Private Equity and Physician Practices: Financial Due Diligence Considerations

By: Mark Billings

Values for healthcare practices have remained strong in the past three years, and private equity (PE) funds are likely to accelerate investments in healthcare businesses over the coming decade. This bullish outlook is due, in part, to the ongoing growth of U.S. personal healthcare spending, which according to the Centers for Medicare & Medicaid Services, is expected to climb an average 5.5% annually through 2026, increasing from 17.9% of GDP in 2017 to 19.7% by 2026.

As PE acquisitions of healthcare businesses have surged over the past decade, investments in physician practices and physician practice management (PPM) companies have accelerated. PE firms have become increasingly comfortable investing in a wider range of physician practices and are moving into areas where it’s beneficial to have a practice outside of a hospital setting. 

Opportunities for Growth

Physician practices present a lot of opportunity for private equity firms. Specialty areas such as dental, dermatology, and ophthalmology, have limited market concentration, making these groups particularly attractive targets for consolidation. Today, we see PE firms showing increasing interest in high-quality practices in subsectors like orthopedics, gastroenterology, and urology, which present other possible “roll up” opportunities.

It’s not just private equity firms that see opportunity – the aging physician workforce is also driving practice sales. As physicians from the Baby Boomer generation start to consider exit strategies, the traditional pattern of selling to a junior associate has declined. One reason is many younger physicians would rather be employees than owners responsible for running a business. Often, this is because more physicians than ever before are carrying sizable student loan debt, which limits their ability to make an investment in a practice.

Many PE deals in this space are based on continued involvement by owner-physicians post-transaction. Typically, PE firms will offer owner-physicians an upfront payment in cash and/or stock in exchange for ownership and a percentage of future profits. The goal is to build the value of the practice, then sell at a later point that aligns with fund lifecycle expectations. The challenge for PE firms is to establish upfront the right return and risk expectations for both themselves and the selling physicians.

More Meaningful Due Diligence 

Whether buy-side, or sell-side, financial due diligence plays a key role in the success of the deal. The smaller the practice, the more likely that bookkeeping will be unsophisticated and financial reporting will be tailored to cash or modified-cash tax reporting.  That’s why a cash proof (agreeing reported revenues and expenses to bank statements) and cash collection analysis of revenue remains critical elements of financial due diligence. Additionally, determining how accounts receivable and accounts payable will be treated after the close is essential. PE funds and sellers must also assess what debt and debt-like items will or will not be assumed in a transaction, including unfunded compensation such as bonuses, student loan pay-off commitments, and retirement plan liabilities.

During the due diligence phase, the initial agreed-upon deal value may be challenged based on findings made throughout the process. Having an independent sell-side due diligence report can mitigate this issue by helping to validate the asking price. 

Most financial due diligence providers go beyond examining the general ledger in ways that are consistent with how physician practices operate. Today’s small and medium practices typically have billing and collection systems which are part of their EMR/Practice Management solution. But few middle market and lower-middle market practices integrate these systems with their general ledger. As practice management systems advance, the collection of relevant, clean, and more reliable operational and financial data will generate more information that can be used in due diligence. Both buyers and sellers of physician practices should take full advantage of this data.

Ultimately, for both PE firms and physician practices, it’s important to find a partner that can effectively navigate the due diligence process and understand the complexities in medical practice valuation, business processes, accounting methods, and technologies. The combination of using current market knowledge and effective due diligence processes will result in deals that both sides view as a successful outcome.

Mark Billings is Senior Director, Transaction Advisory Services Healthcare Leader at CFGI.