Prescription for a Successful Healthcare Rollup
The doctors will see you now, private equity investors.
Over the past few years, physician practices, and other fragmented segments of the healthcare market such as behavioral health, dental, eye-care and urgent care, have become increasingly attractive to private equity (PE) investors who have been busy scooping them up and merging them into “rollups” — a consolidation process that occurs as new market sectors mature. With multiple services and products, the new, consolidated business can offer several advantages over smaller, independent players: It can serve a wider geographic area, enjoy economies of scale and provide greater name recognition. As such, a healthcare rollup is often more than the sum of its parts and can be sold for a huge profit.
What’s driving this buying trend? A few things. Despite the disruption and uncertainty in the healthcare market, capital fundraising remains strong. PE funds have money to put to work, and valuation multiples being paid for companies are high, driven mostly by synergy values built into the market. Although the operational risks of executing a roll-up are greater than purchasing a large entity and simply “tucking in” acquired companies, the appetite for assuming additional risk is tied to the high valuation. As such, this “Build vs. Buy” strategy continues to make sense for many investors.
For PE firms looking to engage in roll-ups in healthcare the payoff can be rewarding. But to succeed, it’s important to understand a few best practices — presented here in the form of diagnoses and prescriptions — that make for a healthy rollup and avoids some of the most common pitfalls.
Diagnosis: Overweight Collections Department
Often the platform company (first-acquired company that is used to start the rollup) may have a satisfactory revenue cycle department — the branch of the business that tracks the entire life cycle of a patient’s account from creation through payment. However, upon adding substantial volume, new contracts and new geographic markets, the department that was merely “hanging together” can collapse upon itself. This has a triple-witching effect of greatly swelling working capital, which in turn causes cash flow issues.
Just as concerning, if not more so, is ignoring new market payors and rates in the consolidated revenue recognition processes. As the billing department falls behind, mistakes compound: current invoices go unprocessed which in turn leads to higher denial rates. If these denials are not worked in a timely fashion, additional bad debt is incurred on invoices that would have otherwise been collectible. Additionally, a poor revenue recognition process leads to inflated accounts receivable, over recognition of revenue and EBITDA, and higher leverage on the business.
Prescription: Invest in the Revenue Cycle Team as Needed
If the platform company has an in-house billing and collections team, it is important to manage resources and tools based on expanding volume requirements. The platform company may need to redesign the processes to ensure that they are fully optimized, proper technology is being leveraged, staffing levels are appropriate and people have received the necessary training. At a certain size and scale, the company may also consider outsourcing portions of the revenue cycle to third-party providers.
The accounting and revenue cycle teams should be coordinated with open lines of communication to ensure that revenue and accounts receivable are being properly valued. Items such as changing payor mix and changing collection rates must be factored into financial statement reporting.
Diagnosis: Anemic Standardized Processes
With acquisition of each new practice, integration with the entities inside the rollup is essential. Otherwise, a number of issues can occur: Outdated processes or overhead left in place from the new entity can add to overhead across the board; anticipated synergies from the newly acquired entity may not be realized; and the new practice may “orbit” around the core businesses, leading to a feeling of alienation, which in turn can spark employee turnover or loss of clients.
Prescription: Ramp up Leadership and Accountability
A strong integration leader and team are essential to successfully onboard and integrate new rollups. The tone, culture, and messaging should be set early and be consistent throughout the process in order to give the new business comfort in their role within the larger business structure. Use measurable metrics to track the integration timeline and synergy realization.
Diagnosis: Swelling Claim Volume
Usually, growing larger within a geographic region adds additional leverage to increase margins. However, that growth rate can also reach a point in which the claim volume appears “on the radar screen” of the commercial payors. Once that happens, payors will start taking action to get better rates, primarily by contracting to in-network rates. Often, the effect (margin compression) to going in-network is minimized and management believes that any reduction in rate is more than offset by additional volumes sent to them by the payor. First, these lower rates are usually much bigger than anticipated; second, it is important to realize that the rate reduction happens from day one, while the volume increase may take some time.
Prescription: Model and Plan for the Impact of Contractions
In analyzing acquisition targets, particularly smaller rollups, which may have more beneficial contracts, buyers should fully analyze payor mix and contract mix. This should also be considered in terms of the increasing size of the overall consolidated business. Rates when going in-network can be 30 to 50% lower than historical rates. As noted earlier, rate reductions occur immediately while volume gains occur over time. The buyers should model the potential impacts and plan for cash flow and working capital reductions during this transition period.
Senior Managing Director, Co-Leader of US Transaction Services