Although investment in the orthopedic sector is not new, private equity investment interest in this specialty area continues to grow. In fact, orthopedics has become one of the leading sectors for private equity investing, just behind cardiology.  

In this episode of The Corner Series, McGuireWoods’ partner, Geoff Cockrell speaks with Scott Davis, Managing Director at Provident Healthcare Partners, one of the leading investment banks providing M&A advisory services, strategic planning, and capital formation to owners and operators of healthcare services businesses. Geoff and Scott focus their discussion on the highly active and evolving orthopedics sector. 

Tune in to hear Scott share his insights into the state of the orthopedic industry and the leading drivers that make it so appealing to investors.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Corner Series, a McGuireWoods series exploring business and legal issues prevalent in today's private equity industry. Tune in with McGuireWoods' partner, Geoff Cockrell, as he and specialists share real world insight to help enhance your knowledge.

Thank you for joining another episode of the Corner Series. I'm your host, Geoff Cockrell, partner at McGuireWoods. Here at The Corner Series, we try to bring together deal makers and thought leaders with respect to private equity investing in healthcare. We run a number of different corners at Bankers Corner, which this one's going to be, which features investment banks. We have a capital corner that features private equity investors, and we have a professor's corner that goes through some more technical things. Thrilled today to be joined by Scott Davis, managing director at Provident Healthcare Partners, one of the leading investment banks in healthcare and healthcare provider services in particular. Scott, maybe give an intro to yourself of Provident and we can jump into some discussion. Today, we're going to be talking about the more specific sector of orthopedics, which is a very interesting and evolving and super active sector. But Scott, maybe give a quick introduction.

Yeah, absolutely. Thanks for having me, Geoff. We're looking forward to our conversation here. Just quickly on Provident Healthcare Partners, as Geoff noted, we're an investment bank. We've been around for 25 years at this point, really doing the same thing since our inception, and that is offering M and A advisory services to the owners and operators of healthcare services businesses. Particular note, the past 10 years or so, we've been largely focused on physician practice management transactions, having done north of a hundred such deals in a variety of different subspecialties, including the musculoskeletal spectrum, which we're here to talk about today. We operate in what we refer to as the lower middle market, assisting a lot of groups that are going through a transaction for their first time. We're headquartered in Boston where I sit. We've got offices in New York and Minneapolis as well, and really go coast to coast working on transactions, wherever those great opportunities lie. So again, appreciate your time here, Geoff, and for having me on.

Thanks, Scott. As I think about some of the different sectors where there've been a lot of private equity investing, they've come online at different points. Everybody started with dental, which was the first one that was starting to consolidate and is continuing, even having done hundreds of dental deals over a long period of time, but other sectors have come online over time. It's been driven by some evolving dynamics within those sectors. What would you describe as the state of the orthopedic industry from the perspective of consolidation and what have been some of the leading drivers of that?

Yeah, I think that's spot on in terms of some kind of outside the market trends, kind of pushing investors into a given subspecialty. Orthopedics, I would say is probably as of right now, maybe only number two or very close to being number one to the cardiology space in terms of level activity that we're seeing within the private equity investment model today. So very, very active. There are trends that are not dissimilar from a lot of the physician practice investment models that we're seeing, and really it's centered around a severe kind of supply-demand imbalance where you've got an aging population demanding more and more orthopedic services as years go by, but actually a shrinking population of providers. My research suggests that the average orthopedic surgeon age today is about 56 years old. 60% of overall orthopedic surgeons are north of 55 years old, and we're on track for a shortage of north of 5,000 surgeons by 2025.

So as you can tell, that's a recipe for a severe kind of labor shortage, as well as demand for services. So that's one of the underpinnings for overall interest in the space. Beyond that, there's significant fragmentation within the orthopedic landscape. Average outpatient practice is going to be less than six providers in total. Having said that, there are a good number of groups that are of scale that really do offer the opportunity for a platform type investment for private equity. So that mix of fragmentation, large, small, medium-sized scale really does paint a pretty good picture for consolidation as a private equity investor. Again, all with the underpinnings of that supply-demand imbalance.

