Private Equity Now Looking to Invest in Professional Practices

Historically, private equity has shied away from investing in professional practices in New York State (for example, accounting firms, medical practices, law firms) due to its strict regulations preventing non-professionals from owning professional practices and its strict fee-splitting laws. Private equity has now cracked the code on how to properly structure the purchase of a professional practice in NYS and private equity firms are investing heavily in this area.

In order to adhere to the strict NYS laws referred to above, a private equity firm will form two separate entities to purchase the assets from a professional practice.   For example, a professional entity (i.e. a PLLC or P.C.) owned by a dentist affiliated with the private equity firm will purchase the professional assets (i.e. patient list, goodwill, etc.) of the seller and a separate business entity (an LLC or corporation) will purchase the non-professional assets (furniture, fixtures, equipment, supplies, etc.).

A management agreement will then be established between the business entity and new professional entity whereby the business entity will be paid a fee for providing management services to the professional entity.

Selling to private equity has many attractive features:

  1. Often the purchase price is higher than that offered by another buyer (typically based on a multiple of EBITDA);
  2. The purchase price is typically allocated to capital assets being sold so that the seller will pay tax at the lower capital gains tax rates;
  3.  A portion of the purchase price is offered as equity of the buyer (so the seller can participate in the growth of the private equity entity, although, like any investment, there is an inherent risk of loss); and
  4.  The seller is typically offered an employment contract with the buyer so he can continue to work for a few years before fully retiring.

One feature many sellers find attractive is that the seller receives rollover equity in the private equity entity (as referred to in #3 above). The expectation is that the management company entity will receive more fees from the additional practices the private equity firm purchases in the future thereby creating more value for the owners of the management company.  When the private equity firm sells the management company at a higher valuation to the next private equity firm, the seller will receive a “second bite of the apple” and receive value for his rollover equity interest.

Some private equity firms have modified the above structure to incorporate a “sub- DSO” concept. Under this new structure, the private equity firm creates a brand-new management company to manage only the seller’s practice. The seller is offered rollover equity in that new sub-DSO entity (not the main DSO). This structure reduces the potential the seller has for a second pay day since the growth potential of the sub-DSO is limited.

Historically, for a partner or shareholder retiring from a professional services firm, the typical buyout offer involved calculating a partner or shareholder’s retirement benefit by taking their current earnings, multiplying it by a multiple (for example, between 1 and 5 times revenue, depending on the quality of earnings) and paying out that sum annually over a period of 5 to 10 years as ordinary income.

Today, private equity investors are unlocking firm and partner/shareholder value by offering a “foundation firm” a multiple of as much as 10 or more times earnings while “tuck-in” firms generally receive six to eight times earnings. Provided that established performance metrics are met, payout takes place within just a few years, as the potential value of equity shares increases and becomes more attractive to other buyers.

With an increase in valuation and quicker payout come tradeoffs. It’s not only the issue of independence, but a whole new organizational structure as well. The governance model so typical in professional service firms does not lend itself to quick decision-making, maximized accountability and optimal growth and profits. In the corporate world, where private equity typically operates, everyone has a boss, organizational charts are clear, and roles and responsibilities are plainly spelled out. Evaluations tied to compensation are the standard. This type of rigor is not the norm in professional service firms.

However, the door to direct private equity investment may remain closed to most firms, as 80% are either too small or don’t meet the profitability threshold to qualify. But “anchor firms” funded by private equity firms will come calling, with an interest in acquiring other practices, which will find themselves in a private equity driven culture.

The entry of private equity as potential investors in the professional services space has created significant opportunities for these practices to have higher sales prices and potential participation in future investment returns, depending on the structure of their specific deal. Making private equity a very attractive option for owners of professional practices to exit these entities.

The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.