Introduction

There are many things to consider if you plan to invest in middle-market healthcare professional practice management (PPM) businesses this year. The hypercompetitive market, combined with residual effects of the pandemic, has made it difficult to find the right professional partners for investment opportunities.

Ari Markenson, a healthcare corporate partner at Venable, recently moderated a panel of experienced executives who discussed some of these issues and the deal environment in general. The panelists—Roy Bejarano, co-founder and CEO, SCALE Healthcare; Andrew Colbert, senior managing director, Ziegler; and Dr. Bede Broome, managing director, Assured Healthcare Partners—answered questions about what's hot and what's not in specific subspecialties, transaction structures, and professional practice management investments. They also discussed developments in valuations, potential for exits, growth capacity, and other significant issues.

Q: M&A transaction volume as a whole is down, and healthcare deals in the aggregate are also down. However, PPM deals seem to be holding strong. What's going on?

A: If you look at the first two quarters of this year, physician deals are up 25% over the same period last year. A number of factors are driving that. About 50% of all physician practices are still independent, so there's a lot of opportunity for consolidation. COVID also served as a wakeup call for many business owners, including physician partners. The groups that got stimulus funding and grant payments weathered the pandemic better than expected, and that led business owners to think about the future and see the value in consolidation.

Additionally, there are few sectors in healthcare that have the degree of fragmentation that the physician landscape has, and if you think about the core private equity playbook, it's buy a platform asset, and then leverage down your multiple over time to do smaller tuck-in deals at lower multiples. It's much harder to do that in areas that are already heavily consolidated.

Also, with other segments getting hit harder, like tech and consumer products, it's actually making healthcare more attractive as an investment focus. Comparing it to other industries, there is no lights out, new technology risk that's putting all of us out of business. So, we can plan ahead, business as usual. You almost have this Goldilocks scenario in healthcare services where economies of scale are good, but they're not too good. If they were too good, we would be too late.

Last, through word of mouth and increased awareness, physicians are now much better educated about consolidation options than they were in the past, and they've seen the benefits and attractive returns enjoyed by their peers.

Q: What is the future of PPM deals in the healthcare sector? Will private practices soon be a thing of the past?

A: Over the next 10 years, small private practices will likely not be as large a segment of the healthcare sector and will change in nature, becoming narrower and more niched.

It used to be that if you were a young physician leaving your fellowship and deciding where to go, you had two choices: work at a hospital or start your own practice. Today, there is an additional option: large, consolidated private equity-backed management services organizations (MSOs).

Eventually, the practices that can be consolidated, will be consolidated. For some, however, while MSOs offer all kinds of upside incentive arrangements and lots of growth, some smaller groups of physicians will still find private practice attractive. Additionally, there will always be rural healthcare, where consolidation just isn't an option.

Q: What specialty health practices are investors interested in at the moment?

A: Every specialty has unique ways of creating value. In one specialty, it might be maximizing some imaging ancillaries, and in another it might be owning a particular type of outpatient center for doing certain types of procedures.

The early days of PPM consolidation focused on driving economies of scale and leveraging scale to negotiate better rates. The "ologies" have evolved as private equity firms have learned the intricacies and ins and outs of different spaces, and the physicians within those spaces have come around to private equity ownership. Now, it's about where you can take costs out of the system. It's focusing on services that can cost significantly less to provide outside of a hospital, such as gastrointestinal (GI) or orthopedic services. Some of that is driven in part by the Centers for Medicare & Medicaid Services (CMS).

Q: Platform acquisitions and add-ons in this space used to have a much lower valuation threshold. Why has that changed?

A: The more confidence and conviction you have in the success of something, the more you're willing to pay for it. And the more tools you have at your disposal to manifest that success, the lower the risk component; and less risk with the same or more return equals a higher upfront price.

