Join Cascade Partners Managing Director, Raj Kothari, and McDonald Hopkins Health Care Practice Chair, Elizabeth Sullivan, as they discuss the unique dynamics in healthcare transactions. Learn about the financial and legal aspects of balancing compliance and regulatory considerations relating to M&A transactions and why you need financial and legal consultants in the initial stages of any financial transaction to advocate for the best interests of yourself, your team and your practice.


Episode Transcript

Welcome to Cascade Conversations! Join the team at Cascade Partners and their network of trusted advisers as they work to demystify details terminology and strategies in the world of acquisitions, divestitures and financings.

Rajesh U Kothari – Managing Director at Cascade Partners:
Welcome to another Cascade Conversations! Today, we’re going to talk about some of the unique dynamics of a transaction in the healthcare sector. I’m Raj Kothari, managing director and founder of Cascade Partners. And joining me today is Elizabeth Sullivan. She’s the chair of McDonald Hopkins Health Care Practice.

Thanks for joining us today, Liz.


Elizabeth Sullivan – Healthcare Practice Chair at McDonald Hopkins:
Absolutely! Thanks so much for having me.


Rajesh Kothari: We’re really looking forward to this conversation, and drawing on some of your great insights and experience helping clients get through a little bit more complicated nature of health care transactions. And so, when we do this, we spend a lot of time doing things preemptively—like quality of earnings and doing some due diligence upfront to make sure we’re really positioning our clients. And I know this is important to you as well.

Can you talk about some of the areas that you particularly focus on from a healthcare point of view, and why you think it’s so important for clients to think about these things in advance?


Elizabeth Sullivan: Absolutely. Okay. So, Raj, you are speaking my language, right? As you alluded to, my practice is primarily compliance counseling and healthcare regulatory work. So, I’m doing this on a day-to-day basis with our provider clients. But because we have a robust healthcare M&A practice, a lot of what I do is also doing this work in the context of M&A and transactions for our clients.

And so, whenever we get involved with these sorts of deals, there are a couple of things that we’re looking for immediately. And it does depend on provider. So, I know we’re going to talk a lot about physician practices today, but, of course, we both work with all sorts of other providers. And so, in that sense, some of these are universal and some of them are unique to the different types of providers.

So, for our physician practices, one of the things that is important right out of the gate—and probably is a big part of what you do—is billing, right? Billing practices. So, this is important right off the bat. There’s a compliance component to it, but there’s also a component to it of what is the value proposition. So, that’s one of the things that we will want to understand right away—What are the billing practices? How is the practice structured? What types of clinicians are involved?—All of those sorts of things are critical because they impact not only the health of the organization and of the practice from a transactional perspective, but also from a compliance standpoint.

Another thing that I am often interested in, and this really is sort of the healthcare component, is business relationships.

So, when we’re talking about a physician practice, the practice may say, “Well, we don’t really have any of those relationships, we don’t really have any written contracts with anybody else. What exactly are you looking for?” And so, two of the areas that pop up a lot in our transactions that we’re dealing with in the course of diligence is real estate. And also, just generally something that seems very innocuous and very simple, but maybe holiday gifts or other types of things that a practice may do with referral sources, or community contacts and things like that.

So, with respect to real estate, many groups own a medical building or they have a lease in a medical building. And one thing that often just isn’t something that occurs to everybody on the front end is, “Who are they leasing from?” or “Who are they leasing to?” And if they’re leasing from or leasing to a referral source, then that is a financial arrangement with a referral source and it does implicate the stark law. It doesn’t mean it’s a violation, just means the stark law is implicated.


Raj Kothari: You just have to look at it.


Elizabeth Sullivan: Exactly. And so, it is sometimes surprising for clients when we get into a deal, how long it takes to sort through that, particularly if there are multiple locations or it’s a complex structure. And so, trying to get out ahead of that and have the answers ready and be confident in the answers really helps in the transaction.


Raj Kothari: We’re big believers in that, right? If you can identify that, “Are we stark compliant?” or “Are we anti-kickback? Do we do all those things ahead of time?” Even if the answer is we didn’t quite do it right, then we have the opportunity to structure it and convey the message we want as opposed to having our partner buyer or the other side identify, and then we’re jammed into a corner.


