Why private-equity firms are buying up primary-care practices

When Oak Street Health, a Chicago-based network of seven primary-care clinics, began looking for investors last year for expansion, it talked with about 40 private-equity funds.

About 15 firms came to Chicago to conduct due diligence, and most ended up bidding, said Oak Street CEO Mike Pykosz, whose group focuses on coordinating care for patients in traditional Medicare and Medicare Advantage plans. The group ultimately chose Harbour Point Capital, a New York-based private-equity firm.

“We had a large amount of interest,” Pykosz said. “It was a competitive process to pick someone. There are not a lot of people who are doing what we're doing.”

The March deal between Oak Street and Harbour Point is one of a small but growing number of investments that private-equity firms are making in primary-care physician practices that are ahead of the curve in offering new care delivery and payment models. Investors see an opportunity in being early participants in value-based care, even as the business case is still unclear given mixed results in Medicare's payment and delivery reform demonstrations so far.

But the niche is well-suited for private-equity firms, which feed on uncertainty, said Todd Spaanstra, a partner at Crowe Horwath, an accounting and consulting firm. Investors are putting faith in the idea that the market is headed toward shared-savings payment models. They're placing their bets to get in on the ground floor.

The long-term opportunity for private-equity firms is the ability to sell these managed-care-savvy medical groups to insurers or health systems, which may pay a premium for the care-coordination expertise and data analytics these practices offer. Primary-care groups that can demonstrate better quality and lower costs in managing medically complex patients will be valuable in a healthcare system that will increasingly reward cost-effective care.

“It's a land-grab right now,” Spaanstra said. “These are very small companies that are really just getting started. They're going for crazy multiples just because (private-equity firms) see the potential there.”

Private-equity firms traditionally have invested in medical groups that offer high-reimbursement potential, such as dermatology, pain management and dentistry. That's still the case. But part of the reason private-equity investors are looking at primary-care groups, and the managed-care space in particular, is because specialty practices are becoming comparatively more expensive.

Most M&A experts still see a seller's market. Provider groups are demanding high prices, and very often they're getting those prices from companies making a strategic play. Private-equity firms, meanwhile, are searching elsewhere for opportunities.

“The large (corporate buyers) are doing deals at valuations that are above their historical comfort levels,” said Slava Girzhel, managing director at KeyBanc Capital Markets. “There's a lot of discussion about private-equity investing in risk-based models, and I do think we'll see more of that.” Part of the reason they're going after less lucrative specialties like primary care is because their traditional provider targets are now too expensive.

Modern Healthcare's Q1 M&A Watch report tracked 294 deals in the first quarter of this year, an increase of 25.1% over the same period in 2014. Deal value, meanwhile, shot up to $97.9 billion, more than twice as high as the comparable period's $48.9 billion.

In the provider sector, deal volume reached 113 deals in the first quarter, a 46.8% increase year over year. Deal value shot up to $18 billion, nearly four times higher than in the same period last year. Private-equity firms increased their dealmaking activity in the first quarter, forging a total of 41 healthcare deals, including 14 in the provider sector. That compares with 28 total deals in the prior-year period, of which 10 were in the provider sector. Deal value, however, totaled only $4.5 billion, down from the comparable period's $8.6 billion.

The typical private-equity investment timetable is short—about five years. At that point, the firm would probably look to sell the practice, ideally to an insurance company or a health system, said Dan Hosler, a principal at private-equity firm Sterling Partners.

The areas of the country that are seeing the most activity are the ones where physicians have experience working with public and commercial managed-care programs. States such as Ohio have been consolidating the number of Medicaid managed-care contracts they're awarding, while moving toward a care-coordination and value-based payment approach. Insurers will be bidding for those contracts, and they need to show they have the expertise to manage complex medical needs, Hosler said. “That's why the insurance companies are excited about it,” he said.

At Oak Street, each patient has a care team consisting of a physician, registered nurse, medical assistant and care manager, along the lines of a patient-centered medical home. An average visit lasts 30 minutes, but a patient could spend as long as 90 minutes meeting with each person on the team. There are four care teams per center and each care team has a maximum of 750 patients. The practice provides concierge-like services, offering connections to social services for patients who need them.

