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What Doctors Should Know Before a Private Equity Sale

Is the creeping presence of private equity in medicine a good or bad thing for doctors? This is a very challenging question. And one that I don’t know an answer to. Thankfully, that is not what we are going to be discussing here.

Because regardless of it is good or bad, private equity is a present reality for doctors. I would argue this does not need to be the case if more doctors achieved financial freedom…but I digress…

Just a few weeks ago, a recent residency grad emailed me asking about the details of joining a private equity group. This is becoming more and more common in my experience. Similarly, more doctors are considering selling their practices to a private equity group.

Such a process is full of potential pitfalls for doctors. That’s why it’s so important to understand the ins and outs of the deal. To help us unpack all of this, I’ve asked Thomas Bodin, CFA, CFP, a practice integration advisor from Buckingham and friend of the blog, to share his expertise!


The reality of private equity for doctors

A growing number of practices in the health care industry are being purchased in a less traditional manner—through agreements with private equity firms. For doctors who have invested years in building and managing their own practices, the eventual sale is a big moment they have been planning for to support their retirement years.

doctors private equity

But is selling to a private equity buyer the best path for doctors? Even if the offer makes you feel like you’ve won the lottery?

What does selling to private equity mean for doctors?

First, it’s important to understand the basics of a private equity sale. You also need to understand how it differs from the most traditional option for selling a practice.

In a traditional transition strategy, the sale price of the practice is based on its current profitability. And the owner generally has limited ongoing liability for the practice’s performance once sold.

In a private equity transaction, the goal of the buyer is to maximize the practice’s profits. This is before eventually selling to another buyer. Unlike a traditional sale, when you sell to a private equity firm, you are also selling future profitability. And you will need to maintain this profitability once you become an employee of the firm. You’ll also likely become a partner to the firm as an ongoing investor.

Evaluating a potential private equity sale

Second, it’s important to understand the assumptions underlying a private equity deal offer.

Each deal will contain unique elements. And they are subject to the notion of caveat emptor – meaning “buyer beware.” As a result, the buyer will do their due diligence to assess the true value of the practice. If the owner misunderstands a deal assumption, this will not be a reason to unwind a deal.

Here are explanations of the most common terms doctors should understand when assessing a private equity deal offer:

EBITA

  • This is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. Because clinician-owned practices rarely have a profit-and-loss statement that conforms to Generally Accepted Accounting Principles (GAAP), the private equity firm will take the practice through a process to “normalize” its financials. Because financing decisions are up to the owner’s discretion, in the process of a sale the buyer will recapitalize the practice and exclude interest expenses when analyzing its cash flow. Also, before the deal, profits are generally taxed as ordinary income, but under a corporate structure, the taxation may change.

Assumed second sale

  • Private equity groups focus on financial—not clinical—outcomes. Their goal is to package revenue and improve group-level cash flow to sell the now-larger entity to another group of investors. As private equity groups bundle more practices, both the revenue and profit grow as well. Investors view these larger organizations as safer investments than individual practices alone.

Assumed market multiple

  • Along with presuming there will be a second sale, a private equity group will assume the future sales price. This is usually represented as a multiple of future cash flows or as a multiple of the owner’s investment. It is generally based on observed deals in the market and historical transactions. However, these are not guarantees of future deals. Often the second sale is assumed to be five to seven years in the future. And it may well happen under quite different market and economic conditions.

Tax assumptions

  • Private equity deals for doctors structure themselves to maximize capital gains. A traditional practice sale breaks down between goodwill, which is taxed at the capital gains rate, and equipment and inventory, which is generally taxed as ordinary income. While the taxation of the sale is unique to each practice, what is most important to a business owner will be the post-tax proceeds. Consult an accountant or tax professional to ensure the seller understands the specifics based on their practice.
  • You can learn more about my tax plan and tax advisor here: An Inside Look at My Personal Tax Plan

Assumed group growth rates

  • As part of estimating the second sale value, the private equity group will need to assume what that future cash flow will be. As such, there is a group revenue growth rate assumption.

Time value of money

  •  All else equal, if invested, a dollar today is worth more than a dollar in the future. With some deals, there is an assumption that the proceeds will be invested for the seller’s future benefit. While the concept of time value of money is appropriate, the seller should understand this element and make sure it aligns with their personal financial plan and investment objectives.
  • Here are some of my (Jordan’s) additional thoughts on the time value of money for doctors: Exploring the Time Value of Money for Physicians

Deferred cash

  • For the deal to work, private equity will need continuity of care and revenue. Most deals contain a deferred cash element. The practice owner may forfeit this deferred compensation if they do not stay for the contractual term. The deferred cash can be a benefit to the seller as it spreads proceeds across multiple tax years, though there is the risk of losing it if they decide working under the private equity ownership is not ideal.

