June 30, 2020

Baird Shares Insights on Physician Practice Management M&A and Due Diligence

Point by Point

This episode of Point By Point was produced prior to the combination of Waller and Holland & Knight.

In this episode, Don Moody, David Marks and Eric Scalzo, partners in Waller’s Healthcare M&A group, are joined by Jason Porter and Brett Skolnik, managing directors on Baird’s global healthcare team. These dealmakers discuss the physician practice management space and what both providers and investors can expect as it relates to M&A activity and due diligence in the coming months, particularly as a result of COVID and forced closures of practices. 


Morgan Ribeiro: Welcome to PointByPoint. This is your host, Morgan Ribeiro. I am joined by Jason Porter and Brett Skolnik, both managing directors at Baird's global healthcare team, and Don Moody, David Marks and Eric Scalzo, partners in Waller's healthcare M&A group. In this episode, we will discuss physician practice management and what both providers and investors can expect as it relates to M&A activity and due diligence in the coming months. Over the last three months, we focused primarily on the immediate response to the pandemic and the economic downturn. Now we are starting to turn our attention to the future and where we go from here. To get started, I would like to get the group's macroeconomic perspectives on the physician practice management space. Jason and Brett, I'll start with you from the economic standpoint.

Brett Skolnik: Look after months where most of the physician practice management sector were meaningfully impacted, we're finally seeing some positive signs within the sector. Generally the reopenings have gone better than expected, although a bit dependent upon geography for sure. Trends are still developing, and we need to see how patient volumes play out over the next two to three months. But physician offices, ASCs and dental groups all are ramping up nicely. As a result, we are having more discussions with companies and investors about ways to play offense in the sector or whether businesses are looking at tuck in acquisitions or more transformative transactions. There's definitely more comfort around COVID and the potential implications now that groups have gone through a shutdown. People can actually model the downside case, which is helpful. We still aren't going to see deal volumes back to where we were pre-COVID levels anytime soon, but we are hearing more and more interest in the private equity community in the sector. For quality companies, this should create opportunities for transactions as we move through 2020 into 2021. Finally, given the sharp reduction in deal volume due to COVID, we are seeing a tremendous imbalance between supply of new deals for investors and the demand for these transactions. At Baird, we are launching more processes and seeing more interest in companies looking to transact to take advantage of these dynamics. It's still early to see these trends impacting the physician practice management sector broadly, but we're already hearing a number of clients who are already back to pre-COVID levels of volume. So it's really just a matter of time before these businesses start reconsidering transactions again.

Morgan: Don, from a legal perspective, what are you seeing and hearing from your physician practice management clients?

Don Moody: Well the good news we're seeing is that things are tending to get back to normal; patient flows, both the medical side and the dental side, seem to be getting back up to pre-COVID levels, which is good. Companies seem to be bringing back personnel, folks who've been on furlough, so folks are getting their own house in order. As a result of that, the acquisition pipeline is also getting back to normal. So deal processes, either buy side or sell side, are picking up. People are revisiting transactions that perhaps were put on pause pre-COVID and are now getting back to that. At the same time, folks are looking for opportunities for those who didn't fare as well during this pandemic. So there's some distressed situations out there and/or practices that no longer want to be alone in this environment and are looking to align with an MSO or DSO.

Morgan: Okay. David, from your point of view, are there certain specialties or practice areas that have been impacted in different ways as a result of COVID-19?

David: Yes, absolutely. In addition to the areas that we've talked about already dental and others like dermatology that were very negatively impacted by We're seeing a strong rebound. There are some other specialty areas that as you zoom in and look at the particular practices in the particular revenue mix are having either unexpected or maybe expected but positive results and in some cases, opportunities for investors. So behavioral is one of those obvious examples where COVID had an impact in increasing demand for mental health and substance abuse services, and increased funding for it. The cares act, as just one example, allocated nearly a half billion dollars towards funding for mental health services. And the government also issued some waivers that really loosen some of the rules around telehealth that are important for behavioral health not having to go to an inpatient rehab clinic for a face to face visit. Being able to do it instead, through telehealth is really important to being able to get patients to actually do it. Show up And then be able to build for it. Some of the other areas where there's expected long term impacts and it's causing some interest among investors are areas like cardiology, where they're it's now documented that COVID-19 has had an impact on heart health and the although the expected impact and what that means for revenue long term is TBD. I think there's certainly increase interest, as well as interest in some areas like virtual care, which now has been proven clinically effective in some areas for cardiology, but that reimbursement isn't quite there. I think the general trends we're seeing in the marketplace towards telehealth will increase investor perception of value in areas like cardiology. Some of the other areas that are very interesting right now and are attracting careful scrutiny among more sophisticated healthcare private equity groups are areas like oncology COVID, has had some impact that people really see immediately impacts on home health. For example, And getting infusions at home will be very important long term, what that actually means in the context of the shift towards value based care and quality care metrics for reimbursement is something that needs to be determined and people are making making their bets right now. But another impact is actually during COVID. While it was really prevalent, and everybody was saying home, people were not getting preventive screenings, the impact that will have there's folks that have documented this and shown that it is likely to result in a shift in the patient mix in terms of late stage cancer. So some oncology groups that really are heavy on surgery. You it's possible that at some point, the mid future, you know, one to three year horizon, we'll see that their revenue will actually decrease because surgical intervention may not be an option for late stage cancers the same way it was before. So I think that'll create a lot of opportunities for investors who are willing to either put into cash and potentially get a discount or who realize that a shift towards radiation treatment and other opportunities may present a really great opportunity for investment if they're looking at that five to six year horizon.

