Private Equity Trends in Healthcare

Explore the rapid evolution and integral role of private equity (PE) in healthcare with expert Max Reiboldt, CPA. This episode is essential for physicians, health system leaders, PE sponsors, payers, and anyone involved in the healthcare industry.

This transcript of their discussion has been edited for clarity and length.

Mike Sacopulos: Our conversation today deals with private equity in healthcare, but I think our audience needs to know you have written a book in conjunction with the American Association for Physician Leadership (AAPL), the parent of this podcast. Can you tell me a little bit about the book and the process of its creation?

Max Reiboldt, CPA: Sure. Thanks for asking. We have written several books in partnership with AAPL and are honored to do so. I didn't write the entire book. I am the principal author, but we have other Coker associates that contributed. I want to make sure they get credit as well. This book was one that I felt was needed because I have seen white papers and articles and so forth, relative to private equity, but not a complete encapsulation of everything that is involved with private equity and healthcare. Thankfully, we partnered in that effort, and I am very happy with the way it turned out.

For benefit of a varied group of listeners, as I know you have listeners that are physicians, administrators, hospital leaders, and others, we wrote the book in a neutral manner. Private equity can be polarizing as it were for various individuals that are involved in the healthcare industry in America, but it really doesn't need to be. We tried to write the book illustrating the good, maybe a little bit of the bad, and even the ugly, if that is the way to put it. It is designed to be informational and educational, and if it can be used as a guidebook for deal-making, which we do a lot of as healthcare consultants, readers will hopefully find it valuable.

Sacopulos: Could you tell us the title of the book?

Reiboldt: Private Equity and Healthcare: Leadership, Economics, and Trends for the Future.

Sacopulos: Max, before we get into the weeds on this, can you give me a sense of private equity's penetration into healthcare? I know we hear a lot about it, but just how common is it now?

Reiboldt: Well, it is hard to measure exactly when it began and for how long, but for the most part and I have been a healthcare advisor/consultant for over three decades here with Coker. I mean, we have always had transactions with doctors and hospitals and so with investor groups.

Private equity is just what the name infers. It is an amalgamation of private, meaning it is not a public entity, investors. They pool their money and invest. It has been over the last 10 years or so, and that is very gray in terms of the timeline of how far back it goes. There have been a number of private equity-backed organizations in existence for years and decades, but more so recently focused on investing in healthcare entities. Now, that could be anywhere from physician groups, practices, to surgery centers, small hospitals, independent emergency room entities, imaging centers, really anything that forms that healthcare provider base. Typically, what we tried to cover in the book was everything from the strategy behind that on both sides as well as the formation and structure of typical transactions, and we looked at the economics as well. I would say more intensive investment in private equity over the last 10 years or so.

Sacopulos: Private equity in healthcare, is it a good fit?

Reiboldt: I guess it depends on who you talk to. I am not trying to be coy when I say that. I would say the jury is still out overall. Why is that the case? Well, there have been a bunch of transactions. Our firm represents, mostly on the sell side, groups and provider entities in healthcare selling to private equity as it were. It clearly works very well for some and maybe not so well for others. The reason I said the jury is still out is many of the transactions are still relatively new, meaning five years or less. Typically, what happens in private equity is there is a point in time where the original investor or private equity conglomerate is ready to cash in, and there is a term for that. We call it recapitalization.

I guess you would say, more illustratively, we sometimes call it the second bite of the apple because most of the investor sellers, let's say, a medical group will sell a hundred percent of their practice or whatever entity we're talking about, but then they'll buy back as such 20 to 30%. That is called the rollover equity, so that is where the second bite of the apple comes about. That is when both parties cash in because often at that point, the original private equity sponsor as it is called, will actually get their return. Now, there is a lot that happens during those three to five years, maybe even seven years that the original private equity investor owns that entity. We will talk more about that as we get into some other things I am sure today, but I will just leave it at that. Is it a good deal? Quickly, I will just say it is favored by older physicians when we are talking about physician-owned entities, and we usually are.

Why would the younger physicians not be as enamored? Well, because the economics of the deal allows the older physician who is closer to retirement to realize their equity value much more than they would if they just wait until they retire, and they sell back their equity as it were to their partners. It gives them a better payday. Now, there is a price for that, which is why the younger physicians aren't as enamored with it. That is private equity essentially takes part of the earnings of the practice that is typically distributed in the form of compensation, and they add it back to the practice value and then apply a multiple to that earnings that is not distributed. That is how they get the upfront money, which is enticing to older physicians. The younger physicians are more concerned about putting their kids through college and other expenditures so they are not as interested in getting that upfront money as such as the older physician would be.

There can be a fairly significant fracturing of the group if we are not careful. We have to be very careful not to let that happen. I will stop there because again, as we get into more and more of the mechanics of the way the deal's structured, I'll comment some more on that.

