Growth in orthopedics increases private equity interest
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Since its emergence in health care, private equity investment in physician practices has steadily increased in specialties that provide outpatient services, have high reimbursement rates and have access to ancillary services revenue.
Although primarily occurring in specialties such as ophthalmology, dermatology, gastroenterology and dentistry, private equity firms began entering into agreements with orthopedic private practices in 2017. These investments are expected to increase along with the rapid growth within the orthopedic field, fueled by the relatively low supply of orthopedic surgeons, fragmentation of the private practice model combined with the rapid growth of orthopedic care due to increased accessibility, utilization and an aging population, according to the published literature.
Source: Leigh Dziemiela
“The opportunity in orthopedics is amazingly strong from a private equity lens because we do great work, we take great care of patients and we have an aging population in the United States that is going to need a lot of orthopedic care,” Alpesh A. Patel, MD, MBA, co-director for the Center for Spine Health at Northwestern Medicine, told Orthopedics Today. “In addition to doing great work and creating a lot of value for patients, orthopedics generates a lot of value on the business side, as well, and so I think physicians are going to be faced with these opportunities or offers more.”
The interest of private equity firms in orthopedics has provided some advantages vs. the challenges related to practice consolidation with hospital systems, according to Louis F. McIntyre, MD, chief quality officer of US Orthopedic Partners. While the identity of an orthopedic private practice is lost when it consolidates with a hospital, a private equity firm usually allows the practice to keep its identity, he said.
“Moving forward with a private equity group, most of them do not make you change your name. They do not make you change your tax ID number. Basically, they recognize the value of your brand and your neighborhood, and they do not want to do anything to disrupt that,” McIntyre, an Orthopedics Today Editorial Board Member, said.
Loss of autonomy
Although partnering with a private equity firm may not be the same as consolidating with a hospital, these transactions have proposed advantages, as well as risks and concerns, according to sources who spoke with Orthopedics Today.
One of the biggest concerns among orthopedic surgeons is the loss of clinical and economic autonomy within the practice. While physicians may not experience a complete loss of autonomy by partnering with a private equity firm, loss of autonomy is still inevitable, Patel said.
“It may not be a complete overthrow, if you will, of the normal governance structure of a practice or the normal voting structure of a practice, but you are bringing a new partner to the table and that partner is going to have opinions and they are going to want an opportunity to voice those opinions and effect change within the practice,” he said. “I think accepting that or understanding what that change in autonomy is going to look like is important.”
Patel said how much control physicians will continue to have in their practice after the transaction can be negotiated as part of the terms of the private equity deal.
“Those things should be thought out, they should be spelled out, they should be part of the negotiated terms so that both sides know what the other is expecting,” Patel said.
Maintain clinical governance
In many cases, partnering with a private equity firm allows for orthopedic private practices to maintain clinical governance at a local level and determine the day-to-day operations of the practice, according to Andy Blankemeyer, MHSA, CEO of OrthoAlliance.
Partnering with a private equity firm provides the infrastructure to support the back-office aspects of a practice, such as credentialing, billing and coding, marketing and compliance, with the help of a management services organization (MSO), Blankemeyer said. It also provides the practice with the capital to grow and invest in ancillary services, he said.
“They are able to capitalize on the business they successfully built and also ‘de-risk’ themselves,” Blankemeyer told Orthopedics Today. “After a transaction, their business risk is not focused solely on their smaller group. So now their risk of a practice is not just on the seven or eight physicians at a few clinic locations. Now that they are part of a larger organization, the individual physician owners’ risk is greatly diversified among many other like-minded practices, all while maintaining their individual practice autonomy. If their practice has a downturn or grows, then the overall platform goes up or goes down.”
Loss of income
Another common consequence that has arisen regarding private equity’s role in private practices is the loss of physician income associated with a private equity transaction, according to David M. Glaser, JD, attorney at Fredrikson and Byron and an Orthopedics Today Editorial Board Member. He said orthopedic surgeons are paid from the revenue leftover after practice expenses are paid. When adding another entity into the practice, like a private equity firm, those services are usually paid for by reducing physician income, Glaser said.
“If you think of the practice as a pie and you are slicing up the pie, how does bringing in another person help you have more pie?” Glaser told Orthopedics Today. “If they are taking 25% of the pie, you have to grow the pie by 25%. How is that going to happen, exactly? Because if it does not, you get less pie.”
Furthermore, there is no guarantee that physicians may wind up making more money from a private equity transaction, Glaser said.
“Doctors are not making widgets. They are selling their own services and orthopedics is different. They are selling a lot of ancillaries, too. Often, they are selling physical therapy or maybe they have an ASC or imaging, but it is not like you can build a bigger factory and have more surgeries done, because the surgeon is the limiting factor in there,” he said.
