ASC Equity Transactions in 2007:

ASC Equity Transactions in 2007:
Emerging Business Trends and Legal Strategies

By Jerry Sokol and Joshua Kaye

Transactional activity in the ambulatory surgical center (ASC) industry has continued at a frenzied pace during the first half of 2007. The second half is shaping up to be just as active, and for good reason. There has been an upward trend in the multiples being received by ASC owners, in large part due to the increased number of buyers as many health systems and “regional” ASC management companies now compete with national ASC companies, all of whom have an insatiable appetite for acquisitions. These increased prices have really fueled interest by ASC owners to consider participating in an ASC equity transaction.

ASC equity transactions can generally be divided into three categories — the sale of ownership interests in an ASC to physicians who use or will be utilizing the ASC; the redemption (i.e., buy-back) of physicians’ equity interests in an ASC; and the sale of an equity interest to a corporate investor (e.g., ASC management companies and health systems). As competition for ASC acquisitions becomes more fierce and the industry becomes more business savvy and mature, certain trends and developments have emerged in connection with these three primary types of equity transactions. This article addresses certain of these recent trends and their likely impact on ASC transactions for the remainder of the 2007 calendar year and beyond.

The Sale of Equity Interests to Physicians and the Group Practice Phenomenon

A recent trend has emerged involving ownership of an ASC by a group practice. The reason for this trend is twofold. First, it may allow for more flexibility in how ASC profits are allocated rather than based on pro rata ownership. Second, it could be a useful basis for departing from the fair market value purchase price requirement that is often an obstacle to selling equity interests to physicians who utilize or who will begin to utilize the ASC.

Group Practice Flexibility in Allocating ASC Profits

Physician owners of an ASC receive distributions on the ASC’s profits in accordance with their pro rata ownership interest in the ASC. As a result, it is very common for physician ownership to become materially inconsistent with physician utilization. In such instances, physician owners of an ASC often desire to reallocate the ownership of the ASC in a manner that is more consistent with each owner’s relative utilization of the ASC. Due to limitations under the anti-kickback statute, however, those who engage in the re-shuffling of ownership interests do so with material regulatory risk.

To the extent any portion of an ASC is owned by members of a group practice, there may be some flexibility in how the ASC profits are allocated among the physicians associated with such group practice. In a group practice, ancillary service revenue from such items as clinical laboratory, medical imaging, and physical therapy are often pooled and may, under the Stark law and other applicable healthcare laws, be allocated among the group practice’s physicians according to the relative professional fees (i.e., an “eat what you kill” compensation formula) generated by each physician as long as such allocation is not directly tied to referrals for the ancillary services.

If all or any part of an ASC is owned by a group practice, there is a reasonable basis that the same compensation formula would apply to the revenue generated by a group physician for his or her use of the group practice’s ASC. Of course, this strategy should only be considered if such an allocation is preferable to an allocation based on relative ownership. Moreover, this strategy involves the group practice becoming the owner of the ASC.

This strategy can also be utilized in those instances when physicians affiliated with the same group own a part of an existing ASC. In such case, the physicians could contribute their ownership interests in the ASC to the group practice in a tax-free transaction. Such physicians could then take advantage of the group practice protection by having the group practice receive its pro rata share of the ASC’s profit distributions and then allocate such profits among the group’s physicians in one of the manners discussed above on a going-forward basis.

Departing from Fair Market Value

The purchase price for an equity interest in an existing ASC is typically based on the following formula: the ASC’s earnings before interest, taxes, depreciation and amortization (EBITDA) for the 12-month period preceding the buy-in date, multiplied by a multiple; less the ASC’s long-term debt; multiplied by the percentage being acquired. For an existing ASC whose EBITDA is already ramped up, this can often result in a significant purchase price. For example, assume an ASC expresses an interest in selling a 5 percent interest to a physician who currently utilizes the ASC but who is not an owner. Suppose further that the ASC has a trailing 12-month EBITDA of $750,000 and no long-term debt. Finally, assume that the fair market value multiple for a minority interest in an ASC is around a three multiple. In such case, the purchase price would equal $112,500 (i.e., $750,000, multiplied by 3, less $0, multiplied by 5 percent).

