As more hospitals partner with doctors to create surgery centers, a new way to finance these joint ventures has emerged: participating bond transactions (PBTs).

Physicians who invest in PBTs to structure hospital-physician joint ventures are secured creditors, not equity investors, which means the business risk will fall largely on the hospital. Hospitals pay physicians interest on debt instead of holding an equity position in the surgery center. What's more, PBTs can yield high rates (generally about 10 percent to 12 percent - much higher than typical healthcare borrowing rates) of tax-exempt interest and offer facilities many of the same advantages tax-exempt entities enjoy.

Highly specialized debt
Participating tax-exempt bonds have been used to finance or refinance a wide variety of projects in the United States for more than 20 years. Only recently have surgeons used them to structure hospital-physician transactions.

Think of PBTs as highly specialized debt that targets physicians as investors and lets them participate in the success or failure of a hospital venture. On the risk scale, participating bonds have much higher risk than traditional tax-exempt bonds, but much less than equity joint-venture investments.

Participating bonds pay investors tax-exempt interest based on the economic performance of the entity on whose behalf the bonds have been issued. If the performance is poor in a given year and dips beneath agreed-upon levels, it would be possible for holders of participating bonds to receive little or no interest for that year. It's this relationship of interest to performance and other factors that makes the interest rate on participating bonds much higher than on traditional fixed-interest bonds.

In hospital-physician transactions, participating bonds generally represent a small portion of the total financing. Most of the capital comes from traditional 30-year, fixed-interest, tax-exempt obligations. In one recent PBT involving an ambulatory surgery center with a capital cost of $8 million, surgeons purchased $1 million of participating bonds. The balance of the capital cost consisted of a $1 million equity contribution from the hospital and $6 million of traditional tax-exempt financing.

My practice is devoted exclusively to PBTs. They're all I do. Our first PBT project involved participating bonds that were priced to pay 12 percent to 15 percent tax-exempt interest to physician-investors.

ABCs of PBTs
Besides the potential to yield high rates of tax-exempt interest, PBTs are proving attractive to hospitals and physicians for a number of other regulatory, financial and political reasons.

• Low risk. From a regulatory perspective, PBTs are low risk. The IRS has issued two favorable Private Letter Rulings concerning PBTs. More importantly, the Office of the Inspector General of the Department of Health and Human Services has reviewed a PBT and said in a letter that it had no questions and was requesting no additional information. Our firm believes that PBTs, properly structured, don't violate the Stark Law, the federal Anti-kickback Statute, the Civil Monetary Penalties Law or the Internal Revenue Code.
• Tax-exempt benefits. Facilities financed as PBTs can take advantage of numerous advantages enjoyed by tax-exempt entities. These advantages include tax-exempt financing, no property taxes, no sales taxes, greater purchasing power and the like. In our experience, PBTs have saved operating costs and taxes in amounts equal to 10 percent to 15 percent of collections. For example, let's take a physician-owned ASC that pays more than $1 million per year in taxes and distributions - $378,000 in property tax, $253,000 in sales tax, $228,000 in higher financing costs and $159,000 in income tax. The same facility, organized as a PBT, saved that more than $1 million per year in taxes and the doctors received about the same return on the bonds as they received on joint-venture distributions.
• Governance. One of the key features of PBTs is their ability to create opportunities for physicians to play a more extensive role in governance and management of charitable healthcare facilities. ASC projects, for example, typically involve the creation of a new charitable corporation, controlled by the sponsoring hospital, that will operate the ASC. Physician bondholders typically will make up 50 percent of the board of directors of that entity. A management company that's majority owned by physician bondholders would handle the day-to-day management of such an ASC.

Why should physicians consider PBTs?
Here's why physicians might consider PBTs, as opposed to traditional joint venture structures:

• Reduced business risk. ASC investments today have more business risk than they used to. There is often a good deal of existing competition. Medicare reimbursement for ASC procedures is frozen for four more years. A number of states have enacted legislation that make ASC investments less attractive. If physicians invest in an ASC PBT they'll be secured creditors, not equity investors. The business risk will fall largely on the hospital.
• Attractive rates of return. Participating bonds issued on behalf of a new ASC may be priced to pay interest in the 12-percent to 15-percent range. These interest rates aren't subject to federal or state income tax. They're also not subject to the alternative minimum tax. The pretax equivalent of these rates is 20 percent to 25 percent. Some ASC joint ventures produce higher returns than this. But the great majority don't.
• Reduced legal risk. ASC joint ventures often present varying degrees of regulatory risk. It is rare that lawyers working on them can render legal opinions that the transaction is lawful. However, PBTs typically don't present meaningful levels of legal risk and favorable opinions of counsel are available.
• Lower operating expense and taxes. ASC PBTs involve the use of charitable ownership structures. This means no property taxes, no sales taxes, no income taxes and lower costs of financing. These savings can amount to 10 percent to 15 percent of collections, annually.
• Less pressure to limit the number of investors. Joint venture sponsors often face pressure to limit the number of investors to those who can refer substantial volume to the ASC immediately. This means that younger physicians or physicians who've moved to town recently often aren't allowed to invest. However, these pressures don't exist with PBTs. In addition, it's easy with a PBT to add new investors later.

To the hospital's health
Let's not forget that PBTs are good for charitable and public hospitals. Among other things, PBTs let the sponsoring hospital preserve a far higher percentage of operating income; retain ownership of all assets and operations; preserve the low-cost operating environment of a tax-exempt charity; and greatly reduce the regulatory risks associated with hospital-physician transactions.