Elizabeth Sullivan: Absolutely.


Rajesh Kothari: I mean, I’m working through it right now and I have a few extra gray hairs as we work through these issues because we couldn’t we couldn’t get enough information to identify it upfront.


Elizabeth Sullivan: (Laughs) Right. Right. And I think your point is exactly the takeaway that I hope everyone would have. It’s not doom and gloom. It’s not the end of the world, but if you can either solve the problem before you go to market or identify it, be prepared, and know how you’re going to handle it and how you are going to discuss it, position it and not get caught flat-footed, that’s going to make the process and the experience much better.


Rajesh Kothari: Our line is, “The best defense is a great offense.” Absolutely. And we are. And we operate completely in that vein.


Elizabeth Sullivan: Absolutely. So, all right, we’re 100 percent on the same page there. And then I think—this is probably a little bit repetitive because the real estate really is a good example—but if a group has ancillary service lines, if they have a relationship, if there’s an ASC involved—sort of any of those other unique, really important from a value standpoint, but complex or unique arrangements, we want to see those in advance and try to figure out what’s going on with those. And sometimes, we will only be involved in the transaction. We weren’t the health care attorneys that were setting those things up, and that’s okay. We’re here to facilitate, so, if we can connect with regulatory counsel and sort of serve as a second level or the translators from regulatory counsel to the deal counsel, we’ll do that as well. And those are the things that we focus on on the physician practice side.

With providers, other types of providers, we do a lot of work with clinical laboratories, behavioral health facilities, home health care. Business arrangements are often more important, so, sort of variation on the same theme, but also sales and marketing teams—we want to understand that right away, when we’re talking about other types of providers. Licensure because that’s going to impact deal-timing potentially, so, we want to know that.

And then, I would say, the last thing that I had on here that I wanted to note for other types of providers is their payer arrangements because it does depend on deal structure. The health of those and how those are structured really may impact deal structure, may impact price. All those things come into play. So, those are the things that right out of the gate we are looking at when we get involved, and we hope that it’s not too much under the hood for the client right away.


Rajesh Kothari: Well, our experience is usually too much for the client because they’re like, “Well, this is just the way we’ve always run.” But the reality is, when that partner is coming in or that new buyer is stepping in and they might have a much bigger enterprise. So, that level of risk doesn’t work for them, or they just have a different risk tolerance and they’re just not willing to take that on.

And honestly, at some point they get larger and larger. They get on the radar screen of the regulators, whether it’s the government regulators or even payers doing their own audit. So, the risk profile changes. And that’s hard, that’s hard for entrepreneurs to understand, “Well, how does this fit? I’ve run it this way.” But helping them understand, “Hey, these are the implications. This is what it can mean in the back end and why the risk profile is different.” Helping them understand this can usually get them get them through that.


Elizabeth Sullivan: That is such a good point. I mean, I really think you are making a great point. We do get into that a lot where we might feel almost adversarial, and that’s not the intent. We want to remind folks that we’re here to facilitate and we’re here to help, but because of the risk tolerance and the risk profile, sometimes we are doing that translation or we have to provide these things just to bring the buyer’s team along and get them comfortable. So, I absolutely think that’s a great point.


Rajesh Kothari: Right, they’re definitely going to take a conservative position. They’re the buyer.


Elizabeth Sullivan: Right. So, switching gears a little bit, one of the things I wanted to ask you about, Raj, was more and more practices are evolving, and private equity just continues to be such a large player and it will continue to be. So, around that issue, there’s increasing discussions around compensation—compensation structures and how all of that fits together. So, what types of conversations are you having with clients? Or what types of trends are you seeing with respect to compensation and private equity models?


Rajesh Kothari: Yeah, so, compensation is always a sensitive subject for everybody. And when we work with providers, and shareholder providers in particular, we have to help them understand that they’re getting two forms of compensation; they’re getting paid as a provider and they’re getting paid as a shareholder. Now, those may come in one check and they may not make the distinction internally, but, in reality, they’re getting paid those two buckets of compensation. And we found it’s important to help separate those so they can see, because the beauty of a private equity transaction is they’re going to continue to get paid as a provider. That’s not going to change. They’re going to continue to serve that role. And it’s important for them to know and understand that compensation is going to continue. And then they freak out because it’s like, “Well, hold it, I was making all this money and you’re telling me I’m only going to make this much?” And it’s reminding them that this component, they’re getting paid as a shareholder and, in exchange for that, they’re going to get a bunch of cash at closing, and they’re going to continue to own a piece of the organization going forward.

