At the time when we initially wrote about the early trend of private equity partnerships and investments in orthopedic groups in November 2020, the COVID-19 global pandemic had been raging for over 10 months, and vaccines were in the early phases of initial testing. We are now entering the third year of the pandemic, and while today COVID vaccines, tests and treatments are readily available, private equity’s interest in orthopedic practices has only increased substantially since the Fall of 2020. Orthopedic care remains one of the fastest growing segments of the U.S. healthcare industry, with orthopedic conditions generating more than 137 million visits to providers on an annual basis.
Unlike its industry peers in segments such as dermatology and dental services, the orthopedic sector remains relatively untouched by the professional investment community, and this high level of fragmentation continues to engender heightened degrees of interest from the private equity community, a trend which is only forecasted to increase in 2022, and beyond.
Due to orthopedic care’s utilization of numerous ancillary clinical services, such as imaging, physical therapy, durable medical equipment, and ambulatory surgery centers (ASCs), orthopedic practices can offer investors access to additional revenue streams, while offering patients an integrated approach to the treatment of the entire continuum of musculoskeletal care. Independent orthopedic practices have historically invested in many of these ancillary services, which provide an attractive alternative to traditional settings of care such as hospitals for certain surgical procedures. Further, orthopedic procedures are often accompanied by numerous advantages shared by other attractive healthcare subsectors, as insurers generally reimburse orthopedic procedures well, and providers often offer elective procedures, which are generally self-pay and not subject to industry-standard discounts by insurers.
Private equity investment in orthopedic practices also poses unique considerations. Investment in the orthopedic segment is typically characterized by a “high price of entry” by virtue of orthopedic practices commanding relatively high valuations. Further, orthopedic practices typically have numerous well-compensated physicians, who are historically used to working independently, and often with incentive-based compensation arrangements. These considerations notwithstanding, the private equity community has rationalized these elements with the organic growth possibilities, as well as with opportunities for continued growth via acquisition of smaller orthopedic groups.
Today, the orthopedic sector is optimally positioned for a continued surge of private equity transactions in the coming years. This highly fragmented market provides for a unique consolidation opportunity, as well as a significant first-mover advantage for orthopedic practices that have the size, scale and infrastructure to capitalize on these opportunities. As of the end of 2020 there were a total of eight (8) private equity (PE) firms that invested in orthopedic group platforms – and now, as of January 2022, there are fourteen (14) PE-backed orthopedic platforms seeking to consolidate musculoskeletal physician practices.
In fact, there were over 30 orthopedic group transactions during 2021, and we expect robust that this momentum will continue this year, and that by the end of 2022, there will be more than twenty (20) private equity platforms focused on orthopedic groups, and dozens of more practices that have joined one of these single-specialty mega-groups.
This strong demand is creating intense competition amongst private equity firms, hospitals, and strategic healthcare companies (like OptumCare, a division of UnitedHealth Group) for orthopedic practices, leading to higher valuations. Also, as more orthopedic physicians have entered into lucrative transactions and become part of PE platforms, word has gotten around and a “mini-FOMO” dynamic has begun, causing more orthopedic groups to explore effectuating transactions.
Why Have There Been So Many Orthopedic Group Transactions over the Last Year?
There are several factors driving the significant uptick in private equity driven consolidation of orthopedics, including a confluence of macro-economic and micro-economic factors. The historical lack of private equity backed platforms in the orthopedic group sector has provided for first-mover advantages for significant growth via both de novo expansion, as well as growth via acquisition of smaller orthopedic practices. The opportunity to face less competition and brand loyalty as a first mover in the fragmented orthopedic market will allow practices to expand via acquisition at highly accretive multiples when compared to other clinical specialty segments.
Key Macro-Economic Factors Driving Increasing Private Equity Investment in Orthopedics.
There are 5 key macro-economic factors that have contributed to the rise in orthopedic practice consolidation by private equity investors.
(1) There continues to be a multitude of highly fragmented small and mid-size independent orthopedic practices across the country, and private equity investors focus on subsectors that can significantly benefit from consolidation.
(2) Orthopedic care payor reimbursement patterns are fast-changing, including a sizeable shift to outpatient care settings for surgical procedures and ancillary services, all of which are highly profitable.
