Transaction Trends in the ASC Industry

Despite an otherwise sluggish economy and continued healthcare regulatory scrutiny of ancillary service arrangements among referring physicians, the ambulatory surgical center (ASC) industry remains an attractive and profitable investment for surgeons, hospitals and corporate investors. While less development of de novo (i.e., start-up) ambulatory surgical centers seems to be occurring due to the number of existing ASCs, there continues to be a frenzy of acquisition activity by hospitals, ASC management companies and other corporate investors purchasing a significant equity interest in existing ASCs. With purchase prices continuing to press upward, it is no surprise that many physician owners are considering whether now may be the right time to bring in a corporate partner.

Selling equity in an ASC to a corporate investor typically involves the following three primary components:

• Identifying an appropriate corporate partner and negotiating the purchase price multiple and other material terms of the purchase transaction;
• Negotiating the operating agreement, shareholders’ agreement or other document governing the ongoing relationship between the physician owners and the corporate investor;
• Negotiating the management arrangement between the ASC and the corporate investor.

This article addresses recent trends and issues that have emerged with each of these components.

Identifying the Corporate Partner and Determining Purchase Price

Choosing the right corporate partner can be a daunting task. If the objective is to simply maximize the purchase price, then it may make sense to “shop” the ASC to as many ASC buyers as possible. The physician owners, however, will retain an equity interest in the on-going operation. So, while maximizing price is usually the primary concern, it is not the only concern. Other important criteria to consider include: the corporate partner’s management experience in the geographic area and with the ASC physicians’ specialties; the corporate partner’s philosophy toward single-specialty or multi-specialty ASCs; whether the corporate partner is a publicly-traded, for-profit but privately held, or not-for-profit company; and whether the physician owners desire to partner with or support the local hospital or health system.

Once discussions commence, a corporate partner will engage in some due diligence of the ASC. Since diligence will include reviewing information about the ASC’s payor contracts, utilizing physicians and other confidential information, be sure that the corporate investor has executed an ASC specific confidentiality agreement.

The next step is to agree upon a purchase price. The purchase price of an ASC is typically determined by the following formula: the ASC’s EBITDA, multiplied by the negotiated multiple, less the ASC’s long-term debt, multiplied by the percentage being acquired. EBITDA means the ASC’s earnings before deducting interest, taxes, depreciation and amortization. For example, suppose an ASC has $1 million in EBITDA and no long-term debt, and the corporate investor agrees to pay a 7 multiple for a 51 percent equity interest, then the purchase price would equal $3.57 million (i.e., $1 million x 7 — $0 x 51 percent).

It is therefore no surprise that the most heavily negotiated term in a transaction is the purchase price multiple. Virtually all corporate investors are paying multiples in at least the range of five or more with a number of hospitals and national ASC management companies paying a multiple of seven or more. A corporate investor’s willingness to pay a higher multiple depends on a number of factors, including the corporate investor’s perception of the ability to attract other physicians to invest in and utilize the ASC, local competition, whether the ASC is located in a certificate of need (CON) state, what percentage of the ASC’s revenue is derived from an out-of-network strategy, as well as the ASC’s current physician specialty mix. The ASC may also try to use pro-forma (i.e., forward looking) EBITDA if it can establish that the ASC’s EBITDA will increase in the future.

At this stage, the corporate investor may request for the ASC and its physician owners to enter into a letter of intent. While executing a letter of intent does not generally require either party to consummate the transaction, physician owners should be cautious of a no-shop or stand-still provision prohibiting the ASC and its physician owners from soliciting or otherwise discussing a sale with any other investor for a certain period of time. A 45 to 60 day no-shop period may be reasonable in light of the time and expense that a corporate investor will incur to determine whether it would like to proceed with the transaction, but there are a number of issues for an ASC and its physician owners to consider before agreeing to be locked down to one suitor for what could be a material period.

