COVID-19 has shaken up the healthcare industry in many ways. Following a downturn in early 2020, merger and acquisition (M&A) activity is expected to return, to support recovery and stabilize post-pandemic operations.[i] This list summarizes ten key considerations specific to healthcare M&A transactions.
- Choose the right transaction form for your business objectives.
M&A transactions are typically structured as “equity sales” (in which the buyer acquires seller equity, and the seller becomes a wholly-owned subsidiary), or “asset sales” (in which the buyer purchases individual assets, and assumes certain liabilities, of the seller). A third common transaction form is a statutory merger, in which any two or more companies merge into a single surviving company (either one of the parties, or a newly formed entity).
Structuring the transaction as an asset sale is generally viewed as buyer-favorable. From a tax perspective, the buyer in a taxable asset sale can “step up” the basis of many assets over their current tax values and obtain, essentially, a depreciation deduction on the purchased assets, including goodwill, generally spread over 15 years. (This structure can have strong disadvantages for the seller. In particular, if the seller is treated as a “C corporation” for tax purposes, an asset sale is prohibitively expensive because it triggers double tax: once at the corporate level and then again at the shareholders’ level.) In addition, the parties to an asset sale have greater flexibility in identifying assets and liabilities to be acquired, which may help shield the buyer from assuming unforeseen liabilities.
Sellers often prefer structuring a transaction as an equity sale or a merger. If the seller is a corporation, an equity sale can help maximize long term capital gains tax treatment on sale proceeds. In addition, an equity sale can force the buyer to take on more of the seller’s liabilities.
A merger can be viewed as a form of asset sale where the buyer survives (a “forward” merger) or an equity sale where the seller survives (a “reverse” merger). Complicating matters is the fact that in some cases, the parties can treat an equity sale as an asset sale for tax purposes. In some situations, either an asset or equity sale can be structured as a tax-deferred transaction to the extent that equity in the buyer (or its parent) is used as consideration.
Although tax considerations often carry the greatest weight, a variety of factors affect the ultimate choice of structure. In a provider acquisition, an equity sale can help preserve billing numbers and keep important contracts in place, which can be particularly important for post-closing cash flow and revenues.
- The corporate practice of medicine can also influence structure.
State law requirements governing the corporate practice of medicine (“CPOM”) can also significantly impact the structure of a physician transaction. A CPOM prohibition effectively prohibits companies that are not owned or controlled by practitioners from owning or controlling a medical practice. In theory, a CPOM prohibition ensures that the owners of a medical practice are practitioners who will prioritize patient care, and not be influenced by commercial considerations or stockholder interests. The doctrine is established through regulation, regulatory opinions/enforcement actions, or case law. Currently, California, New York and South Carolina rank among the most strict in their interpretation of CPOM, and a few states, such as Florida and Arizona, do not have any prohibition (although Florida has a health care clinic license and other fraud and abuse laws that complicate structures). Some states also dictate the type of entity that can employ licensed healthcare professionals, or require that professional entities be organized in-state (and not be “foreign” entities). As a result of CPOM, health M&A buyers often segregate clinical and non-clinical assets into two companies and establish what is known as a “friendly PC” structure, a model which is fairly common, but also carries a level of irreducible CPOM risk. Companies with a regional or national platform may end up with a fairly complex corporate organizational structure to support CPOM.
- Fraud and abuse laws need to be carefully considered.
The principal fraud and abuse laws, the so-called “Stark Law”[ii] (Stark) and the Anti-Kickback Statute[iii] (AKS), can factor into health M&A in a variety of ways. At a very high level, under Stark, if a physician (or his or her immediate family member) has a “financial relationship” with an entity, the physician may not refer Medicare/Medicaid patients to the entity for “designated health services” (DHS), and the entity receiving such a referral may not bill for such services, unless an exception applies. AKS generally prohibits knowing and willful solicitation, receipt, offer or payment of any remuneration in return for the referral of items or services covered by Medicare/Medicaid. Each of these statutes has its own state analogs.
The principal Stark exception for an M&A transaction is the “isolated transactions” exception, which requires that the amount of consideration be consistent with fair market value (“FMV”) and commercially reasonable. Moreover, there cannot be any additional transactions between the parties for six months after the transaction, unless an appropriate Stark exception is met.
Similar to Stark, the AKS has certain “safe harbors”, which if satisfied may provide immunity from allegations of abuse. However, unlike Stark (which is a strict liability statute), failing to satisfy a safe harbor does not create a per se violation of AKS. The primary safe harbor related to the sale of a medical practice generally contemplates that the physician is retiring, and will not be in a position to refer any patients one year following the closing. It is not common for a physician M&A deal to satisfy the applicable requirements of a safe harbor, and the facts and circumstances of the arrangement should be carefully evaluated from a risk management perspective.
Private equity or corporate buyers often rely on the “friendly PC” structure discussed above for health M&A. If that is the case, any use of rollover equity should be carefully structured, particularly if DHS (including lab, physical therapy, or imaging) is involved. That is because the only Stark exception available to protect physician ownership, and the distribution of DHS revenues to physician owners, is the “in-office ancillary services” exception under Stark, which require the owned company to meet several technical requirements as a physician “group practice”, as well as satisfy requirements covering the company’s physical facilities and compensation methodologies. Parties to health M&A are increasingly exploring other ways to incentivize ongoing physician involvement without triggering Stark, such as by establishing bonus pools independent of DHS revenues.
- Special considerations apply in valuing healthcare transactions.