(3) CMS has reduced physician reimbursement levels, and may continue to do so into the future, while increasing value-based payment initiatives. This shifting paradigm requires that orthopedic practices have size and scale and is thus driving more independent groups to consider the pursuit of a partnership with larger organizations.
(4) There is an increasing, long-term demand for musculoskeletal services as our country’s elderly population grows dramatically.
(5) The amount of investable “dry powder” (cash) that private equity firms possess for deployment is at an all-time high, and a significant portion of these funds are being targeted at some of the more attractive segments of the domestic healthcare industry, such as orthopedic care.
Key Micro-Economic Factors Driving Increasing Private Equity Investment in Orthopedics.
There are also 3 major micro-economic factors that are also influencing the trend of orthopedic surgeons and/or practice owners pursuing strategic transactions.
(1) Monetizing the “True Value” of Your Orthopedic Practice:
Most physicians do not consider their ownership interests in their medical practices to be part of their personal wealth portfolios. This is largely because, based on the financial terms of their existing Shareholder/Operating Agreements, when most physicians retire or become disabled (or otherwise depart from their medical practices), their equity typically is “bought out” for a very minimal purchase price (e.g., capital account, a small, fixed price, and/or a percentage of personally generated accounts receivable, or a combination of these).
Now, however, because the market for orthopedic physician practices is so active and valuations are at a premium, orthopedic surgeons are increasingly able to “monetize” the true value of their practices at increasingly preferential market terms. Transactions with private equity funds usually are structured to pay 70-80% of a practice’s enterprise value at the closing of the deal, with the balance of 20-30% to be reflected in “roll-over” equity. And if a physician holding roll-over equity subsequently becomes disabled or retires after several years, they usually are bought out for a fair market value price, equal to or greater than the value of such equity when received at the initial “first bite” transaction.
Moreover, because the healthcare industry faces significant future risks – for example, forecasted declines in payor reimbursement (see above), and a more competitive local/regional market landscape (see item 2 below) – the future value of a medical practice is also at risk to some degree. As a result, many orthopedic practices are concluding that now is a good time to “take some chips off the table” (at the height of the market), with each physician receiving very large payments (commonly multi-million dollar), and investing such proceeds how they see fit (e.g. retirement nest egg, second house, medical school debt, children’s college tuition, etc.).
Importantly, most of these transaction-related payments are received at advantageous long-term capital gain tax rates – versus 18-20% higher “ordinary income” rates. However, the timeline for this lucrative tax arbitrage strategy may be short-lived if the Biden Administration’s proposals to increase long-term capital gains tax rates are enacted into law in the future.
Finally, the value of rollover equity is very “real” – which is best recognized when investor platforms “exit” their investment within 3-6 years (aka “second bite” transactions). Over this time, such investor’s equity – as well as the physicians’ rollover equity – will increase in value (generally 2-4 times), and result in a second bite “liquidity” event for physicians. Such investor “exit” transactions are beneficial for physician owners at all stages of their careers, but additional “exit” transactions may occur every 4-6 years thereafter, which makes these transactions especially beneficial for early and mid-career physicians (as opposed to physicians who retire within 3-5 years of the initial transaction and will not be able to participate in these potential additional exit/liquidity transactions).
(2) Local Competition & Threats to Market Share:
Consolidation of healthcare professionals by large healthcare providers in each geographic market (i.e., Optum, health systems, private equity, etc.) results in larger and better capitalized competitors that over time may erode an independent practice’s market share. The greater access to capital of larger organizations enables them to grow quickly across various service lines, not only via hiring more orthopedists, but also in fast expansion via new offices and new ancillary services (e.g., ASCs, imaging, urgent care, physical therapy, etc.).
An even greater threat is acquisitions by these larger organizations of independent primary care and other physician referral sources, which likely will result in changes over time to existing referral sources and patterns. This is especially the case if these larger entities also begin to employ their own orthopedic surgeons and other specialists, which has started to happen in many markets (e.g., by hospital systems, Optum, etc.).
Further, these competing organizations also are able to invest substantial funds in advanced EMR, data analytics and care coordination initiatives – all of which better prepares them to succeed in value-based care programs, as well as in the development of expertise in direct contracting with self-insured employers (which is also becoming more prevalent). In sum, the proverbial “writing on the wall” is starting to become clearer, and physician practices that are part of larger organizations with extensive corporate infrastructure (see item 3 below) will be optimally positioned to adapt to these challenges in their local marketplace in a manner that enables them to continue to be successful and maintain profitability into the future.
