Healthcare services buyouts and consolidations historically were reserved for a select group of private equity firms with years of specialized experience in the healthcare sector.
More recently, with the aging baby boomer population, increased government spending, and the collapse of the “new economy,” many private equity firms that have not historically focused on the healthcare sector have begun to pursue all forms of healthcare buyouts and consolidations, including those involving:
•Home health and hospice providers;
•Long-term care and assisted living facilities;
•Outpatient surgery centers;
•Physician/dental service providers;
•Health screening/wellness centers; and
Newcomers to the healthcare sector often discover, however, that navigating a minefield of specialized due diligence, transaction structure, legal and regulatory issues can be extremely challenging. Nevertheless, the well-armed investor can maximize returns in the $1.7 trillion U.S. healthcare market by developing a comprehensive approach to evaluating the unique issues and opportunities presented by healthcare services investments. The following are some of the critical business, legal, and regulatory considerations that are essential to a successful deal.
Evaluating The Market Opportunity
First and foremost when analyzing a potential healthcare services buyout or consolidation, an investor is confronted with the challenge of evaluating the market opportunity. Initial questions to be considered include: (a) what is the size of the overall market in the U.S. for the services, (b) what is the growth rate of the particular sub-sector, (c) how fragmented is the market and what portion of the market is already represented by other consolidators (and are they public or private), (d) what is the state and federal regulatory landscape, (e) what size would the typical “follow on” acquisition targets be, (f) is there additional opportunity for de novo development of additional providers in the space, (g) who pays for the services (e.g., government, private insurers, patients) and (h) where is the right geographic focus?
Acquisition Due Diligence
Some of the crucial business and financial due diligence issues relate to the revenue mix and reimbursement risk associated with a particular healthcare services business. A private equity investor evaluating a healthcare services provider heavily dependent on deeply discounted managed care needs to develop a plan to move as much revenue as possible into higher-margin PPO or private pay programs. One of the most difficult aspects of healthcare investing for private equity firms new to the space is acquiring a comfort level with the notion that a significant portion of a provider’s business is entirely dependent on government reimbursement, which is great when Medicare budgets are expanding, but disastrous when the spigot is turned off. Another financial item that requires close attention is the capital expenditure needs for facility maintenance and expansion. In many cases, investors can find that $50 million in projected free cash flow can quickly turn into $40 million if the seller has deferred maintenance and cap ex spending for many years in preparation for a sale.
Developing a comprehensive due diligence approach to healthcare services acquisitions is essential. Examples of legal and regulatory diligence areas unique to this sector include items such as third-party payor contracts, relationships with physicians that may be subject to self-referral and anti-kickback laws, Medicare and Medicaid certification and conditions of participation, licenses and permits, accreditation and other regulatory surveys, and HIPAA compliance-to name a few.
Some of the unique structural considerations relating to healthcare buyouts include those designed to minimize the possibility that the transactions will constitute a change of ownership or “CHOW” for licensure or certification purposes, or trigger anti-assignment provisions in professional service or managed care contracts (which should be avoided if possible because the counterparties often use the consent process to renegotiate or extract additional consideration). CHOW approvals, which vary widely among states, often require purchasers to satisfy byzantine documentation and survey requirements and can take anywhere from days to months to finalize.
One way to minimize the regulatory and contractual approvals required is through a reverse triangular merger structure in which a newly-formed subsidiary of the acquirer merges with and into the parent of the target holding company. Often the providers and facilities are organized as subsidiaries of the target holding company, and in many cases CHOW approvals will not be required using this approach. Similarly, this structure may limit (but not eliminate) the managed care and provider contract consents required.
In addition to outright buyouts of healthcare companies, many private equity firms select a particular industry subsector, partner with an experienced executive or team and pursue a “buy and build” or roll-up consolidation strategy. One common approach of private equity firms is to pursue a sizable initial acquisition in a particular geographic market that will serve as a platform for smaller “add on” acquisitions. Another approach is simultaneously to combine multiple acquisition targets as part of one transaction. Depending on the particular sub-sector, states may require that the service provider be owned exclusively by licensed healthcare professionals (e.g., doctors, dentists, therapists). In these situations, prospective purchasers may only purchase non-clinical assets from these providers and must enter into long-term management arrangements. Under this structure, the provider operates as a professional corporation organized under state law and employs most or all of the provider’s clinicians (in some states, certain clinical personnel can be employed directly by the investor-owned management company).
