The final in our series of posts sharing key takeaways from panels at the Healthcare & Life Sciences Private Equity and Lending Conference discusses physician alignment strategies. I am joined by my colleague Sarah Ahmed in authoring the column.

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Physician Alignment Strategies: Physician Autonomy, Equity and Compensation Models, and Leadership

By Sarah Ahmed and Geoffrey Cockrell

Consolidation of healthcare provider services practices continues at a remarkable pace. Increasingly, the structures of larger consolidated practices are focusing on various aspects of physician alignment. Indeed, finding creative structures of physician alignment can be the difference between a private equity fund winning or losing their bids to acquire these practices.

One panel at our 15th Annual Healthcare and Life Sciences Private Equity and Finance Conference on February 20th explored the evolving structures and philosophies of physician alignment. Our expert panel included Daniel Brinkenhoff (Principal at Centre Partners Management LLC), Goran Dragolovic (Chief Executive Officer of Women’s Health USA), Jonathan Lewis (Partner at Sheridan Capital Partners), and Bill Southwick (Chief Executive Officer of QualDerm Partners). The panel was moderated by Geoffrey Cockrell (Partner at McGuireWoods LLP). The key take-aways from the panel included the following:

1. The most critical aspect of a successful physician alignment strategy is to understand what elements of the structure are most significant to a particular practice. For some, rehabilitating current income after the transaction is paramount. For others, some measure of autonomy over compensation is key. Understanding the physicians’ hot buttons is critical. Often that understanding involves educating the physicians on the various structural tradeoffs.

2. In all of these structures that involve future economics (income repair, rollover value in a subsequent sale, etc.) a choice has to be made as to whether those future economics will be more closely tied to local performance vs performance of the overall organization. The arguments for each approach tend to be more philosophical. Some sponsors prefer everyone pulling and benefiting together. Others prefer the physician’s economics to be more closely connected to the performance they can more directly influence.

3. Some of the newer structures allow physician groups to have autonomy over how current income economics are distributed among the leading physicians. Similarly, some current models move current income away from individual production to a sharing of local profitability. There is a mixed view among sponsors on whether connecting physician compensation to bottom line profit (vs top line revenue production) is a beneficial or complicating feature. The verdict is still out on those structures.

4. There are also varied approaches on physician equity ownership beyond rollover equity. Some sponsors favor wider physician participation as a key feature of physician alignment, while others are skeptical that physician interest is really that high and prefer to limit the availability of equity buy-in opportunities and the related dilution of the sponsor’s equity.

5. All sponsors recognize the difficulty of dealing with younger physicians who were nearly at partner level at the time of the primary transaction. The solutions are imperfect both in economic effect and tax treatment. Advance planning and strong current income plans for new doctors are key.

The next in our series of posts sharing key takeaways from panels at the Healthcare & Life Sciences Private Equity and Lending Conference discusses investing in the pharmacy space. It is authored by our colleagues Trey Andrews and Holly Buckley.

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Pharmacy Investment Trends: Market Consolidation, Non-Traditional Market Participants, and Other Activity – 3 Key Points

By Trey Andrews and Holly Buckley

Vertical consolidation of the pharmacy and drug delivery sector and the entrance of non-traditional players into the pharmacy space will accelerate disruption of the status quo in the drug delivery supply chain in coming years, according to experts who spoke on a panel at the Annual Healthcare and Life Sciences Private Equity & Finance Conference in Chicago on February 21, 2019.

Experts included Taylor Phelps, Senior Vice President at Raymond James, Billy Suddath, Managing Director, HCIT at Robert W. Baird & Co., and Kathy Contratto, Healthcare Technology Consulting Leader at RSM US LLP (moderator).

Here are three (3) key points from the panel discussion.

1, Vertical Consolidation. In 2018, there was significant consolidation in the pharmacy and drug supply chain sector, with non-traditional combinations between insurers and pharmacy benefit managers taking center stage in the market. Panelists noted that vertical consolidation should be expected to continue and will translate into other large market participants entering the drug supply chain. With respect to non-traditional players entering the pharmacy space, there are mounting concerns that significant disruption could be coming to the drug supply chain—particularly by online pharmacies delivering drugs to patients. Both acquisitions in and offerings via the online pharmacy sector continue to expand and in practice are allowing both traditional and non-traditional drug suppliers to reach customers on a much larger scale. Ultimately, panelists are seeing drug distributors consolidate the drug distribution channel in ways that allow distributors to deliver drugs directly to patients and control the entire drug delivery process.

