Q&A: Evaluating private equity in gastroenterology
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In 2016, Audux Private Equity became the first PE fund to invest in gastroenterology. Today, 48 private equity transactions have occurred in the field.
Gut Talk host Sameer Berry, MD, spoke with Praveen Suthrum, co-founder and president of NextServices and author of Scope Forward, about the current landscape of private equity in gastroenterology and points to consider when evaluating private equity.
Berry: When and why did private equity (PE) become interested in gastroenterology?
Suthrum: In 2016, Audax Private Equity became the first fund to invest in gastroenterology By investing in in Gastro Health, a GI group based in Florida. While it was a first for GI, Audax simply reapplied its investment thesis from dermatology and other specialties. For example, Audax invested in Advanced Dermatology & Cosmetic Surgery in 2011. They expanded to 140 locations, increased revenues to $200M and recapitalized the company in 2016. Today, 5 years later, they are looking to exit Gastro Health.
PE’s interest in gastroenterology is because of the intersection of multiple trends. One, with increasing lifespans, there’s a steady demand for GI services. Two, GI practices are fragmented, constrained on resources and can benefit by streamlining. Three, GI practices lend themselves to lucrative ancillary expansion. Four, there’s regional consolidation of health systems increasing pressure on gastroenterologists to make a move.
With access to a large amount of capital, PE firms are keen to “roll up” GI practices, streamline administration and technology, add management talent, hire new physicians and recapitalize their investment in a 3- to 7-year window. That’s the PE model in a nutshell.
Berry: What does the current landscape of PE in GI look like?
Suthrum: As of February 2021, more than 50 PE transactions have occurred in gastroenterology. There are eight PE platforms: Gastro Health (Florida), GI Alliance (Texas), United Digestive (Georgia), US Digestive Health (Pennsylvania), Gastro Care Partners (Colorado), One GI (Tennessee), Pinnacle GI Partners (Michigan), and Allied Digestive Health (New Jersey). While some are pursuing a regional strategy, a few others such as GI Alliance have expanded nationally.
Some estimates say that close to 1,000 gastroenterologists are now employed under a PE model. Most of the large groups and several of the midsize GI groups have consolidated under PE or are going through the PE process or decided against PE.
In 2019, Capital Digestive Care offered an alternative model by building a strategic partnership with Physician’s Endoscopy. Interestingly, Physician’s Endoscopy has also been PE-funded for several years.
Berry: What are some things to consider when evaluating private equity?
Suthrum: First, it’s important to understand what a PE business model is instead of labeling it good or bad. PE companies raise cash and debt (from lenders), buy and restructure companies, sell and distribute profits to their limited partners. They are financially driven to make their investment thesis work. However, PE can go wrong (as it did for retail companies during COVID) when a portfolio company is unable to repay its debt. That’s when a lender can sell the assets of the investee company and even shut its operations down.
Consider the following factors when evaluating private equity.
Speed: Because PE operates in shorter time horizons (typically, 3 to 7 years from investment to exit), the organization will run faster. Pace of operations usually changes significantly.
Makeover: While an infrastructure makeover may or may not happen, a management makeover definitely does. PE will ensure that it has the right leadership team in place. They will iterate until they get the management team that can execute their investment thesis.
Technology: Depending on a PE’s investment philosophy, operations will get a technology upgrade. Especially areas related to financial management. For example, one PE platform invested in dashboards. Another invested in data warehousing to access financial data from disparate EHRs quickly.
Clinical governance: Many PE platforms understand the importance of keeping clinical governance separate from business needs. However, whenever PE-funded platforms have gone terribly wrong, there’s also the underlying problem of business mandates directing clinical operations.
Build vs. buy: Most PE models are about buy, scale and sell. However, a few others focus on improving what is called EBITDA — earnings before interest expense, taxes, depreciation, and amortization — by cleaning up operations and organically growing the business.
Culture: Without question, the culture of the organization will change. It’ll be driven by what’s established top-down.
Change in compensation: PE firms adjust physician compensation to market rates. This helps in a more accurate determination of their market value. Compensation is expected to increase over time (referred to as “income repair”) by adding ancillaries and better insurance contract rates.
There are a list of questions on what to ask when PE comes knocking outlined in my book, Private Equity in Gastroenterology.
Berry: Why do people bring up the PPM debacle of the 1990s when talking about PE in medicine?
