Physician practice management companies: A failed concept. (Book Excerpt).

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IN ORDER TO SURVIVE, a business must create value and capture some of that value. The health care industry in the United States creates value, for consumers. The "captured value" becomes income for health care workers and return on capital for investors. It is instructive to look at a failed concept, an idea that failed the test of the marketplace. We will look at physician practice management companies (PPMCs), a concept that caused massive financial problems for thousands of doctors. PPMCs failed because they failed to create value.

The concept

PPMCs attempted to add value by bringing management services to physicians and facilitating access to capital. Further, PPMCs proposed the development of multispecialty delivery systems by linking together previously independent practices and contracting with national managed care organizations (MCOs) or insurers. The aggregation of independent practices into a network was promoted as a way of increasing negotiating power when dealing with MCOs and other payers.

"The business model originally promised by the industry had been heralded as a vehicle endowing physicians with the financial capital they would need to harvest the synergism of larger groups, to build sophisticated clinical information systems that would help to manage care more efficiently and to develop as a countervailing power against the growing market clout of the managed care industry. The advertised idea was to create genuine value that could be shared at least by physicians and their capitalist allies in the financial markets, but perhaps also by patients, in the form of lower prices or higher quality." (1)

Finally, PPMCs accelerated the growth of their networks by using venture capital funds and money from the sale of stock to purchase thousands of physician practices.

The reality

The two largest PPMCs were Phycor and MedPartners. MedPartners went public in 1995 and had almost 6,000 physicians in acquired practices. Revenue grew from $2.6 billion in 1994 to $6.7 billion in 1998; however, 1994 profits of $80 million turned into a loss of $1.2 billion in 1998. (2) The stock price was as high as $30 in 1997 and had fallen to $1.50 in 1998. (2) By 1998, MedPartners had exited the PPMC business and was reborn as Caremark, a pharmacy benefits company. Phycor went public in 1992 and had 3,800 physicians in acquired practices. In 1996, the company reported earnings of $81 million and a stock price of $40. By 1999, the company reported losses of $444 million and a stock price of $0.10. Other PPMCs had similar trajectories.

The problems

Traditionally, running a physician practice was focused on managing a small staff of office employees. Physicians managed their own practices, using accountants, lawyers and other outside consultants when necessary. Large physician groups often hired professional managers. In the 1980s and 1990s, running a practice became more complicated. With the disappearance of "usual and customary" billing arrangements, physicians found themselves dealing with complicated managed care contracts and multiple fee schedules. Paperwork multiplied, as insurers required detailed documentation and layers of administrative approvals. Many practices required additional management expertise, which PPMCs promised to provide.

Did PPMC management services provide value to the practices in their networks? Some practices found small increases in collections, as a few PPMCs were able to implement better billing processes. However, the PPMC industry was able to offer little that saved money on practice operations. Physician owners had always been careful to control costs in their own practices and the PPMCs added little in this area. In fact, the scattered structure of the PPMC network made it more difficult to manage individual practices. Where physician owners had carefully overseen daily operations of a small office, PPMC managers were supposed to run a network of perhaps thousands of physicians scattered in hundreds of offices. The PPMCs failed to meet this challenge. William R. Dexheimer, co-founder of MedPartners described the dilemma. "I have felt that the tools to manage the industry have been running significantly behind that growth. By "tools" I'm referring to resources such as knowledge base and human capital, but above all I'm referring to the software and other elements that make up those all-important systems." 3

The PPMCs were unable to manage the system they had created. In some cases, the PPMCs produced a negative synergy and destroyed value, as the new arrangement was less efficient than the previously independent practices. Most physicians were disappointed to discover that PPMGs added little or no value to the management side of the practice.

Small physician practices had limited capital requirements. With a traditional office needing little more than furniture, exam tables and simple diagnostic equipment, cash flow from the business was able to finance most capital expenditures. Successful practices were able to borrow money from local banks or vendors for investment in buildings or expensive equipment. It is not clear that physician practices ever suffered from a shortage of capital. Perhaps PPMCs could provide easier access to capital in the form of loans or lease arrangements. In fact, this made little difference to most PPMC practices. Most of the capital raised by the sale of stock was used to purchase practices. Little was invested in sophisticated clinical information systems or other management technology.