Sacopulos: It occurs to me that when I ask the question about whether it was a good fit, I didn't mention metrics, and it seems like the metrics that we all are using are dollars. Is that the appropriate metric? Is that the only metric for these deals?

Reiboldt: No, it is not the only metric. It is a big one because typically, and very simplistically, it is not a real complicated scenario. Let's just say by way of example, a medical practice, an ENT group. They have a million dollars a year of what we might call excess earnings meaning that they are paying their partners a market compensation per doctor, and when it is all said and done, there is a million dollars left over. An advisor like us that would do what's called a quality of earnings review, and let's say we take that million dollars and not only that is taken away from their compensation in the model, but we actually tack on another million dollars that they also have gotten compensated for. Now, there is $2 million of earnings that is left in the business. That is a significant metric.

The other major metric, and it is just multiplication now, is the multiple. The private equity firm will negotiate. It is relative to market. It is relative to interest rates and return on investment and all those things but typically don't want to lock in on a particular multiple. Let's say for an ENT practice that has some procedural components to it there would be a seven or an eight multiple. Well, if you take the eight, multiply it by $2 million, that is $16 million, that is what would be paid. Let's say there are four doctors in the group, so they each get $4 million. Now, for the most part that usually can be qualifying for capital gains rates, which are much lower tax rates than ordinary income. But wait a minute, one or even $2 million that now capitalized and worked off the multiple to get to the upfront payment, that's no longer compensation, so the physicians, all four of them post transaction, take what we call a haircut or it's also called an income scrape.

We have a glossary in the book that describes all these crazy terms, but the scrape of $2 million means they get that much less in compensation going forward. But wait a minute, they got their $4 million each upfront at a lower tax rate. You see what I mean when I say it is good, and it is bad in some ways? It kind of depends on who you are, where you sit, and what you want out of the deal as such. That $4 million might actually only be three and a half million because maybe we have done $500,000 of rollover, so that 500 times four, I know I am throwing out a bunch of numbers here, $2 million of rollover is not paid upfront. It is reinvested, and the hope is in three, five, or seven years when the recap takes place and they have grown this base or platform of purchases, it will be worth twice that or three times that. The second bite of the apple could actually be as good or better than the first one, and that's part of the "pitch" behind private equity.

Sacopulos: When you talk about growth, I assume that that is a mixture of actual more dollars coming in as well as some efficiencies or better management. Is that fair?

Reiboldt: It is fair, and it is sometimes folks like me that are compelled to not necessarily take sides on which one is better, the sale or the buyer opportunities. I prefer to just tell it like it is, so the talk about economies of scale and efficiencies, very true, but overrated in most cases. It doesn't happen as quickly as sometimes it is touted, and it may not be as good. Now with that said, here is another term that we use in these transactions called income repair. What is that?

Well, remember I said there is an income scrape so many private equity firms might say, "Well, we are going to work together, and we're not only going to make it more efficient. We are going to potentially add more practices or more things, services to this base, and we will grow the overall corpus of what we have here. You'll get a part of that because of more efficiencies and overhead and frankly just more revenue." They will also say, "We may negotiate better commercial rates with the payers because we're bigger, we've got more to come to the table with office platform as such." Those are some of the positives that can result, but there are no guarantees. You don't know, but income repair is an effort to do just that, repair that lost income from the scrape that I explained earlier.

Sacopulos: Does this impact the ability to bring new physicians into a practice?

Reiboldt: You are very perceptive. Absolutely. Now, I will give you the pro and the con of that. The pro, and it is totally legit, totally true, is that again, we are talking about a larger critical mass that is being formed of providers. Go back to my ENT example. We have four, there's capacity for two or three more in the next couple of years or five years, so the private equity firm will supply the capital, recruitment costs, recruitment efforts, etc., and maybe even some subsidy as it were in compensation to recruit more ENT surgeons. That is appropriate to the overall platform that we are talking about, and it is very much real, and it is part of the goals and objectives of the private equity firm when they buy. They don't want this thing that they are buying to just sit still and stagnant. It has to grow.

The less positive part of that is there is always a cost to that, and it could, depending on how the deal's structured, come somewhat out of the compensation. It could reduce that cost of recruitment, and the cost of that initial salary goes against whatever earnings might be out there and increase in value if it doesn't realize the increased revenue and bottom line. In effect, indirectly, the doctors might pay for some of that, if you follow what I am saying, so no guarantees. You are in it together. You are putting down some risk as such as is the private equity firm, so hopefully it works out.

Sacopulos: Do you find when physicians are being recruited that there is a hesitancy to join a firm or a practice that's private equity owned in part or in whole because they can never become an equity member of that organization?

