Managing in a merger and acquisition era.

Managing in a Merger and Acquisition Era

Medical group administrators are quickly learning what big business has known for years--mergers and acquisitions represent a new and powerful option. If this option is to be employed successfully, however, group management has to understand the terms and be prepared well before merger or acquisition talk begins.

The health care marketplace has changed drastically in the past few years. Terms such as "market share," "vertical integration," "forward diversification," and "capitation rates," as well as the activities they describe, are commonplace. Group practices have to understand these terms and the concepts that underly them if they are to plan for the future on the basis of their members' goals and interests. Past competitive strategies of groups have been based on the "experience curve." The most experienced producers of medical services (e.g., groups and partnerships) would be able to expand. Reliance on the experience curve did not explain how some solo practitioners could be so successful, however. Three strategies may account for this unpredicted success: * Cost leadership. This is the strategy

that many consider in keeping their

office visit charges lower than those of

colleagues and in contracting with IPAs

and HMOs. * Differentiation. This strategy involves

concentrating on the provision of high-quality

services, on the excellence of

the group's reputation, on high

technology, or on other specific aspects of

health care delivery. * Focus. This strategy involves

servicing a particular market--for example,

selecting expansion areas where there

is little competition or ideas that are

unique to a given market area. With hospitals entering the ambulatory care area because of declining inpatient revenues, many groups are considering merging medicine and management. Solo practitioners are considering joining more established groups that offer reduced competition, the advantage of prepared plans, and reduced cost to maintain a private practice. Groups are considering joint ventures with hospitals in the ambulatory care area for both market share and capital expansion reasons. Hospitals seek to establish feeder networks, as well as to prevent takeovers and to assist groups to amalgamate other practices. Typically, emergence for a group into a new marketplace begins with experimentation, growth of the experimental entities, sorting out unprofitable clinics, and then coordination of the new entities with the original successful model. An example is the rapid development of ambulatory care centers in the past five years. Unfortunately, many of these centers failed, due to poor management, lack of capital, or poor location. Those that remain, however, are in a stronger position to expand through joint ventures or franchise opportunities.

What's a Practice Worth?

Location. Generally, metropolitan practices in growing suburbs have more value than those in mid-size or rural communities. Practices may sell for as much as "a year's net" in a resort, ski, or other desirable area. Equipment. Except as a part of the total "ongoing" practice, equipment generally has little value over "fair market" or "book value." Therefore, a conservative value between "fair market" and depreciated "book value" is probably an accurate evaluation in an appraisal. Real Estate. Ownership of a clinic building generally makes a total practice and clinic sale more difficult to negotiate simultaneously. There is a tendency for the buyer to purchase the clinic real estate and ask that the practice be "thrown in" or appraised at a greatly reduced value. It may be more effective and certainly less complicated to negotiate the sale of the practice and its assets with an option for purchase of the building at a later date. Specialty. Some specialties have a reduced value because of the difficulty in transferring patients' allegiance. Generally, the higher the percentage of patient referrals (versus physician referrals), the higher the practice value. Gross/Net Income. In theory, the value of a practice is its "excess earnings" capability. For example, if a family practice physician's average annual net income (nationally) is $77,000, a practice netting $110,000 per year would have $33,000 "excess capitalization." This translates into a "goodwill multiple." The higher the multiple, the higher the practice value. Accounts Receivable. Because it is difficult to value accounts receivable, they normally are not included in the sale. The buyer may receive a fee for collecting the accounts receivable on behalf of the seller. Deductibility. Generally in a practice sale, what is good for the buyer is bad for the seller, and vice versa. This is a difficult area to assess because group physicians have varying tax situations. The greater the tax liability, the higher the sale price. Terms. Each negotiation is unique. The seller wants "cash at closing," and the buyer wants a "payout based upon the future earnings." The ultimate compromise is partially dictated by what a lending institution will finance. In a nation that is quickly becoming over-doctored and is already burdened by the cost of surplus capacity in the hospital field, experienced marketing is going to become essential for survival. Increased competition from lower cost alternative providers, new medical technology, and a third-party price revolt will cause further complications for organizations that have not already diversified. Hospitals that do not initiate cooperative marketing programs with physicians now may find themselves locked out of such opportunities in the future. Primary care physicians will be able to finance new marketing efforts only by collapsing the referral system and integrating forward. They will then recapture some hospital and specialty revenues they have referred out for the past two decades. Such restructuring will come not only from individual family physicians but also from emerging primary physician networks and multistate corporations. Forward diversifications will pull selected specialty income back into the exploration company. Hospitals and specialists must realize that economic reordering is long overdue primary care physicians will no longer be content to be disproportionately rewarded. The cost of marketing must be borne throughout a financially integrated system of care and not assumed on the front end by primary care physicians alone. Hospitals are left with very little time to adjust to these new realities. Administrators and boards that have lived on cost plus reimbursement will not easily make the change to a cost efficient competitive operation. Bankruptcy, acquisition, merger, changes in the core business, and loss of business to a new generation of investor-owned ambulatory care centers will change the face of many U.S. hospitals in the next five years. At least one major hospital management company is quietly sending "swat teams" to target cities to acquire or seek joint venture partners. A team descends upon a community for a 90-day "blitz," calling on all primary physicians. Initial conversations are "friendly and light." The range of initial responses determines the type of "bonding agreement" the team will develop for future meetings. Examples might be acquisitions, marketing assistance, practice acquisition assistance, or other "assistance packages" designed to develop a future relationship. The key to this program is concentration on "splitters" and "nonusers." (Splitters are groups that use more than one hospital for admissions. Nonuser physicians and groups have a relationship with a competitive hospital and use that hospital exclusively or almost exclusively.) This type of "benefit" selling is done quietly, discreetly, and imaginatively.

