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Medical practices: hot properties of the 90s.

Rick Holdren is not at all surprised by the flurry of activity in the merger and acquisition of group practices. In fact, he predicted it. As president of the Houston-based RH Medical Group, Inc., Holdren has acted as an intermediary between buyers and sellers of medical practices since 1982. He's put together dozens of deals around the country and has spoken and written on the subject numerous times. "Hospitals and their key medical groups must plan acquisition strategies and targets now," Holdren warns. "Consolidation will be the means of survival in the future."

Diana S. Millman, a health department partner in the Washington office of McDermott, Will, and Emery, agrees. "Over the past six months to a year, virtually every McDermott, Will, and Emery office in the country has seen an increase in the number of physician practice acquisitions by hospitals, third-party payers, and large group practices," Millman says. "As we see it, this trend has been spurred by reimbursement changes (such as the advent of RBRVS under Medicare), the growth in managed care, the talk of heath care reform, and demographics."

Some hospitals and large groups don't have to shop for medical practices; smaller groups are coming to them. This is what's happening at Dean Medical Center in Madison, Wis. According to Medical Director William Rock, MD, FACPE, the group numbered 60 a decade ago. Now there are 300 physicians spread over 23 computer-linked sites, but this may not be the end of Dean's tremendous growth.

"We had four practices call within the past two months. We rejected one, agreed to take two and one withdrew its interest and wants to reconsider," Rock says. "Everyone is looking for refuge. They see themselves as helpless in the face of determination by state and federal governments of who's going to practice what kind of medicine where. The only security will be in large groups."

The Time Is Ripe

According to Holdren, this kind of activity is cyclical. In the 1970s, the action centered around hospitals. When there were no more private hospitals to be bought, investors began to buy each other. "We had a sleepy little unconsolidated 'mom and pop' cottage business called hospitals," explains Holdren. "Hospital Corporation of America (HCA) probably started it. It looked around and said, 'What are the opportunities?' Then it created a company to buy sleepy hospitals. It hired managers and recruitment firms and bought hospitals in multiples of 5, 6, and 7. Fortunes can be made in a relatively short time if you buy right, and the public gets enamored of the process. That's what happened in the '70s. "Three hundred hospitals were going out of business every year," Holdren says. "It was time to get into a new marketplace at its infancy and follow it through its mature growth cycle. The time was fight for a cottage business to be consolidated."

All businesses operate on a classic bell curve. At the beginning of the curve is infancy. At the top is maturity. After that, it's decline. The ideal position is "on the left side of a bell curve." This is where the buying and selling cycle for medical practices is now," Holdren contends.

Brent Miller, Director of Government Relations for the American Group Practice Association, agrees. "We got a phone call from a venture group recently saying it was interested in buying up group practices and was willing to invest $5 million to $30 million," Miller says. "Group practices are concerned about how to position themselves for the future. They are thinking about whether they should merge with a hospital, about how to buy more equipment to expand their sphere of influence."

Big Changes for Physicians

Many physicians who give up solo practice are becoming salaried employees or contract workers at hospitals. According to a study by the American Medical Association, the number of physicians working as independent contractors grew from 4.3 percent to 6.9 percent in 1991. Last year, the figure dropped to 5.6 percent. The drop is attributed to the fact that hospitals are now hiring physicians instead of paying them as independent contractors.

The IRS was in part responsible for the decline. The agency is cracking down on hospitals that hire independent contractors and misclassify their job status for tax purposes. Because there's a fine line between an independent contractor and an employee, the IRS established 20 factors that define independent contractors. Among them are direction, termination, and payment method. The more the service recipient directs and controls the worker, the more likely the worker will be considered an employee. Control should be limited to outcome, not means, the IRS maintains. Termination of an independent contractor cannot be accomplished unless he or she fails to meet contractual obligations. As for the payment method, the IRS' position is that contractors are paid per job, not by the hour, day, week, or month.

Legal Pitfalls

While the atmosphere of managed care, decreased reimbursement, high administrative costs, and fear of the direction of health care reform have boosted provider consolidations, the legal system has not kept pace, according to Millman. "In fact, obstacles to such transactions are imposed by current antitrust, tax exemption, Medicare fraud and abuse, and physician self-referral laws and regulations," she says. "Perhaps some of the most crucial tax issues arise on the hospital side of the equation; if the IRS finds that the transaction results in substantial 'private inurement' to the physicians, the hospital's taxexempt status may be jeopardized."