Morgan: And things are continuing to shift quickly, so I think it's important for practices to continue to keep a pulse on what's happening and be in regular communication with outside advisors like yourselves, who can certainly provide insight on what we're seeing at a macro level. So in this evolving environment, I'd like to hear more about specifically the merger and acquisition landscape and what both buyers and sellers can expect between now and the end of the year. Jason, I'll start with you.

Jason Porter: Evolving environment is absolutely the right way to describe it. And really think about it in three phases: what's the near term look like, the next 4, 8, 12 weeks; the medium term, what those Q3 turn into and then going into Q4; and then really the more long term outlook, and that's a Q4 into 2021 and when something resembling normalcy returns. In the near term, you're certainly going to see tuck in transactions continue to occur. They're happening. They've been happening through COVID. And they're continuing to happen today. The vast majority of these deals, the diligence was primarily done pre-COVID. The valuation conversations were set pre-COVID. And so there's certainly been some potential restructuring of the components of the transaction, but those deals are able to get done and will continue to get done through this. We're also seeing a handful of distressed transactions that usually are involving groups that were struggling heading into COVID, and COVID certainly didn't do them any favors. And those will also be done in the near term. Then you move into the more medium term and mid to late Q3 and early Q4. I think we'll see some really interesting transactions evolve. Providers and consolidators never really acquired other large groups. And so I think COVID is going to be the catalyst for those platforms to begin consolidating. So you'll have sellers that might be constrained from a capital perspective, and they'll be much more open to structuring unique transactions or mergers where equity is rolled over and you're able to put two platforms together, allow them to have additional access to capital and continue to grow and pursue the strategy that they really had pre-COVID but starting from a longer base. And then moving into late Q4, early 2021, that's when you're going to start to see much more normal platform auction processes take place, once you've had a couple of months have normalized performance, and buyers can really get comfortable that the business performance is on even plane and they can underwrite the transaction and have the conviction needed to pay market clearing multiples.

Morgan: What are some of the main considerations currently related to valuations in the physician practice management space and how will that look different than it has in the past?

Brett: There are still several COVID-related items that are going to have meaningful impact on valuations in the sector. In the short term, we're still dealing with some groups that aren't back yet to pre-COVID levels, and there's really a question as to if sellers will want to transact when profitability is impacted by COVID, or certain instances where buyers might be willing to look beyond the COVID impacts, but visibility on what is the new normal is going to be really important. On the cost side, and Jason alluded to this earlier, for many groups, there's a lot of changes going on, some additional costs related to how they're changing operations or additional equipment, etc. Many groups are also taking advantage of the shutdowns to rethink certain operational processes and their overall cost structure. Traditional sacred cows that might have been untouchable previously are definitely being revisited by many. And as a result, there's going to need to be some history around these new cost structures in order to be able to get people comfortable, and that's all going to impact thinking around valuation. And it definitely depends upon what we're talking about, whether its existing platforms that private equity groups already own or if we're talking about sort of more of those tuck in smaller deals. For the platforms, growth prospects and the pipeline for new deals have always been and will remain critically important. Clearly this was impacted by COVID and showing a rebound in M&A is going to add to comfort around valuation for buyers and for the sort of the smaller tuck ins, add ons, etc., it was always about the synergy and utilization of ancillaries, and that won't change. Definitely seeing and will see more deal structures used in order to bridge gaps and especially in cases where you want to keep the headline valuation numbers at a certain level, earnouts can definitely be used to bridge the gap to help the buyers and sellers share risk. And then finally, leverage levels, debt markets, access to capital, all were pretty well impacted by COVID. There are some groups that are going to come through this better capitalized than others, and those better capitalized groups are going to have more flexibility in how they think about valuation and they're going to have more flexibility looking more towards long term where others that are more impacted are going to be more constrained and as a result could end up being more conservative on valuation likely.

