (S.B.A. 1997)). In Orange Grove, a managed physician practice applied for a loan under the SBA’s 504 loan program and was initially denied because the SBA District Office found that the practice entity was an affiliate of the hospital that provided management services to it and, when combined with the hospital under the affiliation rules, was too large to meet the applicable size requirements. On appeal, the OHA reversed the decision, determining that the management services agreement (MSA) at issue did not create affiliation.
The MSA in Orange Grove provided that the management company would manage the non-clinical aspects of the physician practice in exchange for a management fee of 40% of the practice’s gross collections, while the practice exercised full authority over the clinical aspects of the business. Importantly, the OHA noted that the practice “retained control over all the medical functions, specifically, hiring and supervision of all physicians, setting medical fees, ordering pharmaceuticals, and approval of the firm’s advertising and publicity.” Based on the terms of the MSA, the OHA concluded that the practice had not “relinquished control of the core of its business, its ultimate product, and its primary task” and that the hospital was “merely […] a vendor of office management services” and had “no more control over the business than any other vendor.”
Key facts in the OHA’s analysis concluding that the practice and the hospital were not affiliates included:
- The practice continued to hire and supervise its physicians, while the hospital hired and supervised all non-medical personnel.
- The practice maintained control of its bank account, and the hospital only had access to the bank accounts for the purpose of carrying out the MSA and could not withdraw funds if the withdrawal would leave the practice entity unable to meet any accounts payable.
- The practice shared joint authority over its budget and set its fees for services.
- The term of the MSA was for one year, with three one-year renewal options, and the practice could elect not to renew the MSA at the end of each year.
- The hospital had a right of first refusal to purchase the practice, triggered only if the owners of the practice received an offer to purchase or transfer ownership of the practice.
The facts in Orange Grove provide a potential roadmap for a managed physician practice structure in which the SBA may find that the practice is not an affiliate of the MSO, but there are important differences between the hospital-practice relationship in Orange Grove and the structure of many private equity-backed MSOs. In Orange Grove, the OHA emphasized the ability of the practice to elect whether to renew the MSA on an annual basis, a dynamic that is not common in private equity MSO structures. Similarly, while Orange Grove does not offer any analysis of the types of provisions commonly found in equity transfer restriction agreements (such as the typical requirement that the physician owners sell their ownership interest in the practice upon the occurrence of certain events), the fact that the hospital did not have a right to force the sale of the practice appeared to be important to the OHA’s analysis.
Unfortunately, there is little direct guidance from the SBA as to the application of the affiliation rules to managed physician practices, and the Interim Final Rule issued on Friday, April 3, does not provide meaningful new guidance.
What seems clear is that the affiliation rules often could result in private equity-backed MSOs being deemed to be affiliated with the private equity sponsor and its other controlled portfolio companies, which will in most cases result in the MSO being ineligible to receive a PPP loan.
The affiliation analysis with respect to the managed practice entity should be conducted on a case-by-case basis, and conclusions will be fact-specific. There may be circumstances in which a practice would not be deemed an affiliate of the MSO, but in the case of a prototypical private equity-backed MSO model where the private equity sponsor, via the MSO, exercises significant operational and financial control over the practice, the SBA may consider the physician practice to be an affiliate of the MSO, and therefore also an affiliate of the sponsor and its other portfolio companies for purposes of evaluating eligible size standards.
We understand that various interest groups and certain members of Congress continue to lobby vigorously for more relief from the affiliation rules for private equity-backed companies, particularly in the healthcare sectors that have been significantly impacted by the COVID-19 pandemic. We are engaged in these conversations and will continue to monitor this topic for our private equity clients.
The Bass, Berry & Sims Healthcare Private Equity Team is focused on serving and adding value in the middle- and lower-middle market, and is uniquely positioned to provide the cost-effective yet sophisticated transactional solutions the current environment demands. If you would like more insights on this topic, please contact the authors or your relationship partner at the firm.
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