Explanations provided by industry experts
Glossary of Terms Defined:
- EBITDA
- Enterprise Value
- Income Repair
- Multiple
- Scrape percentage
- Second bite and rollover equity
- Triple net lease (NNN lease)
- Quality of earnings (QofE)
- Value Based Enterprise
- Value Based Care (VBC)
EBITDA
EBITDA is an acronym that stands for “earnings before interest, tax, depreciation, and amortization”. EBITDA, therefore, represents the financial results of a company’s activities, with interest costs and interest earned as well as all depreciation being excluded.
EBITDA is typically utilized as a financial metric to compare the underlying profitability of a company regardless of its depreciation assumptions and/or internal financing decisions. EBITDA is most often used in company valuation ratios, notably in combination with Enterprise Value as EV/EBITDA, also known as the Enterprise Multiple, Transaction Multiple, or simply the Multiple.
The core purpose of EBITDA is to enable the comparison of profitability across varying industries or businesses and is most often utilized to evaluate a company’s financial performance. EBITDA can be a useful tool for better understanding a company’s underlying operating results, comparing it to similar businesses, and understanding the impact of the company’s capital structure on its bottom line and cash flows.
EBITDA can also be a beneficial metric when comparing companies subject to disparate tax treatments and capital costs or analyzing them in situations where these elements are likely to change.
Definition provided by:
Managing Director
Enterprise Value
Enterprise Value (“EV”) is defined as Invested Capital, which is the sum of the value of the equity of the practice and any interest-bearing debt, less cash and short-term investments. The reason that we use EV in the context of these deal negotiations is that a (prospective) buyer (e.g. PE firm) prices the transaction as a “multiple of EBITDA”, which is a term most physicians understand as “Earnings before interest, taxes, depreciation and amortization” (i.e., it is a “proxy” for cash flow before accounting for any debt services associated with principal payments and interest).
The formula is as follows: Enterprise Value (i.e., EBITDA) Multiple = Enterprise Value/EBITDA
Since EV includes the value of any interest-bearing debt on the balance sheet (e.g. loans, notes payable, capital leases) we must then subtract the value of the debt in determining the value of the equity, which ultimately represents what the physicians will get. Here is a simple example:
Enterprise Value = EBITDA X EBITDA Multiple (reworking the formula from above)
$50 million EV = $5 million EBITDA X 10.0 multiple
If we assume that there is $15 million of debt, then the value of the equity is calculated as follows:
EV – Debt = Equity
$50 million – $15 million (debt) = $35 million equity value. The debt is paid off at close, and the physicians receive the remaining value of the equity (i.e., $35 million in this example).
There are other things to consider such as “normalizing” the EBITDA to make certain it is representative of what the buyer can expect to earn in the first year after the transaction (examples to normalize include removing personal/non-recurring expenses, removing extraordinary expenses, restating legal fees to a “typical level, backing out one-time revenue events, etc.). The point is that there is a lot of time and effort in arriving at the EBITDA number for purposes of the valuation.
Definition provided by:
Senior Managing Director
Income Repair
Physicians typically “sell” some of their historic take-home compensation as part of a private equity transaction. Immediately after a deal, they earn less on an annual basis than they did before. “Income Repair” refers to an increase in revenue and/or profitability that offsets this decrease, “repairing” the selling physician’s income. Income Repair can come from a variety of sources, such as adding new ancillary revenue, optimizing payer contracts, or simply increasing production.
It is important to pay attention to each buyer’s potential to repair income, and this is often a case-by-case situation dictated by the local market and other factors. A buyer with a strong ability to repair income might present a superior offer, even if the transaction value is not the highest. The goal is to optimize the total package including both transaction value and post-transaction income.
Definition provided by:
Managing Director & Healthcare Team Leader
Multiple
A “multiple” is a short-hand metric used to value an enterprise, a Company, based on the Company’s annual financial performance. The investor calculates the enterprise value based on how many total years of the Company’s EBITDA it is willing to pay for given prevailing market circumstances.
For instance, if the Company generates $10 million in EBITDA and the investor ascribes a 10x multiple, then the investor has valued the Company at an enterprise value of $100m ($10 x 10 = $100).
There are many factors that are considered in determining the appropriate multiple to use. Some of them include the quality of the business, future growth prospects, risk profile, and other operational and financial characteristics. The multiple approach to calculating a valuation is short-hand to a comprehensive approach that analyzes the future risk-adjusted cash flow generating capability of the Company into perpetuity (called a Discounted Cash Flow Analysis).
The multiple approach is a simplified version that approximates the Discounted (risk-adjusted) Cash Flow Analysis approach. This is one of the most widely utilized valuation metrics in articulating the Enterprise Value of a Company.
Definition provided by:
Managing Director
Scrape percentage
Scrape percentage refers to the percentage of Earnings Before Partner Compensation (EBPC) of a practice that an investor pays a multiple of to determine the purchase price. This percentage of EBPC represents profitability that will be swept to the management company post-closing, an entity in which both the investor and physicians will have ownership.
This is important for physicians to know because the higher the scrape percentage, the more earnings the physician owners are “selling” in the transaction. This equates to a higher purchase price – meaning the practice owners receive a larger check when the sale closes – but decreased compensation post-closing.