In addition to the purchase price, the parties will also negotiate a number of other provisions of a purchase agreement, including the indemnity provisions and the non-compete. The indemnity provisions provide under what circumstances will the corporate investor have a right to recover all or a portion of the purchase price from the sellers based upon issues related to the ASC’s pre-closing operations. For example, if the selling physicians breach a representation in the purchase agreement related to pre-closing operations, then the corporate investor may have a right to recover all or a portion of the purchase price.

The market for a corporate investor’s indemnity rights have historically been capped at the full amount of the purchase price. However, the more recent trend is for indemnity rights to be capped at some smaller percentage (i.e., 50 to 75 percent) of the purchase price. While the market for indemnity caps in ASC transactions is still significantly higher than caps common in imaging sales transactions and other sectors of the healthcare industry, a percentage of the purchase price is certainly a step toward that direction.

Operating Agreement or Governing Document

A number of recent trends have emerged in governing documents between physician owners and a corporate investor. First, a corporate investor may require anti-dilution rights meaning that if the ASC brings in new physician investors, the ownership percentage of each existing physician owner will decrease while the corporate investor’s percentage remains the same. Due to the high profit margin of additional ASC procedures, syndicating the ASC to new physician investors could maximize an ASC’s profitability and a physician owner receiving a smaller share of a much greater profit could put more dollars in his or her pocket.

Nonetheless, it is important to at least set certain limits on anti-dilution rights. For example, the existing physician owners may want the right to approve the admission of any new physician owner or for there to be a dilution cap, so that any equity issued in excess of the cap (perhaps the first 10 percent) dilutes both the physician owners and the corporate investor on a pro-rata basis.

Another recent trend relates to the ability of the ASC or the corporate investor to redeem or buy-back a physician owner’s interests upon the occurrence of certain events, such as death or disability. The list of redemption events is typically very broad, as ASCs continue to formulate creative methods of ensuring that it is owned solely by utilizing physicians. While it could be in the best interests of all physician investors for the ASC to be owned solely by productive physicians who work well together, careful attention should be given to any redemption event that is subjectively determined or otherwise tied to a physician’s utilization, as it can pose both business and healthcare regulatory issues.

A closely related issue is the redemption price. While a number of methods exist, the most common is for the buy-out price to be determined based on the same EBITDA buy-in formula discussed above. However, the multiple will obviously be less than the multiple paid by a corporate investor and often varies depending on the reason for the physician’s buy-out. For example, death or disability is often associated with a two to four multiple, while breach of the non-compete or other “for cause” events could be closer to a half-multiple or some substantially lesser amount.

Another important negotiation point is the level of involvement that the physicians will have in the ASC’s decision making. While the corporate investor will likely control the day-to-day management or operations, the physician owners often have input on certain “major” decisions affecting the ASC (e.g., capital calls, incurrence of material debt, significant capital expenditures, issuing new equity, etc.). Careful negotiation of this list of material decisions is critical to the physician owner’s leverage over the corporate investor once the sales transaction has closed. Non-competes in the governing document, which prohibit physicians from owning another ASC while they are owners and for some period thereafter, are also heavily negotiated.

Management Arrangement

The management arrangement is not as heavily negotiated as the other components discussed above. However, a few important points to keep in mind including limiting the corporate investor’s ability to be reimbursed solely to third party out-of-pocket expenses and not corporate overhead, holding the corporate investor to certain benchmarks in fulfilling its management obligations (e.g., collecting accounts receivable consistent with historical operations), and agreeing upon a reasonable management fee, which is often in the range of 4 to 6 percent of an ASC’s net revenue.

ASCs continue to be a popular and attractive investment for physicians. For those ASCs that do not currently have a corporate partner, selling an equity interest to a hospital, ASC management company or other corporate investor can provide an ASC’s physician owners with a rare opportunity to participate in a substantial liquidity event. Engaging experienced ASC healthcare consultants is vital to understanding how these transactions are structured and the recent trends and issues that have emerged.

Jerry J. Sokol, JD, is a board-certified healthcare lawyer and a partner in the health law department of McDermott, Will & Emery. He can be reached at jsokol@mwe.com.

Joshua M. Kaye, JD, is an attorney in the health law department of McDermott, Will & Emery’s Miami office. He can be reached at jkaye@mwe.com