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Defying the shaky economy, surgery centers continue to be among the most profitable businesses in the health care sector. It is not uncommon for well-run and properly utilized surgery centers to have earnings of up to 30 percent of their revenues. These kinds of profit margins have made Wall Street sit up and take notice. In fact, AmSurg, one of the largest public ASC companies, has had an almost 30 percent increase in its stock value over the last 12 months, a period in which the NASDAQ fell by nearly 30 percent. Another ASC company, Nashville-based Symbion, filed with the SEC on May 31, 2002, to become a public company. All of this excitement has led to the emergence of numerous ASC companies that are well funded with money from private equity funds, venture capitalists, and even public offerings. These companies are in the business of buying equity positions in ASCs.What does this mean for existing ASCs? Well, if you have not already done a deal with an ASC company, you may be faced with the decision of whether or not to sell an interest to and partner with one of these companies in the very near future. To be prepared for such a decision, it is important to understand why this trend is happening, how the deals are structured, and how to prepare for a potential transaction.
Why all the action?
In the ongoing effort to contain health care costs, freestanding outpatient surgery centers have emerged over the last several years as the most cost-efficient and patient-friendly environment for providing surgeries that do not require an overnight hospital stay. In fact, it is estimated that 70 percent of all surgeries performed in the US last year were performed in ASCs, up from around 15 percent in 1980.
Three factors have enabled ASCs to become extremely profitable. First, payors often believe that these facilities are more cost efficient than hospitals. Second, the comfortable environment of ASCs continues to attract more and more surgical patients. Third, healthcare laws have recognized ASCs as extensions of surgeons' practices and therefore allow properly structured physician ownership, allowing these physicians to give full reign to their entrepreneurial drives. However, unlike physician practices, which we now realize were always well run by physicians (much to the dismay of former physician practice management executives and shareholders), ASCs are businesses that are typically run independent of physician practices. Therefore, they are usually in need of qualified management that can enhance operations and profitability and provide necessary capital. This need has fueled the emergence of these ASC companies, which appear to have an insatiable appetite for acquisitions.
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How are the Deals Structured?
General Structure:
The ASC company will usually strive to structure its acquisition in a manner that best serves the tax interests of the physicians. In most cases, the entity that will operate the ASC after the transaction is completed will be a limited liability company ("LLC"), because this is the entity that provides the most favorable tax results when physicians are partnering with a corporate entity. It may be a newly formed LLC or a continuation of the LLC that already existed, depending upon the ASC company and the existing entity structure of the target ASC.
LLCs do not pay federal income taxes and are exempt from state income taxes in most states; they are taxed only at the member (i.e. owner) level. If you have a choice in deciding what type of entity to use for your ASC, you are best positioned for a transaction with an ASC company if your ASC operates as an LLC. If, however, your existing ASC is an S-corporation, that will not pose an impediment to doing a tax favorable deal, but the ASC would likely be converted into an LLC as part of the transaction.
In most ASC transactions, the ASC company will purchase an equity interest in the ASC. Since the entity that will operate the ASC after the transaction will likely be an LLC, the acquired equity interest would be member interests (the LLC equivalent to stock). Also, in many ASC company transactions, the ASC company will form a management agreement with the ASC after the transaction, in which the company manages the ASC for a fee based on a percentage of the ASC revenue, a flat fee, or some other agreed upon fee. Some ASC companies do not take a management fee; instead, they split the management obligations with the physicians, and neither party receives incremental payment for management services.
Percentage Acquired:
One big question that ASC owners wonder when contemplating this type of transaction is "how much of the ASC will the ASC company want to acquire?" The answer to this question varies depending upon the strategy of the particular ASC company, but there are two guiding yet somewhat competing principles. One principle is that the ASC company does not want to acquire too large of a percentage and dramatically reduce the physicians' share of profits, because then the physicians will not have the same commitment to the ASC. This is a lesson learned from the PPM companies, as well as from early generation ASC transactions in which the ASC companies were buying large percentages (often as much as 80 percent) in order to appease the selling physicians and to grow the ASC company revenues as quickly as possible. ASC companies are now more disciplined and often prefer not to acquire more than 30 to 40 percent to ensure that the physicians' and the ASC company's incentives are aligned after the transaction.