2. Rise of Specialty Pharmacies. The fastest growing subsector in drug distribution is specialty drugs. Panelists cited data that the specialty drug market will very quickly become greater than fifty percent of annual drug spend in the United States. Currently, oncology drugs are the specialty drug category with the greatest annual spend. Panelists expressed that the prominence of spend focused on oncology drugs could be a factor in investors increased interest in infusion therapy centers, where patient access to oncology drugs has increased in recent years. Orphan drugs—drugs manufactured for small patient populations—continue to be the fastest growing subsector in the drug distribution space. Large-scale specialty pharmacies should continue to be able to take advantage of the speed and prevalence in which orphan drugs are growing on an annual basis. Regional specialty pharmacies, which tend to focus on a specific therapeutic class of drugs, will also be able to capture significant growth in this vertical model. Panelists explained that some hurdles could prevent significant growth for regional specialty pharmacies, including, the ability to obtain consistent access to drugs and to provide value add to patients by developing data to support the patient experience. Panelists also noted that large health systems are beginning to enter into the specialty pharmacy sector to avoid losing refill business to retail pharmacies. In the coming years, it is likely that hospital pharmacies will begin moving out into communities to offer drugs to patients through ancillary pharmacies.

3. Year of the Consumer. 2019 will be the year of the consumer with respect to pharmacies. Consumers continue to demand pricing transparency and increased access via online pharmacies will continue to drive pricing transparency. In combination with pricing transparency for consumers, drug price reductions from manufacturers continue to be a significant focus in politics. Panelists highlighted several congressional hearings and proposed administrative regulatory changes to how rebates are provided as likely to influence overall drug pricing. Panelists noted that pharmacies are continuing to promote medication adherence, for both clinical and economic reasons, which will continue to integrate pharmacies into value-based care models with the intention of reducing hospitalizations. Some pharmacies are currently offering drug adherence tracking and monitoring to assist patients, and the pharmacy sector should continue to expect these types of offerings to be developed and integrated.

The next in our series of posts sharing key takeaways from panels at the Healthcare & Life Sciences Private Equity and Lending Conference discusses investing in ophthalmology. It is authored by our colleagues Amanda Roenius and Holly Buckley.

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Key Opportunities and Issues in Ophthalmology Investments – Five Takeaways

By Amanda Roenius and Holly Buckley

Private equity investment in ophthalmology and optometry practices has remained steady over recent years, and, according to experts who spoke on a panel titled “Key Opportunities and Issues in Ophthalmology Investments” at the 16th Annual Healthcare and Life Sciences Private Equity & Finance Conference, held in Chicago on February 20 and 21, 2019, private equity investors still have their eyes on this space.

Experts included Brett Skolnik, Managing Director at Provident Healthcare Partners, Andrey Vakhovskiy, Principal at HIG Capital, and Andrew Welch, Managing Director at Revelstoke Capital Partners. The panel was moderated by Holly Buckley, Partner at McGuireWoods LLP.

Here are five key takeaways from the panel discussion.

1. With acquisition activity accelerating, the vision space remains ripe for investment. Investments of scale are often highly competitive. Experts commented that while investment in this space may have lagged behind some other healthcare sectors, such a dermatology and dental, investors have seen tremendous success over the past few years, and competitors have taken note. Experts estimate that while there are approximately thirty (30) investors currently in the market, the vision space remains highly fragmented, so there is still tremendous room for consolidation.

2. Physician alignment remains the key to success, but such alignment must reach beyond compensation. As is the case in numerous other subspecialties, the number of retiring ophthalmologists is outpacing the number of physicians who are beginning their careers in this space, which creates competition for recruitment of talent. This landscape puts additional pressure on investors to develop innovative incentive and alignment strategies. Experts discussed a number of these strategies, emphasizing that while raw compensation will always remain a consideration, other benefits and the cultural fit matter just as much. Investors should consider ways to engage younger physicians, such as through involvement in committees, research, platform development, and alternative work arrangements.