So, sometimes breaking those components down has been really helpful for our clients to think through. And when we talk about compensation, we always talk about, “Hey, let’s get to the market,” and usually the shareholders are above average producers, they’re more experienced, so, we’re typically trying to take them towards that  two thirds, 75th percentile of where the market is.

But when you go off of market data and you look at what they’re doing with their own associate docs, it gives a very honest and credible metric to use internally and with the private equity partners to say, “Hey, this is where the market is, this is what it’s going to take to replace,” because that shareholder compensation becomes a big part of the cash flow that becomes part of what the practice is going to be valued at.

When you break it down and look at it before tax and after tax, it has a significant impact. Today it’s about a 20+ percent impact. And oftentimes physicians, their role is about cash flow, and they think in terms of cash flow. They’re like, “Well, I was making this much and now you’re telling me I’m going to make this?” And when we take them back and show them what it means after tax, the distance between the two numbers is actually much, much closer than they realize. And that’s one of the tools that we’ve used to help them get more comfortable.

But you’ve seen it, I’m sure, in the deals that you’ve worked on, right? Some are doing the production percent of collections production model—eat what you kill, if you will. The others are doing, “Hey, let’s do a shared component.” And increasingly we’re seeing these earnings before physician compensation bonus pools. Trying to keep the physicians aligned with the cost structure, incentivize on the cost structure. You know, an okay model, I think it’s a challenge and one of the things we remind our private equity partners and our physician clients is when they have control over that—that expense side—that makes some sense. When they don’t, that can be a hard thing. So, part of the partner is driving the operations of the practice.


Elizabeth Sullivan: Absolutely.


Rajesh Kothari: So, it becomes a very important conversation. It’s one we have early and often with our clients because it takes time to process it, digest it and understand what it means to them personally.


Elizabeth Sullivan: Right.


Rajesh Kothari: So, when they’re meeting with that partner for the first time and they’re talking about it, they’re like, “Okay, I’ve really thought through this,” and then I can ask them more thoughtful questions and the impactful questions. Then the initial reaction of, “Holy cow, what do you mean my compensation is going to change?”


Elizabeth Sullivan: Yeah, I think that’s so insightful and I think that’s a way that you are really preparing your clients for that conversation because we do, as you noted, see that and we see that hesitation and, “Wow, this is so different from my day-to-day practice.” Not necessarily appreciating—we are also talking about the cash at closing, which is part of that—but then, you being able to understand how this is going to work on the go-forward, particularly for folks who are in a practice where, as you said, they didn’t have to think about these sorts of things. They were just looking at cash flow, it’s a huge step. That’s a huge win as far as preparing your clients to go through that process and be knowledgeable.


Rajesh Kothari: As we’re talking about compensation, one of the natural elements is rollover equity. It’s become a very significant part of the value creation for the physicians and, as we’re looking at these deals, increasingly we’re seeing clawbacks and other provisions that are putting strings and attachments to the equity that the physician owns, and that’s part of their real consideration.

How are you guys looking at that? How are you guys approaching those conversations with your clients about the clawbacks and elements of the rollover?


Elizabeth Sullivan: Right. Well, it’s interesting as you think about it—and some of our discussion has already touched on these points—but when you think about the physician and the value of the transaction, equity is part of that. And those are dollars that aren’t coming in somewhere else. And so, what we’ve tried to do with clients, and tried to counsel them on is help them to understand when is this going to be in effect or when these forfeitures would take place.

Oftentimes, where we’re seeing it is with termination or productivity based on historical productivity. And so, essentially the provisions are usually drafted based on one of those points. But what it comes down to, I think—it’s sort of boiling that down to a more basic concept—is what are the terms of the departure of the physician? Is it something that was for cause on? Was it meaning that there is a reason that the relationship was terminated, that both parties sort of negotiated, that they agree that this would be an appropriate situation? Or is it something that feels inequitable to one side or the other?

