Understanding "Acquisition" and "Same Store" Growth in PPMs
New practices can be acquired with either debt or equity. Debt acquisition provides new sources of earnings for the existing shares of stock, less the interest expense incurred. Equity acquisitions increase the number of shares outstanding which may or may not dilute the earnings per share of the PPM post-acquisition. Clearly, if the market is valuing stocks based upon growth in earnings per share, a dilutive acquisition will be unattractive, all other things being equal. Dilution must be seen not only in terms of current EPS, but also in the growth rate in EPS. Debt, of course, lowers the PPM's weighted average cost of capital as well perhaps enabling it to obtain more capital than would otherwise be available. (If it is cheaper for the PPM to use debt, perhaps physicians should consider this alternative, rather than selling a portion of their earnings equity to the PPM in exchange for capital.) New acquisitions, carefully structured to be non-dilutive, thus offer the PPM the opportunity to enhance total earnings and earnings per share.
Although highly simplified, the examples below illustrate some of the concepts.
EXISTING PHYSICIANS, NO INFLATION
| Historical | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| Revenue | 4,000,000 | 4,182,558 | 4,373,448 | 4,573,051 | 4,781,762 | 5,000,000 |
| Expense | (2,000,000) | (2,091,279) | (2,186,724) | (2,286,525) | (2,390,881) | (2,500,000) |
| Pre Distribution Earnings | 2,000,000 | 2,091,279 | 2,186,724 | 2,286,525 | 2,390,881 | 2,500,000 |
| Management Fee | (400,000) | (418,256) | (437,345) | (457,305) | (478,176) | (500,000) |
| Available for Physician Compensation | 1,600,000 | 1,673,023 | 1,749,379 | 1,829,220 | 1,912,705 | 2,000,000 |
| Net (Decrease) Increase | (400,000) | 73,023 | 76,356 | 79,841 | 83,485 | 87,295 |
| Cumulative | (326,977) | (250,621) | (170,780) | (87,295) | 0 |
Physician Compensation
| Historical | 2,000,000 |
| After Management Fee | 1,600,000 |
| Period | 5 |
| Nominal Growth Rate Needed | 4.56% |
| Increase Needed | 400,000 |
Purchase Price
| Management Fee | 400,000 |
| Multiple Paid | 5 |
| Total | 2,000,000 |
|---|---|
| Arbitrage Multiple | 6 |
| Market Value | 12,000,000 |
The first example, EXISTING PHYSICIANS, NO INFLATION, illustrates the impact on the PPM - and the physicians - of the initial acquisition transaction. The PPM can essentially buy earnings; the $400,000 in the example will be reported as revenue in the PPM's financials in subsequent years. In the early stages of a consolidating market, a company can maintain earnings growth much easier through acquisition, as should be readily apparent from the series of examples. In later stages, when good acquisitions are harder to fund, earnings growth must be generated internally from previous acquisitions The use of PPM capital to acquire new practices rather than grow existing practices can create a conflict between already-acquired practices and the PPM.
From the standpoint of the physician/sellers, they are very concerned about growth in revenues and earnings as well, providing aligned incentives with the PPM, at least on the surface. The physicians, of course, unless they are getting stock as part of the purchase price, are more concerned with same store growth, which benefits their own bottom lines, than with acquisition growth. If it isn't obvious, the physicians should be concerned with acquisition growth that comes at the expense of their own same store growth. PPMs looking to establish a presence in a market and grow earnings, may find it much easier to acquire those earnings on the outside rather than grow them from the inside.
