In the past year or two, hospitals have been in a feeding frenzy, buying medical practices one after the other. Primary care physicians, cardiologists, ob/gyns and a handful of other specialists have been the targets of these acquisitions. With increasing costs, and sideways or dropping reimbursement rates, hospital offers have been too tempting for some physicians to turn down, and many have made the choice to sell their practice assets and become hospital employees. This article discusses what factors are motivating hospitals, the long-term prospects of selling a practice to a hospital, and some of the critical terms to negotiate in the sale documents.
Why are Hospitals Buying Practices?
Let’s get one thing straight. The vast majority of hospitals lose money on the professional fees generated by acquired practices. Sometimes, they lose a lot of money. Break down the economics, and it makes perfect sense. Hospitals induce physicians to sell their practice assets in exchange for a lump-sum purchase price, plus a salary that is 10% to more than 25% greater than what the physicians were previously earning, assuming their volume remains roughly the same. Hospitals are generally no better (and usually much worse) at billing and collecting professional fees than is the average physician-owned medical practice. Therefore, hospital-owned practices incur greater costs (higher salaries) and collect less money than their physician-owned counterparts. Since most medical practices do not have a year-end surplus (i.e., all profits are distributed as income to the physicians), there is really no extra “fat” that enables the hospital-acquirer to offset the loss. A medical practice’s balance sheet turns red and usually stays red from the moment it is bought by a hospital.
This begs the question, “if hospitals lose money when they buy medical practices, why are hospitals buying them?” One common answer is that hospitals make plenty of money on the inpatient facility fees generated by the practices they buy, and this more than offsets the loss in professional fees. While potentially true, this theory is debunked by the fact that most practices bought by hospitals already have a history of referring patients to that very same hospital. Hospitals are essentially buying what they already have.
In the case of some specialists, like cardiologists, hospitals can theoretically make more money billing certain diagnostic services through a hospital outpatient department than the practice could on its own. In practice, due to new rules governing HOPD billing, the differential is much less than many hospitals originally anticipated, and most of us predict that the amount of the differential is probably short-lived.
The best explanation for the recent frenzy in medical practice acquisitions by hospitals is that hospitals are afraid that if they don’t do it, a competitor will. The battle is over market share. In a fight for market-share, short-term profits are secondary, and often insignificant. The loser in a battle for market share ceases to exist, and most businesses, hospitals included, will do just about anything to prevent their extinction, even lose lots of money.
The problem with the market-share strategy is that once the feeding frenzy ends, many hospitals will be left with an assortment of money-losing practices. If they cannot parlay those practices into something that ultimately generates income (e.g., integration into a profitable Accountable Care Organization (ACO)), then the acquiring hospitals will become less profitable than before, and few hospitals can afford this in the long run.
Long-Term Factors
The likely response by those hospitals that continue to lose money will be to either shed the acquired practices after the initial employment terms run-out, or significantly reduce the compensation offered to employed physicians. Remember, the finances of most hospitals are run by bean-counters. In three to five years, those bean-counters may be brand new hospital employees who were completely removed from the original acquisition, and are unaware of the synergies that justified the hospital’s willingness to lose money on professional fees. All they will see is red, and they’ll want to turn it black any way they can.
One might think, if hospitals try to lower physician compensation, the physicians will simply run to the next hospital, continuing to play hospitals against each other. In order to avoid this possibility, hospitals traditionally include a restrictive covenant in their acquisition documents that prohibits physicians from selling to, or working for, a competing hospital for two or more years after the termination of the relationship. Many hospitals are beginning to extend the restriction to prevent physicians from joining an existing medical practice (e.g., a large group practice), leaving the physicians with only two practical choices – accept the compensation reduction or go back to their old practice and restart an engine that hasn’t been turned on for three to five years.
If you want to test the theory that hospitals are acquiring practices to prevent their competitors from gaining market share, try negotiating the restrictive covenant out of a physician contract. You will fail. You might squeeze out higher compensation, or a higher purchase price, but hospitals will protect the restrictive covenant provision like it’s a matter of life and death – and it is.
Critical Factors in Negotiating Sale Documents
There are dozens of important considerations physicians and their attorneys should make while negotiating documents related to a hospital acquisition. This article will not recite an exhaustive list of those considerations. Rather, it will focus on those that deal specifically with the aforementioned problems likely to confront physicians at the end of their initial employment terms. In this regard, there are two especially important contractual provisions that should be appropriately negotiated – the physicians’ right of repurchase, and the restrictive covenant.
A right of repurchase references the physicians’ right to buy-back the practice assets if and when the hospital contract ends. Without a right of repurchase, the physicians would have to start from scratch if they cannot negotiate a favorable renewal term with the hospital. This reduces the physicians’ negotiating leverage at the time of renewal. Negotiating leverage is everything, and having more and better choices increases negotiating leverage. A right of repurchase gives physicians the option of reconstituting their old practice if things don’t work out with the hospital. While this may not be optimal, it is better to have this option than not to have it.
The right to repurchase assets is actually a misnomer if it is properly negotiated, because there are more than assets at stake. The provision should also deal with what happens to the practice’s employees (who have since become employees of the hospital), newly-implemented EMR systems, post-termination billing and collections issues, the old practice entity, newly-purchased equipment, office leases that were assigned to the hospital, and the like. Another factor is how to set the price for the repurchase. If the hospital spent $300,000 on leasehold improvements, how will those improvements be appraised at the time of repurchase? One of the most important concerns relates to ownership of the patient charts. The ability of a physicians to reconstitute their practices is seriously hampered if the practice does not own, or have copies of, its patient charts. This should include patients treated both before the hospital purchase and thereafter. All of these factors, and more, must be carefully negotiated in order to make the potential transition back to private practice as easy and inexpensive as possible.
Negotiating the restrictive covenant will be very challenging, because, as discussed above, its purpose goes to the hospital’s core motivation for entering into the relationship. However, if the restrictive covenant cannot be pared down to the point at which it allows the physicians sufficient options to survive without the hospital at the end of the relationship, then serious thought should be given to walking away from the deal. The future of health care is too uncertain for physicians to limit their options so severely that they may not be able to survive without accepting whatever the hospital offers them after the expiration of the initial term.
It is not the goal of this article to dissuade every physician from selling their practice to a hospital. There are certainly instances when it makes sense to sell. For example, if a physician is very close to retirement, if the practice is not in a position to merge with a larger group practice, or where the practice is able to negotiate a reasonable exit strategy with the acquiring hospital. However, we fear that selling to a hospital is not the long-term solution that many physicians think it is, and the decision to sell should be done with a more realistic understanding of the risks, and more attention to the exit strategy. If you are considering selling your medical practice, contact Frier Levitt to speak to one of our attorneys.