In such situations, it is quite common for a purchasing physician to resist parting with such an amount of cash and argue that the ASC should offer the interests at a discounted price. From a business perspective, such physician makes a good case since he or she increased his or her own purchase price by performing procedures at the ASC and contributing to the ASC’s revenue. Due to the federal anti-kickback statute, however, the purchase price for each equity interest must typically be equal to at least fair market value. With limited exception, failing to sell the interests for at least fair market value to a physician who utilizes or will begin utilizing the ASC would produce a significant level of regulatory risk.

A recent trend has emerged that could provide a basis for departing from the fair market value requirement without creating meaningful health law regulatory risk. It involves those instances where a group practice has enough surgical volume to justify an ASC affiliated solely with that practice. Such ASCs are more prevalent in certain specialties such as ophthalmology and gastroenterology, but could apply to any large single specialty or multidisciplinary group practice.

In considering whether an ASC has a basis to depart from the fair market value requirement, all of the physician owners of the ASC should be members of the same single or multi specialty group practice and each physician owner should be utilizing the ASC as an active extension of his or her practice (i.e., no primary care physicians).

The regulatory basis for departing from the fair market value requirement comes in part from the federal anti-kickback statute safe harbor for a physician’s investment in a group practice and in part from the regulatory concept that an ASC should only be owned by physicians who use the ASC as an active extension of their practice. To be clear, arrangements in which physicians from a single group practice have ownership in a separate ASC entity won’t meet all of the criteria of the group practice safe harbor because, by its terms, the safe harbor only applies to investments in the group practice entity itself and not to ancillary ventures owned by the group’s physicians.

Failure to meet a safe harbor, however, does not mean that the arrangement is not permitted. Indeed, it is often worthwhile for an arrangement to approximate compliance with a safe harbor by meeting as many elements of such safe harbor as possible. In that regard, the group practice safe harbor does not require for investments in the group practice to be at fair market value.

Thus, a physician purchasing an equity interest in a group practice is not subject to a fair market value requirement. The same should also hold true for a physician’s investment in a group practice even where the group practice in turn is the owner of an ASC. Taking this same analysis one step further, a fair market value requirement arguably does not apply in those instances where an ASC is owned by the same physicians associated with a single group practice even though the ASC and the group practice are two very distinct entities.

Depending on the specific facts and circumstances underlying the transaction, ASCs owned by the physicians of a single group practice may consider selling equity to new group practice owners at a price lower than fair market value. In such instances, the price should still be based on an objective formula that is unrelated to the investor’s volume of referrals to the group practice’s ASC.

Redemption of Physician Equity Interests and Squeeze-Out Mergers

One of the primary causes of physician animosity in an ASC results from a physician partner who does not use the ASC as an extension of his or her practice, yet profits from the procedures performed by the other surgeons. Such inactive physicians also serve as an impediment to consummating the more profitable transaction of selling an interest to an ASC management company or health system.

A recent and successful trend has been developing that allows the ASC to eliminate (or squeeze out) these physicians through a properly approved transaction. These transactions could prove to be of even greater utilization in connection with both cleaning up physician ownership of a distressed ASC with such inactive physicians and simultaneously consummating the sale of an equity interest to an ASC management company or health system at a premium.

A squeeze-out merger is a concept that has been implemented in other corporate, but non-healthcare, settings for sometime and basically involves two steps. First, the physicians who intend to continue to utilize the ASC as an extension of their practice (and perhaps the ASC management company or health system) form a new entity. Second, the new entity and the existing ASC take the appropriate corporate vote and are then merged together. In order to minimize any disruptions in operation from both a cash flow and licensure perspective, the existing ASC should be named as the surviving entity in connection with the merger.

As part of the merger, the physicians being squeezed out are entitled to merger consideration equal to the fair market value for their equity interests. The remaining physicians (and the ASC management company or health system, if one has participated) receive equity in the surviving entity, and thus become the sole owners of the ASC on a going-forward basis. In practice, a squeeze-out merger can also serve as a successful negotiation tool to consummating the buy-back of equity interests from such inactive physicians who may otherwise not have been willing to cooperate in such a transaction.

There are two important caveats. First, a squeeze-out merger can only be performed if the owners of the existing ASC who desire to effectuate the transaction can obtain the requisite vote in the existing ASC entity to authorize the merger. If, for example, the governing document of the existing ASC requires that the approval of a merger be subject to a higher voting threshold and the non-performing physicians have enough of such vote to block the merger, then a squeeze-out may not be able to be effectuated. Absent a provision in the governing document providing for the contrary, state laws would generally require that a merger be approved by the holders of a majority of the equity interest in the existing ASC.