Reiboldt: Yes, we do run into that. Usually, we are talking about a younger physician, someone who has not been in practice, let's say, even as much as 10 years or even a lot less than that. Their perspective is a little different than perhaps a physician who has been in practice even 15 or 20 years and certainly much longer. In that, equity and ownership are not unimportant. That is two negatives. I should say it is important to them, but their whole goal and objective of their careers are somewhat different. Employment absent equity is not necessarily up there, number one, on their list of goals for their career, and so we can get through such transactions. Now, in some cases, additional equity could be awarded to a newly recruited physician, again, in that rollover entity because remember, they're going to retain equity, meaning the doctors in my example, in the rollover and what could be a result of some dilution of them. When they bring in a new doctor, they could certainly have some ownership.

The other thing about equity is we do a fair number of what we call buy-sell agreements among existing groups where you bring in a new partner and, "Okay, what's it going to cost to buy into the partnership?" What I always say is if it is a private setting, it is whatever you want to make it, if you know what I mean, in terms of what the buy-in would be, but you want to make it affordable. You also want to create an atmosphere where the newly recruited physician, even after a couple years, if it takes that long, feels like a partner, and you mitigate that through governance and leadership structure where you give that new "partner" a say in the way the practice is run and governed. Sometimes, that is enough to offset the lack of equity that you are asking about.

Sacopulos: We have got to talk about some of these studies out there that show increased morbidity, mortality associated with private equity. This might fall under your category of the ugly part of the conversation, but what do you say?

Reiboldt: Well, I think I have not personally experienced what you are referring to, but I haven't been exposed to all the hundreds of private equity sponsors and deals as such. The only comparison that we can make to what you are asking about, and it truly resulted in morbidity, was what we called in the 90s, the PPMC, physician practice management companies. I won't name names, although, well, I could. There were several prominent names, but the model that was there and it didn't work had some similarities to private equity. A major difference was the real end goal in those deals was public offerings, and that is not what this is. While you might say, "Well, it could be comparable." Yes, it could be to private equity, but when you set up a company that the end goal is to go public, you are really looking at and very much dependent upon the quirkiness of the public market and the rules that go with it.

Practice management companies like MedPartners, I will go ahead and name one, in the 90s really didn't work for the most part. I personally don't think we are talking about the same structure and situation in this case. I think there are some safety nets with private equity, but to be fair, we try to point this out in the book, we don't know the future and interest rates... I will say one thing, ever since we wrote the book, which was very recent that we finished it, that the multiples, generally speaking, are not quite as high as they were. Why is that? Well, one reason is the cost of money is higher. Now, who knows what is going to happen? We have a new administration. Who knows exactly what will happen with interest rates? If they don't go down, I don't think the multiples will go up. That made sense. If they do go down, I don't think there are any guarantees and furthermore, there is always a period of lag there.

The last thing I'll say about all this though is there is still a lot of money, a lot of capital out there that wants to be invested and wants to be invested in healthcare because healthcare in this country is becoming more and more a greater percentage of our gross national product. With the longer lives that people are living and the quality of life, and even to some extent that quality of life being better, I think people are able to retire a little earlier than maybe I would have although I haven't retired but I sure could have, all that comes into play here, and we just don't know exactly. It is a fun thing, and it is certainly an option for physicians these days.

Sacopulos: We have been talking about private equity in healthcare. It seems to me that there might be differences depending upon the area of healthcare. Perhaps private equity is a better fit for some areas of healthcare than others. Long-term care may be different than the ENT group example that you gave. Am I right about that or should we just look at it across the board as private equity in healthcare?

Reiboldt: You are spot-on, correct. For example, there's a couple of specialties that have really clicked with private equity and vice versa. One's dermatology. Now, why is that? Another would be ophthalmology, even radiology. They are still interested and certainly care about dermatology, radiology, for sure, ophthalmology, but other than radiology, the other two that I named are not significantly involved with hospitals and health systems and vice versa. We helped represent a large dermatology practice selling to private equity. I am not even sure they were credentialed at a hospital, and it was not because they couldn't have been or didn't like hospitals. They just didn't need to be because they can do all their work in their own procedure rooms or their clinic, so there are specialties that fit better.

Now, with that said, some of the other specialties that have a definite interest and vice versa in health systems and hospitals are doing private equity deals. Let me give you a couple examples, orthopedics, musculoskeletal, very interested. Now, another would be cardiology. They need to work and have available to work in a hospital because there are some surgeries and other procedures that those specialists are doing that are best for the patient. Frankly, in many cases, the payer requires it based on age and condition of the patient, etc., to do the work inside a hospital. They will do it there as opposed to a surgery center or their own private Cath lab or whatever. Is that going to enamor the cardiology practice to a health system and vice versa? The answer is no. Why would that be? Well, because they are pulling a lot of work out of that, what would otherwise be done in the hospital, there is a tug and pull based on specialty.