3. Investment in vision practices brings additional benefits to consumers through high-volume ancillary businesses and premium services. Many ophthalmology and optometry practices own ancillary business lines, such as ambulatory surgery centers and optical shops. While these ancillary businesses are often lucrative for investors, they also provide investors the opportunity to add value to the practice through the provision of proactive and comprehensive management and compliance strategies. In addition to ancillaries, vision businesses can diversify from a reimbursement perspective by providing premium eye-care service offerings, such as LASIK, premium intraocular lens, and dry-eye treatments, all of which are generally cash pay and provide healthy margins.

4. Retina practices present attractive investment opportunities, but such investments are often costly. The retina subspecialty has seen an increased demand for investment from private equity. Experts opined that this increase in demand is likely due to the unique dynamics of this subspecialty, including but not limited to injectable drugs, such as those used to treat wet age-related macular degeneration (e.g., Lucentis, Eyelea, and Avastin), which are highly profitable. Investment in retina also poses challenges, however, as the price for such specialty practices is generally high.

5. Experts predict a flurry of growth followed by consolidation in this space over the coming years. Transaction volume is expected to accelerate in the near future, with additional platforms being formed and add-on targets being acquired. Experts caution, however, that there is the potential for growing too quickly, urging investors to take careful consideration in selecting practices with whom to partner.

The next in our series of posts sharing key takeaways from panels at the Healthcare & Life Sciences Private Equity and Lending Conference discusses investing in companies operating under or negotiating corporate integrity agreements (CIAs). It is authored by our colleagues Tim Loveland and Helen Suh.

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Assessment and Management of Known and Unknown Risks: 6 Points on Corporate Integrity Agreements, Ongoing Investigations, and Other Challenges and Opportunities

By Tim Loveland and Helen Suh

There are opportunities and strategies for mitigating risk when investing in companies operating under or negotiating CIAs, according to experts who spoke on a panel at the Annual Healthcare and Life Sciences Private Equity & Finance Conference in Chicago on February 21 and 22.

Experts included Scott Brown, Vice President at The Edgewater Funds, David Campbell, Managing Director at Getzler Henrich, & Associates, LLC, Eric D. Coburn, Managing Director at Health Care Investment Banking, Duff and Phelps, Catherine Hess, Senior Counsel at McGuireWoods LLP, and Helen Suh, Senior Counsel at McGuireWoods LLP (moderator).

Here are 6 key points from the panel discussion:

1. There are multiple reasons to invest in companies currently operating under a CIA. Such companies, which may experience minimal growth during the term of the CIA due to the administrative burdens related to compliance, may be poised for significant growth once the CIA term expires. It is often difficult for such companies to balance sales growth and maintain the compliance obligations associated with a strict monitor. Changes in investment or ownership structures in companies with expiring CIAs may yield a revitalized focus on growth or provide novel opportunities for partnership. Sellers that are or have been subject to CIAs also demonstrate a particular resilience going through the process and coming out the other side. Such sellers have also made significant investments in compliance infrastructure, which may increase the comfort level of an investor partner, particularly an investor partner with a lower risk tolerance.

2. Continued enforcement efforts by the Office of Inspector General (OIG) have been focused on a number of high-risk markets. Some of the market areas where enforcement efforts have been focused in recent years have included compounding pharmacies, home health, hospice, nursing homes, and behavioral health (with a heavy focus on detox programs). The OIG’s investigation efforts infrequently result in CIA settlements, however, the cost imposed on companies that settle and agree to a CIA has also increased, as five (5) years is now the standard length of a CIA (previously, 3 years was common) and independent review organizations are required for many CIA parties. The OIG publishes an annual “Work Plan”, which identifies government enforcement priorities over the upcoming calendar year, and which provides invaluable insight into particular market focal points.