The other competing factor is the ASC company's desire to be able to "consolidate" the ASC's revenue. What this means is that under the accounting rules, if the ASC owns a certain percentage (51 percent), the ASC company can recognize the entire revenue of the ASC on the financial statements of the ASC company. Revenue and growth are critical to the stock performance of a public company. So, this provides great leverage for an ASC company. For a purchase price just over 50 percent of the value of an ASC, the ASC company gets to recognize (don't worry, not receive), 100 percent of the revenue and profits on its financial statements. "Recognizing" simply means that the revenue is reflected on the financial statements of the ASC company that are filed with the SEC and does not affect how much is "received" by the ASC company. Stock analysts and stock prices are greatly affected by changes in revenue.
These two principles converge to result in ASC companies typically acquiring between 30-51 percent of the equity of an ASC. It seems that deals are currently either done in the 30-35 percent range or at 51 percent, with the range in between being like a "no man's land." That is because the ASC company will either decide to buy 51 percent and consolidate the ASC's revenues, or otherwise buy only around 35 percent, and make sure that utilizing surgeons stay tied to the ASC with the remaining 65 percent ownership.
ASC Valuation:
The biggest question to physicians is always "How much will I get paid for the interest that is acquired?" The value of an ASC interest that is acquired by the ASC company is calculated by multiplying what is called EBITDA (earnings before interest, taxes, depreciation and amortization) by a number that is called the multiple, which is the most negotiated item in these transactions. Although many ASC companies will actually perform their own return on investment analysis and other analyses to determine if the acquisition is accretive, the common negotiation between the ASC company and the physicians is what the "multiple" will be. When deciding on the multiple, the company will consider if the ASC is located in a particularly desirable geographic area, if the EBITDA history is solid, or if it is based on pro-forma information (i.e. expected future earnings, not actual history), and various other factors.
Currently ASC companies usually pay physicians in cash. However, as they move further along the public company path, they may start to use company stock as part of the purchase price. For example, once the price is established, a portion would be paid in cash and a portion in stock. Paying the purchase price in this manner allows the ASC company to leverage its cash to do more deals. The benefit of using stock must be balanced against the dilutive effect on current shares. This stock provides the selling physicians with the possibility of receiving an "IPO kick" if the stock received is pre-public company stock. Of course, any stock received, particularly in a pre-public company, involves risk.
Other Key Terms of the Deal:
Once the parties agree upon what percentage of the ASC will be sold and the multiple, they have made an agreement on price and have jumped the largest hurdle. Of course, there are other key points that will need to be negotiated, including:
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How to prepare for a transaction
If you're considering partnering with an ASC management company, there are certain things that you can do to prepare. Here are three moves that may make your facility a more attractive buy and may help the process go more smoothly.
Divide and distribute the ownership pie: Facilities that are only owned by one physician don't have as much potential as ones that are owned by several. ASC companies will want to know that after the acquisition, the utilizing surgeons are tied in to the center with ownership interests and non-competes. Therefore, you may want to consider selling interests to your utilizing doctors to facilitate a transaction.
Do your due diligence: Research the ASC companies with whom you are talking and ask for references from centers with which they are currently affiliated. Most of these deals are done for two reasons. One reason is to take some nice cash out of your ASC on the portion you sell. The second reason is to reap the benefits of having the ASC company as the manager. This is the part that you should research. Find out if the ASC company really manages or just collects a fee.
Get professional help: You also should ensure that you have health care transactional counsel familiar with this industry and these types of transactions. The ASC company will actually want you to have competent advisors in order to facilitate a smooth transaction, so it does not become a drawn out process. You may even want to hire a transaction facilitator, separate from your health care counsel. This person can help you prepare the type of financial statements that ASC companies want to see, contact the ASC companies for you, and negotiate the "business" terms of the transaction on your behalf.
Prognosis on the Industry
Many of these emerging ASC companies are well funded, well managed, and are nicely positioned for the times, as there is great confidence that there will be increased demand for surgeries performed in the ASC setting. Naysayers have tried to equate this recent ASC company phenomenon with the failed PPM industry. However, there are some substantial differences that reject such a comparison. ASCs have withstood the test of time having been around for over 30 years, while the PPM was a short-lived concept. ASC companies are buying a portion of a physician's "ancillary" income, and not part of his or her historical practice income. The PPM's reaching into the physician's salary "pocket" is often perceived as the greatest flaw in the PPM model. Finally, ASCs are complex businesses. Although the surgeries themselves are extensions of the physicians' practices, the business operations of ASCs are truly distinct from the business operations of physicians' regular practices. To date, many ASC companies have been proving that they can truly add value in their management of this distinct business. And the public money is betting that they will continue to add such value into the future.
Jerry J. Sokol, Esq. is a health care partner in McDermott, Will
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