Morgan: David, earnouts were mentioned earlier. Let's discuss those in more detail for a minute. What about earnouts for those who are sellers?

David Marks: Earnouts are a very important tool right now, particularly for practices that have valuation uncertainty. For the dental practices that have already recovered and already have had a rebound and can show sustained numbers, they're probably less important. But really for the types of practices in regions that have been really hit hard and don't yet have good numbers to back them up, or where there's some uncertainty, for example, some cosmetic practices that were the elective procedures and the volume of elective procedures that are higher profit, it's unclear when they'll come back and if they'll come back to the same extent. What earnouts in this context allow you to do is to say the buyer can pay a portion of the purchase price upfront that it's comfortable doing based on the number so far, and then later, if the seller is able to demonstrate that it can return to the pre-COVID levels, based on the metrics such EBITDA, then the buyer essentially trues up the purchase price to what it would have paid had it reached those EBITDA levels pre-COVID. There are things that buyers and sellers need to be really cautious about, as most people in the industry know in healthcare, generally the OIG has looked at earnouts as potentially suspect. They're really concerned about using earnouts to modify behavior or create incentives for driving up patient volume and business. In this context, we feel relatively comfortable, so long as certain parameters are followed, that the goal should be not behavior modification, but rather to solve for valuation uncertainty. And in that context, I think earnouts are a powerful tool. The other thing that a lot of folks should be careful about is making sure they're talking to their lenders regularly and making sure their strategy is vetted because lenders are going to be sensitive to earnouts and may want to treat it as debt.

Morgan: So Jason, from the buyer perspective, what are you seeing related to platform acquisitions?

Jason: Really, we're seeing two types of add ons. There are those where valuation conversations had taken place and were settled in a pre-COVID basis and those where it was a little bit too early to have those valuation conversations. Where valuation conversations had taken place, where numbers were put out there and either agreed upon or at least surfaced, I think buyers are doing whatever they can to maintain those headline numbers. Clearly they're using other structural elements besides cash to achieve that, they're using seller financing when there's limited or no additional third party debt available. They're using earnouts or contingent payments, which is an area as was stated before where clearly there are regulatory constraints to that, but they're being creative and they're trying to maintain headline valuation while introducing downside protection to them so that if something occurs with the business or the business doesn't return to its previous profitable self, they're protected. And then there's those conversations which are either were more preliminary pre-COVID or are just starting up now, where valuation had not been surfaced. I think that's where groups are still trying to maintain pre-COVID multiples because, as everybody knows, seller expectations do not move quickly, and if a group thought they were worth x in January or February, they're gonna think that they're still worth x for a while to come. But there again, you're seeing much more heavily structured transactions, transactions where the cash component is somewhat limited. Cash is still very important to sellers, will always be very important to sellers., but buyers are not exposing themselves or overreaching from a cash perspective. They want to maintain liquidity in house to the extent possible in case they need to deal with any future issues that pop up or any potential resurgence of the virus. So they're still pursuing it. They're trying to maintain headline values, but they're using structure where they can. And then I think the third piece is really around when do normal platform acquisitions take place? And when do groups feel comfortable taking a platform out to market and achieving the valuation that they expected on a pre-COVID basis? And, as was said before, that's really going to be, once you've seen a quarter or two of normal, consistent and steady profitability and business operations. And so that's late this year. That's early 2021.

Morgan: Brett, what about established platforms that are facing capital constraints from either lenders or sponsors?

Brett: Many groups are going to actually come through the COVID shutdowns intact. Some obviously won't make it out, but a significant majority will. But many of these established platforms are going to face capital constraints, either from their lenders or sponsors, which are really going to impact their ability to grow going forward. The buy and build model is capital intensive, and the only way to grow value is by doing more transactions. The groups that are going to be most impacted are going to be those who are struggling ahead of time, either with operational issues or capital structure problems. Those that had those issues going into COVID are going to be more likely to face lender constraints or other capital issues. Performing assets might no longer have support from a sponsor, and in those situations, they are going to look to other sources for additional capital. And that could be anything from a growth capital infusion from another investor, a merger with a similar size platform, which would also provide scale and allow for some deleveraging to the extent that there was a meaningful rollover, or an acquisition by a larger platform. I think we're going to see all of those options be utilized by folks out in the market.

