How to successfully compete with private equity buyers and align with physicians

Many of the physician practices that health systems seek to acquire are owned by physicians who are not particularly interested in selling their practices.

These practices often have a strong procedural or technical component; examples include hematology/oncology with infusion treatment, GI practices with an endoscopy facility, orthopedics with physical therapy, and any practice with significant imaging or radiology services.

Aligning with these practices can be challenging. The procedural components of their practices are frequently profitable and many of these physicians are less concerned about receiving the purchase price for their practice, and more focused on continuing to benefit from the future growth of their practice.

Acquisition and employment generally prevent these physicians from sharing in any profits related to the technical component of the business, due to regulatory requirements which dictate that employed physicians can only be compensated for personally performed professional services.

The Private Equity Threat
At the same time, private equity firms are offering to purchase an equity stake in practices with large procedural or technical components, with the goal of increasing practice profitability, and thus, earnings to owners. Investors like the investment safety of routine medical care, combined with highly profitable procedures.1 Physicians continue to maintain control of their practices, and benefit financially.

PE firms, which are not under the same regulatory constraints as hospitals, may be better able to create attractive offers for physicians. Unfortunately for healthcare organizations, these firms are interested in the same high-performing practices that hospitals would like to acquire.

According to PE Hub, a typical PE firm strategy is to partner with an established practice group and then acquire and roll up smaller practices to establish regional and national brands.2 The threat to existing physician-hospital relationships is clear.

What Hospitals Can Do
Hospitals/health systems need to move quickly to establish deals with those high- technical-component practices that are an important complement to the services they are providing to the community. But how?

It is possible to structure a transaction that will address the issues that regulatory constraints impose on hospitals/health systems and physicians, by considering each component of the physicians’ practice separately. Transaction and contractual arrangements with multiple components can preserve some degree of physician control over clinical operations while utilizing the resources and expertise of the hospital to increase quality and focus on patient care. Of course, in the end, we must consider the transaction as a whole when evaluating its reasonableness.

Pulling the Components Apart
Components for these practices usually include the core clinical practice, one or more ancillary or therapy services, and possibly a research element. For example, an orthopedic practice might have imaging, physical therapy, and a DME component. These share space, staffing, and furniture, fixtures, and equipment.

The hospital/system can acquire some of these components and lease others, while the physician(s) retain still others. A management services organization (MSO) can then be established as a joint venture between the practice and the health system or hospital. Transaction structures may differ; this is one example.

The Acquisition
The hospital may acquire 100% of the ancillary components of the practice (such as imaging, pharmacy, or laboratory services) in a one-time cash purchase. The physicians can then use this this payment to satisfy debt, fund retirement plans, or assist in the transition to the new practice structure.

The purchase price is based on estimated future cash flows of the ancillary components being acquired; a valuation must be performed to assure that the price is consistent with FMV. Historically, the owners had received these cash flows as compensation. Once the services are acquired, the health system/hospital can support their further development through capital upgrades, quality initiatives, and responses to new payer requirements and clinical regulations.

The health system/hospital bills and collects for the ancillary services, and any surplus from operations of those services accrues to it.

The Management Services Organization
The practice and the hospital own the Management Services Organization jointly; both parties make a capital investment in the MSO—the hospital/system in the form of cash, and the physician practice in the form of practice assets. The MSO provides a means by which physicians can hold an equity position that allows them to retain an interest in future MSO earnings. Those earnings are split between the health system or hospital and physicians, the owners of the joint venture.

The Provision of Clinical Services
The hospital/health system can transition the clinical practice operations from the practice to the hospital/health system through two separate agreements: a professional services agreement (PSA) and a practice resources lease. As the entity providing clinical services, the system/hospital bills and collects for clinical services and, as such, must arrange for the provision of resources required to generate the clinical collections, which would occur through the two ongoing agreements.

The Professional Services Agreement
The PSA relates to the provider-related resources needed to provide clinical services. Under the PSA, physicians can be compensated for providing patient care on a WRVU basis, with incentive compensation (productivity and quality components) as agreed upon. In additional, compensation can be provided for the clinical supervision of ancillary services, which can vary based on the degree of oversight being provided. Professional related expenses (e.g. malpractice insurance, continuing medical education) are reimbursed at cost.

By maintaining the “practice” as an independent legal entity (whether a PC, LLC, pass-through entity, or other form) for practitioner professional services, physician owners have a mechanism through which their practice operations can be leased, and through which they can have part ownership in the MSO joint venture.

The Practice Resources Agreement
The health system or hospital establishes a Management Services Agreement with the MSO, under which the MSO manages operations for the clinical and ancillary services, the leased clinical services, and the practice assets which the MSO controls. The lease agreement with the MSO covers non-provider resources required to provide clinical and ancillary services, such as administrative staff, medical and office supplies, facility rent, and equipment. It should be noted that depending on the initial transaction, certain elements associated with the ancillary acquisition (such as direct ancillary staff) cannot be provided under the management services agreement and should be provided directly by the hospital/health system.

The MSO is paid on a cost-plus basis—operating expenses plus a reasonable profit margin.

The lease and PSA must conform to FMV; a valuation will be required. Physician compensation is based on professional services only; it is not possible to use historical compensation in determining FMV as the physicians no longer own the ancillary services that have been acquired from them.

There are undoubtedly other ways to structure a transaction that will achieve similar goals for the practice and the health system or hospital. The ancillary component could become the initial capital contribution to a joint venture with a hospital or health system, with the venture providing management of the ancillary services. Similarly, the hospital/system could acquire the clinical practice at FMV instead of through a lease arrangement. Each variation has its benefits and drawbacks; it is up to all the parties involved (and their representative legal counsels) to identify the option that best supports the goals of the transaction while maintaining compliance.

By creating a transaction and operating structure in which ownership and function of each practice component are addressed separately, hospitals can position themselves to align with physicians in attractive practices with high technical components, before the opportunity is foreclosed by private equity partnerships.

Karin Chernoff Kaplan, MBA, CVA, Director - Veralon
Karin is an expert in healthcare valuation, and in strategy, finance, and operations. She has more than 30 years of experience in healthcare consulting and management. She works with health systems, hospitals, physicians, and other healthcare providers.

Karin is a certified valuation analyst (CVA) of the National Association of Certified Valuators and Analysts. She frequently speaks on valuation and has taught courses and webinars on physician compensation design and valuation for AHLA, NACVA, HFMA, and MGMA. She is a national thought leader on design of physician compensation in the context of value-based payment models and quality incentives.

Denise Palencik, CVA, Manager - Veralon
Denise has 10 years of experience working with academic medical centers, health systems, community hospitals, and health plans. A Certified Valuation Analyst, she assists Veralon clients with a broad range of both physician compensation and business valuations (including valuation of hospitals), physician compensation planning, development of business arrangements, and financial projections.

Jessica E. Stack, MBA, Senior Manager - Veralon
Jessica has worked with hospitals, health systems, physician organizations, and healthcare attorneys across the nation. She advises Veralon’s clients on valuation of healthcare businesses, design of physician compensation arrangements, and fair market value of business arrangements.

Jessica has more than nine years of experience providing fair market value opinions for business enterprises, compensation arrangements and other ownership interests and assets, including providing advisory services to healthcare providers nationwide.

1 Patrick Krause, Why PE Firms are Buying Orthopedic and Ophthalmology Practices, PE Hub, August 3, 2017. At
2 Op cit.

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