September 25, 2023 •Michael Bannon
Private equity's growing imprint on American healthcare is unmistakable. Financial buyers poured nearly $1 trillion into the industry over the past decade and associated transaction volume remains robust.
That's meant meaningful payouts for physicians and shareholders. But concerns of declining medical access, care quality, and workforce stability have also emerged. In addition, a notable number of practitioners and business owners have expressed seller's remorse, lamenting their loss of autonomy following private equity (PE) transactions.
PE can create optimal outcomes for healthcare stakeholders, but it's not a magic bullet. As a result, there's growing demand for alternative transactions. Employee stock ownership plans have emerged as compelling strategies — especially in instances where independence, tax efficiency, and continuity are paramount.
What's Unique About a Healthcare ESOP?
An ESOP transaction is effectively a leveraged buyout on one's own healthcare practice or company. What sets it apart from private equity is that deal financing is secured directly by the firm and ownership interest flows to employees, rather than outside investors. The Employee Retirement Income Security Act of 1974 (ERISA) governs how plans work.
When equity is sold to an employee stock ownership trust, the transaction unlocks unique tax benefits for all stakeholders. Plan sponsors gain corporate income tax deductions, selling shareholders can defer capital gains burdens on their proceeds, and employees' benefits gradually accumulate in tax-deferred retirement accounts.
ESOPs are also proven to enhance staff cohesion and retention. Both are critical components of care continuity. Furthermore, plans offer clear pathways to ownership for rising practitioners and managers. PE often leaves little upside these next-generation leaders.
Comparing Private Equity and Leveraged ESOPs
The operational and strategic expertise of a private equity investor can yield post-sale advantages. But the trade-off is often a loss of control. A PE firm will usually have final say in business decisions moving forward.
Conversely, an employee-owned company maintains its independence and is overseen by its board of directors. Practices remain physician-led.
PE and ESOP transactions should yield equivalent fair market valuations. Although PE may offer selling shareholders more cash at closing, the proceeds are subject to capital gains taxes. In addition, sellers are generally required to carry equity over to the post-acquisition structure (typically a roll-up of similar practices or healthcare companies). It's also common for sellers to invest additional cash during subsequent platform acquisitions to prevent dilution of ownership.
ESOPs do carry an added regulatory burden. Plans are overseen by the Department of Labor and trustees serve as fiduciaries. Nevertheless, employee-owned firms are free to engage in M&A activity, including acquisitions and third-party sales.
Corporate Practice of Medicine Considerations
In states where medical practice ownership is restricted to physicians, ESOPs employ transaction structures that parallel private equity. Management service organizations (MSO) are spun-off from professional corporations (PC) to handle all non-clinical operations, including administrative, billing, and payroll functions.
Equity in the MSO, rather than the PC, is what's ultimately sold in an ESOP transaction. To establish a valuation, the MSO retains a portion of a practice’s total cash flow.
ESOP-led Growth Strategies
Private equity strategies often hinge on the initial purchase of sizeable practices, MSOs, or healthcare firms. After acquiring a "platform company" in a leveraged buy-out, a PE buyer may use that firm's cash flow to acquire additional, often smaller, providers.
Larger businesses are generally valued at higher multiples. In consolidating add-on acquisitions (purchased at lower multiples), PE firms attempt to create enterprises that can eventually be sold at higher overall multiples, thereby generating greater returns on their investments.
An ESOP growth strategy effectively replicates this model. The key difference is that shareholders and employee owners continue to benefit from enterprise appreciation. The corporate income tax benefits associated with an employee stock ownership plan also enable platform companies to more efficiently accumulate cash for potential acquisitions.
Employee Ownership is a More Than a Transaction
When providers and healthcare companies build ESOPs, they're betting on themselves. While a well-crafted plan can offer shareholders a fair market liquidity event, it also represents an ongoing commitment to team members, their communities and professional legacies. Self-reliant, entrepreneurial firms are often best suited to embrace an employee ownership mindset.
Therefore, practices need to both adequately prepare for an ESOP and continue to build internal capacity post-transaction. Capable, organized teams with strong benches are critical. Although selling shareholders can maintain meaningful roles long after a plan is formed, other leaders must share the burdens of management for a firm to perpetuate and grow.