Millman says the IRS usually analyzes the total amount paid for the practice (including the types of items for which the physician receives payment) and the amount the physician is compensated for providing services to patients under any new employment (or independent contractor) agreement that the hospital enters into with the physician. "In addition, the Office of the Inspector General appears to view hospital acquisitions of physician practices as potentially troublesome," she notes.

In a letter dated Dec. 22, 1992, D. McCarty Thornten, Associate General Counsel, Inspector General Counsel, Inspector General Division, Department of Health and Human Services outlined his findings to T.J. Sullivan, Office of the Associate Chief Counsel, Internal Revenue Service. Thornton wrote that it is "necessary to consider the amounts paid for the practice or as compensation to determine whether they reasonably reflect the fair market value of the practice or the services rendered, in order to determine whether such items in reality constitute remuneration for referrals." He continued that "it can be inferred that the excess amount paid over fair market value is intended as payment for the referral of program-related business."

The following are considered red flags by Thornton:

* Payment for goodwill.

* Payment for value of ongoing business unit.

* Payment for covenants not to compete.

* Payment for exclusive dealing agreements.

* Payment for patient lists.

* Payment for patient records.

"We believe a very revealing inquiry would be to compare the financial welfare of the physicians involved before and after the acquisition," Thornton wrote. "Another revealing inquiry would be to compare referral patterns before and after the acquisition, specifically, whether the sellers become increasingly 'loyal' to the buyer."

Thornton summed up his feelings on the subject by saying that he believes "many of these arrangements are merely sophisticated disguises to share the profits of business at a hospital with referring physicians, in order to induce the physicians to steer referrals to the hospital."

"Other legal obstacles to hospital acquisitions of physician practices may be posed by federal and state antitrust laws, as well as by federal and state self-referral laws," Millman points out. "All of these legal issues must be analyzed before a practice acquisition is finalized."

Considerations in Buying or Selling

When Holdren appraises a medical practice, he considers the following:

Location. Metropolitan practices in growing suburbs generally are more valuable than those in mid-sized or rural areas. Practices in resort or ski areas command an even higher price.

Equipment. Because equipment doesn't have much value over fair market or book value, a conservative value between the two is used.

Real Estate. If a building is part of the deal, negotiations can be complicated. Holdren says there's a tendency for the sale to be based on the building, with the condition that the practice be included or appraised at a reduced rate. As a result, he counsels sellers to negotiate the sale of the practice and its assets first, with an option to buy the building later.

Specialty. Some specialties aren't worth as much because of patient allegiance. Holdren's rule of thumb here is: The higher the percentage of patient referrals (vs. physician referrals), the higher the practice value.

Gross/Net Income. The value of a practice is in its net earnings, Holdren says. For example, if the average income for a family physician is $77,000 nationally, for a practice that nets $110,000, the $33,000 overage is considered "excess capitalization." Holdren says that capitalization in this sense is only the number of years that goodwill is valuable. For example, if the goodwill value is 3 years times the aforementioned $33,000 overage, the value is $99,000, he says.

Deductibility. The greater the tax liability, the higher the sale price.

Accounts Receivable. They are not normally included in the sale.

Why a Written Appraisal Is Necessary. A written appraisal serves as a basis for buyer/seller negotiations and gives potential buyers something tangible to look at when considering the merits of the purchase. Millman points out that a written appraisal is also necessary in order to defend the transaction against potential challenge under Medicare's anti-kickback laws. Holdren advises that the appraisal be conducted by an experienced independent appraiser.

The Four Steps to a Sale

Holdren stresses that the following steps must be followed in order to successfully complete a transaction. The average time it takes to consummate a deal from beginning to end is about 6 months, Holdren says. Here's what's transpiring during that period:

* Prospecting for buyers.

* Getting a buyer to sign a simple contract, which includes earnest money.

* Taking the simple contract and putting it into final form.

* Arranging the financing and handling the sale closing.

Why Use an Intermediary?

Physicians can sell their own practices, and hospitals can use their lawyers or accountants to buy practices, but there are pitfalls to be avoided. "There are public corporations out there that we call bottom feeders," Holdren warns. "They are barely a business. They're a risky venture. Their stock isn't widely traded and fluctuates wildly," Holdren said. "If you sell to one of them, you could end up giving your practice away."

Holdren recommends calling Information America, in Atlanta, a firm that investigates the backgrounds of people and businesses. "That sounds drastic, but you're talking about selling your worldly goods." He also recommends talking to people the corporation has done business with previously.