Morgan: What about platform exit opportunities? Do you think in this current environment that we'll see more of that activity?

Brett: For the larger, more developed platforms that have demonstrated success over a longer period of time, they'll likely to be able to successfully test the market as early as later this year, depending upon how the pandemic evolves, for sure. The lack of deal flow with private equity is going to result in some groups aggressively pursuing some of these best in class platforms as things continue to improve. And so we expect that activity to pick up for sure. Those processes are going to look a little bit differently. There might be one-off discussions, although likely those will be fewer and far between. But the modified processes that we are seeing and that we are actually running currently in some deals at our firm are going to be more targeted, more interaction, dialogue and information sharing earlier on the process, and we don't expect this to change in the foreseeable future, at least while COVID is around and there are the challenges as it relates to travel, meeting companies, meeting managements, etc.

Morgan: Are there unique issues that are popping up as it relates to financial due diligence, and what can sellers expect buyers will focus on in a sales process in the current environment?

Jason: There's clearly, from a closing perspective, challenges in determining what networking capital is supposed to be, what's the target, and then how do you measure that? Do you measure it now at closing? Do you measure it in the future when things have returned to normal and compare it to what it was it closing? You've got to take into account the government programs, the additional liquidity that's on many of these groups' balance sheets, and really figure out how best to measure that. Going forward, a lot of these groups are rightfully using this as a way to make their organizations leaner. So their cost structure coming out of this on a normalized basis might not look like their cost structure coming into it. And so all of these things have to be taken into account, particularly when you look at a networking capital, and that not only goes to the other financial diligence question, which is really what are normalized earnings kind of during this period, what things have been implemented and done and what are the COVID adjustments? We've heard the term now, EBITDAC: earnings before interest, taxes, depreciation, amortization, and COVID. And I think you're gonna have to figure out really what that is, what that looks like, and the only way to do that is to truly document the things that were done over the last four to eight weeks and what's going to be done going forward.

Morgan: Don, what changes are you seeing in legal due diligence and the related representations and warranties that are specifically in reaction to the COVID-19 pandemic?

Don: Morgan, in our practice, we are certainly focusing on both the sell side transactions we're working on and the buy side transactions we work on, on COVID-related issues, and those fall into three categories as we think about them. One is around economic and funding, has this company or practice participated in any of the various COVID-related funding programs that PPP paycheck protection program, EIDL loans, have they received provided relief funds from HHS, do they get advanced payments of Medicare funds? Did they defer any payroll taxes? Did they get any state program funds? All of which may have come with terms and conditions that require some compliance and restrictions on the use of those funds, so particularly focused on those issues. Then we focus on compliance, both again with those funding programs that they may have participated in, as well as the various stay at home orders that states and municipalities may have issued, and then also around employment issues. You've got a lot of furloughs that have happened, you've got a lot of layoffs that have happened. Were those done correctly in accordance with labor laws and also around OSHA and termed OSHA and similar laws that would apply if you've had anyone who's been exposed or developed symptoms or diagnosis having COVID. And lastly, around operational issues. Were they shut down? If so, for how long? Where are they at in that process? Did they lay people off, and where are they in that process? Are employees back at work? Are they still laid off? Do they have patients or any personnel that were diagnosed with COVID? What has been done about that?

Morgan: Due diligence was complicated enough on these healthcare transactions before COVID, and this definitely adds another layer to things to look into. David, how has the pandemic and the economic downturn impacted reps and warranties insurance, and what are underwriters looking for wanting to exclude?

David: Well, I think we've seen an evolution over time. Early on, everybody in the industry was really focused on those areas that Don talked about in terms of participation programs as well as ripple effects and compliance. But what we saw really early on from rep and warranty insurance markets is a general exclusion of anything having to do with COVID. And I think that was especially true if you were trying to sign a deal and bind insurance really early on with a long lead time before you close. There was some reluctance in the process. What we've seen is general improvement. As buyers get better at showing that they've done due diligence to vet their predictions and expectations, both in terms of future numbers, accuracy, financial statements, as well as compliance with CARES Act program and other types of programs out there. There has been a trend in the insurance markets away from those broad based exclusions, but there is nonetheless very much an expectation that the buyers that come to the table be very prepared on an underwriting call to answer all those questions that Don went through and to show it not just for the buyer satisfaction, but to the insurance satisfaction that those issues have been addressed, that there's real accuracy and meat behind the financial statements as being somewhat representative of the company, notwithstanding the existence of COVID. So the more you can do from a diligence standpoint, the better off you are going to be from a rep and warranty insurance standpoint.

