BLOG: Rollover equity: Linking arms with your private equity partner
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Key takeaways:
- Sellers must understand rollover equity to maximize future value upon a second sale.
- A portion of sale proceeds are tied to the success of the practice and management services organization platform.
As we discussed in our overview of the private equity, or PE, physician practice model, the buyer in an acquisition is often a PE-sponsored management services organization that purchases the nonclinical aspects of the practice’s business.
The buyer then enters into a management agreement with the practice at closing, and the consideration paid to the selling physicians is generally in the form of cash and “rollover equity” in the buyer’s management services organization (MSO) platform (roughly split 75-25). Today’s post focuses on rollover equity issued in exchange for part of the value of the physicians’ business.
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Rollover equity aligns selling physicians’ interests with the PE partner by giving selling physicians an opportunity for additional upside in the future. When physicians become part-owners of the MSO’s capital structure through rollover equity, physicians can share in the increases in the value of the MSO platform that might come from ongoing and future growth, follow-on acquisitions and increased efficiency. (Of course, physicians will also share in any decreases as well.) Rollover equity keeps a portion of selling physicians’ sale proceeds tied to the ongoing success of their practice and the broader MSO platform. The hope is that a successful platform will ultimately fetch a much higher valuation on a second sale or “exit” transaction compared with what the MSO platform had at the closing of any particular practice acquisition. Physicians who believe in a platform’s potential often view their rollover equity as the most valuable part of a deal.
How the platform’s stakeholders share the proceeds from an ultimate “exit” transaction is determined by the platform’s capital structure at the time of the exit. The key parts of the capital structure typically include equity, incentive equity and debt. After the MSO platform pays off (or reserves for) its debts and other liabilities, equity holders can then receive payouts based on the platform’s “waterfall.” Imagine a tower of water glasses; water poured into the top level of glasses spills down to lower levels only if and after the top levels are full. Some capital structures are simple, like a single level of water glasses, while other capital structures have multiple classes of equity that pay distributions in a fixed amount, increase over time or change dramatically upon achieving certain milestones. For tax reasons, incentive equity holders (who may be associate physicians or executives who did not have an equity stake in the acquired practice and therefore did not have equity to “rollover”) might not receive any proceeds from an exit unless the MSO platform sells for a minimum amount.
One key deal point is how a platform’s value is to be divided between the PE sponsors and selling physicians. Sometimes the PE sponsors’ equity will be “pari passu” with physicians, which means that the PE sponsors and physicians share proceeds from an exit pro rata based on ownership percentages — like the single level of water glasses — but other times the PE sponsors negotiate to be paid first, before the physicians or anyone else. Rollover equity’s value and risks depend on both the capital structure of the MSO platform at closing and how that structure could change over the life of the platform.
But it’s not just the MSO platform’s valuation in an exit transaction that affects the payout on a physician’s rollover equity. Rollover equity might be repurchased (or “bought back”) by the PE sponsors in certain circumstances, which can reduce a physician’s payout when an exit finally happens, leaving a physician with only a fraction of the equity’s fair value at the time of the buyback (if anything). We will look at a few common buyback triggers in a later post, as well as how a buyback might work in practice. Because rollover equity can be so valuable, physicians should understand the basics of how their rollover equity might be taken away.
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