Earn out note/preferred equity

  • As part of the deal, the group may present the seller with preferred equity or a note in the private equity group, or both. This is a debt investment on the seller’s behalf with a portion of the “practice purchase price.” This investment pays a contractual rate of return for a specified period. This is like making a loan investment in the private equity group. Based on current rates, this rate should appropriately reflect the risk of the presenting organization. If this is “preferred equity” the investment will act as an earnout note by prioritizing the seller’s share of cash flow.

Add-on EBITDA

  • The value of the deal ties heavily to its scope. The larger the entity, the more secure the forward-looking cash flow assumptions are to investors. Some deals incentivize clinicians to recruit others through acquisition targets. An add-on EBITDA provides financial incentive for this activity, putting a premium multiple on the deal if additional practices become a part of the deal as it heads toward closing.

Rollover equity or PIK

  • Commonly, a portion of the presented proceeds will be reinvested as equity into the deal in one of two ways. First, it may be as a rollover equity position in the term sheet, which clearly identifies as a holdback investment versus cash at closing. It can also be a payment in kind (PIK), which is essentially the same investment from the seller’s perspective. But a PIK can roll into the cash at closing figure.

Incentive units

  • A private equity buyer desires a positive financial outcome, which is in the seller’s best interest as well. Many of these deals include incentive units, which either grant or allow a discount equity purchase in the future if they meet certain financial targets.

The deal is in the details

Wealth advisors have experience in reviewing these deal assumptions to make sure they align with the clinician’s overall financial picture and lifestyle.

Due to a lack of dealmaking experience, many practice owners may look at the bottom-line number with limited understanding of the terms and their impact on the transaction.

These deals can be a great opportunity. But you only have one chance to sell your practice. So it is critical to fully understand the terms of the agreement before signing on the dotted line.

Types of risk involved in a private equity sale

For clinical practice owners looking to sell, a private equity deal offer may be enticing. However, it’s important to assess the three types of risks present when considering the offer:

  • Risks you can control,
  • Risks you can influence
  • And risks you can’t control.

When making any investment decision, consider the correlated risk and return.

We should not expect safe investments to provide the same returns as riskier investments. And we also would not accept low expected returns when taking on more risk. Here are the sources of risk you should know about to make sure they align with your return assumptions.

Risks you can control

Cash at closing (minus PIK): The cash you receive at the closing table is yours to keep and invest based on your risk tolerance and financial plan. If there is a payment-in-kind (PIK) element that reinvests as an equity roll, your financial plan should not include this amount.

Salary: The payments you receive as salary are also under your control. Like deferred compensation elements, you can choose to terminate your employment arrangement and forfeit these dollars.

Bonus: You can also directly influence any bonus assigned to your specific clinical performance as part of the deal. If you choose to continue to grow the practice, financially you and your team can control the likelihood that these payments release.

Deferred compensation: As your taxable income will be lower in future years, an element of deferred compensation can be a tax-effective way to realize sale proceeds over time. Deferred compensation should carry no performance threshold or incentive, but your willingness to remain a provider for the private equity group will determine if these payments are received.

The above risks are ones that are under your control. The next level of risks you may be exposed to are shared by clinicians in the larger group practice.

Risks you can influence

Group growth rates: Practice values are a product of cash flow. When you enter a private equity deal, you become part of a larger organization. The value of the second deal will be based on the revenue the group practice is recognizing at the time. As such, there can be incentives at the group level to grow revenue and profitability. Even if you are in a growth phase and eager to expand your practice size, your fellow clinicians may not be in that same position. Conversely, if you sell your practice as way to exit clinical work, you may not be as motivated to grow revenue for the private equity group as you were for your own practice. Both the second sale and any group-based financial incentive should be viewed as contributors to these financial outcomes.

Earnout notes with targets: Some earnout notes contain revenue targets. This revenue target is usually set at the private equity entity level. If your earnout note contains these targets, you won’t have total control over releasing these funds.

Add-on EBITDA: This element tries to attract more clinicians into the initial deal size. Often dealmakers will lean on you and your professional network to identify other viable practices. As such, you will not be in full control of achieving add-on earnings before interest, taxes, depreciation, and amortization (EBITDA) goals, but you can influence the likelihood of hitting these targets.

Some risks associated with a private equity deal can’t be controlled. You should understand these before signing the term sheet and entering a deal.

Risks you can’t control

Second sale: A sizable portion of the value of a sale to a private equity firm is associated with its exit strategy. This is when it in turn sells the initially aggregated practices. It is rare for someone who is not a founding member or initial investor of a private equity firm to be offered a board seat or controlling interest. As such, the private equity group will not need to consult you on the value or timing of the second sale. The private equity group will work diligently toward maximizing its (and thus your) return, but there is no certainty on the value or timing of the second sale or if it will occur.

Market multiple: The value of the second sale is generally a multiple of your return on investment or an assumed multiple of the private equity group’s EBITDA at a point in the future. Deal multiples are a factor of supply and demand, current market forces and underlying interest rates, all of which are outside your control.