So, I think this is something that, as we were sort of preparing for this—you shared some of your insight with respect to what you’re seeing, and I thought some of that was very interesting and insightful—I don’t know if you want to share some of the things that you’re seeing in these types of situations.


Rajesh Kothari: Yeah, I think you said it well. It’s really the term we’re all using is, “good leaver, bad leaver.” Did you leave for a good reason? Something that wasn’t in your control? Something else that happened? You died, but they call it a good leader. It’s not so good for that, but meaning how it impacts that equity value. And badly is I want to cross the street and I’m going to set up a competitive operation. That’s reasonable to say, “Gosh, that, that was completely in my control, and I did that and that’s diminishing value.” But there are a lot of variables, and not all of it is in the control of the physician.

And so, it’s a relatively new strategy since COVID that folks have been trying to go after this. There’s clawback provisions. I always try to point out it’s a two-way street. They want the doctor, they’re buying that cash flow, the doctor generates all that volume. Their single biggest fear is, the day after closing, the physicians are working less or leave, and that’s a very legitimate fair concern.

But in turn, the doctor is make a very significant bet with that rollover equity that the partner they’re picking is the one that’s going to take them to the finish line. And the private equity guys can’t guarantee they’re there, they can’t even guarantee the management staying. And so, we always feel it’s a little one-sided, and so—you describe kind of managing that term, making sure that it weans off and invests over time—so as time goes on their ability to crawl back goes down further and further.

We totally agree that those are really critical things. In fact, we try to negotiate those upfront, and we work with you and your team to make sure as part of that LOI where we’ve got maximum leverage—we’re like, “Let’s be specific. What’s a good leaver? What’s a bad leaver?” Let’s not be generic. Firing people because they did bad as an employee, that’s an employer’s discretion. But when it impacts your equity, that really changes the implications. And we are working harder and harder to separate those two.

So, if you have all the causes you want, we didn’t follow your rules and you want to fire us, that’s great. But that can’t be a reason that you’re taking back my equity. That’s just a different scale. And so, that’s a lot of times that we’re thinking about it and helping approach and sharing the other side of the private equity partner that, “Hey, is this really balanced? Is this really a fair position?”


Elizabeth Sullivan: Right. And I think you’re right. It’s a situation where both advisors are going to be aligned. So, you’re digging into that detail and then, on our side, what we’re trying to do is really craft that language in a way that it makes it clear these are the places that there is going to be a forfeiture and these are the places where that is protected and that’s going to be safe. And I think your point to really be detailed with it is important. And I think it’s a really good point. And I think as this continues to evolve to the extent that this is something that is coming up more and more and we’re seeing more of it…


Rajesh Kothari: It’s not going away.


Elizabeth Sullivan: Right…Then there’s more experience and that helps us draft and negotiate that circumstance better for our clients.


Rajesh Kothari: Well, and we were talking about, all by itself in its own little box it sounds reasonable.


Elizabeth Sullivan: Right, exactly.


Rajesh Kothari: And what you and I are often doing is helping our clients understand you got to put it in the bigger box, and in the bigger box it’s not quite as reasonable—or at least we don’t think it’s quite as reasonable. Having that discussion upfront, early and often to drive alignment, it becomes a significant negotiating point, there’s no doubt.

But folks have to realize if that equity is more and more at risk, the value of it to the physician is lower. So, why do they want to roll as much?


Elizabeth Sullivan: Right.


Rajesh Kothari: I think that’s the other side that people have to realize is, the more claws you put out, the less they’re going to want to roll. And that the opposite incentive that I think the private equity partners try to achieve with all this.


Elizabeth Sullivan: Yeah, absolutely. I think that’s right.


Rajesh Kothari: So, as part of this, we talked about good leaver and bad leaver non-competes, non-solicits, our critical components, but I’m not sure everybody really realizes that there are three or four of these elements in every transaction; I have my non-compete as a selling shareholder, I have my non-compete as an employee and I have my non-compete as a new shareholder in the new company.

How are you guys thinking about those differently or how do you help clients negotiate those differently because they have different risk and different parameters and different implications?


