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What independent practice leaders need to know about a possible M&A transaction

While the healthcare merger and acquisition environment may be cooling, independently owned private practices remain an appealing target for M&A transactions — especially in specialty areas like orthopedics, pain management and neurology, among others.

To better understand the M&A landscape, trends and best practices, Becker's Healthcare recently spoke with Scott Davis, Managing Director at Provident Healthcare Partners, an investment bank that specializes in advising independent practice owners in M&A transactions.

Note: Responses edited for length and clarity.

Question: What is your assessment of current M&A trends in healthcare and your outlook for the rest of 2023?

Scott Davis: There has been consolidation of independent practices going back 20 to 30 years, but transaction volume and valuations have increased significantly over the past 10.  This is largely due to the involvement of private equity investors who have taken a progressively more sub-specialized focus, getting closer to what have historically been hospital-based services that are now transitioning to the outpatient setting. 

Current trends include a slight decrease in transactions, although Provident's deal flow has remained strong. The average number of offers a practice might receive has declined in the past couple years, as investors are being more selective and diligence requirements have increased.

Much of this relates to the current lending environment where rates remain elevated as compared to years prior.  With the Fed’s most recent pause on interest rates hikes and a growing sentiment that they will reverse course in 2024, this will likely lead to further loosening of the M&A markets and a status quo between now and then.

Q: What is an optimal transaction strategy for an independently owned practice and what best practices come to mind?

SD: The optimal strategy starts with understanding the goals of a practice, educating practice leaders about their ability to achieve their goals and helping them understand their likely valuation. Education should also include helping practice leaders understand market conditions and their place in the market as well as the transaction process.

Best practices include ensuring alignment among stakeholders about their goals and being mindful of the expectations of the associates in the practice.

Another best practice is to start planning early for a potential transaction. Pulling together the appropriate documentation and ensuring operational capacity is in place to prevent downward performance during an intensive transaction process will lead to best possible outcome.

Q: What is the concept of compensation normalization? How does this work in practice and what are potential benefits?

SD: Many physician practices have little or no net income because the shareholders take the cash out of the business in the form of distributions. To be marketable to investors, practices need to show sustainable earnings, or adjusted EBITDA, and the best way to create this is to normalize shareholder compensation.  While there can be other contributing factors to EBITDA, shareholder compensation is easily the largest driver.  By looking at the practice’s earnings before shareholder compensation you’ve essentially got a profit pool that can be split between go-forward compensation to the partners and EBITDA that an investor will apply a multiple to to calculate an enterprise value.  The next step is to "scrape away" from those profits a percentage that leaves a large enough pool for the physicians to remain compensated at or above the industry norm, taking into account their sub-specialty of medicine, geography and other local market dynamics.  The percentage scrape can vary based on the sub-specialty of the practice and the desires of the investor, but will generally fall within the 20-50% range

This method provides an EBITDA figure for valuation purposes and gets physician shareholders to think about bottom line production, as opposed to a percentage of collections model that focuses on top line production and can misalign incentives between the physicians and investors. 

Q: When deals fall through, what typically happens?

SD: The most common reasons for a deal to fall apart are to poor financial performance or a lack of shareholder alignment.  Ideally, a practice has third-party advisors guiding them through the process and taking as much of the work of their plate as possible.  If physicians or management are consumed by the process, they won’t be as effective in generating revenue or maximizing performance.  As for shareholder alignment, this should be addressed at the outset of a process through open communication and ensuring your third-party advisors are looking to achieve the precise goals of the group and that all stakeholders are aware of developments throughout the deal.  Misrepresentation of practice goals and/or surprises at the finish line could easily lead to a failed process.       

Q: What advice do you have for independent practice owners who are thinking about a transaction?

SD: Whether a transaction is something you currently think is the right move or not, it would be wise to educate yourself to make as an informed decision as possible. One guarantee is that the outside forces that come with the constantly changing healthcare environment are going to persist, so best to have evaluated all avenues to combat those forces than be left in a weaker position.  As part of this education process, seek input from strong, independent third-party advisors, such as an investment bank like Provident, a CPA firm and legal counsel. These experts can provide valuable, candid advice and guidance, which can make a significant difference as practice owners and operators make strategic decisions for the business.

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