Ways for doctors to analyze a private equity deal

When financial advisors work with clinician owners on these opportunities, they review multiple scenarios and model how these will affect the practice owner’s financial plan.

It is important to consider that much of the value of a private equity deal will be outside of your control. Private equity offers also come with considerable nuances and forward-looking opportunities.

Remember, clinical practice owners can only sell their practice once. So we should not only understand the offer. But also how the deal will fit into their financial plan.

There are two ways clinician owners can assess the financial reward of a private equity offer:

  • The first is to incorporate only the deal elements that are guaranteed (the worst-case scenario)
  • The second is to assume all cash flow will be realized at optimistic assumptions (the best-case scenario). If the deal offer supports your financial plan in the worst-case scenario, you can be confident it will work in the best-case scenario.

A case study

Let’s explore this with the elements of a doctor’s hypothetical private equity deal.

The doctor’s profitability is approximately $1.5 million per year. The private equity group offered the surgeon a deal valued at $10,480,000, or approximately 7x the practice’s earnings before interest, taxes, depreciation, and amortization (EBITDA). By comparison, a common multiple is 3x for a traditional sale (a sale and walk away).

The practice’s collections are very steady. Based on a conservative multiple valuation of 3x EBITDA for a sale and walk away, or $4.5 million, the private equity deal offer looks incredibly appealing.

The deal elements are as follows:

  • Cash at closing: $1.6 million
  • Add-on EBITDA at closing: $270,000
  • Second-year add-on EBITDA: $540,000
  • Earnout note: $500,000
  • Rollover equity: $2.6 million (assumed in year five at four times the initial equity roll)
  • Incentive units: $700,000 valued at the second sale
  • Salary: $1,233,995 (with a 7.5% increase for three years and 5% for seven additional years)
  • Interest earned on all proceeds at 5% for the next 20 years

If we assume no lifestyle expenditure and a mix of capital gains and income tax, and we discount all those cash flows at 10%, the result is a net present value (NPV) of $10,480,000.

This is by far a best-case scenario

In reality, you will spend money on your lifestyle. This needs to be factored in. While an annualized investment return of 5% is a reasonable assumption, your returns will be based on your portfolio and will not be a straight line. Add-on EBTDA will be mostly outside of your control. The second sale will be outside your control. And the salary growth rate will be based on your actual production.

The only adjustments made were adding in the clinician’s lifestyle expenditures, overriding the assumed investment growth rates and incorporating the expected return of the clinician’s risk tolerance.

By assuming a second sale in five years, including additional income streams and a larger year-one deal, which releases the add-on EBITDA, the wealth analysis resulted in a 98% likelihood of success, which is fantastic.

By comparison, let’s look at the worst-case scenario

This is based on what we can count on and what we can control.

Of the above elements, that includes the $1.6 million cash at closing, $500,000 earnout note, and the salary component for the employment contract term, which we did not inflate at 7.5%. With this perspective, the doctor is sure to receive $1.6 million at closing and a $500,000 earn out over years two to five.

We then model the clinician’s typical lifestyle expenses of approximately 50% of salary. With these adjustments, the NPV of the deal was $3.5 million, much less than the $10.5 million presented.

When considering the existing investment portfolio, risk tolerance and individual wealth analysis, the result was a comfortable 87% likelihood of success.

Pulling it all together

In the above hypothetical example, we discovered that the clinician could assume the risk of a private equity deal based on the financial life established.

Private equity deals may be an opportunity to secure your financial plan and invest in the private equity entity for a possible larger future return.

As with any other transition model, clinician owners should seek a deal that aligns with their clinical desires, financial plan, and risks and opportunities they are comfortable taking.

If you are interested in more resources regarding the financial aspects of practice management, check out these posts!

What do you think? Have you ever considered a private equity deal? Do you work for private equity? What has your experience been – positive or negative? Why? Let us know in the comments below!

This article is provided for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Individuals should speak with qualified professionals based upon their own circumstances. The opinions expressed here are their own and may not accurately reflect those of Buckingham Strategic Wealth®

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    Jordan Frey MD, a plastic surgeon in Buffalo, NY, is one of the fastest-growing physician finance bloggers in the world. See how he went from financially clueless to increasing his net worth by $1M in 1 year and how you can do the same! Feel free to send Jordan a message at [email protected]

    2 thoughts on “What Doctors Should Know Before a Private Equity Sale”

    1. How about some discussion on the differential benefits to about-to-retire partners/owners, mid-career partners, and new non-partner physicians? I read accounts where it’s great if you’re about to retire and you just have to stick out your three years under PE ownership. It’s terrible for a new physician who had planned to buy in and get the benefits of ownership.

      Reply
      • Great point. I think your career position definitely plays a role in the decision although it calls into question our responsibility to other docs and the field of medicine. The lack of autonomy doctors currently experience is tied to the control of our practices that we have given up…

        Reply

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