Private equity and ophthalmology

I wanted to learn what the fuss about private equity is about so went to a course at last year’s AAO, here is a summary:

The model of private equity was based on the ability to increase the value of a corporation and then sell it. They’re not interested in running a practice or the long term stability of the practice. They just want to pump up the value so they can sell at a profit.

They don’t really care about ophthalmology itself; their goal is to increase the value of the practice and sell it for a profit. (Which leads me to believe this is a Ponzi scheme, similar to the real estate crash of 2008 – the years right before the crash when prices were going up folks would flip houses (or a practice) for a profit. The folks left holding the real estate when it crashed took the hit, in this case probably at the IPO of the practice.)

By notating that ophthalmology is fragmented, they believe that by consolidation they can run things more efficiently, therefore decreasing overhead, as well as negotiate rates with insurances better. They are most interested in a practice with optical, ASC, etc. They tend to target large practices with satellite offices. It’s the same spiel about how standardizing software, billing, TIN will lead to a more efficient practice. Except when it won’t, as we’ve seen many times over.

It was stated that the pros of private equity were to provide a partner for growth and a exit strategy.

However the cons include unknowns for the future- if the private equity group resold the practice there might be many unknowns (and if you put a clause in the contract preventing this then it defeats the reasons why a PE company would want to buy), a focus on the bottom line (although we as practice owners do the same to varying extents), operational conflicts, and purchase price vs future earnings.

The advantage to the doctor is they get paid a lump sum for their practice at the get go. Here’s a chart of a hypothetical situation: instead of a $400k salary, there’s a lump sum payment of $1.2 million and a $200k yearly salary.

Supposedly the break even point is approximately five to eight years. If you look at the sum of the money it’s five years. But this doesn’t take into consideration the time value of money- if you properly invest the $1.2 million you get upfront and the stock market has average returns (doesn’t crash), then the break even point is really about eight years. If I knew I was gonna earn $400k for the next 15 years, a total of $6 million, I’d happily trade that for $4.5 million right now.

The $1.2 million upfront should be paid in cash or stock. The idea is that the PE company can grow the value of the stock at about 20% per year. I think I already run my practice pretty efficiently- so are they going to make me work longer hours and push more elective procedures to pad the bottom line?

This 20% return is over twice as much as the return I expect to get- about 8% from the stock market. But there is higher risk in taking shares rather than cash- if the model doesn’t work then the value of the stock crashes. Typically it might be 50/50 (personally I’d take 85 cash/ 15 stock), but it was mentioned that in the 1990s with PPMCs buying practices if the stock crashed, the shareholder who got paid out for his practice in 100% shares and no cash was worth zero.

It was also mentioned that often times a junior partner in the practice would be reluctant to go along with the sale to PE. Most states have dissenters rights laws regarding mergers or sales where the dissenter can demand (in court if necessary) to be bought out for the fair market value based on an appraisal (FMV based on traditional calculations of goodwill, equipment and AR). But if one or two doctors left the practice then the PE company might might feel the practice is less attractive and view this unfavorably, get nervous, and the sale might blow up.

Junior associates who are about to become partner get screwed because after the sale, they are an employee with no potential for buy in. But if their salary gets reduced to $200,000 from $300-400,000, what incentive do they have to stay with the current practice? They’d probably just go solo and join our thread! Or become an associate in a different practice and maybe have the pattern repeat when they sell to private equity.

So how do you calculate what the PE company will buy the practice for? Typically a company is valued at a multiple of EBITDA (earnings before interest, tax, depreciation and amortization). But “normalized” EBITDA is used- which is EBITDA minus physician salary. And the multiple used is about six. I did some quick research and couldn’t find how to calculate normalized EBITDA based on physician salary (my LLC, or S corp if you have one, is a pass through so anything after expenses is my compensation, making my company profit and thus EBITDA zero). But if you look at the chart above and assume it’s accurate , the initial buyout amount would be about three times yearly salary. Using the traditional model of goodwill plus equipment plus AR, 70% (valuation percent) of a practice that collects $800k (assume 50% overhead gives salary of $400k) a buyer based on the traditional formula would pay $560,000 rather than a multiple of EBITDA per private equity or $1.2 million. So how is the buyer gonna make up the $600,000?

I hope it isn’t by dictating the way we practice or the hours we work. Ideally, the private equity company will resell to a bigger firm at a higher EBITDA when the practice is worth more.

Which leads me to the final point- PPMCs in the 1990s failed supposedly because they were underfunded, didn’t acquire 100% of the practice, and weren’t as centralized. PE today is supposed to be different since it acquires 100% and has more control.

And in the next slide for the talk I went to, it is advocated to aggressively negotiate the employment and managing contract to “prevent power struggles between professionals and corporate” and to “ensure a happier group of professionals.” This is the reason why I’m skeptical- the interests of the docs in practicing the way they want to may not be aligned with the financial interests of the acquiring company.

This sounds exactly like what happened when my multispecialty clinic which employed me got bought out by the biggest group in town .. and we all know how that ended, with many doctors leaving.

In summary, PE sees fragmentation as an opportunity to buy practices, increase their value, and resell them as a profit perhaps at a IPO. But my opinion is that it isn’t good for our profession if investors expect our practices to increase profits by 20% every year. Even as a relatively new practice I grow about 10-20% per year in revenue, a mature practice I have heard grows 3-5%. Where would the remaining growth come from? From pushing unnecessary tests or treatments on patients? How will they run a practice more efficiently than Ho Sun does?

Here are some additional articles about private equity and ophthalmology:

Leave a Reply