The success of its approach is evident in strong patient-satisfaction scores and an admission rate that is 40% lower than the benchmark in Cook County, Ill., Pykosz said.

“A large part of what Oak Street is doing, with a high-touch approach, is that they're able to prevent small problems from becoming big ones,” said Robert Juneja, who co-founded Harbour Point Capital in January. “They bring together a lot of different themes that we're excited about.”

Hospital systems also have been purchasing physician groups at a rapid clip to build their provider networks and prepare for the time when they will be paid based on their effectiveness in keeping their enrolled populations healthy. Robust primary care will be central to that mandate, and fragmented healthcare markets around the country have been consolidating.

On the provider side, DaVita made one of the largest bets on value-based healthcare in 2012 when it paid $4.4 billion to buy HealthCare Partners, a multispecialty, multistate medical group with deep experience working with capitated contracts, Medicare Advantage plans and other risk-based contracts. But DaVita's investment has underperformed investors' financial expectations, as DaVita leaders say they have struggled with internal operational issues in the medical group.

But large health systems are still buying medical practices. In the greater Chicago area, for example, Alexian Brothers Health System, which operates 375-bed Alexian Brothers Medical Center in Elk Grove Village, Ill., in February bought the Medical Care Group, a six-site primary-care practice in suburban Chicago, for an undisclosed price. Alexian itself merged with Adventist Midwest Health earlier this year.

One of the key benefits of acquiring the Medical Care Group, Alexian Brothers said, was its experience in managed-care contracting with public and private insurers. The practice operates an independent physician association that manages care for about 3,000 individuals, giving it significant training in managing the health of its covered population. “Their experience will provide a lot of value to us,” said Kimberly Zimmermann, chief operating officer of Alexian Brothers Medical Group, in a news release announcing the deal.

Still, many systems have yet to see a return on their investment in buying physician practices. Employing physicians means they need to pay hefty salaries and benefits, as well as the overhead costs associated with office-based practices. Many health systems acquiring physician practices have adopted productivity-based compensation models, to avoid the costly mistakes they made in the 1990s, when they last rushed to buy physician groups.

Hospital systems that receive a significant portion of their payments from capitated contracts also have reported that their revenue has decreased because the end goal of those contracts is to reduce utilization.

Those realities have led some for-profit companies, particularly publicly traded hospital chains, to take a wait-and-see approach to population health management. But other investors see opportunities in being early adopters. “For the people who are well-prepared and understand how those payments will work, there's a tremendous competitive advantage and clearly a lot of money to be made,” said Jeff Swearingen, a managing director at Edgemont Capital Partners, who specializes in deals involving physician groups.

Many states have moved to Medicaid managed care to control costs, and the number of people enrolling in Medicaid plans is growing rapidly, said Hosler of Sterling Partners. Medical groups skilled in population health management could fetch a premium price from insurers looking to win Medicaid managed-care contracts from states.

“That is a newly increasing population,” Hosler said. But working with Medicaid patients often requires a different approach than physicians might use with commercially insured patients. “The best providers are the ones who can manage complex medical needs,” he added.

Physician groups that specialize in capitated payments benefit when they can keep their overhead costs low. Partnering with a private-equity firm provides a growth opportunity that allows them to spread their costs over a wider base. “It's scale,” said Mark Claster, a partner at Carl Marks Advisors. “People get paid for being more efficient. If you're able to take many of the central costs out of that business, you can do that very well.”

Insurers such as Cigna Corp. and Centene Corp. also have been buying medical groups that specialize in chronic disease management. In September 2013, Cigna purchased Chicago-based Alegis Care from Triton Pacific Capital Partners. Alegis coordinates care for homebound Medicare and Medicaid beneficiaries. In December 2013, Centene purchased a $200 million majority stake in Troy, Mich.-based U.S. Medical Management, which also provides home health services for high-risk patients.

Value-based payment models will create challenges for insurers and providers, but some investors are hoping that there will be a first-mover advantage. Healthcare providers that excel at managing population health will make up the lost revenue from lower utilization with more volume and greater market share.

“This is an area where there are winners and losers,” said Dr. Andrei Gonzales, director for value-based reimbursement initiatives at McKesson Health Solutions. “It's everyone trying to get a slice of the pie that's getting smaller.”