A Day at the Office: Private Practice and Private Equity

While talking to a few of my private-practice colleagues recently, our conversation turned to private-equity (PE) investment in orthopaedic private practices. It was impossible to ignore the buzz surrounding this topic among my peers. It seems there is substantial interest in external investment in our specialty [1]. Rumors abound regarding massive payouts, as shareholders are convinced that outside investors are willing to pay them vast sums of money for the pleasure of being associated with their practice. But there is the obvious question: What’s the catch?

Private equity specifically refers to closed investment funds that generally seek high returns by investing in platforms (such as medical practices) that are not otherwise available in the general-equities marketplace [3]. A PE firm hopes to rapidly increase the fiscal value of the practice it invested in with the goal of selling the practice to a second purchaser, preferably in a short timeframe. Since these investments have poor liquidity (that is, they may be difficult to sell quickly), there must be a high return to attract investors.

Typically, PE firms increase the value of their investments by decreasing expenses and/or consolidating other practices. Practices with staff overlap, superfluous office space, or unnecessary luxuries will likely see their budgets cut or their physicians bought out. The “consolidation play”, as it is sometimes called in the PE world, involves firms buying a majority interest in a company and then combining the newly purchased company with several similar companies to create one big player in a given industry, with the goal of driving up profitability through cost efficiency and scale [4].

Private practices in dermatology, dentistry, and ophthalmology are currently experiencing consolidation by PE firms [5], and private orthopaedic surgery practices are not immune to PE investment [1]. Still, I do not believe that market consolidation through PE will be as prevalent in orthopaedics as in other medical specialties specifically because orthopaedic surgeons tend to be independent and we often invest in practice-based ancillary services that provide a broader base of revenue compared to professional services alone [2]. Certainly, other physicians (such as ophthalmologists and plastic surgeons) invest in ancillary services, but the broad range available to orthopaedic surgeons seems to give us a feeling of autonomy. That being said, PE investment will likely garner considerable interest from our private-practice colleagues. In conversations with leaders of other larger orthopaedic groups, I have learned that PE firms have already approached many of these practices, and the physician owners are cautiously waiting to see what happens in the market.

Why Engage in the Process?

It remains to be seen whether PE firms approaching private orthopaedic surgery practices is a positive trend [2]. As much as I favor the independent private practice of medicine, PE may be a good answer to the ongoing financial pressures that plague us every day.

But before jumping into a PE transaction head on, private-practice leaders need to ensure that their shareholders’ or leadership group’s motivations for engaging in this process are completely clear. What do your shareholders hope to achieve by doing this transaction? Does your private practice need money to expand into newer markets or purchase ancillary services? This would be an excellent reason to consider a PE investment since your shareholders’ motivations are generally aligned with the PE firm’s goals. Does your leadership have a general idea of the practice’s overall financial performance? The financial value of the practice is determined from a calculated “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA). The EBITDA is a good indicator of your organization’s operational cash flow and profitability.

Majority Versus Minority Control

If there is mutual interest between the two parties, the question becomes will the PE firm buy a majority or minority interest in your practice? Although they will likely insist on running the business side of the practice in a more-efficient manner, PE firms interested in majority control typically rely on physician leaders to make the professional side successful. Still, PE investors prefer majority control so that they can protect their investment by overriding physician decisions that they may feel are foolish. Sometimes though, they purchase a minority position in a practice knowing that the physician owners will maintain a larger degree of control. The physicians in this situation do not have ultimate control, however, because the PE firm will protect their investment in the contract language even if they only own a minority share. When a PE firm assumes a greater risk with limited control of the practice, they will pay a lower multiple of earnings for a minority share than they would for a majority share.

After the transaction, the practice will, in essence, become a new company and the original shareholders are now employed physicians. It is in the PE firm’s best interests for the newly employed physicians to share in the common goal of expanding the value of the practice. For this reason, the PE firm will often require the physicians who received a buyout to invest some of their transaction proceeds into this new company. If the employed physicians are invested in the new company, they are much more likely to work to make the new company successful and increase its value.

Since the practice’s shareholders will permanently forfeit some amount of future earnings to the buyer, the PE firm compensates the shareholder physicians for this future loss when the deal is closed. This buyout is calculated from the amount of EBITDA that is taken by the PE and multiplied by a factor (the multiple) to compensate the physicians for this future loss of income. This buyout is the first yield to the physician shareholders. If a subsequent sale of the practice proceeds the way that the PE firm envisions, this second transaction will yield a second significant yield to the physician as well as the PE investors.

The Downside

Throughout the process, your practice’s shareholders must recognize that PE firms have no desire to own any medical practice other than for its investment value. If your practice’s shareholders want to maintain complete control, obviously they shouldn’t consider selling the practice. Firms will implement changes to the practice as needed to increase the value of their asset so that they can flip it to another investor. The physicians are the key to continued productivity, but the focus on profitability and the culture that results from deep overhead cuts can impact job satisfaction and morale among the staff.

Additionally, entertaining a PE transaction is an expensive endeavor that includes fees for attorneys and investment bankers who are well-versed in these types of transactions. The attorneys will carefully evaluate your business’s structure, and confirm to your leadership group when the practice’s legal composition is ready for investment. The investment bankers will “package” your practice so that you will get the best deal in the market. The investment bankers have relationships with many private-equity firms, and they will broker the deal for your practice. Since the investment banker is usually incentivized to secure the best financial deal possible, their motivations are generally aligned with your firm.

These expenses begin to add up as the lead up to the transaction rolls forward. The practice will have to obtain a Quality of Earnings report, which is an accurate assessment of the financial health of the practice generated by an entity that routinely performs this analysis, and they will determine the all-important EBITDA. The investment bankers make their money when the transaction closes, but they may require earnest money protecting them in case you get cold feet and bail out early in the process.

Your Patients

This column has almost completely focused on the return-on-investment for the private practice’s shareholders and the PE firm. But where do orthopaedic patients fit into all of this?

I think one of the following two scenarios is likely to play out. If the PE firm believes that the commoditization of orthopaedic surgery is the endgame, and that pillaging the system to make quick money is most important, then patients will suffer from the commercialization of our specialty. The patients will feel as if it is “all about the money” and they will perceive that they are just a commodity. If, however, the firm decides to invest their financial power and managerial expertise to revolutionize orthopaedic practices to produce value-based, patient-centered care, patients will wonder why practices didn’t do this earlier. With the increased focus on the value of health care, this second scenario may well be a good opportunity for PE to finance the change in health care. Only time will tell.