Elizabeth Sullivan: That’s an excellent question. I think for us, it does relate to what is the nature of that restriction? And so, we talked a lot already about the clawback of the rollover. In that circumstance, we’re talking about a situation where a physician is taking a risk. Right and that’s something that’s important to them. It’s part of you know, it’s part of sort of the larger transaction, the value that’s there. And so, I think that is a place where we want to be very careful and thoughtful, as you said, about the details and the circumstances upon which that’s going to go into effect.

The same is true, obviously, when we’re talking about any of these restrictions, but I think, when we’re talking about sort of employment—whether it’s as a shareholder, the seller or we’re talking about as a new employee of the organization or as a new shareholder. In all of those cases it’s, “Okay, well, what is the purpose of this and what is it going to mean long term to that individual?” So, we do try to be thoughtful when we’ve got different folks that are in different categories, but certainly when we’re talking about the shareholders of the sellers, it’s a conversation about what is most important.

I think that’s where we really operate from. So, when we’re talking about getting the deal done, what are the most important components to them? What do they see as sort of their future state? What is their expertise for post-transaction and what does that really mean to them? And then try to work from there.

And the other thing to consider is when you have a group that is selling, the expectations might be different among the group members. And so, trying to reconcile that and make sure that everybody is on the same page and feels comfortable, feels protected or advocated for is a large part of that.


Rajesh Kothari: Fine. It’s a balancing act. So, we’re trying to manage all of the expectations of the shareholders and our clients. But at the same time, the partner and the buyer has an expectation of perfection because they’re looking for the ability to generate that cash flow, and they know they don’t want to make it easy for the backs to leave because they just paid them a whole bunch of money. And we recognize that’s fair and balanced.

We’re often seeing on a selling shareholder, a five year or nine—subject to state—but typically a five year non-compete and kind of two years, 1-2 years post-employment, 1-2 years post new shareholder, meaning that they have a non-compete for 1-2 years after they’re done being a shareholder in the new company, the holding company.

Are those the same metrics that you’re seeing in the marketplace today?


Elizabeth Sullivan: I think those are pretty consistent. That is also what we are seeing. And I think you’re right. One of the things that you pointed out was, I think for our clients to look at these and say, “What does this mean for me?” that’s always where we’re working from.

But if you think about the buyer’s perspective, so much of the value of the business is related to the physicians and potentially also the leadership of some of the folks that are involved in leadership. And so, the protection—what is the investment? What are they purchasing if folks can just walk out the door, walk across the street and set up shop? So, it is a balancing act, and I think you’re right. I think those metrics really are consistent with sort of what we’re seeing in the marketplace.

Okay, so we’ve talked a lot about the shareholders and many of the things that come up in the transaction with respect to the shareholders, but one of the other things that is involved in this are the other physicians. Some of the non-owners of the younger physicians that are in a practice. Oftentimes, they are looking at this and feeling like a PE transaction—or really any type of transaction, any sale, regardless of the type of buyer—might not be in their best interest.

So, how do you perceive that or what advice would you give to physicians that are not necessarily in that shareholder camp or maybe are young shareholders and are just looking at it and saying, “What does this mean for me? Because I’m not at the end of my career and this transaction is happening.”


Rajesh Kothari: There’s an interesting dynamic. Someone must be running around all the residency programs around the country saying, “PE is horrible!” That’s the common feedback we hear and, usually, it’s because of a lack of information. They just don’t know or someone is telling them it’s not—I don’t know who is telling them this—but I remind people, just as there are bad private equity partnerships out there, there are bad private practices. There is good and bad, and you got to find the right partner.

And so, when we’re working with younger folks, it starts out with shareholder physicians because this conversation is really happening at a shareholder level. And the older doctor like was like, “This is great, I can get realize the value in my practice a way I never could.” And the young doctor is like, “Hold it, I’m giving up 20 years of cash flow.” And we’ve helped groups go through and understand this is actually better for younger physicians. And the reason is it’s a shift in mindset. It’s a shift from cash flow, which is how they were trained and what they’ve been experiencing and moving them towards thinking about equity because every group is going to want those physician shareholders to roll equity, meaning they’re going to put part of their proceeds into owning equity in the holding company that’s been created that the private equity groups are creating to consolidate all these.