For many physicians, the idea of becoming part of a larger network appeared to have real advantages. Independent practitioners found themselves competing in a market of large insurers and large MCOs. Physicians in large group practices were able to resist many of the pressures from MCOs. Using the leverage of a large network, PPMCs promised to negotiate more favorable managed care contracts. A physician could have the independence of a solo practice and the negotiating position of a large group. PPMCs attempted to create real value by improving the market position of their physicians. This also was a failure.

Our analysis of the physician dominant market can help explain the failure of PPMCs to improve the market position of previously independent medical practices. Doctor dominance requires more than improved bargaining clout with MCOs and buyers. A dominant physician group is also able to minimize rivalry among physicians and maintain high entry barriers that keep new physicians out of the market. PPMCs had no effect on physician rivalry or entry of new physicians into a geographic market. In addition, it is not clear that PPMCs were able to negotiate unusually favorable contracts. This is because PPMCs misunderstood an important concept: medical markets are geographically limited. The PPMCs thought multi-market size would be an advantage against national MCOs. In fact, national MCOs became successful by treating each geographic market as a separate venture. A national network that includes thousands of doctors will have little bargaining power in markets where network physicians are a minority. In most urban m arkets, MCOs found plenty of non-PPMG physicians who were willing to sign contracts. The MCOs were able to form networks with or without PPMC physicians.

Financing failure

Business failures are common. Numerous network PPOs and other loose confederations of independent practices have disappeared without a ripple. The failure of PPMCs would barely be remembered except for the financial dealings that propelled the concept. PPMCs were not simply management companies contractually agreeing to provide services to a practice. PPMCs purchased the practices in their network. The financial failure of the PPMG industry also pushed many practices to the brink of financial disaster.

The legal details of the purchase arrangements between PPMCs and their practices are so complicated that many knowledgeable physician participants are confused. Often physicians would sell only portions of their practices. The physician and the PPMC would become co-owners of the practice. Some physicians received cash for their practices. However, most physicians received stock in PPMCs in exchange for assets in their practice.

Stock purchases are common on Wall Street. Mergers and acquisitions often involve stock. The problem with PPMGs was that their stock was overvalued. A stock's current trading price is essentially an educated guess, using all available information about the company's future earning potential. Market theory and empirical evidence suggest that markets are usually pretty good at determining the "correct" price for a stock. However, investors sometimes overestimate a company's earning potential and overvalue a stock's price. The dot-coin craze of the late 1990s is an example, as small Internet companies were unable to achieve the earning levels implied by their stock prices. Similarly, PPMCs convinced investors that the acquisition of physician practices would fuel earnings growth as better management practices were implemented and the networks negotiated better contracts with MCOs. As noted, the efficiencies and improved contracts never materialized. PPMCs were temporarily able to "grow earnings" by buying more practices. However, the projected profits vanished and investors re-evaluated PPMC stock prices. As stock prices collapsed, many physicians realized they had sold their practices for nearly worthless stock.

In summary

Is there a lesson? Famed investor Warren Buffet claims he never buys a company unless he personally understands the business. He admits he has missed a few real opportunities in the high technology sector. However, he is pleased to have avoided many disasters.

Many physicians entered into PPMG deals without completely understanding the concept. Perhaps the lesson is to simply avoid a deal that does not make sense. Understand the market. Understand the business. If you, as a buyer, seller or partner cannot clearly understand how a transaction creates value that you can capture, walk away.

References

(1.) Reinhardt, U. "The Rise and Fall of the Physician Practice Management Industry." Health Affairs. Jan.-Feb. 2000, 19(1):42-55.

(2.) Financial data from MedPartners annual reports, 1996, 1997, and 1998.

(3.) Dexheimer, W. Beyond the Smoke and Mirrors, Turmoil in the PPM Industry. Montgomery, Ala., Starhill Press, 1999, p. 83.

Stephen E. Kraft, MD, MBA, practices ophthalmology in St. Louis, Missouri. He is director of continuing physician education at the Washington University Olin School of Business, assistant clinical professor of ophthalmology at the St. Louis University School of Medicine and a health care consultant with Clinical Intelligence. He can be reached by phone at 314/935-7040 or by e-mail at [e-mail].