We're also seeing an interest in the space as a result of the shift of care to the outpatient setting. Again, very common theme, physician deals, but really amplified in orthopedics. Just a couple of weeks back, we saw the approval for Medicare reimbursement for total shoulder replacements starting in January of 2024. So that's something we've seen even in orthopedics back in 2019 with total knee replacements approved, in 2021 total hip replacements approved. So this push of procedures, particularly to these outpatient ambulatory surgery centers is really kind of pushing people into the space further and further. So all things for excitement for investors and owners and operators of these practices as well.

What about ancillary services? The ability of a platform to get a little bit of scale and internalize some of those ancillary services revenue streams has been a driver in a number of sectors. Do you see that present in orthopedic as well?

Absolutely. I would say probably more than many other sectors realistically. I mean, for us as we look for opportunities to work with, there's really three legs to the stool that are almost a given or you would hope for in an opportunity of scale, and those would be ambulatory surgery ownership, imaging ownership, and physical therapy. Those are standalone terrific investment models and ones that bring great benefit to a practice on top of the more traditional E and M code evaluation type stuff going on in the clinic. So those are relatively common, I'd say in orthopedics. And you can continue to expand down the care continuum, whether it be DME, podiatry, pain management, neuro, on and on. It's a space that really does lend itself to very wide potential care continuum capture and really we've seen a lot of groups go ahead and capitalize on that. So they present really robust opportunities right out of the gate, which again is very appealing from the investor perspective.

From the perspective of value-based care contracting, what opportunities do you think that orthopedic practices present in that arena?

Yeah, it's a great question and another major reason, albeit a little bit longer term focus as to the investor interest in ortho. Again, I would say next to certainly primary care, but then cardiology being the other space that really offers probably the quickest pathway and greatest opportunity to really have a successful value-based care contracting program in-house would be orthopedics. So just getting back to that care continuum I mentioned, if you play it out, some of these robust platforms, you've got orthopedic urgent care on the front end, so you've got the triage of initial patients coming in, not necessarily dependent on third party referrals to have that happen. You've got that patient going to one of two avenues, likely imaging to start, offered in-house, potentially to physical therapy. If something more acute in nature or invasive is needed, they've got internal pain management offerings, they've got the ambulatory surgery center for actual traditional surgery, and then beyond that, they revert back to the rehab program internally as well.

So what that means is you've got a very wide set of services offered to most of the patients that are coming through the door. You are then allowed to capture really the outcomes across a large number of patients, but across a very large continuum, and it's the ability to track that information, show good outcomes, potentially cost savings for the system that will allow for the long-term value-based care contracting to come into place, albeit there's some definite skills and capabilities needed internally to do that on kind of the admin side of the house. And that's what we're seeing a lot of the investor interest around, just the ability to kind of bring that data to bear and use it thoughtfully and really develop those contracting relationships.

Whether it's ASCs or imaging or PT or value-based care contracting, all of those topics require a certain amount of scale. As you're talking to groups in the lower middle market below a certain size, really it's difficult to make the investments that would enable you to realize those revenue streams. Where's the line, do you think, from a size perspective when a practice could start leaning into those different revenue streams?

Yeah, it's a good question and probably varies from different types of service offering to the next. I would say something of a line of demarcation for traditional private equity interest and scale on a physician count, which doesn't necessarily lead to financial production, but it's a good proxy, in and around that kind of 15 to 20 physician active surgeon, full-time, physician scale is where things appear to be getting interesting. Again, a lot of that's dependent on how active those providers are and also what their existing reimbursement environment is, but at that point you're seeing enough production to realistically internally fund things like that physical therapy program. Think about JV opportunities or potentially developing a wholly owned ASC in their local market supported by the necessary amount of volume that it takes to make that profitable and worth their time. Again, a strong flow of patients coming through that it just makes sense to invest in that piece of imaging equipment and have that in-house.