So, that shift from cash flow to equity is that role. Well, the private equity group has got to grow that. They only make a return if they can grow the value of the equity. And they’re targeting two, three, five, X what they’ve invested. So, think about if I sold my practice for $100 and I took $30 and I rolled into the new and they generated a three X return, now I’ve got $90. Well, if I take $60 and put it in my pocket and roll another $30 to do it again, right now I’m really accelerating my equity value and my value creation.


Elizabeth Sullivan: Right.


Rajesh Kothari: That’s very different than cash flow and I’m doing it all at a capital gains rate. So, I’m saving 20 percent right off the bat in most places right there. And so, there’s a tremendous amount of value creation and younger doctors can do that flip multiple times. An older physician is typically doing it maybe once, and then they’re approaching retirement age and they’re not practicing anymore, so they’ll lose that opportunity.

If you look at some of them, very successful private equity provider roll ups started with single practices and gone through multiple private equity—a couple of the largest—and emergency medicine went public. So, physicians rode that whole way up and then they took those same two public companies, then went private by the two largest private equity groups in the country. But all that way physicians got to ride that wealth creation.

So, when we’ve helped younger physicians understand this dynamic, there’s been much more appreciation. We have one practice where a young associate doctor became a shareholder as part of the transaction without having to buy in because the value now of your practice—10 years ago, 15 years ago—they tossed out equity in practices because it didn’t really have a lot of value. And as I was a partner, we advise all our clients today is, “Stop using the term ‘partners’ and start using the term ‘shareholder.'”


Elizabeth Sullivan: Right.


Rajesh Kothari: Because now they’re a shareholder, and that’s the dynamic that’s changing. And, in this particular case, that person has gone on to now lead the group and is actually representing the group as part of its board representation.

So, it can be a great opportunity and, very long-term, create a lot of value creation far and above kind of the current income stream that they think they’re forgoing.


Elizabeth Sullivan: Right, and I think there’s a couple other things. Oftentimes, I feel like, in my role, it’s probably more about some of the concerns about work/life balance or what is it going to look like, how is it going to impact clinical day-to-day and those sorts of things. And I think you made a really good point, which is find the right partner.

So, in the right situation with the right private equity group, not only is all of this available, but you’ve also potentially got economy of scale with the type of—whether it’s infrastructure, compliance, support, billing—all of the things that a practice has to do on its own and that folks would need to support on their own, that’s all going to be taken to a higher level. It’s going to be taken off of folks’ desks. There’s also leadership opportunities, as you are describing.

So, there’s a lot of things that can be really great if the right organization is identified.


Rajesh Kothari: And people focus on the value, and they think, “Oh, you’re an investment banker. All you care about is money.” It’s like, no. At the end we advise our clients. The money doesn’t matter. At the end, the money will all be roughly the same, but, if you pick a really bad partner, it doesn’t matter how much money you got. You’re going to be miserable, you’re going to be cranky, you’re going to be unhappy with the whole concept.

But, if you do it right, you get a partner who understands how to manage physicians and how to grow and build a business. Private equity guys, they don’t know anything about practicing medicine. They leave that to the clinicians. Clinicians are always worried, “Oh, they’re going to tell me how to practice…” No! They’re not going to tell you how to practice medicine. Every good group out there knows high quality care is the most important thing. Not saving a nickel, a dime or $10 by doing something different. But they know that if we build a really good organization, there’s tons of value that can be created through just efficiencies and synergies, as you described.

But they have built tens, dozens, hundreds of companies before, and that’s what they’re experts and that’s what they’re going to do with your practice. And they’re going to let you continue to be a good clinician.

I describe to physicians all the time, “Being a great clinician is a full-time job. Being a great CEO is a full-time job. You can’t do both.”


Elizabeth Sullivan: Yeah, absolutely. I think that’s a great point. And I think it does it offers a really incredible perspective for younger shareholders that may be a little bit hesitant and concerned about a transaction.


Rajesh Kothari: Absolutely. Well, Liz, thank you very much for saying great insights today, along with a lot of elements to help physicians and other health care entrepreneurs think about what they might do in a transaction.

Again, I’m Raj Kothari, with Cascade Partners, with Liz Sullivan, from McDonald Hopkins. Thanks for joining us for another Cascade Conversations!