We see almost a bell curve when we think about value relative to the size of the practice. There's a sweet spot where there's a maximum number of bidders and buyers and interest for a business. If a practice is too small, like one to three doctors, then it's naturally valued lower. But there's also the other end of the extreme, where you see the big public companies and massive platforms that have thousands of doctors, and the growth is just hard to keep up. It's challenging to continue to grow by 30% when you're earning $2 billion in revenue. There comes a point where you've gotten too big, and the multiple starts to come back down. If you're in private equity, you want to get in at the right moment, but you also want to get out at the right moment. No one wants to be trying to sell a multi-billion-dollar private practice. That's a challenging deal to do, and there's only a handful of buyers. The sweet spot is probably between $10 million and $200 million in earnings before interest, taxes, depreciation, and amortization (EBITA) to maximize value potential.

Q: How important is the alignment between the investors and the professionals? What are the keys to getting that right, and how can it go wrong?

A: It is extremely important to get it right. The relationship requires constant communication and a recognition that the relationship with the physician group is far and away the most valuable asset that you have. Most of the time, the feedback they provide is the right feedback for what the organization needs. So, you can't gather enough feedback from a physician group. Relying on one representative leader is a common mistake. There are many voices and opinions that must be heard and considered.

A partnership model will likely be more successful than an ownership model, because at the end of the day, from a legal perspective, the physicians maintain complete and total autonomy with regard to all of their clinical decisions. From a practice perspective, physicians have strong opinions on how they want to carry out their day.

Alignment begins with making sure that the physicians remain invested in the business from a financial perspective, and they are seeing a lot of that financial return over time. It's also important to think about both the younger physician and the older physician. Practices aren't just a group of 40- to 50-year-old physicians. There are some who are right out of fellowship and thinking about how they're going to have a 30+ year career in medicine, and there are others who are two years away from retirement. The incentives and the alignment that you need to create with each of those pools of physicians are very different.

Q: What are some other challenges in getting this alignment right?

A: A lot of effort must be put into informing and educating physicians throughout the entire relationship. Physicians are often on board as long as they see timely reporting. They become disruptive when you can no longer provide honest, open, reliable feedback on how your organization is doing.

Another challenge is understanding the different economic mentalities of private equity investors and physicians—they can be polar opposites. Physicians in private practice typically measure their economic success by how much they make in a given year or quarter. In private equity, it is fundamentally about what you bought at and sold at, rather than gains and losses in a single year or quarter. Investors are more concerned with long-term gains. So, a challenge is making sure the doctors understand that this alignment model will pay off, but EBITA may go down over the course of the investment, or it may stay flat for a few years. It's hard sometimes for them to see that and have the same confidence as the investor. They also need to understand the context of a bad quarter or a bad year and look at the larger picture.

You also must be very careful and selective about protecting and preserving the culture of the organization by being conscientious about who you let in thereafter. You must hold on to that culture of open communication and growth and orientation as well as risk management. Culture is probably more rapidly and more frequently ruined by excessive growth than anything else. Excessive growth equals dilution in the quality of the team around you and dilution in the ability of the operations infrastructure to handle that.

Q: From an operational perspective, how are practices doing? What challenges are they facing that private equity investors and consolidation can help with?

A: More patients in later-stage diseases are putting a burden on the practices. Many practices are feeling the pain of labor shortages and the complexity of the practice operations, and that is where private equity consolidation can help. By being part of a larger organization and having greater ability to recruit and optimize different components and practice operations, physicians can alleviate some of these challenges.

Q: Has there been any sort of challenge to the MSO model recently that has given investors pause?

A: There have been more attempts to hold investors liable for pulling strings they shouldn't be pulling. A state regulator may believe that an investor is sticking their hands in the professional practice more than they should be.

The likelihood that an investor is going to be telling a professional involved in investment whether they should be doing surgery is extremely low. An investor might share ideas on different ways to schedule patients and those kinds of things, but the likelihood that any investor is truly sticking their nose in the clinical practice of the professional is very unlikely. It must be very clear from the onset with any relationship that clinical autonomy is 100%.