Many or most of the commonly used Stark exceptions and AKS safe-harbors require FMV compensation. The FMV construct should be applied to each aspect of a physician’s financial arrangements, with each specific arrangement being reviewed separately for compliance, and the sum total being reviewed to ensure there is no “stacking” or duplication of payments. This matters both for due diligence, and also in structuring the transaction.
Unlike standard business valuations, under applicable regulatory guidance, health M&A valuations should reflect the fundamental principal that “fair market value” cannot take into account, directly or indirectly, the value or volume of any past or future referrals or the ability to influence the flow of business between the parties. (Stark and AKS each track the definition slightly differently; and there is a separate requirement under Stark that transactions be “commercially reasonable.”) This valuation construct may be more flexible in the future. In 2019, the government proposed modifying the “fair market value” definition to create more flexibility, by tying it to the value of an arm’s-length transaction with like parties and under like circumstances, without adjustment for referrals. As of this writing, the proposed regulations are still pending.
- Earn-outs and contingency payments may not be available.
M&A buyers often try to limit their financial exposure through “earn-outs” or contingent payments. However, as described above, the applicable Stark exception and AKS safe harbor for practice sales require that aggregate transaction payments be fixed in advance. In physician deals, purchase price adjustments based on financial or revenue-based metrics can arguably be linked to post-transaction referrals by the physician sellers, and as such could be impermissible under Stark and also carry risk under AKS.
Depending on the situation, there may be ways to accomplish similar goals, with lower risk. “Success fees” could be tied to implementing appropriate cost reduction measures or achieving business objectives such as a “tuck-in” acquisition or a specific customer win. Buyers are also increasingly using metrics that are not directly or indirectly tied to DHS or even Medicare/Medicaid referrals (and therefore may fall outside of Stark, although AKS and state law considerations may still apply). Installment sales are also permissible; however, the installments would need to be integral to the transaction and guaranteed, even in a default.
- Determine a timeline and “road map” up front.
Federal and state licensure requirements can significantly impact structure and timing of a transaction. If the transaction qualifies as a “change of ownership” or “change of information” for a particular government license or health care program enrollment, a state or federal regulatory body may expect some sort of filing, in some cases as much as 90 days pre-closing. These requirements should be evaluated early on, to avoid frustrating delays or any impact to cash flow post-closing.
- Physician non-competes may be unenforceable.
Although it also makes good business sense to ensure that physician sellers do not turn around and compete with the buyer, in some states, physician covenants not to compete are not enforceable. This is the case in California, Massachusetts and New Hampshire, to name a few. Enforceability can vary by jurisdiction, and in some cases, including the restrictive covenants in a purchase agreement (rather than an employment agreement) may be effective. Buyers should check state law in this area, and may need to think of a creative work-around if prohibitions apply.
- Follow a thorough due diligence process, with focused evaluation of compliance risks.
The healthcare industry is heavily regulated at both the federal and state levels, and compliance issues will be the greatest area of concern for a buyer in an M&A transaction. Prior to starting diligence, carefully consider the industry and the regulatory profile of a target company. Don’t limit review to contracts, but also test the target company’s compliance culture, including training, hotlines, and enforcement. Compliance programs can not only evidence the regulatory health of a company but help mitigate enforcement risk should an issue arise in the future.
Vetting for any actual or potential governmental inquiries or qui tam actions is important. Stark and AKS apply to any company (including a medical device or practice management company) that has financial relationships with physicians. Given the significant risks of recoupment of payments, penalties, and false claims act liability for Medicare/Medicaid noncompliance, where applicable, participation in these programs also needs to be carefully diligenced. Other key compliance areas are CPOM; privacy and security (HIPAA); billing and coding; employment including appropriate classifications of independent contractors and screening for sanctioned or excluded employees; and state requirements of licensure, certification and certificate or determination of need programs.
- There is no need to enter into a business associate agreement (BAA) in connection with due diligence.
One common misconception in healthcare M&A revolves around whether the two parties to a transaction need to enter into a BAA under HIPAA if any protected health information, or “PHI”, will be shared. Under HIPAA, the sale, transfer, merger, or consolidation of all or part of a covered entity with another covered entity, or an entity that following such activity will become a covered entity, and due diligence related to such activity, constitute a permissible health care operation, for which a separate BAA is not required.[iv] However, HIPAA’s requirements of limiting disclosures of PHI to the minimum necessary to accomplish the intended purpose still need to be observed. Parties sometimes consider entering into a BAA anyway, but BAAs impose contractual obligations that should be considered.
- Where successor liability may apply, structure indemnification and escrows appropriately.
Where due diligence uncovers a potential liability, disclaiming liability in the purchase agreement may not be sufficient to avoid successor liability. With respect to Medicare, a buyer that assumes the provider agreement of a “provider of services” (such as a hospital or skilled nursing facility) or a certified supplier (such as an ASC or ESRD facility) in a change of ownership transaction assumes all the seller’s penalties and sanctions under the program, including repayment of accrued overpayments. The rules are somewhat different for purchases of other types of suppliers (such as physician practices). The 60-day Repayment Rule, enacted in 2010, also had the practical impact of making new owners responsible for actively investigating any potential billing issues that arise post-closing, even if related to pre-closing activities; and, if substantiated, making repayments to Medicare/Medicaid. The parties should consider special indemnities and/or set aside an escrow to address any specific liabilities that are identified in the due diligence process.
[i] See Ernst & Young report “Health Organizations Find Themselves in the Eye of a Perfect Storm”, available at: https://www.ey.com/en_us/ccb/health-mergers-acquisitions
[ii] 41 U.S.C. §1395nn
[iii] 42 U.S.C. 1320a-7b(b)
[iv] 45 C.F.R. 164.501(6)(iv)