Physician practice management (PPM) platforms have been a staple for over a decade in their current form and are considered a mainstay of private equity’s investment in healthcare. PPMs have a number of unique transaction structures and operational challenges that persist, both with initial platform acquisitions and exit transactions. Below we explore some of these and some constructive approaches to address each.
1. Division of Proceeds
Physicians often desire to distribute proceeds from an initial sale transaction based on relative productivity. However, many physician practices are organized as S corporations for income tax purposes. To comply with the applicable income tax requirements, the S corporation practice is limited to a single class of stock, which generally requires that distributions (including distributions of the initial proceeds from the sale transaction) be made in accordance with share ownership. In certain circumstances, a practice that historically has been an S corporation can be reorganized on a tax-free basis into a professional limited liability company in which profit participation equity interests may be issued, generally on a tax-free basis, in accordance with the desired sharing percentages based on productivity).
If this restructuring occurs before receiving indications of interest, a valuation of the existing S corporation practice at close to book value without taking into account the post-transaction compensation structure often can be obtained. Thus, much of the value created by the transaction may be able to pass to the physicians outside of the S corporation through their profit participation equity interests in the reorganized entity above the baseline valuation, often as a long-term capital gain for federal income tax purposes. Identifying an appropriate opportunity for such a restructuring may provide a competitive advantage to a well-advised PE buyer who can provide a solution to a seller in early conversations, long in advance of the launch of a formal process. If the practice is organized as a C corporation and the form of the acquisition is limited to a sale of stock, there are other alternatives to achieve a similar result that an astute PE buyer can present to the practice.
2. Structures for Rollover Equity
Many first-generation PPM platforms have experienced a myriad of physician alignment issues in connection with recruiting and retaining their physician partners. In addition, first-generation platforms that provide physicians with full tag-along rights have had to navigate physician buy-in and rollover equity in exits. Many of these issues can be addressed on the front end with modifications to transaction structures. When evaluating new physician platforms or add-on transactions, consideration should be given to the following items as it relates to rollover equity:
- Tying a portion of the rollover equity vesting schedule (anywhere from 20-50%) to a parent company exit transaction.
- Limiting tag-along rights to only a portion of the rollover equity (50-70%) so that physicians still have some skin in the game with the second buyer following the exit transaction.
- A clawback of cash proceeds (such as 20% per year) if a physician stays less than some period of time (typically five years), including mandating that the sellers address this issue with an escrow on the sell-side of the transaction.
- Including local management services organization (MSO) joint ventures in combination with parent rollover equity to allow for ongoing distributions to physicians at the local practice level, either with or without put/call liquidity for some or all of the local MSO equity in a parent company exit transaction.
3. Participation of Junior Physicians
One issue that many physician practice platforms confront is how to allow junior “on-track” physicians to share in the cash proceeds or rollover equity (or both) from the initial sale transaction. Awarding a bonus to allow for an equity buy-in is one approach, but that payment is treated as compensation income subject to ordinary tax rates and employment (or self-employment) taxes. Physicians who receive rollover equity in the parent company of the MSO should consider holding that equity in a physician holding company that can issue equity options or profit participation equity interests, as applicable, thereby allowing junior physicians to participate in go-forward value creation. In an exit transaction, this holding company structure is flexible enough to allow the junior physicians to receive their full “share” of the value of the rollover equity in the exit or only their share of the appreciation of the rollover equity in the exit, whichever the business arrangement may be.
This approach also can help bridge the gap with senior physicians who feel that they should be fully compensated for value creation up to the point of the initial sale transaction. Moreover, this local-level physician holding company structure also can allow future physician “partners” to share in the MSO ownership through a more traditional buy-in without diluting the ownership of physicians from other practices or holding companies within the platform or the PE buyer. Finally, this approach can be used to facilitate intra-physician liquidity upon death or retirement.