Investors are generally wary of compensation scrape percentages above 40% as they fear owners will be underpaid post-close, and therefore less motivated.
Definition provided by:
Managing Director
Second bite and rollover equity
Acquisitions are often structured with two separate liquidity events. The first liquidity event is the initial sale of your practice/business, in which you sell a portion or all of your equity in the business.
If only a portion of the equity is sold during that initial transaction, then the existing shareholders maintain the remaining equity, which is known as rollover equity. The “second bite” is the capital received when any rollover equity is sold.
The second bite is important for several reasons:
#1. It aligns incentives between buyers and sellers by creating a vested interest in maximizing the value of the business.
#2. If the existing shareholders remain employees of the company, they may face a compensation decrease in return for the potential upside compensation received from the “second bite.”
#3. There are tax advantages from the capital gains received from the second bite versus W-2 income.
#4. This structure provides potential buyers with more flexibility as less capital is required at the initial purchase price.
Definition provided by:
Principal
Triple net lease
Also sometimes written as “NNN Lease,” it is a type of lease whereby in addition to rent, a tenant is also responsible for the cost of property taxes, building insurance and maintenance, repairs, and replacements to the building. Such leases are common in single-tenant and multi-tenant buildings, regardless of use, including retail stores, industrial operations, and medical practices.
NNN leases are important for physicians to understand and have in place if they own their practice or surgical center real estate. This structure of lease provides the practice/tenant with the most control of the building, while also creating a predictable and consistent stream of rental cash flow for the landlord, resulting in maximized value if a sale is ever to occur.
Definition provided by:
CEO and Managing Director
ERE Healthcare Real Estate Advisors
Quality of earnings
Quality of Earnings or “QofE” refers to the portion of a practice’s net income resulting from its core or recurring business operations – such as those office visits and surgical or other procedures that the practice routinely performs.
For example, imagine a practice’s net income rose due to increased patient revenue while at the same time, the practice reduced its overhead expenses. If this scenario was likely to continue going forward then that practice would be seen as having a high quality of earnings.
However, if a practice’s net income increased solely because of a change in its accounting methods, or because it converted its loan repayment obligation from one of principal and interest to one of interest-only, thereby lowering the amount of its debt expense in the short-term, such a practice would be viewed as having a low quality of earnings.
In the PE/healthcare context, private equity firms typically value potential practice acquisition targets using an EBITDA multiple. In doing so, PE firms often rely upon QofE as one of the factors in analyzing a practice’s revenue – both from a historical and forecasting perspective.
Definition provided by:
Partner
Value-Based Enterprise:
A value-based enterprise is a formal partnership between two or more healthcare entities collaborating to advance value-based care goals and is subject to well-defined regulatory requirements. The Stark Law and Anti-Kickback Statute each define exceptions for value-based enterprises that allow for greater flexibility in how providers are paid in exchange for the enterprise adopting downside payment risk.
Value-based care (VBC) refers to the delivery of medical services whereby providers are financially accountable for the quality and/or cost of their services. The primary reason to care about VBC is that payers (Medicare, Medicaid, commercial insurers) are changing how they reimburse physicians for what they do.
Value-based reimbursement to physicians is usually based on one of three models:
#1. A hybrid of fee-for-service payments with an at-risk component. (Example: $90 for an established patient visit with the opportunity to earn up to an additional $20 based on predetermined outcome measures)
#2. Episode-based payments. (Example: $20,000 for medical services associated with knee replacement, including physician services)
#3. Capitated payments for all prospective care over a time period. (Example: $40 per patient per month for all potential physician services related to the management of diabetes).
There are many reasons why value-based care should matter to physicians in the context of M&A negotiations. Here are a few of the highlights:
- Many investors in physician practices, including private equity, health systems, and payers, are focused on acquiring groups that they can attach to an existing platform for VBC. The investment thesis is that the more covered lives an organization can wrap under a value-based reimbursement contract, the more risk can be mitigated and economies of scale leveraged. Right now, the focus is on specialties like primary care and behavioral health.
- The substantial growth in Medicare Advantage plans (nearly half of all Medicare beneficiaries are enrolled in a Medicare Advantage plan) has increased the investment value of practices able to succeed in VBC. This is because, as a gross simplification, Medicare Advantage plans are funded by the government through capitated contracts (per member per month); in addition, they earn more from the government the better they perform on predetermined quality metrics. They have less risk and greater opportunities to profit if they can reimburse physicians under similar capitated value-based reimbursement models with rewards for higher quality.
- The substantial growth in health insurance premiums has led businesses to seek ways to control this very large expense item on their profit and loss statements. Many companies have employer-sponsored health plans, which basically means that they pay for their employees’ healthcare needs out of their own pockets, with an insurance company essentially acting as a third-party administrator of how the plans reimburse healthcare providers. Many third-party administrators have successfully approached large companies by arguing that they can manage out-of-control health spending through value-based reimbursement models with the physicians that provide care to their employees. The harder it is for companies to afford health insurance, the more they will exert pressure on physician practices to adopt VBC.
Definition provided by:
Partner
Glossary of terms compiled by Erin Laviola, a writer for Levin Associates
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