You rarely hear of an issue where a dermatology practice who has done a deal with private equity has any kind of crossways with a hospital for that reason, but there are those that definitely do. Now, I will just quickly say there are ways to navigate through this. We have done three-way deals where ... GI is a good example, where that works pretty well because you will have GI practices, gastroenterology, that will have invested in an endoscopy center, maybe with a health system, a joint venture. They want to do a private equity deal, meaning the group, so the group may come in, albeit a minority interest, and have a partial ownership in that endoscopy center with the health system. Maybe the health system dilutes some of its equity, maybe not. Maybe it all comes from the group in a three-way deal, but it is possible to be done. We have done some of those, but not necessarily the most popular thing with hospitals.

Sacopulos: Do you believe regulatory concerns, which really to date have not been as prominent as they could be, start to pop up?

Reiboldt: Well, let me be careful here. We always have whoever you want to call, Uncle Sam or the government, federal and states, looking over our shoulder in healthcare and for good reasons. I mean, I don't have to go into all the reasons. Private equity has not been immune from the rules by any means, but let's just say they have not been as subject to the regulations and the requirements that are very much akin to the Stark regulations and anti-kickback. I am not saying that they haven't been somewhat, but not as much as hospitals for sure. We really have to toe the mark with deals with hospitals, fair market value, commercially reasonable, buying referrals or hopefully not, etc.

However, as more and more private equity deals are completed, we're seeing more and more interest from Congress all the way down to different regulators in government, both state and federal in private equity deal's structure. Kind of a long answer, but yes, I think we are going to see more and more regulations particularly as more and more deals take place, and you see the multiples still being pretty high in the kind of dollars that are being paid doctors who own groups etc.

Sacopulos: A little bit of business and economic training would seem to indicate that that potential risk for private equity might make them demand a higher reward. Is that fair going forward?

Reiboldt: Absolutely. Yes. It is just a logical progression as such, and remember, as far as I know, I am sure there might be some exceptions. I don't know what they would be. We are talking about for-profit entities now that are investors. Private equity is not not-for-profit. Now, that is no criticism intended of them because I want to quickly say the private equity firms that we've worked with or even across from are very concerned about quality, good care, and all those things that the not-for-profits and the for-profit hospitals and practices are as well. With that said, there is no denying that private equity's looking for a return on their investment and a pretty good one. Health systems that are not-for-profit, we always use the term, you have heard it for them, no money no mission, for a not-for-profit. Well, that is true. You have got to be able to make ends meet and hopefully even have a little excess left over if you are a not-for-profit. Just because you don't pay income taxes per se, doesn't mean you can't have a margin or shouldn't, but private equity makes no bones about it. They are looking for a good return.

Sacopulos: As our time together comes to an end, I'm going to ask you to make a prediction. Where do you see private equity in the healthcare industry three years from now?

Reiboldt: My old crystal ball. Well, first of all, I am typically off a little, but with that caveat, I would say that over the next three years and in three years, we will still have a lot of private equity transactions being done. What we will see in three years that we have not seen as much of yet is the recaps and the second bite that will really tell the tale. Going back to my example in the ENT group, and we're talking about a physician who made $3 or $4 million upfront, less taxes but reinvested, let's say, 500 of that $3.5 or $4 million, if that 500 turns into another $3 million, then you're going to hear a lot of positive because that's a really good investment return. By then, we will start to see these recapitalization deals happening whereas even though there's been private equity deals being done for at least a decade, like I said earlier, the real core and bulk of them are not that old per se, so I think we'll see that.

The other thing, I don't think multiples will go dramatically higher or lower than where they are now. I think they will be fairly stable, and it will depend. You ask about different specialties, and I should have mentioned this. Even then, the multiples can be different based on what you bring to the table. If an orthopedic group has a surgery center that comes along, trails along in the deal with the practice, then there's a good chance that the private equity firm will pay a higher multiple because multiples on profitable surgery centers will go higher than multiples of just the practice with imaging or ancillaries like that. I think we will see multiples fairly comparable, not that much more, not that much less, in three years.

The other thing, the last thing I will say is I think there is still a lot of capital to be invested, and I see no reason why there will not be in the next three years. In three years, I think there will still be a lot of money out there. We will see how that all fits into the equation relative to private groups, private equity hospitals, and health systems, both for-profit and not-for-profit, etc., etc. It is an exciting time in healthcare. I truly mean that, and private equity is a part of that.

Sacopulos: The book is Private Equity in Healthcare, the author and my guest is Max Reiboldt, chairman of Coker Group. Max, thank you so much for your time and for being on SoundPractice.

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