The past decade has seen a tremendous amount of private equity investment in physician practice recapitalizations, primarily in hospital-based practices such as anesthesiology and radiology as well as “retail medicine practices” like dermatology and ophthalmology/optometry, to name a few. Orthopedics, on the other hand, has received less attention from investors, but we believe that trend is about to change, and in a significant way.

For those interested in orthopedic surgical practice investment, the following six considerations will be relevant to investors and physician practice owners alike.

1. Valuations

The market for physician recapitalizations remains robust, as do valuations (some as high as the mid-teens multiplied by recast EBITDA). We fully expect the same level of valuation for orthopedic surgical practices, especially given the leverage and ability to generate significant cash flow apart from physician services. Many such practices have explored the ownership of ancillaries such as interests in ambulatory surgical centers or surgical hospitals, imaging, physical therapy and durable medical equipment (DME).  In addition to the above, orthopedics lends itself well to the increasing interest of the Medicare program and many private payers in alternative payment arrangements, such as the Bundled Payment for Care Improvement (BPCI) Initiative introduced by the Centers for Medicare and Medicaid Services (CMS) that will test a new iteration of bundled payments for 32 Clinical Episodes and aim to align incentives among participating health care providers for reducing expenditures and improving quality of care for Medicare beneficiaries. For example, the BPCI-Advanced model, recently introduced by CMS, will cover 29 procedures, nine of which are orthopedic in nature including spinal fusions, upper and lower extremity major joint replacements, and back and neck procedures, etc.

2. Recasting EBITDA

In most transactions, forecasted EBITDA (free cash flow) is recast by:

• restructuring physician compensation and
• (ii) valuing projected growth initiatives and adding these amounts to base level EBITDA.

It is our experience that the greatest gains often come from restructured physician compensation. Meaning that physician owners will agree to reduce their projected compensation to levels historically paid to employed (non-owner) physicians (e.g., 45-50% of net collections). This reduced compensation is then added to base level EBITDA for purposes of practice valuation. As discussed below, since some owners will give up greater levels of compensation than others, this disparity is, generally, compensated for by allocating more purchase consideration to those physician owners who give up a disproportionate amount of compensation as compared to the other owners. Projected growth initiatives are often annualized and a full-year’s credit is usually granted for new providers proposed to join the practice. Other initiatives for which a practice will be given credit may include new clinic additions, ancillary services expansion, and changes in reimbursement.

3. Purchase Price and The Importance of Tax

As an initial matter, it is important to understand that purchase price in recapitalization transactions is usually allocated between cash and equity in the recapitalized company, with the physician owners receiving between 60 and 90 percent of the purchase price in cash and remainder in equity (so-called “rollover equity”). The tax treatment of recapitalization transactions is important and, at times, can be complex. First, and foremost, these transactions only work if the rollover equity is received on a tax-free basis so as to avoid the recognition of “phantom income” (i.e., taxable income without the corresponding receipt of cash). As a general rule, the cash received should be taxed at long-term capital gains rates. One important caveat to the foregoing relates to excess purchase price allocated to physician owners who give up a disproportionate amount of compensation. If any owner receives an allocation of purchase price in excess of his or her percentage ownership in the practice, such excess is likely to be treated as compensation and taxed at ordinary income rates. Another consideration is the tax status of the practice. If it is a subchapter S corporation, care will need to be exercised to structure the retention of rollover equity in a fashion so as not to trigger any gain built into that equity.

4. The Impact of the Move Toward Outpatient Settings

Closely related to the value-based payment alternatives described above is the push by payers to encourage more effective use of outpatient settings, such as ambulatory surgery centers (ASCs). CMS regularly approves additional procedures that can be completed in an ASC setting. When coupled with improved technology, the concept of recovery care center and other technological improvements, the ASC is going to hold a prominent place in the patient care setting. Orthopedic surgery practices are often investors in ASCs and, as such, those groups are likely to be prized by outside investors. In many of the deals we see, outside investors seek, at least, a majority interest in the ASC and a management relationship therewith (so as to allow for financial consolidation), with the physician investors retaining a significant minority ownership in the center. Should the group be a co-investor with a hospital or a management company, that co-investor relationship likely will need to be restructured as part of the recapitalization deal. ASC relationships between surgeons and ASCs also may implicate the federal Anti-Kickback Statute (AKS). Those relationships will undergo significant scrutiny with respect to, among other things, compliance with the Medicare safe harbors (e.g., the so-called “1/3 tests”), relationships with anesthesia providers, etc.

5. Ownership of Ancillaries and Legal Considerations

Because orthopedics is one of the few practices that utilize multiple ancillary services, it is  critical that the relationships between those services and the physicians who refer them are structured correctly and comply with all applicable federal anti-referral laws, e.g., the federal Stark Law and the federal AKS. For example, referrals for designated health services such as imaging, physical therapy, and DME must be structured to comply with the so-called “in office ancillary services” exception to the federal Stark Law, a fairly complicated exception with strict requirements related to the structure of the physician practice, the situs, supervision and billing of the services provided, and the sharing of the profits therefrom. As noted above, ASC ownership and the distribution of profits to the federal AKS. Failure to structure these relationships in a legally compliant manner may not only subject the practice to recoupment of Medicare dollars, fines and penalties, but also may negatively impact the quality of a practice’s earnings, thus reducing overall practice value.

6. Diligence Will Be Important

For the many reasons discussed above, investors are likely to focus on diligence in their assessment of these practices. Ownership of ASCs by orthopedic surgeons and/or their groups implicates the AKS and could be an area of focus for regulators in the coming years. Moreover, the ownership of, and referral to ancillaries, such as imaging, physical therapy and DME, if not structured properly, can result in violations of the Stark Law, as well as the AKS or other laws and rules that can increase enforcement risk. In addition, increasing use of extenders by orthopedic physicians has the potential for creating billing problems and irregularities. Finally, while usually not considered a “physician-centric” set of issues, investors are likely going to want to review relationships, such as clinical co-management or medical director arrangements with hospitals. The obvious reason for this review is to determine the legal and regulatory risk into which an investor could be buying. However, and equally as important, this review can have an effect on the quality of the practice’s earnings and, ultimately, the purchase price an investor is willing to pay.

With the coming wave of orthopedic practice acquisitions, it will be incumbent upon investors and physicians alike to be cognizant of the reasons for consolidation and the various considerations attendant to such transactions.