(3) Benefits of Larger Corporate Infrastructure for Growth and Success:
An important benefit of transacting with private equity is greater access to capital to fund ongoing clinical and non-clinical practice operations and expansion, including new offices, physician recruitment, build out of ancillary services, investment in the latest information technology, advanced data analytics, EMR and virtual care platforms to best compete and succeed in the changing environment – all without reducing physician compensation.
Further, private equity-backed platforms bring experienced and sophisticated corporate executives to successfully guide the practice’s physicians through many competitive challenges and industry changes. This includes a seasoned C-suite consisting of a CEO, CFO, COO, CIO, VP of HR, VP of Managed Care, Finance Director, Billing Director, Credentialing Director, and Compliance Officer. Moreover, substantial cost savings can be achieved through the consolidation of back-office functions (e.g., mid-level management, revenue cycle function, IT systems, call centers, etc.), as well as through group purchasing of health benefits, malpractice insurance, expensive equipment and supplies, and other items and services.
Conclusions
M&A deal activity over the last year alone highlights the strong and growing demand for orthopedic practices, and the resulting premium valuations being realized by orthopedic groups across the nation. As a result, many orthopedic physicians recently have entered into transactions with private equity investors – and in 2022, more orthopedic groups than ever will be seriously exploring potential transactions for the various reasons described above, including: (1) Fear of missing our” (e.g. “FOMO”) with respect to lucrative financial terms from monetizing the true value of medical practices; and (2) the many benefits of being part of a larger, well-capitalized organization with experienced executives and extensive corporate infrastructure.
About the Authors
Gary W. Herschman, Member, Healthcare and Life Sciences Practice
Epstein, Becker & Green, P.C.
Gary W. Herschman is a member of Epstein, Becker & Green, P.C.’s Health Care and Life Sciences practice, and serves on the firm’s Board of Directors in addition to its National Health Care and Life Sciences Steering Committee. Gary is a healthcare attorney who focuses on mergers and acquisitions and other strategic transactions. This primarily includes advising physician groups (including orthopedic groups and many other specialty practices) across the country on private equity partnerships, consolidations, merger, and affiliations, as well as JVs, hospital-physician alignment, PSAs, Co-management, clinically integrated networks, ACOs, MSOs, IPAs, PHOs, and population health contracts. Gary also advises healthcare clients on regulatory compliance (federal and state), Stark, fraud and abuse, corporate compliance, HIPAA, government investigations, and civil and administrative healthcare litigation.
Anjana D. Patel, Member, Healthcare and Life Sciences Practice
Epstein, Becker & Green, P.C.
Anjana D. Patel is a member of Epstein Becker & Green, P.C.’s Health Care and Life Sciences practice, and serves on its National Health Care and Life Sciences Steering Committee. Anjana is a healthcare attorney that leverages more than two decades of legal experience to advise health care providers and businesses nationwide on health care mergers and acquisitions, private equity recapitalizations, and other strategic transactions such as joint ventures, affiliations, formation of MSOs, co-management arrangements and value-based arrangements. Anjana also advises clients on regulatory compliance issues, including, without limitation, compliance with federal and state anti-kickback and self-referral laws, corporate practice of medicine and fee-splitting prohibitions, licensure, and other federal and state health care regulatory compliance matters.
Hector M. Torres, Managing Director, Co-Leader of Healthcare Investment Banking
FocalPoint Partners, LLC, a B. Riley Financial Company (NASDAQ:RILY)
Hector M. Torres is a Managing Director and Co-Leader of the Healthcare Investment Banking practice of FocalPoint Partners, LLC, a leading global investment banking and financial advisory services firm with offices in Los Angeles, Chicago, New York, and Shanghai. With over 16 years of experience providing investment banking and financial advisory services to healthcare organizations nationwide, he has completed more than 25 M&A transactions with a cumulative value of more than $2.8 billion in the last six years alone. His clients include large physician practices and groups, national and multi-regional health systems, academic medical centers, health insurers, non-acute care providers, medical device companies and capital providers to healthcare entities.