Federal And State Regulatory Issues
Investors in healthcare services are well advised to familiarize themselves with the broad array of regulatory issues relevant to such transactions. Below are some of the key regulatory issues common to most healthcare services consolidations.
• Anti-Kickback and Civil Monetary Penalty Laws
The Federal Anti-Kickback Statute prohibits the knowing and willful solicitation or receipt of something of value in exchange for referrals involving items or services that are paid for by a federal healthcare program. Violations of the Federal Anti-Kickback Statute constitute felonies and may result in large penalties, imprisonment, and exclusion from participation in Medicare, Medicaid, and other federal healthcare programs. Many states have enacted their own anti-kickback statutes, some of which apply to business dealings with private payers as well as government ones. The Federal Civil Monetary Penalty (“CMP”) Laws, among other things, prohibit gifts or other inducements to federal healthcare program patients to influence where or how they get their care. Violations can result in significant financial penalties and program exclusion.
• HIPAA Privacy and Security Laws
In 2003, privacy regulations were issued under the authority of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) to establish a nationwide baseline level of confidentiality for protected health information (“PHI”). Generally, the regulations permit healthcare providers, plans, and certain other individuals and entities (“Covered Entities”) to share medical information for treatment, payment, and operations purposes without obtaining specific authorization from patients or their representatives. In most other situations, however, prior written approval to use or disclose information is required. In 2005, HIPAA security regulations became effective, requiring providers to implement physical, environmental, and technological measures to ensure the security and integrity of the PHI they maintain or provide to certain third parties. Evaluating a target’s compliance with HIPAA requires not only a review of policies and procedures, but often entails auditing information systems and having discussions with the entity’s privacy officer.
• Physician Self-Referral Laws
The Federal Physician Self-Referral Law, more commonly known as the Stark Law, prohibits physicians and their immediate family members from referring business for designated health services (including but not limited to clinical laboratory tests, certain imaging and diagnostic studies, home health and hospital services) to entities with which the physician (or his/her family) has a prohibited ownership, investment, or compensation relationship. Evaluating the exceptions to the law is complex and requires close review. In addition, and particularly in the context of consolidations that will combine businesses operating in different states, attention must be paid to state or so-called “Baby Stark” laws which may not permit practices that the federal law and regulations do permit. Effective January 1, 2007, nuclear imaging and diagnostic services will be added to the list of designated health services subject to the Stark law. This change likely will require many physicians and investors to restructure or divest entirely their existing ownership or other interests in nuclear diagnostic equipment or imaging centers.
• Certification and Successor Liability
In order to provide covered services to Medicare and Medicaid recipients, healthcare providers must be certified by those programs and obtain provider numbers. Purchasers need to be aware that if they wish to use the Medicare and Medicaid provider numbers of the target entity(ies), the government will require the purchaser to assume all liabilities associated with these numbers, regardless of the form of the transaction (e.g., stock vs. asset). In light of lengthy statutes of limitation in the case of anti-kickback, Stark, and false claims violations (up to 10 years in some cases), indemnification provisions, escrows, and holdback provisions take on added importance.
• Other Frequent Regulatory Considerations
Corporate Practice of Medicine—state laws governing the degree to which a corporation may exert control over a physician’s practice without engaging in the unauthorized practice of medicine.
Fee-Splitting/Brokering Arrangements—state laws may limit for require restructuring of otherwise legitimate payments made by physicians for third party administrative or ancillary services.
Limitations on the Use of Non-Compete and Non-Solicitation Agreements—several states have imposed significant geographic and time limits on the ability of companies to preclude employed or contract physicians from competing with them at the end of their affiliation.
Given the favorable demographics and seemingly limitless demands that will be placed on our healthcare system in the coming years, private equity investors new to healthcare buyouts can generate attractive returns if they are prepared to address the myriad regulatory and unique issues presented by these transactions.
Lee Feldman is a partner in Choate, Hall & Stewart LLP’s Private Equity Practice Group and Christine Solt is a partner and Chair of the Firm’s Healthcare Practice Group.