The Partnership Question

Many physicians/groups seek joint venture partners in association with other physicians, groups, hospitals, or "managed care" providers. The advantages of this strategy are: * Consolidation through partnership

often results in partners realizing

benefits through "economies of scale." * The right partner, selected to balance

management skills and interests, can

lead strength to the overall

management of the practice. The best

partnerships create a "synergy," where far

more is accomplished than could be

done by the individuals alone. * The increased capital base generated

through acquisition provides faster

growth and the ability to investigate

other acquisition opportunities. * A partner may provide the confidence

and psychological support needed to

implement a new structure. Often, a

partnership is nothing more than an

arrangement where two individuals

can muster the collective courage to

do what they fear to do independently. The disadvantages of the strategy are: * The success of a partnership depends

upon the ability of the partners to be

compatible and develop a good

working relationship. This is a critical

drawback of a partnership and

becomes more critical with an increase

in the number of partners. * A partnership will add financial strain

to the business unless the partnership

provides revenues sufficient to

support the additional overhead expense. * A partnership is no better or worse

than the partners. An active partner

should never be selected on the basis

of financial need alone. * Creating a successful partnership

requires that all details--retirement, buy-outs,

dissolution, etc.--be addressed at

the beginning in a legal form. Creating a successful partnership hinges primarily on the selection of partners and the development of a structure that will maximize the association and minimize the opportunities for future conflict.

Steps to a Successful Acquisition

A large percentage of sales are abandoned because of confusion and communication gaps. It should be decided beforehand who will "orchestrate" the negotiations and sales agreement. Often, there is no time to locate appropriate advisors once a good opportunity is located, so the team should be ready in advance. Also, advisors can help plan the acquisition strategy and provide objectivity in deciding many of the issues raised in the process. Identify the right opportunity. First identify everything that would make a practice desirable--location, cash flow, etc. Categorize the wish list into "must have," "want to have," and "it sure would be nice if." For example: Must be primary care. Must be within 20 miles of city. Must have $200,000 a year gross. Want retiring doctor to stay on 3 months. Want to be within 10 miles of city. Want no obstetrics in the practice. It sure would be nice if it was within walking distance of the hospital. It sure would be nice if the retiring doctor would stay on one year. Then locate practices available for acquisition. In the personal approach, a doctor approaches a buyer at a meeting or approaches the hospital administrator directly. In direct solicitation, the buyer aggressively approaches "target" practices for possible acquisition. Finally, in brokered arrangements, the buyer uses a third party to initiate confidential blind inquiries on its behalf. This approach is useful when confidentiality is a consideration. Independent valuation of identified practices. Step two is to determine the relative worth of the targeted acquisition. A qualified medical practice appraiser can provide an independent analysis of the practice's fair market value, taking into account such factors as practice activity, financial data, the number of active and inactive charts, the desirability of the area, competition, and types of procedures performed. In addition, the appraiser should be able to provide the worth of the practice based on the buyer's economic position, the cost to create an equivalent cash flow, the cost of not acquiring the practice, and the cost of staffing, maintaining, and running the practice. An independent appraisal establishes credibility and provides the basis to begin negotiations. Negotiating price and terms. Each transaction should be approached on its own merits. It is in this critical phase that most ventures abort. A check list of all important items should be made so that nothing is left out. Many factors besides price and terms enter into the final cost of a practice, including: * How long will the selling doctor

remain in the practice? * How will the selling physician be

compensated? * What is the distance and duration of

the noncompetition agreement? * How will outstanding receivables be

handled? * Under what structure will the new

practice operate? * What are the tax allocation

implications of the sale? * How will the transactions be announced,

if at all? * If a new doctor is involved, how will he

or she be introduced to patients and

referring physicians? Finalizing the transaction. The final and most important steps in turning the "agreements in principle" into written agreement documents are arranging any needed financing, meeting all technical and legal requirements, and signing the closing documents.

Richard C. Holdren is President of RH Medical Group, a medical practice appraisal and brokerage firm in Houston, Tex.