Affiliate with a practice management company?

By Mark D. Abruzzo, Esq.

We have devoted a significant part of our practice during the past two to three years representing physician groups in their negotiations with Physician Practice Management Companies (PPMCs). Commonly, at the instance we are engaged by a group, its owners want to know whether “affiliating” with a PPMC is financially prudent for them.

Assessing the financial benefits requires a basic understanding of the arrangement from the PPMC end of the table. I always urge the physician practice owners I represent to see the deal for what it is. In its simplest form, the PPMC deal is the sale of a portion of a practice’s cash stream. The practice receives consideration (i.e., a purchase price) up front—typically cash, a promissory note, stock mixture—in exchange for a large percentage of the practice earnings (the “management fee”) annually over a long-term period (usually 40 years).

Yes, the PPMC will provide management services during that period; but the large majority of the annual management fee represents a return on the PPMC’s investment. And, over time, the PPMC will recoup its investment in the practice, and then some. In the long-term, of course, the PPMC is almost certain to profit handsomely from the arrangement. If not for this potential, the PPMC would not make it to Wall Street. The flipside of the PPMC’s profit, of course, is financial diminution to the practice. It’s this simple: if the PPMC is profiting, the practice isn’t.

However, the foregoing does not mean that affiliation with a PPMC will not make financial sense to a practice shareholder and recipient of the up-front purchase price. For example, the doctors receiving this payment (or the equivalent) are rarely still with the practice at the point when the PPMC recoups its investment and then begins to profit off of the deal. Therefore, the threshold question that clients need to consider is this: How far down the road will this happen? (While long-term concerns of the practice and of future doctors, as opposed to those of current owners, are important considerations in determining whether to affiliate with a PPMC, they are beyond the scope of this article.)

In theory, the analysis begins with a fairly simple comparison of what the practice owners will give up in compensation (i.e., the management fee comes from earnings which would otherwise be paid as compensation to the practice owners) over a given period, versus what they will receive (the “purchase consideration”). The analysis gets a bit more complex when considering the various factors. These typically are:

• Varying tax rates. For Federal income tax purposes, foregone compensation would be taxable at ordinary tax rates. If the deal is structured properly, the purchase consideration would be taxable at the capital gains tax rate.

• Applicable taxes. Taxes such as the Medicare portion of FICA and, in many cases, local wage taxes that are applicable to compensation are not applicable to purchase consideration.

• The “time value of money.” Commonly, a large portion of the purchase consideration is payable in cash or stock on the date of sale. In contrast, compensation is surrendered to the PPMC over time. Sometimes, a portion of the purchase consideration is payable over time in the form of a promissory note with interest. If that interest is at a market rate, then this can be viewed the same as cash up-front. Conversely, interest calculated below or above market rates becomes a factor in the negotiation.

• Performance of the PPMC. Where stock of the PPMC is part of the purchase consideration, the PPMC’s performance factors into the value of the purchase consideration—either enhancing or adversely impacting the stock value. The PPMC’s performance can also play a part in increasing the group’s future earnings, which may serve to offset management fees.

The best way to factor in these issues is to perform the financial analysis on a present-value, after-tax basis. For example, consider the following scenario. A group of four doctors (all owners) affiliate with a PPMC. The group will receive purchase consideration of $1,000,000 as follows: $500,000 cash, a promissory note for $250,000 (at a market rate of interest) and stock in the PPMC worth $250,000. The group will pay an annual management fee equal to 40 percent of its net earnings. The group’s annual net earnings over the past three years have averaged $800,000. The purchase consideration is structured in a manner to take advantage of favorable capital gain rates.

Quite often, a group’s initial reaction is that management fees over the first four years will exceed the value of the purchase consideration. That is, assuming zero growth in the group’s revenues and expenses, the management fee would be $320,000 per year (i.e., 40 percent of $800,000). In four years, management fees (foregone compensation) will have totaled $1,280,000, thus exceeding the $1,000,000 purchase consideration. More precisely, the “break-even point” would be at about the first quarter mark of year four.

However, a better analysis would be as follows. Determine present value of the foregone compensation over the same four years. The present value of $1,280,000, assuming a reasonable discount rate of 9 percent, is approximately 1,036,709.

Determine the taxes that would be due on the present value of the foregone compensation. Federal income taxes and Medicare taxes would be $388,248, assuming an effective Federal income tax rate of 36 percent plus the employee portion of Medicare taxes.

Determine the taxes that would be due on the purchase consideration. At a capital gain rate of 20 percent, the taxes would be $200,000.

The after-tax, present value of the foregone compensation over four years is $648,461 (i.e., the present value of $1,036,709 less applicable taxes of $388,248). Compare this to the after-tax, present value of the purchase consideration of $800,000 (i.e., $1,000,000 less 20 percent). In reality then, the deal is still a positive to the group’s owners after four years by a little more than $150,000 (i.e., $800,000 versus $648,461). Using this analysis, the “break-even point” would not come until year seven. This is drastically different from the result on a non-taxed, non-present valued basis (i.e., where the group’s owners yielded $1,280,000 in compensation versus the purchase consideration of $1,000,000).

For the sake of simplicity, I assumed zero growth in both the group’s net earnings and in the value of the PPMC stock. I also assumed a market rate of interest on the promissory note. A more detailed analysis would include several iterations, each applying different assumptions regarding growth rates in the group’s net earnings and in the value of the PPMC stock. And, often, the promissory note must be “present valued” to account for a below market rate of interest. Such assumptions become very important elements of the entire analysis.

In conclusion, to fairly evaluate the PPMC deal from a financial perspective, a practice must have a true appreciation of what the deal really represents and clearly understand the benefits that are intended to accrue to each party. In addition, the practice should also be cognizant of the various factors that apply to the circumstances surrounding the deal. Only then can a practice make an informed decision about whether affiliation with a PPMC is a good move financially.

Mark D. Abruzzo, Esq., is a partner in the law firm of of Wade, Goldstein, Landau, Abruzzo, Mackarey & Davidson.