In the example, we use a period of five years since a 5-times multiple was paid for the practice and this approximates a 'payback' analysis, ignoring present value (clearly, the rate actually used should reflect the relative risk for the specific circumstance). In effect, the physicians in the example are getting five years of earnings up-front and paying it back over five years without interest. (In reality of course, the physicians are giving up 20 to 40 years of earnings.) Given pre-transaction compensation of $2.0 million and post-transaction compensation of $1.6 million (20% less, a typical deal), physician earnings must grow at a compound rate of 4.56% per annum, assuming no purchasing power loss from inflation, to regain their pre-transaction compensation. This growth can come from better contracts or expansion of revenue to existing providers. Advisers and their clients need to carefully evaluate the prospects for better reimbursement; this is often the proverbial pie-in-the-sky PPM promise, particularly where insurers control rates, as is more often than not the case. To put this in perspective, WHAT DOES THIS GROWTH MEAN looks at the required dollar increases in an initial $50 fee for a 99213 visit, the service which typically accounts for the greatest portion of revenue in a primary care practice. Without increases for inflation, reimbursement has to increase by $12.50 over five years; with inflation, the number is $22.45. The author suspects there are few places where the last five years would indicate a likelihood of such an occurrence.
What does this Growth Mean?
| Historical | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| Fee, 99213 not adjusted for inflation | 50.00 | 52.28 | 54.67 | 57.16 | 59.77 | 62.50 |
| Difference between Historical and Year 5 | 12.50 | |||||
| Fee, 99213 adjusted for inflation | 50.00 | 53.85 | 58.00 | 62.46 | 67.27 | 72.45 |
| Difference between Historical and Year 5 | 22.45 |
Revenue expansion within the practice may offer better prospects in the right circumstances. The addition of ancillaries such as laboratory and cardiac testing services, can create significant revenue (see, e.g., Valuation of Medical Practices, Strategies for Creating Merger Value ). In considering this alternative, be aware that the PPM will often seek to keep the lion's share of ancillary revenue for itself.
Profits (as opposed to adequate fee-for-service-equivalent reimbursement) from risk-based reimbursement, e.g. capitation, offer another significant revenue opportunity. In order to capitalize on this however, a number of conditions precedent must be achieved. Among others, the PPM must bring the expertise necessary to manage capitation successfully, the physicians must use the expertise, and capitation rates must afford a reasonable likelihood of profit. This latter condition generally exists only in those markets undergoing the transition from fee-for-service to capitation, where capitation rates are consistent with historical (and higher) fee-for-service spending. Getting in at this point with the right management systems, utilization control and financial incentives creates an excellent profit opportunity. On the other hand, later stage or mature capitated markets tend to have squeezed out the profits in favor of lower premiums and market share for insurers. Quality representation is important in negotiating capitated arrangements. Insurers can reap windfalls by offering providers an 'opportunity' to take capitation. A typical ploy is offer a rate 10% to 20% below historical PMPM spending, assuring providers they can profit from utilization controls. Don't be fooled.
Profits from existing practices can also be increased through cost cutting. This sets up the potential for conflict between physicians and PPM once again. The typical PPM transaction gives the PPM broad authority over virtually all aspects of the practice, except for clinical decisions. The December 1977 issue of PPMC from The Sherlock Company, an investment advisory firm, noted that MedPartners was consolidating its Southern California operations, with 600 employees and 120 physicians to be affected.
NEW PHYSICIANS, NO INFLATION
| Cummulative New Providers | 1 | 2 | 3 | 4 | 5 | |
| Historical | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| Revenue, existing | 4,000,000 | 4,182,558 | 4,373,448 | 4,573,051 | 4,781,762 | 5,000,000 |
| Revenue, new | 418,256 | 874,690 | 1,371,915 | 1,912,705 | 2,500,000 | |
| Total Revenue | 4,600,814 | 5,248,138 | 5,944,966 | 6,694,467 | 7,500,000 | |
| Expense (50%) | (2,000,000) | (2,300,407) | (2,624,069) | (2,972,483) | (3,347,234) | (3,750,000) |
| Pre Distribution Earnings | 2,000,000 | 2,300,407 | 2,624,069 | 2,972,483 | 3,347,234 | 3,750,000 |
| Management Fee (20%) | (400,000) | (460,081) | (524,814) | (594,497) | (669,447) | (750,000) |