In addition to experiencing a possible loss of income, Patel said partners of the private practice may have to reinvest their own money into the practice if the private equity investment is not going well.
“The debt that is being used to leverage the deal ends up being debt the practice is responsible for,” Patel said, noting physicians should keep in mind that the practice is ultimately responsible for meeting the needs associated with such debt.
Know your practice
Despite these risks, change is inevitable in a transaction with a private equity firm. The goal, therefore, should be for the practice to become more efficient, according to Patel.
“If it is not changing anything, then the investment is not doing a lot. The equity partners will not make their returns that they are targeting if they do not fundamentally change the practice to function better, to operate better, to be more efficient. To be either top-line revenue growth or bottom-line revenue growth, something has to change with an equity partner,” Patel said.
When a private practice considers whether to enter into a transaction with a private equity firm, P. Marshall Maran, co-founder and CEO of M2 Orthopedics, a practice management firm for orthopedic surgeons, said physicians need to know their practice and where they want their practice to be in the short term and long term.
One aspect of orthopedists knowing their practice involves knowing why they either need the private equity capital or the expertise of a private equity firm for their practice. They also need to know what they are going to do with the money after it has been acquired, according to Patel.
“The ‘why’ is going to be driven by the values of the practice as well as, obviously, by their financial situation and by the makeup or breakdown of their partners,” Patel said.
It is also important for practices with multiple physicians to have a clear discussion about the investment and how it may affect members of the current practice, as well as the potential recruitment of future physicians, he said.
“Some practices are transparent, and they have clear conversations, but not every practice is that way. If there is no alignment with the physicians about why they are doing this, then it is going to be challenging to get alignment down the road,” Patel said.
Gain knowledge through advice
Sources who spoke with Orthopedics Today said physicians should gather advice from colleagues who have already been through a private equity transaction prior to making a decision. McIntyre said physicians can learn about the process behind private equity transactions by reading articles that specifically review equity transactions in orthopedics, as well as by reaching out to financial advisors to see if they have related experience.
“I would not take the advice of someone who has not been involved in orthopedic private equity transactions,” McIntyre said. “As orthopedics is a fairly individualized practice, I think there are things that are unique to orthopedics that would require you to seek the advice of somebody who has done this in the orthopedic space.”
Sources said it is also important for physicians in an orthopedic private practice to educate themselves on private equity transactions and understand the terminology.
“There is a lot of vocabulary to learn. Obviously, there is a lot of knowledge that private equity is going to bring to the table and there can be a bit of information asymmetry between surgeons and their potential equity partners,” Patel said. “I absolutely agree that surgeons need to fill that gap, learn and become more proficient in the financial and strategic aspects of the venture that equity brings that maybe, as surgeons, we do not have the training or background in.”
One term that is important for physicians to know is earnings before interest, taxes, depreciation and amortization (EBITDA), according to McIntyre.
“EBITDA is the measurement by which private equity values things that it is going to buy, including practices,” McIntyre said. “So you have to know what EBITDA is, you have to know what the EBITDA of your practice is and the way that EBITDA is calculated.”
He said physicians should know how private equity uses a practice’s EBITDA to determine total enterprise value or purchase price, and physicians should be familiar with the terms “share” and “share price,” and how these are allocated and calculated in transactions, as well as the term “equity event” or sale.
However, while there are benchmarks such as EBITDA to determine the value of the business, a report published in Investopedia noted the valuation of private firms are not as transparent as a public company and require significant assumptions and estimates. The report added that private equity owners will look for methods to provide comparable information that helps achieve the best valuations.
Terms to know
“Scrape” is another term physicians should be familiar with as it is a large part of the basis for how many private equity transactions occur, according to Maran.
“In a private equity/physician practice acquisition, you cannot buy all the net income of the practice because there would be nothing left for the physicians in terms of compensation. So, the typical construct is that a private equity firm will come in and buy a portion, or what people call a ‘scrape,’ of the physician’s income,” Maran told Orthopedics Today. “If a physician is making a million dollars a year, a private equity firm may come in and buy $250,000 of that yearly income and the physician keeps $750,000.”
Maran said he finds the term sounds as if physicians are being taxed when the money a private equity firm acquires from the transaction is often reinvested into the business.
“What they are doing is making a contribution back into the business that will allow the business to grow and to make investments into all the things that are necessary to further develop the business, whether that is new technology, adding new locations, hiring new physicians, acquiring new practices,” Maran said. “All of that helps to create earnings growth, which equates to equity value increase for the equity that our physician partners have in the business. It is more of a virtuous cycle than a vicious cycle.”
Blankemeyer said physicians should also understand the compensation formula on a go-forward basis model and make sure that their previous compensation model is similar to the go forward compensation model.
