Anjana Patel
Healthcare Transactional Attorney
Anjana Patel is a healthcare transactional attorney at Epstein Becker Green.

While the volume of large-scale transactions continues to decline, there is still significant growth potential for private equity buyers in the physician services sector, particularly in transacting with small and mid-sized physician groups within their target specialty. This article delves into the reasons behind this latest trend and explores key issues that PE investors should focus on in healthcare add-on transactions.

What’s Different in 2023?

Due to macroeconomic headwinds, PE investors are more selective when it comes to add-on acquisitions. Higher borrowing costs and increased focus on loan covenant compliance by lenders have compelled PE platforms to emphasize thorough due diligence, even for smaller add-on targets. A comprehensive scrutiny of the target not only provides more security to a PE buyer but also helps avoid potential issues and compliance concerns following the closing that could lead to more significant problems in the future.

Here are 10 key areas of focus that PE investors should address to optimize add-on transactions and reduce post-close integration risk:

1. Healthcare Regulatory Issues. Physician services, like almost every subsector of the healthcare industry, are substantially regulated. Most add-on physician practices are smaller organizations that may not, historically, have had strong compliance controls in place. Thus, to avoid surprises during due diligence and nasty post-closing compliance surprises, it is important that both sellers and buyers address the key regulatory risk areas affecting the target.

One area of key concern is billing and coding. PE buyers should undertake a billing and coding audit, focused on those risk areas most likely to give rise to problems in the practice’s particular specialty. These types of audits can help verify the integrity of the target’s billing practices and help support the purchase price to be paid. If the target’s revenues are primarily based on questionable billing practices, then it may not be worthwhile for the buyer to pursue the acquisition – or reduce its initially offered purchase price — because of the impact these practices have not only in sustaining existing profits, but also on future growth. 

Another area of concern affecting healthcare companies is fraud and abuse. Here again, the risk areas can be uniquely specific to the type of provider. For example, physicians are subject to the Stark law which dictates how they may refer patients to facilities in which they have a financial interest (such as contracts with hospitals), and also how they split profits from “designated health services” (e.g., lab, imaging, therapy, DME) provided within the practice. 

Moreover, several federal laws (including the False Claims Act) require that any overpayments from Medicare and other federal healthcare programs that are identified by a medical group be returned promptly to the appropriate agency. Failure to do so could result in draconian penalties (over $10,000 per each claim), plus treble damages. Thus, PE buyers should ensure they have performed a thorough diligence review of a target practice’s regulatory compliance.

2. HR & Benefits. Buyers should review the human resources and benefit programs, policies, and procedures of the target to assess any potential employment and benefits-related risk. For physician practices, the main “assets” are the people, and thus certain areas of risk will be carefully examined by a buyer, such as for example, correct classification of workers (W-2 v. 1099), correctly paying for overtime, and avoiding harassment and discriminatory or retaliatory conduct.  

3. Investigations & Audits; Litigation. Any existing or past governmental or payor investigations and audits are another key area that PE buyers should focus on. Buyers should ensure that any identified past non-compliance has been corrected. In addition, any existing or prior litigation or disputes (commercial, employment-related, or otherwise) that could result in exposure to the PE buyer, especially in an equity purchase transaction, should be resolved in advance of a deal, if feasible.

4. Payor Mix. Diversity of payor mix will also be scrutinized by the PE buyer because PE buyers generally prefer that the practice is “in-network” with multiple payors, as “out-of-network” payments are generally trending downward. 

5. Debt & Financings. All debt and financing arrangements, including capital leases, should be “in order” – meaning old lines of credit should be terminated (along with the related liens, UCC-1s, etc.). In this regard, it is important to note that any outstanding debt and capital leases may need to be paid off in full at closing with the cash proceeds of the transaction, which the PE buyer should make clear early on to the selling physicians.   

6. Restrictive Covenants. The existence of any non-competes and “rights of first refusal” to which the selling practice is subject should also be scrutinized by the PE buyer as this could impact future growth. 

7.  IT & HIPAA. Cybersecurity is increasingly become a major area of substantial potential exposure, and therefore diligence focus. The EMR of the selling practice, its information systems, and any related cybersecurity and HIPAA/privacy policies, procedures and any breaches should all be carefully reviewed by a PE buyer. This includes, for example, having in place HIPAA-compliant policies, procedures and patient forms, training staff on these matters on an annual basis, and conducting “penetration testing” from time to time to confirm effective IT security mechanisms are in place. 

8. Ongoing Exclusion Checks. Federal and State laws require that all staff (both employees and independent contractors), of a medical practice that participates in any federal or state healthcare program, be checked against various “exclusion lists” and prohibit the engagement of any person who is on such lists. Violating this requirement can result in the practice being exposed to very substantial penalties and damages.

9.  Credit Balances. Many medical practices are not aware that state “unclaimed property” or “escheatment” laws require that credit balances be returned (e.g., to patients and healthcare plans/payors) within a certain timeframe, and that reports of such amounts be periodically reported on state-mandated forms. PE buyers should proactively review and address any credit balances.

10.  Compliance Program. PE platforms should also ask to see a medical practice’s compliance program, which should be a written set of policies and procedures that are in place and adhered to, including a non-retaliation policy, encouraging reports of compliance issues, conducting proactive compliance audits, and training all staff on such policies on an annual basis.   

In light of a physician practice’s various potential liabilities and exposures that are scrutinized in due diligence, indemnification provisions tend to be one of the most hotly negotiated provisions of definitive transaction agreements. In recent years, the widespread availability and prevalence of representation and warranty insurance (“RWI”) has taken some of the pressure off the negotiation of these provisions in larger transactions, but, historically, many add-on deals were not of a size where it made economic sense to purchase this typically expensive insurance product. However, the tides may be changing as the cost of this insurance seems to be decreasing, and coverage availability has expanded for smaller deals. As a result, these changes in the RWI market could drastically ease the parties’ pressure to heavily negotiate indemnification provisions. 

PE buyers should ensure that even for smaller add-on acquisitions, they conduct in-depth diligence of the target physician practice utilizing skilled professionals who have the familiarity and extensive experience in handling physician practice transactions. These experts, including investment bankers, attorneys, and accountants, possess industry-specific knowledge, including a deep understanding of the unique operations and potential risks involved, that is invaluable in ensuring a smooth and successful transaction.