Welcome to Foley & Lardner LLP’s Health Care MarketTrends. In this issue, we examine private equity investment in specialty areas of the health care industry, specifically dermatology and orthopedics.

Positive or Perilous: The Impact of Private Equity on the Health Care Industry

The U.S. health care industry is currently undergoing a transformation to consumerism. Patients are no longer passive recipients of health care services, but have begun to actively participate in managing their own health. They seek an experience similar to that which they experience during online shopping—services that incorporate clear and compelling communication with convenience.

As a result, the health care industry is slowly adopting strategies successful in the retail market segment—developing locations that answer the consumer’s emphasis on convenience, adopting lower cost, less capital-intensive delivery systems, and creating solutions that optimize scale within local markets. Health care is “moving to meet people where they are”—both physically and experientially by growing outpatient market share and improving facility aesthetics, improving technology access, offering transparent pricing, etc. Since consolidation and efficiency are watchwords of the private equity investor, this alteration of a business model for maximum audience appeal is extremely attractive. Success, then, depends on finding a physician partner in a specialty area such as dermatology, dental, vision, urgent care, and other segments who is open to blending the retail and health care missions.

Private equity deals in the U.S. health care market more than doubled over the past decade, jumping from 325 in 2008 to 788 in 2018, according to PitchBook. Private equity in particular has historically been attracted to ancillary service offerings resulting from the increase of outpatient procedures as well as falling reimbursement levels, which make greater scale and scope increasingly favorable.

Private equity investors bet on what a company could become rather than what it is. Aligning a number of similar practices can increase the size and scale of offerings, thereby improving leverage in negotiations with physicians and payers. For this reason, private equity investors view fragmented industry segments—like dermatology and orthopedics—as attractive profit-generation platforms. For example, in 2011, only one private equity investor was present in the dermatology market; in 2018, there were over 30 such investors.

The Rise in Dermatology Private Equity Investment

According to a 2018 report authored by Provident Healthcare Partners, “Dermatology has been one of the fastest growing subsectors within physician services in recent years. The $13 billion market is expected to grow at a rate of 5.8 percent to upwards of $16 billion through 2019.” The dermatology sector has been very active in terms of M&A activity. Private equity, again, plays an important role in the large consolidation trend in dermatology.

The dermatology niche has been, and continues to be, targeted by private equity investors for a variety of reasons: its status as a growth market, a durable recession-proof segment, the opportunity for consolidation, its retail component, and repeatable customer population. Dermatologists, in turn, view private equity as a way to shift some of the administrative burdens—particularly regulatory compliance, to renew their focus on patients, and, unsurprisingly, to achieve personal financial stability.

But even in a perceived win-win relationship, there are risks to consider. By its very nature, the private equity business model is based on buying for the purpose of selling for a profit for investors and involves taking on debt to finance deals. Practitioners who accept private capital can lose decision-making control and experience greater pressure to grow the practice at an accelerated rate.

Orthopedic Practices Welcome Private Equity Investment

The aging population and its demands for quality specialists will keep the health care industry (for lack of a better term) “healthy” for the foreseeable future. As such, private equity investors continue to identify specific services seniors will require as they age. This exploration has revealed (1) a dramatic increase in hip and knee replacements and (2) the migration of those surgeries to less expensive outpatient settings. The health care industry could, very likely, expect to see a flurry of investment from private equity into orthopedic practices over the next five years.

Two surprising factors fueling growth in this space include an increase in the number of procedures that the Centers for Medicare & Medicaid Services (CMS) now allows to be done in an outpatient setting, which is encouraging to investors, and falling reimbursement rates, which causes practitioners concern. This trend has allowed private orthopedic practices to develop alternatives to partnering with local health systems and create new facilities with a variety of patient services, such as physical therapy, urgent care, X-ray, MRI, pain management, durable medical equipment (DME), and more. Trends within the health care sector continue to favor large providers with scale, strong management, strategic vision, and access to capital. The recent partnerships between investors and orthopedic practices will surely be the first of many in a wave of outside investment into the orthopedic space.

One thing to note is that unlike traditional “retail” practices, such as dermatology, orthopedic practices involve very little self pay, and the creation of scale is expensive. Moreover, orthopedic surgeons tend to be very entrepreneurial and independent and may resist outside investment. These factors are going to put pressure on financial investors to prove their merit to these practices.

It is important for investors and orthopedic physicians alike to consider the following before investing: valuations, recasting EBITDA, purchase price and tax, the impact of Ambulatory Surgery Centers (ASC) or other outpatient settings, clearly defining ownership of ancillary services, diligence, and regulatory compliance.

Legal Update

While there are pros and cons to private equity investment in any specialty area, it is important to investigate the following if you are engaged in these types of transactions.

Anti-Kickback Issues - The Federal Anti-Kickback Statute (AKS) makes it illegal to knowingly and willfully offer, pay, solicit or receive remuneration, in cash or in kind, in order to induce or reward the referral of business reimbursable under federal health care programs (e.g., Medicare and Medicaid). The most common AKS risk attendant to orthopedic deals is often found in ASC investments by the group or its physicians. We often see private equity investors take substantial stakes in ASCs owned by practices or physicians, thus making the AKS risk something relevant to those investors.

Stark Law Issues - The Stark Law is a federal anti-referral statute that prohibits certain referrals by a physician for designated health services (DHS) to any entity with which the physician has a financial relationship, whether through ownership of the entity or a compensation arrangement with the entity. The Stark Law is of concern to investors because a physician’s referrals for DHS to his or her own group practice can implicate the law, specifically when the practice owns and bills for services such as imaging, physical therapy, DME, and orthotics. Violations of the Stark Law can render referrals to the practice illegal and can negate the practice’s billings to Medicare and Medicaid (because they are not payable if billed in violation of the Stark Law), requiring repayment to CMS along with possible penalties and fines.

Billing and Coding Issues - It is common (and highly recommended) for acquirers to undertake audits of the coding and billing practices of acquired groups. Persistent mistakes in the coding and billing of procedures or services can affect the quality of a practice’s earnings, to say nothing of invoking compliance risks, which may not otherwise surface until after the deal has closed.