3. There are a number of different considerations for buyers and investors when engaging with target companies with existing CIAs or that are in the course of negotiations with the government regarding a CIA. It is imperative to ensure that a buyer/investor conducts comprehensive and thorough diligence on the target company prior to investment, including an in-depth inquiry into the circumstances giving rise to the CIA. As part of that process a buyer/investor should confirm that the target company is willing to address the issues that gave rise to the investigation or CIA. The target company should also be capable of incurring the ongoing cost of the monitor and other compliance obligations and have freely disclosed risks and documentation relating to the CIA during the diligence process.

4. There are also several circumstances in which the buyer/investor should reconsider the investment. For example, if the fraud alleged by the government goes to the core of the target’s business model, the business may no longer be viable after the implementation of a CIA. The investment risk would also shift substantially if the target insists on engaging in litigation rather than entering into a CIA, which may not be conducive to a culture of change and may lead to exclusion from federal government programs (and potential abandonment by commercial payors as a result). In addition, understanding the scope of the CIA is imperative, as prospective buyers/investors may inadvertently take on the risk that the CIA opens the buyer’s entire business to scrutiny as well.

5. There are several structural tactics to consider during deal negotiations with a company under a CIA which an investing party may utilize to lessen the impact the CIA may have on investor returns. Some tactics include longer and larger escrows, representation and warranty insurance (which could be very expensive for certain high-risk markets identified above and typically exclude known liabilities), escrow release dates tied to chart audits, or certain other special indemnities.

6. Seller should also consider how best to minimize the impact of the CIA on the value of the business moving forward. There are a number of operational tactics that might be employed. One such way to demonstrate the value of the business is to ensure that certain quantitative metrics are set up to track information to present to prospective investors. In addition, consistent management oversight, accountability, and involvement demonstrates commitment to the future of the business and may be viewed positively by prospective investment partners.

The next in our series of posts sharing key takeaways from panels at the Healthcare & Life Sciences Private Equity and Lending Conference discusses investing in designated primary market makers and private placement memorandums. It is authored by our colleagues Tamara Senikidze and Gerald Thomas as well as George Douvris of RSM US LLP.

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Advanced Issues for DPM & PPM Transactions and Platforms: Business Tax Issues in Light of Tax Reform – Key Takeaways

By Tamara Senikidze, McguireWoods LLP; Gerald Thomas, McguireWoods LLP; and George Douvris, RSM US LLP

In light of the 2017 tax law, commonly known as the Tax Cuts and Jobs Act (TCJA), it is important for a private equity firms investing in DPMs and PPMs will need to evaluate each business its invests in to determine what type of entity should be utilized, according to experts who spoke on a panel at the Annual Healthcare and Life Sciences Private Equity & Finance Conference in Chicago on February 21 and 22.

Experts included George Douvris, Tax M&A Partner, RSM US LLP, Linda Epstein, Controller, Silver Oak Services Partners, LLC, and Shane Goss, Managing Director, Huron Consulting Group. The panel was moderated by Gerald Thomas, a partner at McGuireWoods LLP.

Here are five key points from the panel discussion.

1. The key components of tax reform affecting PE-backed health care companies include the pass-through tax deduction, interest expense limitation and bonus depreciation.

2. Healthcare pass-through companies performing medical services and employing physicians, nurses, medical assistants, or healthcare professionals are generally not eligible to receive the benefit of the new pass-through tax deduction. Yet, some companies are exploring ways to restructure their businesses to take advantage of the deduction in limited settings.

3. Many of the elements of tax reform (e.g., repeal of the interest stripping rule, adoption of limitations on deductibility of interest, limitation computations at partnership level, exclusion of certain trades and business from limitations, and expanding the definition of “qualified property” in the context of business depreciation) continue to evolve as additional regulations and guidance are issued by the IRS, leaving practitioners and taxpayers in a bit of flux as the new rules are navigated this current filing season.

4. The general consensus is that more proactive planning and collaboration between taxpayers and their tax return preparers/attorneys is necessary to understand and properly navigate the new rules.

5. The new tax rate structure is generating significant discussion related to tax entity choice (corporate vs. pass-through). While current entities are ultimately not making any changes to their entity status, new platforms and funds are spending considerable time determining what type of entity makes sense for them.