And so I would say that's where things start to get interesting in terms of the ability to scale your practice internally, regardless of third party investor interest. Below that, things can be a little bit more difficult. I think in those scenarios you probably see a little bit closer relationship between that practice and the hospital and health system, certainly third party referral sources. And above that scale, certainly you would almost assume at that point that the requisite ancillaries have been developed, that they're being leveraged in a thoughtful manner and the business is running quite efficiently at that point.

You mentioned joint ventures, thinking of joint ventures with health systems in the area of orthopedics, you think the value proposition of the joint venture with the health system is?

Yeah, I'd say the most readily apparent one is in that ambulatory surgery center. So I think at this point, hospitals and health systems recognize that the procedures are shifting to the outpatient setting, that CMS approval being a perfect example of that, and so they're kind of fighting the tide to prevent that from happening to some extent. How can they still retain some level of revenue by this service line? Well, develop relationships with those outpatient clinics that are going to be fruitful to you and still allow you to use something of your referral relationship with them. Maximize that by having that JV relationship where you're bringing those procedures to a friendly practice. And also seen happen is, many of those groups, if done correctly and through regulatory approval, being able to get higher code reimbursement as a result of that JV relationship as opposed to a purely privately owned ASC.

So there's benefits to both sides in doing so, the retention of some level of revenue on the hospital side and then certainly access to patients and potentially higher reimbursement rates if you're that private practice. So that's an obvious one. There's additional kind of overlap in ancillary services that could be yield positive relationships as well, but that'd say that's probably the number one avenue we're seeing for collaboration.

One area where there's often friction as platforms scale is in the arena of how they think about provider alignment, whether that's compensation, ownership at a holdco level, ownership at a subsidiary JV level. How do you think about provider alignment when you're advising sellers?

Yeah, great topic and one that really has to be thought out really ahead of time to ensure that you go down the path with the right partner and that it's structured properly. So alignment between investor parties and practice is supreme. The way we're going to arrive at value within the transactions, candidly, by reducing compensation for the shareholder physicians, really understanding on the front end what the preexisting compensation arrangements are, how to manipulate those in a way that will be well received by the investor community, and also not allow that practice to be in a position where post-close, they're not able to recruit or potentially compete with our local hospitals and health systems. That's a very fine balance, and one that needs to be yielded to and done really thoughtfully because a lot of these practices, if they've done the development that we're talking about, development of ancillaries, scaling of physicians, very broad shareholder group that comes with complex kind of compensation structures behind the scenes.

And so whenever there's movement in those, you really have to be mindful of how they're treated, that people really understand how it's going to be treated post-close, and make sure that again, you're going to be in a competitive position longer term. So that balance is important, I would say for sure.

A lot of times, the path of least resistance to getting through the closing is to take the comp model that's there, recreate it in our system and scrape something out of it versus rolling out a completely different construct. How do you think about that topic? Because I find that that is a source of friction later on.

Yeah, that's exactly right. I mean, this concept of scrapes we alluded to that is the newer of the kind of physician practice consolidation models that we're seeing. In years prior, there was utilization more often of just a percentage of collections model, which was more tied to the top line production of a practice, and you could argue that in doing that approach, there's potential for misalignment between the go forward physician shareholders and the new partner and investment partners, and that you're not thinking about as the physician shareholder, the efficiency and margin of that business. You're now mindful of driving revenue and less worried about the cost. So a great way to work around that and create alignment is this concept of the scrape, as you allude to Geoff. And that's simply as it sounds, scraping away a percentage of the overall compensation pool. We refer to it as earnings before physician compensation.