“We like to have our [compensation model] based on profitability of the individual clinics and physicians because then we are jointly aligned on making sure we continue to maintain strong margins and grow into the future,” Blankemeyer said.
Medical Economics reported physician owners should understand the short- and long-term consequences related to the compensation model proposed in the private equity ownership transition. As additional income is redirected toward the growth and investment of the new company, it is not unusual for physician compensation to decrease up to 30%. The Medical Economics report also noted the physician may or may not receive a check that is equal to or better than the compensation they would have received in their prior model depending on the next transaction or sale of the company.
Find the best partner
When members of a practice review possible private equity firms with which to partner, Maran said it is important for physicians to remember that not all private equity firms and MSOs are the same.
“Each firm has their own unique approach to the market, how they partner with orthopedic groups, their cultures, their operating models,” Maran said.
Blankemeyer said physicians should find a capital partner willing to support the practice’s growth and has the same entrepreneurial mindset as the physicians.
“You want to make sure you find someone that is coming in and trying to elevate the group, utilize the resources that are already there that have made it successful in the past. They should be excited to come and continue growing what has already worked well in your practice without reinventing the wheel,” Blankemeyer said.
Not only should an orthopedic private practice understand the private equity firm and what they stand for, but they should also understand the private equity partner’s fund cycle, Patel said.
“[The fund cycle] will determine the lead time, if you will, for what changes are going to need to happen within the practice,” Patel said. “If you are working with a private equity firm that is late in its fund cycle, they may have to generate returns quickly, in which case, the pace of change for the practice is going to be fast ... whereas entering with a private equity firm relatively early in their fund cycle gives the practice more time to create that value or generate that value for their equity partners over a longer period of time.”
With leverage at the core of the private equity business model, the private equity partners risk little of their own money, typically investing 1% to 2% of the purchase price while the limited partners may fund up to 98% of the equity, according to an article published in LSE Business Review. Despite investing a small percentage, the article noted private equity firms typically claim up to 20% of the gains.
Private equity not for every practice
Whether an orthopedic private practice is suited for striking an agreement with a private equity firm depends on the maturity and the timeline of the practice, Patel said.
McIntyre said an ideal time for orthopedic private practices to investigate entering into a private equity transaction would be when the practice is at its strongest economically.
“If you are at your strongest point and you feel that you do not need to do a [private equity] deal, this is the time to investigate because that is going to be when you are going to be at the height of your economic strength,” McIntyre said. “For practices that are stressed already and maybe in a position where they have to do something, they have less leverage in that situation.”
Physicians should also make sure that a private equity transaction is the right model for their practice, according to Blankemeyer.
“It is not for everybody, and it is not for every practice,” Blankemeyer said. “It is a model for growth. So, if you are looking to just keep the status quo and not change, then this is not the model for you. This is a model for individuals who want to grow their practice.”
Maran said leaders of an orthopedic private practice who feel that a private equity transaction is right for them should put effort into the transaction from the beginning to establish good and clear relationships.
“Most good things take time, and it is worthwhile to all parties to invest the time into this relationship because it will pay dividends down the road,” he said. “Everyone will understand what they got into, there will be shared vision, shared purpose and that will come from putting the time into the transaction early on.”
- References:
- McIntyre LF. Consolidation: The role of private equity in orthopaedics. www.aaos.org/aaosnow/2021/mar/managing/managing04/. Published March 21, 2021. Accessed March 14, 2022.
- Mikhail C, et al. J Am Acad Orthop Surg Glob Res Rev. 2021;doi:10.5435/JAAOSGlobal-D-21-00162.
- Murphy CB. How to value private companies. https://www.investopedia.com/articles/fundamental-analysis/11/valuing-private-companies.asp. Published Nov. 30, 2021. Accessed April 5, 2022.
- Patel AA, et al. J Am Acad Orthop Surg. 2021;doi:10.5435/JAAOS-D-21-00058.
- Shryock T. Private equity in healthcare. https://www.medicaleconomics.com/view/private-equity-healthcare. Published Nov. 12, 2019. Accessed April 5, 2022.
- For more information:
- Andy Blankemeyer, MHSA, can be reached at 50 E. Business Way, Suite 200, Cincinnati, OH 45241; email: ablankemeyer@beaconortho.com.
- David M. Glaser, JD, can be reached at 200 South Sixth St., #4000, Minneapolis, MN 55402; email: dglaser@fredlaw.com.
- P. Marshall Maran can be reached at marshall@m2orthopartners.com.
- Louis F. McIntyre, MD, can be reached at 35 Avondale Rd., White Plains, NY 10605; email: lfm@woapc.com.
- Alpesh A. Patel, MD, MBA, can be reached at 251 East Huron St., Chicago, IL 60611; email: ldziemie@nm.org.
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