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Both junior and senior practice partners could benefit from private equity transaction
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In the following paragraphs I would like to present an illustration of how a private equity transaction might work for an ophthalmology private practice, and it is important to emphasize the word “might” with the usual caveats about inability to predict the future. Nonetheless, I think the illustration will help many understand the economics.
First, a few personal thoughts and disclosures. My partners and I at Minnesota Eye Consultants (MEC) recently completed a private equity (PE) transaction with Waud Capital of Chicago to create an entity called United Vision Partners (UVP). So, I am walking the walk, not just talking the talk. The current PE transactions occurring in ophthalmology are very different from the physician practice management company (PPMC) roll-ups that occurred in the late 1990s. I can state this from experience because I was the chief medical officer and a member of the board of directors of Vision 21, a PPMC that MEC partnered with from 1996 to 2000. The Vision 21 deal was all stock and no cash to the partners. If a partner sold his stock at the high-water mark, he had a great outcome. Of course, none of us did that.
Vision 21 invested heavily in our practice and acquired several other MD and OD practices in the Twin Cities and surround. Over 5 years we grew from top-line revenues of about $12 million to $75 million. Then, it collapsed. It collapsed for several reasons, but primarily because it employed a centralized management model that was too expensive and very out of touch with the needs of each individual practice. We are still in practice at MEC 17 years later, so what happened?
I suspect what happened is also the worst-case scenario for a transaction with a PE group. Vision 21 borrowed money from a large bank, the Bank of Montreal, and when the Vision 21 corporation failed, the bank ended up owning all the assets. So, while our stock was worth zero, we bought back nearly $10 million of Vision 21 investments in MEC that occurred over 5 years from the Bank of Montreal for $2 million. We also managed a reasonably painless exit for our other Vision 21 partners, and they are all still active in practice. One could argue that the 5 years in Vision 21 was the best thing that ever happened to MEC, but it was very painful for me to unwind it, and I do not intend to repeat the experience in our PE partnership with Waud Capital and UVP, in which I am assuming a similar leadership role.
Next, why do well-managed PE companies have so much money? Large foundations such as those at Stanford, Harvard and the University of Minnesota, where I am a trustee, along with pension funds and high-net-worth individuals invest 5% to 15% of their money in venture capital and/or PE. Over the past decade, PE, which invests in cash flowing operating companies and grows them, has outperformed venture capital, which invests in pre-revenue startups. Thus, a significant amount of money is flowing into well-managed PE companies. They are looking for places to invest, and health care and those medical practices that work outside hospitals, such as dentistry, dermatology, behavioral health, physical therapy, aesthetic plastic surgery and of course ophthalmology, are an attractive option.
So, how does a transaction work for the ophthalmology private practice equity-owning partners young and old in a high-quality PE transaction? My model practice will have four equal MD partners, two employee MDs and four employee optometrists. They own an ASC and have $10 million in top-line revenue with a 70% overhead. They are growing at 6% per year and want to grow faster. They have $1 million in personally guaranteed bank debt. Their ages are 34, 46, 58 and 70 years old. The buy/sell is $500,000. After 6 months of due diligence, they decide to do a PE transaction. They commit through a change in their compensation plan to move a portion of their revenue to the bottom line to generate positive earnings for the practice, rather than distribute 100% of income to the partners. They are offered a multiple (ultimate purchase multiples depend on a range of factors, including practice scale, reputation, performance and growth profile) on that earnings level as a total valuation or practice purchase price. For the sake of example, let’s assume the valuation for this practice was $6 million. After the $1 million bank debt is retired, they have $5 million to distribute to the equity-owning partners. At closing, each doctor receives $1.25 million in cash.
The senior partner decides to retire. He has received a $1.25 million buyout rather than the $500,000 per his former practice buy/sell agreement. Definitely a win for the senior partner, who can either retire or become a full- or part-time employee doctor at 25% of productivity. Dr. Senior pays his taxes and puts the remaining cash along with his 401k savings into an annuity that will pay $15,000 a month for the rest of his life. Dr. Senior owns two homes mortgage-free and has other savings. With Social Security, he will have a lifetime guaranteed income of nearly $20,000 per month. Dr. Senior is a happy camper.
