Collaborations between hospitals and health systems (HHSs) and private equity (PE) firms are on the rise, often taking new, creative forms. HHSs are looking for new partners to help diversify and transform their business, and PE is increasingly investing in entire health systems, exiting investments by selling to health systems, purchasing a division of a health system as either a platform or portfolio company add-on, and engaging in other innovative joint ventures. These creative HHS-PE collaborations result in myriad benefits, suggesting the trend will accelerate in the years to come. HHSs and PE firms can capitalize on the opportunities these partnerships open for both parties by having a clear plan for navigating the unique challenges that arise in negotiating and operating these ventures.
The benefits: freedom to think big
Uncertainty around continued healthcare reform, accelerated consolidation, limited access to capital and the rise of consumerism has created unprecedented pressure on HHSs to innovate and supplement, or transform, their core business lines. In addition to providing capital infusion, collaborating with a PE firm can offer access to alternative leadership perspectives and service line expertise, expanded geographic reach and market share, and equity investor support for revenue growth. Adding these factors to the equation can give HHS leadership teams the ability to pursue bold, creative solutions that typically would not be feasible under their traditional business model. HHSs can jointly embark with PE through novel partnerships to tackle long-standing challenges such as physician burnout, accessing and deploying health data effectively, and addressing social determinants of health.
For example, an HHS might partner with a PE firm to pursue consolidation options in the physical therapy sector, leverage synergies with existing PE holdings such as revenue cycle management systems, or back an orthopedic device company. It can be difficult for an HHS to pursue these ventures alone; collaborating with a PE firm can empower an HHS to move faster and accomplish its goals. By building out its own ecosystem in this way, an HHS can serve its patients at additional touchpoints along the care continuum, and curate more of their care within the HHS — scaling its reach and influence in the process. This type of bold thinking can be particularly valuable in the evolution away from fee-for-service environments. The ability to transform healthcare ultimately rests with the patient and the physician, and the right PE partnership is an opportunity to pour both capital and creativity into new patient-centered, value-based care models.
At the same time, the benefits of these partnerships cut both ways: an HHS’s involvement in a venture with PE allows the PE firm to make use of the HHS’s deep knowledge and understanding of the space and unique resources — including medical staff, data, and connectivity with patients and consumers — which can enable better long-term strategy and decision-making at the PE firm. HHS partnerships also provide PE firms with access to a large market share more quickly than the PE firm could have developed had it taken on the investment alone. Further, HHS partnerships provide PE firms with additional markets for their existing PE holdings that may have synergies with the HHS partner, whether or not the HHS makes an investment in those ancillary holdings. Ultimately, these partnerships with HHSs unlock access to new strategies for PE firms to increase their investment returns, which in turn also flows back to the HHS.
The challenges: getting on the same page for success
Like any transaction, a collaboration between an HHS and a PE firm must overcome several challenges. Two major factors determine how well a collaboration will overcome these issues. First, picking the right PE partner — namely, one that understands the healthcare space and shares the HHS’s values — is the bedrock of a successful venture. Second, communicating effectively, early and often can ensure transparency and eliminate a host of potential problems down the road.
· Decision making: At the very outset of a potential deal, it’s important to get on the same page regarding the pace of decision-making, including both during the transaction and post-closing in operations. HHSs, particularly those in the nonprofit space, often have a more complicated governance structure and a broader range of constituents involved in the decision-making process. This can be a surprise to some PE partners, so it is important to reconcile expectations regarding timelines and the speed at which the venture might proceed. Setting up regular deal team calls can be helpful to move the transaction forward at a measured pace while allowing the HHS to meet its responsibilities for vetting deal terms with its constituents. PE firms will likely advocate for allocating more power and decision-making at the venture level (i.e., a board with HHS representation), where operational decisions can be made quickly without having to vet each issue through the HHS governance structure.
· Timelines and exit options: The investment horizon is another important timing aspect that merits discussion early in the transaction process. Most PE investments operate on a five-to-seven-year timeline, whereby the PE firm will need to liquidate its investment to pay returns to its investors. In contrast, most HHSs will have a longer-term strategic perspective on the partnership. HHSs should consider and discuss with their partner how they would deal with a change in underlying investor or owner, including issues such as blocking rights, tag-a-long and drag-a-long rights, and rights of first refusal.
· Vision and strategy: As important as shared timing expectations are, one of the most significant determinants of success is alignment of vision. If a party to the venture places a higher priority on quarterly results or particular milestones than it does on the ultimate goal of improved care, problems are more likely to arise. It is important for the HHS to do its due diligence on the PE firm early and to develop a thorough understanding of the PE firm’s industry reputation, management expertise and stability, and return strategy (e.g., margin improvement through cost cutting). The parties should also be aligned on other major strategic decisions beforehand, including appetite for risk; the potential for future expansion and additional capital contributions; and corresponding legal rights, such as pre-emptive rights, default loans and equity dilution.
· Regulatory and Tax-Exemption: In addition to aligning vision and timing expectations, HHS-PE collaborators should carefully examine all potential legal and tax implications of a new venture. For example, the governance rights in a joint venture between a PE firm and a nonprofit HHS are different from a typical PE investment. A tax-exempt HHS may often expect a tax-exempt return on its investment. If the HHS is a minority interest holder, Internal Revenue Service rules dictate certain governance rights that the HHS should have in place in order to avoid unrelated business income tax — and to protect its tax exemption. These governance rights may include the ability to veto budgets or approve leadership and executive roles, or unilateral control over charity care policies — rights that are further reaching than may be typical for a minority interest holder.
A look ahead: where are the opportunities?
There are ample opportunities for HHS and PE-backed ventures in the healthcare market today. Some of the best opportunities for innovation exist in sectors that can take advantage of consumerism and move care to lower cost settings while delivering excellent outcomes. In particular, ventures that focus on keeping patients out of the inpatient acute care and emergency settings have a great deal of promise. For example, attractive areas for joint venture deals and investments include physician consolidation, urgent care, home care and hospice services. Creative collaborations that can combine the right personnel and monitoring technology to deliver acute care in the home setting are emerging and have strong potential to drive value. Similarly, behavioral health, ambulatory surgery centers and Medicare’s Program of All-Inclusive Care for the Elderly are areas ripe for innovation and transformation between the right HHS and PE partners.
Kerrin B. Slattery and Brad Dennis are partners at McDermott Will & Emery LLP.