How to choose the right capitalization option - finance options for physician group practices

Healthcare Financial Management, Dec, 1996 by Jim Vaughan, Joan Wise

Physician group practices and networks must have ready access to capital to finance their working capital needs, capital equipment acquisitions, and real estate purchases, as well as to fund the acquisition of additional practices.

At least three options for capitalization are available to group practices and networks: debt financing, equity financing, or a combination of the two. The best option for physician group practices and networks depends on the costs of capital and the impact the strategy will have on decision making and governance.

The one constant in a changing healthcare marketplace is the need for capital. Physician group practices and physician networks need working capital as well as capital for the purchase of equipment and real estate, and for financing the acquisition of additional practices. Regardless of the size of a physician group practice or network, access to capital is critical if the practice is to successfully compete.

In the past, sole practitioners who required capital to expand their practices would use their personal resources and borrow from commercial banks while pledging personal and practice assets to secure a loan. Larger, well-established, not-for-profit group practices have had access to the tax-exempt debt markets for their facility and equipment needs. Both short-term or long-term debt maturities are available in this market. Further, privately held, for-profit group practices have had access to the taxable debt markets and traditional commercial loans secured by physician guarantees and practice assets, and they have also obtained needed equity from strategic partners and venture capital funds.

More recently, in the process of rolling up other physician practices, publicly owned physician practice management (PPM) companies have begun to access the equity debt markets and secure cash flow loans from major lending institutions.

As the financing needs of healthcare providers have changed, a number of different entities wishing to partner with physicians has surfaced. These entities can bring with them more than an infusion of capital. In many instances, these partners also offer economies of scale and management skills with the attendant contracting leverage and administrative infrastructure. The array of partners includes traditional sources, such as hospitals and private investors, but the spectrum has broadened recently to include insurance companies, venture capitalists, hospital management companies, dedicated PPMs, and in one instance, a pharmaceutical firm.

Moreover, the consolidation of physician practices and the formation of networks have forced those establishing or acquiring physician practices to investigate alternative ways of raising capital. These methods include debt and equity financing. With a broad array of financing mechanisms available, the question then becomes, which to choose? Both debt and equity financing are attractive alternatives for capitalization; however, each has advantages and disadvantages that a group practice or network must carefully consider before embarking on a strategy.

Debt Financing

For a large physician group practice or network, debt financing often can be the cheapest source of capital available. For example, interest rates on debt can range from money market rates of approximately 5 percent to high-yield, subordinated debt rates of more than 20 percent, depending on the credit profile of the borrower. In contrast, early-stage equity "seed" capital may return anywhere from 30 percent to 100 percent, and the public equity market may seek returns of 15 percent to 35 percent.

As a capital formation tool, debt financing requires:

* Security or collateral for the lender;

* Timely debt service payments; and

* A credible credit profile of the borrower (market position, revenue, earnings).

For group practices and networks, debt financing can be particularly useful for providing working capital, acquiring income-producing businesses, and for financing plant and equipment purchases.

Financing working capital. For physician networks in particular, debt financing is the best tool to meet working capital needs. Unlike permanent equity, debt carries with it a fixed term that can be structured to coincide with business cycles. For instance, debt can be used as a short-term financing vehicle (for a period of several months to a year) to ease periods of negative cash flow, such as during planned growth phases or business slowdowns.

Acquiring income-producing businesses. Properly structured debt is also a flexible tool for acquiring income-producing businesses. A growing physician network, for example, can structure an intermediate-term financing arrangement (two to five years) to fund new physician practice acquisitions. As the newly acquired practices generate revenue for the network, the revenue can be used to redeem the outstanding debt.

Financing plant and equipment purchases. For accounting and asset management purposes, plant and equipment can be financed by long-term debt. The term of the debt should match the expected useful life of the equipment. As principal and interest payments are made, they will be partially offset by depreciation expenses on the organization's income statement.