What about the youngest partner? At 34, this young partner pays $250,000 in taxes after deduction for his $500,000 basis in the practice, rolls $250,000 over into the partnership investing alongside the PE firm and puts $750,000 into his IRA. Planning to work until age 70, that $750,000 invested tax-free at 6% will double every 12 years. Dr. Junior will therefore get three doublings, meaning the $750,000 will grow to $6 million by age 70. If needed along the way, Dr. Junior can borrow from his IRA for emergencies, including his children’s education. There is almost no other way that a 34-year-old could save $6 million by age 70.
But that is not all. Together, over the next 6 years, the remaining three ophthalmologists and their PE partner grow the practice to $20 million in revenues with 10 MD ophthalmologists and 10 optometrists. The PE firm capitalizes this growth. In 6 years, the PE partner sells to another PE firm, and the $250,000 invested returns a three times multiple of $750,000 to Dr. Junior and each of his partners. The young doctor pays his taxes again and nets another $500,000. Dr. Junior takes out $250,000 to invest or spend as desired and reinvests $250,000 again with his new PE partner. This might be repeated two or three times. Finally, a PE partner takes the company public, and instead of a three times multiple on the final $250,000 investment, Dr. Junior receives a 10 times multiple, or $2.5 million. After a 1-year lock-up, Dr. Junior can sell or hold this final exit publicly traded stock as desired.
Too good to be true, you say — there must be a catch. There is — the catch is that in this highly productive practice, the young surgeon has reduced his annual income from $750,000 per year to $500,000 per year. After taxes, depending on the state, that is about a $150,000 per year reduction for 36 years, or about $5.4 million. If the young doctor saved it all, the amount could be higher, but it is likely most would be spent. In addition, the practice growth catalyzed by the PE firm partnership can be expected to accelerate and increase the partner doctors’ net income each year, with the opportunity to recapture most, if not all, of the lost income. Finally, Dr. Junior is now debt-free, sleeping better and finding it easier to borrow money for other purposes such as buying a home.
Every ophthalmologist considering a PE transaction should undertake careful financial analysis and diligence, modeling with one’s financial advisers how the transaction will impact him personally before committing. But my analysis suggests that the monetization opportunity is even greater for the younger partner than the senior partner, with any loss in annual income more than replaced by the transaction opportunity. Each individual can plug in his own numbers, and the opportunity in the PE transaction for the 46-year-old and 58-year-old can also be calculated. Bottom line: A PE transaction promises to be a financial win for partners of all ages if the PE partner is high quality and the partnership performs.
There are, of course, no guarantees that the second and third transactions or a public offering will ever occur, and under- or over performance compared with the above illustration is a possibility. But there are several good examples of similar or superior returns in PE transactions in other medical fields. Dermatology is a good example, and any doctor and his financial advisers can look them up.
What if the bottom falls out of ophthalmology and cataracts are reimbursed at $500 per eye with a facility fee of $500? The financial strength of a well-capitalized PE partner will be a welcome safe harbor and allow time to adapt. In addition, because there is a significant cash payment to the doctor at closing based on today’s quite healthy external economic environment, the greatest risk is actually borne by the PE firm and its investors.
A PE transaction is not for every practice or every ophthalmologist and requires careful due diligence and thoughtful planning. It is important to pick a PE partner that is a cultural fit. Especially important to our practice was a decentralized management structure that allowed our doctors to continue to teach, consult, do research and practice as they had in prior years. But for the ambitious practice that has experienced strong growth over the last few decades and is motivated to continue to grow in scale and strength in the next decade, it is worth investigating. It is also to me the best way for a quality practice’s equity-owning senior and junior partners to monetize some of the value they have created over several decades of hard work. Best of all, as I do the numbers, it works for partners of all ages.
Disclosure: Lindstrom reports he is a partner in Minnesota Eye Consultants and has equity in United Vision Partners.