What does it cost for an intermediary's services? Holdren's firm charges a flat fee to appraise a practice and a percentage of the selling price as commission. The exact figures vary around the country, and there are only about a dozen intermediaries that specialize in medical practices.

Questions to Ask an Intermediary

* How will the practice be marketed?

* Does the seller have a voice in choosing the buyer?

* Is the broker experienced in the specialty being marketed?

* Is the broker familiar with the community?

* How will the sale be financed?

* What is the time frame of the listing agreement?

The Role of the Physician Executive As medical director at Dean Medical Center, Rock says, his main concern is assuring quality as his group acquires new practices. But there are other activities that have been taking more of his time than he expected: dealing with behavior problems and umpiring disagreements between departments and among physicians. "Our social consciousness of sexual and verbal harassment is much higher now than it was. Part of that is reinforced by the threat of three potential lawsuits, two of which came from nurses. Discipline problems are the new guys on the block," Rock says.

Then there are the constant clashes between specialists and family practitioners and internists. As reimbursements have been cut, physicians have had to see more patients to earn the same amount of money. And if a physician loses a patient to another doctor--especially one in his or her own group--they bristle, and Rock has to step in. "Physicians are worried about who's going to do what," says Rock. "Urologists complain that the family practitioners are doing vasectomies, and surgeons are angry about who does what best. I also find myself refereeing department disagreements and having to sit in on all their meetings."

Why Hospitals Are Buying Practices

As hospitals struggle to stay solvent in the face of DRGs, competition, managed care, and reimbursement cuts, their leaders are looking at ways to lock in market share, to downsize, or to change the hospital's focus. "Practice acquisition remains a dramatic choice for hospitals," Holdren said. "This strategy is the fastest, most effective method to boost utilization and bring in new patients in bunches."

"The way hospitals play this game is a concept called 'vertical integration,'" Holdren says. "For instance, a hospital buys a three-person family practice group. It pays a 'three multiple.' For every $1 in family practice revenue, there's $3 in revenue that goes out of that practice. For example, twice a week, a case goes to an orthopedist. Three times a week, patients are sent to surgeons. Outpatient tests are ordered. These activities don't show up on the group's books." If the hospital pays a three multiple, it gets all the extra revenue for free. "It gets all the specialty revenue that used to go to someone else," Holdren explains. "If it buys out a practice for $1.5 million, it might get $4.5 million in hospital revenue. Specialists have to use the hospital." Holdren says "the only thing that's going to stop a hospital from doing this is independent state laws. It could be a violation of practicing medicine without a license law where a practice must be owned by a doctor, but that's not true everywhere."

Holdren says that, theoretically, doctors can't send their patients to a particular hospital. But there's a way to structure the transaction to minimize the risk. "The hospital buys the assets of a corporation--the equipment and lease--but it doesn't own the doctors. They are independent contractors. The hospital signs a long-term management contract to manage that practice," Holdren says. "Instead of the profit going to the dinic, it comes to the hospital as a fixed management fee every month. Most of the corporate entities are set up that way."

Wisconsin Gov. Tommy Thompson has proposed a state health care plan that would divide the state into four provider segments, one of which surrounds the Madison area. Although the plan will not be formally considered until this fall, the health care providers in the state have already begun to prepare. Large group practices have been acquiring small ones at a rapid rate, and hospitals are aligning themselves with the large groups and HMOs.

In Madison, the major health care players are the Dean Clinic, which has allied itself with St. Mary's Hospital; Meriter Hospital, which has a part ownership in Physicians Plus; and the University of Wisconsin Medical School, which has a group of about 400 physicians and which may merge with Physician Plus, according to Carl B. Weston, MD, Vice President of Medical Affairs at Meriter Hospital.

"We're working with Physician Plus to build up clinics in Madison," Weston says. "It recruits the physicians, and we help get the clinics going. "We have to be careful," says Weston of Meriter's relationship with Physician Plus. "It's not as easy to do as it was five years ago. We're part owner of the Physician Plus HMO. We're in a big managed care area. It's dose to 45 to 50 percent (penetration). You could not come into this town and set up a practice and survive."

How Insurance Companies and HMOs Are Involved

It appears some form of managed care will be the wave of the health care reform future. While they wait to see how things shake out, managed care and insurance companies are opening their own clinics. "I have an insurance company that comes to me, and it says it knows it costs $675,000 to start a clinic in a new area," Holdren says. "It would have to hire a professional staff, recruit doctors, find a location, make deposits on a lease, and fund its losses until the clinic becomes profitable." To save time and money, the insurance company can hire an intermediary to locate an established practice.