Suthrum: In the 1990s, physician practice management companies (PPMs) followed a similar model as private equity of today and blew up billions of dollars. Nearly all PPMs imploded. In the end, doctors were scrambling to rebuild their practices. It’s important to understand the PPM debacle of the 90s to avoid making similar mistakes again.
PPMs aimed to consolidate fragmented medical practices. They brought in fresh capital and management talent. They also added ancillaries and negotiated better contracts with insurance companies. Many of them were listed on Wall Street. Doctors were given stock in the PPMs and everyone waited for the big pay day when a company would IPO.
However, in their rush to consolidate, PPMs overpaid for medical practices. They also charged hefty management fees (15% to 20% of net income). They underestimated the complexity of running a medical practice business and turning profit. If that wasn’t enough, they used confusing accounting practices to show the market that their companies were more profitable than they actually were. Eventually, they struggled to execute on their business plans. PPM stocks tanked. Money was pulled out of the market. When doctors started leaving, they were sued by the PPMs. Attorneys and consultants stepped in to help doctors rebuild their lives for a post-PPM era.
Private equity companies argue that their strategy today is different, and they have access to newer technology tools that didn’t exist in the 1990s. However, time will reveal if indeed the history of PPMs helped us make more prudent decisions.
Berry: How are deals usually valued?
Suthrum: PE uses a measure called EBITDA to value medical practices. Think of EBITDA as a measure of profitability. PE firms use a multiple of EBITDA to arrive at valuation.
When computing EBITDA, physician compensation is usually adjusted to market rates, while adding back one-time and discretionary expenses. Doing so results in what’s referred to as “normalized” EBITDA. A firm then determines a multiple of EBITDA to value a medical practice. What that multiple is depends on a variety of factors from competition to regional factors.
Berry: What is the one thing about PE a GI may not know that they should?
Suthrum: Here’s one factor that hardly gets discussed. PE is valuing GI practices based on future physician productivity. To determine that future productivity, PE valuations are extrapolating the past. Such an assumption means that GI as an industry will continue to function in a way that’s similar to the past 5 to 10 years, relying on screening colonoscopy-led revenues. However, as we know there’s plenty of disruption coming to gastroenterology — from liquid biopsy for cancer screening to technology companies offering GI digital health services.
GI practices consider colonoscopy as an asset. However, as Larry Kosinski, MD, MBA, told me in his interview, it’s actually a "significant vulnerability.” If colonoscopy gets disrupted, all associated ancillary income (eg, biopsies from pathology and anesthesia) would also disappear.
The challenge for the PE model is that if their thesis about the future goes wrong, then there’s no clear plan B. Most people are expecting that such a future is not immediate and that it might only be a problem for future PE acquirers. However, industry cycles are becoming shorter because of digitization. Such an assumption poses a significant risk for PE in GI space. Regardless of PE exit horizons, it’s a better industry practice to point the rudder in the right direction. In the future, GI care will move from the realm of physicians to a care team that includes technology such as AI as part of the team. The industry must develop better valuation models considering such a future.
Berry: What do you see as the future of GI in the realm of PE?
Suthrum: Looking over the shoulders of PE in dermatology, I predicted in early 2019 that there would be eight to 12 PE platforms in gastroenterology. As of today, we do have eight PE in GI platforms. There are many deal announcements underway. And we’ll see the market heat up throughout 2021 and 2022.
In my book, Private Equity in Gastroenterology, I had forecasted that we would see a spur of mergers and acquisitions activity around 2021. With Gastro Health on the block for an exit, it’ll be the first time GI will experience what’s called the “second bite of the apple.” It’ll also demonstrate what happens when a PE platform changes hands. We’ll see even more exits from 2023 to 2025. Statistically speaking, there’s a possibility that a PE platform might fail on its investment thesis (we just don’t know which one).
We will also see newer forms of technology-driven PE companies. Considering the risks of existing PE platforms, these newer companies will peg valuations beyond physician compensation. They will be in tune with emerging patient trends — for example, in the areas of technology-led disease reversal. These digital health companies (not just private practices) will meet the demand for GI care with a combination of clinicians, a care team and advanced technology. The time to prepare for such a future is today.
Perspective
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Maged K. Rizk, MD, MBA
This is a very well written overview of the current landscape of private equity investment in gastroenterology, the rationale for equity dollar inflow, and the expectations of private equity regarding exit from investments. The cautionary tale of physician practice management companies in the 1990s and the parallels with current trends is also helpful in understanding what variable drivers to success and failure might be. But most importantly, this overview provides a realistic perspective as to the impact that this trend could have on physicians who decide to participate in such arrangements.
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