Consider operational, financial structures before private equity investment
August 28, 2023
5 min read
In the past decade, the financial and operational ground has shifted in orthopedics and other medical specialties.
What started in the early 2000s with private equity investment and consolidation in the dental sector has evolved to affect the future of independent practices throughout all specialties, including orthopedics, eye care, dermatology and more.
Orthopedics is one of the fastest consolidating specialties in the U.S., as there are now more than 15 private equity-backed orthopedic platforms operating nationwide. Private equity investors seek to build upon the initial platforms through acquisitions, expansion of service lines and new business startups. They also provide management and administrative services for the practices with which they partner. The goal is to build business scale, achieve operational synergies and gain financial leverage when dealing with payers. In 2022, there were more than 20 orthopedic transactions completed by private equity-backed platforms. And this pace has not slowed in 2023.
By now, most successful orthopedic physicians have been approached by a platform about a practice partnership or they have learned about the consolidation through colleagues, podcasts or other health care news. With all the talk, rumors and misinformation abound, accurate information is not always easy to find. Our firm has guided more than 50 physician practices through private equity transactions in the past 5 years with significant experience in orthopedics. We believe it is important to stay educated to understand whether a private equity partnership would benefit your practice or if it is best to continue to operate independently.
Reasons to find a partner
Among the recent economic turmoil, the stress of the pandemic and other challenges, many independent practices have turned to private equity and are seeking to retain their independence while also securing capital for growth, gaining administrative support and (most importantly) ensuring future clinical autonomy. The consolidation in orthopedics is still at an early stage and has only been going on over the last several years. This creates a prime opportunity to pick and choose the best private equity partners and benefit from joining a platform at the early stage of its growth.
When it comes to funding growth initiatives or infrastructure and equipment improvements, it can be difficult for doctors to find capital on their own. With a private equity partner, they will have the funds available to open new offices, hire more staff, add service lines and grow the practice.
Experienced health care private equity firms have the resources, human capital and management expertise to help make these investments successful, whether it means opening an ASC, expanding DME services or offering physical therapy services. These activities can improve the patient’s experience while relieving the doctor of the financial burden and headaches of business operations, thus allowing them to focus on patient practice and medical/surgical case load.
Select the right partner
Our firm has talked to hundreds of practices and doctors since 2017, guiding more than 50 groups to a successful private equity partnership. Based on this experience, we believe that running a competitive process with an advisor is the best way to find the right partner.
It is important to fully vet all partners and options, focusing first on cultural fit, clinical autonomy and operational alignment. The successful private equity backed platforms allow the physicians to maintain clinical control and autonomy at the local level through a local governance charter. Without guidance, too often practices will only consider the initial financial outcome. This can lead to serious “buyer’s remorse” once the doctors and staff realize that they now must work within a framework to which they may not have paid close attention.
Given the considerable amount of consolidation going on in orthopedics, depending on the region, there are generally many different parties that may have interest in partnering with a successful practice. Completing the proper due diligence on each potential partner requires a comprehensive evaluation of their financial and operational track record, mapping out the post-transaction benefits of joining together (ie, payer rate lift, supply purchasing power, etc.), determining if there is a cultural fit and alignment with the overarching practice strategy.
It also means speaking with physician references, examining their success with growth and infrastructure initiatives post-transaction and if the physician has ultimately benefitted from the private equity relationship. Lastly, it is imperative to understand the partnership path for current and future associates.
It is essential to choose the “right” private equity platform because physicians will have to live with this relationship for, potentially, the rest of their career.
Key financial considerations
Although private equity-backed platforms can be vastly different based on culture, operational alignment, geography and service mix, there are similarities in the financial structures used to complete transactions. As a rule, transactions are structured with most of the transaction value paid to the practice as cash proceeds, and the remaining portion will be rolled into the equity of the overall organization.
Rollover equity is a tool to create alignment between the private equity-backed platform and the selling physicians. Most transactions are structured with 20% to 40% of the transaction value being treated as rollover equity, but there is some flexibility here. The future value of the rollover equity for physicians is directly related to whether they have selected a successful partner. A strong partnership ultimately will result in the rollover equity growing to a greater value in the future compared with its current value.
Another key consideration for physician owners is the calculation of compensation on a go-forward basis and how it aligns with the future growth of the organization. Orthopedic platforms use the following various methods to calculate go forward shareholder compensation:
- The “percentage of collections” model, which compensates physicians based on their individual percentage of revenue collected by the practice for services provided, is the least common. Providers can only see a limited number of patients, making it challenging to increase collections.
- The “scrape” model allows physician owners to give up a portion of their historical compensation and apply it to their earnings before interest, taxes, depreciation and amortization to calculate transaction value. The scrape is typically anywhere between 30% to 40%. This approach creates an opportunity for “income repair,” aligning physician compensation with the practice’s growth and increasing profitability, incentivizing physicians to improve performance. As a result, when the overall profits increase, the physician owner’s compensation increases dollar for dollar.
Each orthopedic private equity platform has a slight variance in compensation structure and physician owners should select one that rewards growth and performance to position themselves for long-term success in the competitive health care marketplace. A successful partnership for a physician owner is generally seen when the practice has achieved a few key milestones: equity appreciation, income repair and, most importantly, best-in-class clinical care for patients.
With the health care industry becoming increasingly competitive, independent orthopedic groups are facing significant challenges, including rising costs, declining reimbursements and increasing regulatory burdens. As consolidation continues in the orthopedic space, private equity-backed platforms offer physicians the opportunity to achieve economies of scale, reduce operational headaches and enhance leverage with payers.
Given these factors, it is essential for independent orthopedic groups to consider private equity as a tool for practice growth and long-term sustainability, while ensuring they maintain clinical autonomy. Evaluating private equity partnerships and doing proper due diligence will allow a practice to make informed decisions and be better equipped to succeed in the future. Collaborating with experienced transaction advisors, consulting with colleagues who have already undergone similar transitions, engaging with industry associations and communicating with active private equity-backed platforms in the market will ensure that orthopedic groups are well-informed and positioned to thrive in a highly competitive marketplace.
For more information:
Michael Kroin, MBA, is the CEO and a managing partner of Physician Growth Partners. He can be reached at firstname.lastname@example.org.
Ezra Simons is a managing partner at Physician Growth Partners. He can be reached at email@example.com.