"If the company can buy the clinic for a 3 multiple, that translates to half of what it would cost to create a new clinic," he says. "For $350,000, the company could buy an existing clinic, save $325,000, and make a profit from day one. It would add its patients to the existing base and use the patients in the practice to bargain with hospitals to get a better rate."

Because many states require HMOs to cover a certain percentage of Medicaid and Medicare business or pay a tax penalty, Holdren says, the trend is for the companies to buy practices that cater to indigent patients. "That's how HMOs use medical practice acquisitions to beat the system," Holdren says. "The government encourages these types of 'normal competition.'"

Group Practices Branch Out

Group practices and hospitals in Wisconsin are competing for small practices to buy, according to William Rock. "But our goal is to keep small, rural hospitals open," Rock said. "We only scoop up tertiary care. What we have now is a road show. Half our specialists go out on the road, and send tertiary surgical patients back to our hospital."

When Dean is ready to add another medical practice, it looks at referral patterns first, then sends its vice president of outreach and a retired surgeon who knows most of the area physicians as front men to look at the operation. The financial aspects of acquisitions are handled by an attorney, a consulting firm, the vice president of finance, and the heads of information services and marketing. Then the principals vote on whether to acquire the practice. If it's accepted, the deal is turned over to the attorney for legal processing. Disadvantage of Selling a Practice Holdten admits there is a downside to selling out. What's gained monetarily may be offset by loss of decision making. "In America, we are still a nation of independent people. If a corporation owns your practice, you lost your autonomy. That's not a financial decision," Holdren says. Brent Miller agrees. "Group practices that are owned by physicians have a mentality totally different from that of a business," he says. "Physicians get into the governance, the mission, the ideals of physicians. If they sell, they could be subordinated to financial interests."

Further Reading

The following additional sources of information on hospital/group practice combinations were obtained through a computerized search of databases. For further information on citations, contact Gwen Zins, Director of information Services, at College headquartes, 813/287-2000.

Benvenuto, J., and others. "From 12 Solo Practicos to a Hospital-Based LMSG (Large Multispecialty Group) in 100 Easy Stops." Medical Group Management Journal 38(4):84,86,88 passim, July-Aug. 1991.

Coile, R. "Physician-Hospital Partnering: Medical Clinic Foundations, Practico Acquisitions, Morgors, and MSOs." Hospital Strategy Report 4(9):5-7, July 1992.

Golembesky, H., and others. "The Faces of Group Practice. Physician/Hospital Medical Foundations. A Future Model for Integrated Health Care." Medical Group Management Journal 39(4):96,98-100, 102-4, July-Aug. 1992.

Grant, P. "Weaving Together New Alliances. Competition, Collaboration and Change: The Emergence of California's New Integrated Delivery Systems." California Hospitals 7(2):12,31, March-April 1993.

Hastings, D., and Leopold, A. "Developing Integrated Delivery Systems: An Era of Change in Hospital-Physician Relationships." Physician Executive 18(6):18-21, Nov.-Dec. 1992.

Hull, B. "Tho Faces of Group Practice. Medical Groups, Hospitals Affiliate to Survive." Medical Group Management Journal 39(4):66,68,70-2, July-Aug. 1992.

Kopit, W. Vertical Restraints: The Proper Analysis of Physician Agreements with Health Plans and Hospitals." Hospital Law Newsletter 10(4):5-8, Feb. 1993.

McManis, G., and Stewat, J. "Hospital-Physician Alliances: Building an Integrated Medical Delivery System." Healthcare Executive 7(2):18-21, March-April 1992.

Siwicki, B. "Hospital, Clinic Morger Provos Advantageous, Perhaps Prophetic." Healthcare Financial Management 47(4):94, April 1993.

Slomski, A. "Practice Sales to Hospitals: Who Gets the Best Deal?" Medical Economics 70(4):136-40,143-6, Feb. 22, 1993.

Stromberg, R. "Now Modols for Hospital-Affiliated Medical Group Practice: The Use of Medical Foundations and Management Service Organizations." Hospital Strategy Report 4(9):1,3-5, July 1992.

Unland, J. "Group Practices and Hospital Affiliation of Medical Practices." Health Care Strategic Management 11(3):15-9, March 1993.

Donna Vavala is contributing Editor of Physician Executives and Managing Editor of College Digest, ACPE's bimonthly newsletter.
COPYRIGHT 1993 American College of Physician Executives
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Vavala, Donna
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Date:Sep 1, 1993
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