| Available for Physician Compensation | 1,600,000 | 1,840,326 | 2,099,255 | 2,377,986 | 2,677,787 | 3,000,000 |
| Number of Physicians | 10 | 11 | 12 | 13 | 14 | 15 |
| Compensation per Physician | 160,000 | 167,302 | 174,938 | 182,922 | 191,270 | 200,000 |
PPM
| Management Fee | 400,000 | 460,081 | 524,814 | 594,497 | 669,447 | 750,000 |
| Multiple Paid | 5 | 5 | 5 | 5 | 5 | 5 |
| 2,000,000 | 2,300,407 | 2,624,069 | 2,972,483 | 3,347,234 | 3,750,000 | |
|---|---|---|---|---|---|---|
| Arbitrage Multiple | 6 | 6 | 6 | 6 | 6 | 6 |
| Market Value | 12,000,000 | 13,802,442 | 15,744,414 | 17,834,897 | 20,083,402 | 22,500,000 |
| Number of Shares | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 |
| Price per Share | 12 | 14 | 16 | 18 | 20 | 23 |
| Compound Growth | 15.02% | 14.54% | 14.12% | 13.74% | 13.40% | |
| Revenue Growth | 15.02% | 14.07% | 13.28% | 12.61% | 12.03% | |
| Earnings Growth | 15.02% | 14.07% | 13.28% | 12.61% | 12.03% |
NEW PHYSICIANS, NO INFLATION looks at the effect on both the practice and the PPM of adding new providers to an acquired practice, a common representation during the pre-transaction negotiations. Before accepting this premise of growth, advisers should be certain that the demographics of an area will support the addition of new providers. If the new providers must be added at the expense of existing competing practices, the likelihood of success is far less. Many of the greater metropolitan areas in the United States are over-doctored, making the likelihood of this form of same store growth much less.
The example looks at the revenue growth added by one physician each year, with the revenue per physician based upon the 4.56% growth rate developed earlier (that necessary to restore the compensation to $200,000 per physician at the end of year 5). Even though the practice grows from $4.0 million to $7.5 million, per physician income only recovers to its original pre-transaction level. The original owners may be able to 'leverage' new physicians by paying them less than they produce, but in the author's experience this is difficult to do and infrequently accomplished.
The second half of the example (highly simplified) looks at the effect of this particular growth strategy on the stock of the PPM, assuming a constant 1 million shares outstanding. To keep the example simple, we assume the PPM is borrowing whatever funds are necessary to support the addition of physicians. The differences in the PPM's earnings growth rate and that of the individual physicians is striking. The fundamental explanation for this is that the PPM only purchased the earnings of the original practice. It gets 20% of all future earnings, regardless of whether they come from the original physician group or physicians added later without any further payment. Of course, the PPM would argue, with some justification, that the purchase price multiple included the expectation of earnings from the new physicians. It seems that growth in numbers of providers is far more valuable to the PPM than to the physician group in the absence of a synergistic effect permitting the group to realize the better contracts, or the expansion of revenue to existing providers, described previously.
Physicians considering joining the practice later on may not like the fact that they won't have a similar opportunity to sell, since their practice is effectively owned by the PPM. This generally results in new physicians being recruited right out of residency training or settings such as staff model HMOs where they lack a practice base. Whether or not such physicians will have the same motivation to develop a practice as successful as those who sold is a judgment to be made in each situation.
Whenever there is a disconnect between the interests of the physicians and the PPM regarding growth strategies, the expectations of one or both parties are likely to be unrealized. Wall Street is an unforgiving sugar daddy and the publicly-traded PPM that fails to maintain earnings growth will see its value plummet, just as the pre-IPO PPM will never see its value recognized. These transactions need to be evaluated very carefully with a significant focus on fleshing out the true goals of the acquirer. Don't accept platitudes and well intentioned representations about support for future growth. Be particularly aware of the statements of various individual members of the PPM negotiating team and those individuals who will serve on the transition team. Fully explore and understand any inconsistencies in what these PPM individuals say versus what the transaction documents say. If necessary, have the documents rewritten. As my Uncle Charlie used to tell me "Trust Everyone, But Cut The Cards".
Author's Note: I don't really have an Uncle Charlie, but I always wished I did and that he had said this to me. For tax issues associated with PPM transactions, see Valuation of Medical Practices, Tax Strategies for PPM Transactions )..