That pool for that given practice, you scrape away in this space traditionally around the 30% mark is what's industry norm, and it's that pool that creates EBITDA that's marketed to the industry. It's essentially your MSO fee on a go forward basis, and it leaves behind the requisite, in this example is 70% of the pool, to be distributed to those physicians however they see fit. And to your point, Geoff, what we've seen most successful in the past is just let those physicians decide how to distribute it post-close as they see fit, and most often it's doing it the same way they did pre-close because if it's not broke, why fix it type of thing. And albeit it's a smaller pool at first, it's one that's distributed in a way that they're comfortable with that they understand and it just causes for less friction, to your point, post-close.

We see a lot of the EBPC pool models. When you're thinking about that and advising a target that's in a sales process, given that the EBPC construct is a comp plan construct, you have the flexibility of making it hyper-local versus a larger kind of subset or an entire state. How do you think of the topic of how local should the EBPC pool be given that you have that flexibility?

Yeah, I would say that scrape component on the top of the model itself is generally going to be symmetrical across most markets, even for a broad private equity backed platform. There could be some nuance to that. Obviously on the lower end, scraping less than my example of 30% is an effective way to make sure post-close there's not any kind of shock as it relates to the paychecks and the months and years to follow a transaction. Obviously you're getting less EBITDA, therefore the proceeds are less. So that needs to be modeled out and very clear to the prospective sellers on the front end. But generally speaking, you're going to see in that kind of 25 to 30% scrape range across most transactions, and that's generally accepted across the industry. Going above that to your prior point, that could lead to why is my paycheck so small immediately post-close, kind of forgetting the proceeds taken on the front end.

So to avoid that potential, that 25 to 30% window is really what's become the industry norm. And then as it relates to the exact comp formula below that, like I was saying before, keeping that local, keeping it specific to that practice really makes a lot of sense. Where you might see some changes to potential comp plans at that level would be for the truly localized tuck-in acquisitions where a private equity team has made an investment, 25 physician group in a certain metro market and they're rolling in groups at 2, 3, 4, 5 providers. In certain instances, it may make sense to align that comp formula with the kind of mothership in that metro market, but beyond that, it's really been beneficial to allow those larger groups to retain their own kind of formulas.

There's a lot of variation in how localized things get, and I find that it's as much kind of a philosophical perspective from the private equity folks point of view, and that some of them will have the we're all in this together kind of frame in that usually leads them towards having equity ownership at a topco level across the entire platform versus kind of progressively more localized equity ownership with the similar answers on the comp plans themselves. If it's a we're all in this together type of philosophy, those pools tend to be broader, maybe an entire state, as opposed to the kind of reverse philosophical point of view of let's directly connect people's incentives to things that they can specifically impact. But there's quite a bit of variation that I see in the market on that topic.

Yeah, absolutely. As it relates to equity ownership, I mean generally speaking and every situation's different. What our goal is, as sell-side representation, is to push for what we refer to as pari-passu ownership. So in that MSO kind of topco vehicle you alluded to, owning in that vehicle, ideally at the same type of equity type and class as the private equity investors and the MSO management team. Obviously upside to being at topco is you've got diversification of risk across a broader set of practices, regions and so forth that are part of that platform.

The downside there is you control less of the ultimate performance and equity because again, if it were tied to solely your localized practice, your involvement or performance would more readily be seen. But the diversification play is a fruitful one. It does keep people really tied to the overall platform over time, and sometimes we actually see a mix of those two things, localized and parent level, but to each their own as it relates to the investment model. But I would say there's a mix of the two with a leaning towards preferably topco ownership to some extent, if not exclusively.

Physician practice management has had some headwinds. A lot of the tailwinds that you described are still very much present, but whether that is anxiety around antitrust enforcement, anxiety around the impact of a tighter labor market when you're employing a bunch of providers or just the impact on pricing of higher cost of capital, those headwinds have been real. What's your prognosis from where you sit and the pipeline that you see for the next, let's call it 12 months in this sector?

