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As private equity scrutiny Increases, physicians consider ESOPs as liquidity alternatives


While private equity investments in health care are on the rise, the pitfalls are coming into focus.

As private equity scrutiny Increases, physicians consider ESOPs as liquidity alternatives

New data reaffirms the firsthand observations of countless medical practitioners: private equity (PE) investments in U.S. healthcare are surging.

Estimated annual PE deal values in healthcare services doubled between 2016 and 2021, soaring from $36.3 billion to $77.5 billion, according to Pitchbook. More than 730 transactions were completed in 2021 alone, and healthcare industry deals represented 15% of all PE deals nationwide. Most industry analysts anticipate a continuation of these trends in the decade ahead.

Such elevated market activity has pushed valuations to new heights, and a number of physician-owners have benefited financially. But PE’s encroachment on the medical establishment is also stirring discontent among providers, patients and industry organizations alike.

A recent National Bureau of Economic Research study estimated that PE-ownership of nursing facilities “increases the short-term mortality of Medicare patients by 10%.” That “is accompanied by declines in other measures of patient well-being, such as lower mobility,” as well as an 11% increase in per-patient taxpayer spending.

This growing chorus of negative op-eds includes particularly pointed commentary by the American Antitrust Institute. The nonprofit argues the private equity business model is “fundamentally incompatible with a stable, competitive healthcare system that serves patients.”

Beyond suboptimal patient outcomes, there are other potential PE pitfalls to consider:

  • Loss of Autonomy – a PE buyer will install its own “friendly physician” to oversee the practice. As a result, most operational, staffing and strategic decisions become the purview of the PE firm.
  • Staffing Challenges – paths to future ownership or upside are limited in PE-owned practices. This can make it harder to hire and retain talented physicians.
  • New Financial Constraints – to fund transactions, PE firms lever-up an acquisition target’s balance sheet with private debt. Post-tax dollars are used to pay off the financing, straining cash flow.

Mounting dissatisfaction with PE has fueled consideration of alternative liquidity transactions. An increasing number of healthcare firms have turned to unlikely M&A model: the employee stock ownership plan. An ESOP is a defined-contribution plan that mainly invests in employer stock. It effectively enables a tax-advantaged, leveraged buyout of physician-owners by a practice’s staff – in lieu of a PE firm doing the same.

There are several advantages to leveraged ESOPs:

  • A known buyer (an employee trust) purchases physician-owners’ stock at fair market value
  • Staff physicians and other team members earn stock over time, at no cost to themselves
  • Practices gain tax deductions equivalent to the ESOP sale value
  • A fully ESOP-owned practice can operate income-tax-free
  • A practice’s day-to-day operations remain unchanged

When equity is sold to an ESOP, shares are held by an employee trust. Individual employee-owners cannot sell their allocated shares to third parties. Instead, when plan participants retire or depart, their vested stock is sold back to the practice at a current valuation. Partnership track physicians and key staff may also receive additional grants of synthetic or phantom equity.

Employee ownership fosters operational independence, continuity of care and a deepened commitment to a practice’s continued growth and success. Partial sales are common, and additional equity can be sold to an employee trust in subsequent transactions.

Practices typically finance leveraged ESOPs through a combination of seller notes and third-party debt. The latter can be negotiated without personal guarantees by selling shareholders. That enables physician-owners to diversify and de-disk, without sacrificing the independence of their organization. Selling shareholders can also defer and potentially even eliminate capital gains taxes on their sale proceeds.

ESOP sales navigate corporate practice of medicine (CPOM) in a similar fashion to PE

In states with CPOM doctrines, a practice forms a management services organization (MSO), which handles all non-clinical services (including administrative, payroll and billing functions). The relationship is formalized with a management services agreement between the physician-owned professional corporation and the MSO.

Equity in the MSO is then sold to the ESOP. As a basis for valuation, the MSO will generally retain 25% to 35% of a practice’s total cash flow.

Whether an employee stock ownership trust has a stake in the MSO or the overall practice, either structure can be used as a tax-advantaged growth platform. Like similar PE strategies, smaller practices can be acquired at lower multiples and integrated to drive revenue, economies of scale and other efficiencies. But with an ESOP growth platform, the practice and its employee owners retain equity upside. Moreover, acquisition targets can gain the same shareholder liquidity, tax and retirement benefits as the original ESOP-owned practice.

Entrepreneurial practices are best suited for employee ownership

Physicians who choose the ESOP alternative are betting on themselves to grow and adapt to changes in the healthcare industry. Practices without an appetite or capacity for business management may be better served by private equity. Despite the potential downsides of PE, the right firm can help a practice professionalize operations and orchestrate future transaction.

Furthermore, leveraged ESOP transactions can be complex and require careful planning. Working with an experienced ESOP advisor is critical.

In the end, ESOPs are a viable liquidity alternative for equity partners who value independence, legacy-building, strong teams and patient-focused outcomes. Physician-led medicine remains a paramount goal of many doctors nationwide. Employee ownership may represent the right path for practices that want to actively shape the future of healthcare.

Michael Bannon is a vice president at CSG Partners.

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