Morgan: Eric, in the pre-COVID world, any loans would almost always be paid off at closing; is that the only option for loans under the CARES Act, which has favorable terms and may be forgiven, or are buyers and sellers finding ways to be creative?

Eric: The short answer is yes. People are definitely trying to take advantage of or capitalize on the favorable terms of the loans that are out there. It comes down to what structure are you using for these acquisitions? Are you forming a new PC or do you have a separate PC that you're going to be taking over operations for the location or locations or do you no, leaving the PC in place. And it comes down to timing, for the PPP loan in particular, are you going to wait for the forgiveness period to end so the loan is entirely forgiven for closing? Are you going to sign the deal and wait and have a non simultaneous? Are you going to wait till the end for a simultaneous? Are you going to be able to and will your lenders get on board with a concept of you know, a lot of healthcare transactions you have transition services period post-closing delaying the transfer of assets and/or equipment to the buyer by post closing and will the lenders allow something like that? So folks are getting creative. It's taking seeking consensus from either your lenders or the SBA lenders for the PPP loan in particular, and different loans have different implications of course. The EIDL loans have restrictions on dividends, distributions out to the owners, so obviously, if you're doing a transaction that results in cash out to the owner, that's likely going to be a trigger or prohibited rather by the EIDL. So do you pay that off as if it was traditional debt despite its favorable terms, and/or do you treat the PPP loans differently? So it all comes down to the unique situation and the risk tolerance for the parties involved.

Don: I would add to that for the PPP loans, it was recently extended, as folks know, to allow additional time to use those funds, so that's kind of good news, perhaps bad news. That means the funds may not have been used entirely at the time of an acquisition. So kind of focusing on that, where are they in the use of those and whether or not that's transferable to a buyer is critical. Otherwise you might end up having to repay loans that you anticipated were going to be forgiven. And the other thing we're seeing is, what do you do about loans that have the potential that they're not going to be forgiven because there's a 60 day lender review process and up to 90 day SBA lender SBA review process, so that forgiveness process could take some period of time. So a way to approach that would be to have an escrow of funds set aside solely for those PPP loans that are outstanding. If they're ultimately forgiven, they could be released, but there are funds set aside, similar to the way you might do for a networking capital adjustment, more of a short term escrow.

Morgan: If there's a practice that's looking to do a transaction right now, they're considering their options, are there specific things that these organizations should be considering, any kind of practical suggestions from you all?

Eric: Definitely. Potential sellers need to be, just like any potential sale process, need to be getting their house in order, and part of the house is now the COVID-related operational issues that Don spoke about previously, the additional regulatory OSHA issues related with operating with somebody that may or may not have been diagnosed with COVID-19 as part of your staff, the government programs, the PPP and the EIDL and provider relief funds. So getting your house in order I think is very important for sellers, especially if reps and warranty insurance is going to be part of the transaction because as we all know, the due diligence will be due diligence, and so making sure that you can answer all the questions for the buyer, potential underwriters for any R&W policy, I think is really important to make sure the transaction goes as quickly as it can, and as smoothly as it can, given the uncertainties in the market.
In addition, one of the steps that needs to be done is getting in touch with the SBA lenders with regards to any required consensus part of the transaction and getting in touch with the SBA lenders, and in our experience it has proven difficult. They're flooded with requests, they've seen unprecedented amounts of loans, particularly under the PPP and applications coming through, so getting their attention has been difficult. And then once you do get their attention, getting them to consent to a transaction for this loan is all in very uncharted waters. So nobody really has the immediate answer, and they need to run it up the chain. So that's definitely one thing that needs to be thought through if you're going to market or if you're looking at acquiring in this environment is tackling that process early on, because the review time is lengthy and getting a response is often an extended process.

Jason: I think from a documentation standpoint and getting credit standpoint in a transaction, it's imperative to document what you did while you're doing it. There are a lot of changes that are taking place both organizationally structurally, financially, and it's going to be much more challenging in four to six weeks to try to think about all of the things that you did and document them kind of post fact. Really take the time now to sit down, write out the specific steps that were taken and the resulting financial implications and costs that were incurred so that you have the documentation ready to go when the diligence questions come, because they will come.

Morgan: Great. Thank you all so much for joining me today, and I look forward to future conversations with all of you.

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