Yeah, I would say it's one that's going to be robust in terms of the deal flow. I mean, you mentioned a number of things that at the private practice level in particular, non-private equity involvement, are real and difficult. And ironically, the involvement of things like private equity investors or even hospitals and health systems joining some of these practices is they're kind of upping the ante in terms of what your capabilities internally have to be. Whether that be your management capabilities, whether it be your IT infrastructure, your ability to get to value-based care contracting and everything that comes with it a little bit further down the line. And so as a result of that, we're seeing more and more prospective sellers think about these partnerships. Having said that, we do see this highly fragmented space ripe for additional platform investments. We just saw another one pop up several weeks back.

Ortho Nebraska was recapitalized by InTandem Capital Partners. We've seen somewhere between eight and 10 total platforms be created just since the start of 2021. With each of those platforms we know soon to follow will be a severe amount of add-on activity. And we're also aware of several large groups that are out there looking right now to maybe be a platform of their own. So I think when you couple that with the fact that a number of these platforms have been in existence for quite a while, dating back to the 2017, 2018 timeframe, the likelihood that a number of them are going to evaluate a transaction of their own, we're going to see really activity at all levels, add-on platform and the recapitalization of existing consolidators. So I expect a lot to happen in the next 12 to 24 months, and activity will definitely be high.

The pathway of going from physician owned to a smaller platform, a smaller platform selling to a bigger private equity fund or combining with another larger platform, it always kind begs the question of, well, is there any terminal buyer, the backend of this consolidation process? When you think of kind of terminal buyers, if that's even appropriate construct, how do you think about the backend buyers of larger platforms?

Yeah, it's a common question and I think as it relates to the private equity community, which is obviously fueling a lot of this interest, we're talking about the kind of deals that are getting done today relatively, lower to mid-market activity. So I would say for the foreseeable future, there is definitely pathways to larger and larger private equity funds to where the recapitalizations through the traditional PE model is going to precipitate for quite a while. Now, we're also going to see the involvement of unique, I think strategic acquirers many years down the road, if not maybe a little bit sooner. So think groups like an Optum, for example, tied to UnitedHealth could be very interesting if you acquire a very large orthopedic platform in markets that you already have dense, large patient populations on the payer side of things.

And so we've seen them be active in that capacity when they can control large populations and get things on both the physician practice side, as well as the payer side. I think not as successful historically, although there's probably some learnings to be had, would be potentially development for publicly traded physician practice groups. So we've seen that happen in years prior here, some successfully, some less. So I think that's potential as well. But between the payers, the large multi-specialty systems, large health systems, and the potential of going public, those are probably the largest avenues we see, albeit the necessity of those is probably many years down the road.

In a number of sectors where private equity investment and consolidation has occurred, it starts with the broader sector and then sub-sectors emerge that become their own platforms. Do you think that orthopedics lends itself to that kind of subspecialty?

I do. I mean, we've seen a variety of different things we naturally put within the musculoskeletal spectrum be fantastic investment platforms in their own right, whether it be physical therapy or pain management or imaging. Neurology is one that's really getting off the ground these days. So yes, I definitely think there's the opportunity for some of these more subspecialized categories to either continue to consolidate or to begin consolidating as a standalone kind of focus. I do think beyond that and longer term, there's a natural tendency for these capabilities to come together, getting back to that value-based care contracting concepts, being able to capture the full continuum of care in one centralized system will have value longer term and probably fuel the consolidation of these truly sub-specialized practices. But yes, without a doubt, there are individualized opportunities across these a little bit more nascent sub-specialized categories.

Scott, I think we could talk for quite a bit on this topic, but let's end it there. Thanks a ton for spending a few minutes with us. Your insights and market presence is tremendous. Thanks again. It's been a ton of fun.

Thanks, Geoff. Appreciate it.

Thank you for joining us on this installment of The Corner Series. To learn more about today's discussion, please email host, Geoff Cockrell, at gcockrell@mcguirewoods.com. We look forward to hearing from you. This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.