4. Incentive Equity
PE-backed platforms often desire to issue incentive equity in the parent company of the platform to new physicians where there are no local-level holding companies, and dilution across all platform owners (including the PE firm) is not an issue. These equity issuances present regulatory issues if the physician grantees do not provide legitimate services to the MSO. The practice entity may award a bonus to the physician as part of W-2 compensation that can be used to help fund a purchase of equity. However, an attractive alternative to the funds needed to acquire a full-value equity interest may be to allow physicians to purchase profit participation equity interests or options. The valuation of a profit participation interest or an option will result in a lower physician investment requirement than if the physician were purchasing a common share or unit of the MSO but will limit participation to upside value creation.
5. Practical Implications of Invoking Drag-Along Rights
All PE platforms contain drag-along rights provisions, right? However, invoking them is easier said than done. Based on experience in sell-side exits, buyers will want all or most of the non-PE platform owners to execute letters of transmittal (in a merger) and joinders to the go-forward governing documents. Permitting direct ownership by individual physicians in the platform can complicate what is intended to be an otherwise orderly process, especially where there is a significant number of physician owners. Implementing holding companies as discussed above for individual acquisitions as you go with governing boards and officers with authority to approve and execute these documents, even if not required for tax structuring, can help minimize the need to chase down individual physician signatures that can hold up a transaction.
6. Planning for the Second Sale Now
To minimize transactional inefficiencies and friction with a future buyer, consider building rollover equity requirements and a subsequent vesting “restart” into the drag-along provisions for the initial platform transaction. In addition to addressing the vesting of the initial rollover equity and co-sale requirements, provide for what will be required for future rollover and vesting in a second sale now. Solving these issues at the time of the initial platform can help avoid protracted negotiations between buyers and physician owners; reduce obstacles to completing a successful transaction; and provide for a “rinse and repeat” model that lives with the platform and the physicians, who have a much longer investment horizon than the PE owners.
7. MSA Bonus Payments
Many states have fee splitting and other laws that may necessitate a management fee payment based on a flat fee. This can result in cash being trapped in the practices as well as phantom income to the MSO from year to year. Consider including bonus payments for the MSO in the management services agreement (MSA) based on quality metrics that can be used to offset this issue and minimize any tax timing differences.
8. Streamlining Payor Contracting
Many MSOs are looking to streamline payor contracting across all their physician practices, including utilizing the same rates across all practices. Although this has proven to present challenges with payors, utilizing a single practice tax ID may be a viable option depending on your situation. In addition, having identical or 80% common ownership across all practices should allow the MSO to negotiate a single set of payor rates in compliance with antitrust requirements. However, be mindful that doing so may trigger notice and consent requirements.
9. Addressing Benefits Issues
Many platform transactions are structured with multiple physician practices that have different owners. This may be desired for business reasons, but having identical or at least 80% common ownership across all practices in your platform may allow the practices to utilize one set of benefit plans, which would result in significant cost savings and simplify the administration of the benefit plans, particularly with regard to health insurance benefits. In addition, some MSOs erroneously employ all employees, including physicians, at the parent company MSO level and issue W-2s from that entity, notwithstanding that the physicians have employment agreements with the physician practices. Doing so can present regulatory issues under the federal Stark Law and state laws that prohibit the corporate practice of medicine, among others, and could result in unintended noncompliance issues for the MSO benefit plans if these physicians are also permitted to participate in the MSO benefit plans.
10. Considerations Regarding Non-Competes
With the proposed rules released by the Federal Trade Commission (FTC), as well as state statutes and the flurry of recent employee favorable case law, the future of non-competes remains uncertain. PE buyers should be more thoughtful than ever when structuring restrictive covenants to ensure enforceability and reduce the risk of the entirety of the covenants being voided as overly broad. For more information on the FTC rules, please see our previous alert here. The public comment period has been extended until April 19, so it remains to be seen whether and in what form the final rules will be adopted.
Please contact the authors with any questions about PPM operational structures or challenges.