Grow your own:

Case study of a capital alternative

By Michael J. Pulaski, FACMPE

Abstract
The physician-administrator team can take all that is good from the physician practice management company (PPMC) model and apply a variation of self-financing called a "tithe" in order to facilitate their group's growth. Essentially, a group can create its own PPMC for local consolidation purposes, contracting with payers, spreading risk contracts over a larger base of providers, getting access to ancillary services, centralized business office services, bulk purchasing and many other of the advantages extolled by PPMCs. Organization has value, especially in times of specific industry consolidation. Although most everyone agrees that the medical industry is undergoing tremendous consolidation, consolidation will not likely occur "top-down." Rather, it will occur more slowly - one group at a time, one locale at a time. If a group positions itself as a local consolidation leader and amalgamates other groups onto its "token ring," then all participants - especially those who initiate this consolidation - will reap the benefits.

Learn from the PPMCs
The rise in power of managed care eroded physicians' autonomy over their fee schedules, driving their practice overhead up and their incomes down. The physicians' quest for income generated by ancillary services increased - as did the cost to acquire such capabilities. Competition intensified among physicians to participate on the better-paying provider panels. The pressure on practicing physicians to keep their medical businesses viable in this environment became unbearable for most, driving some of them into the hands of "practice consolidators" or physician practice management companies (PPMCs).

PPMCs gained their popularity because they offered a way for medical groups to:

• access significant financing for growth;
• access business information systems;
• access group purchasing advantages;
• access sophisticated management;
• confederate with other providers into a single bargaining unit that would have impact on payers' decisions; and
• leverage their assets in exchange for cash and/or stock in the purchasing PPMC.

The most common reasons given for the recent tightening of the PPMC market are:

• They did not provide an added value commensurate with the management fee they charged;
• The publicly traded PPMCs were forced into producing quarterly financial results - a time cycle that is not well suited to the medical business;
• The publicly traded PPMCs diverted too much of their management fees into their own overhead or into shareholder dividends (essentially, they inflated their earnings to influence their stock trading price). Soon, investors lost confidence in the PPMC model;
• They never seemed to have enough capital to invest in infrastructure for their physician-clients;
• They largely replaced local operational decision making with centralized, absentee management; and
• They promised more than they could deliver.

Although there is general agreement that the health care delivery system is undergoing rapid change and is moving away from a "cottage industry," the fact that nearly 75 percent of all physicians today are in groups of 10 or less shows that this anticipated consolidation has quite a way to go. Similarly, most mid-size to large metropolitan areas are not dominated by one group; rather, a number of groups, anywhere in size from five to 25 physicians, vie with each other for market share and dominance. Therefore, there exists an opportunity in most metropolitan areas for a smaller group - if only it can identify a strategy to influence or lead a consolidation of its local provider market.

It is important to understand that the consolidation of our industry will take much longer than the PPMCs envisioned; it will involve countless "smaller steps" - one group and one community at a time - in order to take effect. If you want your group to take an active part in this stepped process, then begin developing a strategy to make it happen.

The strategy
Consider a strategy that puts your group in the best position no matter what the future will bring - while at the same time enjoying short term success. This strategy assumes a continuing consolidation in our industry. The particulars of how that consolidation occurs remain unclear, but it doesn't matter. A winning strategy fits into any scenario of what future consolidation may bring, and it will afford your success. Put your group in the pathway of consolidation - as a "speed bump" that commands negotiation.

Most entrepreneurial physician-administrator teams in smaller groups are faced with the question of how to develop a strategy for growth and consolidation, a strategy that will provide:

• access to capital;
• preservation of autonomy;
• local leadership and management;
• increased bargaining power with payers;
• increased market share - even market dominance;
• access to bulk purchasing; and
• access to sophisticated information systems.

• develop a written strategic plan that will provide the mission statement, budgets and financing;
• ensure that the group members "buy into" the plan. The only way to do this is by having the physicians' pledge their personal funds for an extended period of time;
• have community-recognized physician and business leaders; and
• have developed a "entity vehicle" for this consolidation and growth.

Having community-recognized leadership is the most difficult part of the strategy to assess. Because considerable ego-inflation is found rampant among all participants in our particular industry, the chance is great of making a miscalculation of your group's leadership potential. If, however, after brutal self-assessment, you believe your group has the individuals who can provide the necessary leadership, then the investment of time and money becomes worthwhile.

Although there are a number of "entity vehicles" to choose, the creation of a management services organization (MSO), formed as a limited liability corporation (LLC), is favored. The MSO becomes a spin-off company of the host medical group (perhaps your group) and is controlled by that host.

The MSO essentially operates as a "token ring," to which groups in this local consolidation can attach themselves as individual tokens, each keeping its own employer identification number (EIN), compensation formula and governance. However, ancillary development, information systems access and development, on-call schedules, payer contracting and bulk purchasing can be pooled.

The "token ring" design is similar to what many PPMCs tried to accomplish in various locales with moderate success. The management companies discovered that the intangible cost of merging different cultures into one EIN was enormous and time consuming. The "token ring" design obviates this problem.

Real-life example
Historically, medical groups have run their businesses by the "eat what you kill" or "Darwinian" method. That is, the physicians take home whatever money is left after income is received and expenses are paid, leaving no corporate earnings. Minimizing tax on corporate income is considered a virtue in this model.

Normally, capital acquisitions are made using either debt or leases. These capital acquisitions, along with satellite office expansion and the addition of contracted physician employees, sometimes means that the pool of money available for distribution to the group is diminished by the added expense. Usually this comes as a "surprise" - and the result is to borrow money to maintain physician compensation at current levels. Oftentimes, the borrowing group does not focus on the repayment mechanism of this debt.

The consolidation of a marketplace takes considerable capital expense - more than the average group practicing the Darwinian compensation scheme and tax strategy is willing to pay. The organizers of PPMCs knew this and created a popular sales tool by representing their ability to finance significant projects. Actually, all the PPMCs did was leverage the management fees they collected from their physician clients.

The usual management fee that a PPMC charges is 15 percent of its client's practice income. Ordinarily, a physician practice agrees to pay the management fee for 40 years. The fees that a PPMC collects from all its clients is its revenue stream - a stream that can be pledged, in part, to a venture capitalist or other financiers for a cash loan to the PPMC. The PPMC, in turn, agrees to pay back the loan principle with interest using a portion of its income stream received from its physician practice clients.

The group taking the leadership position in local consolidation will install a variation of the model of leveraged financing that the PPMCs use. At Peachtree Orthopaedic Clinic, we call it the "tithe."

Each participant of the tithe agrees in writing to have 10 percent of his/her compensation withheld for five years. The money is accounted separately and used according to a group-ratified strategic plan budget.

The tithe becomes an income stream that is leveraged for this growth and consolidation. The tithe agreement documents along with the strategic plan budgets are presented to financiers so the medical group can acquire a significant line of credit, which, in turn, is used for all the planned operations and acquisitions. Like the PPMCs, the group pledges its tithe revenue stream as payment of principle and interest for any use of credit facilities.

Perceptions are powerful. The implementation of a tithe strategy can give your group an edge compared with other groups of even greater size in your area, but still practicing the Darwinian business model. Consider that if your group installs a tithe plan for five years, then your group could be perceived to be five times bigger than it actually is. This is due to your group's capability of affording more growth activity through its tithe strategy. Similarly, your tithing group will be perceived as more formidable by your local hospital administration, medical product companies and insurers, making them more likely to strike favorable joint venture deals with your group.

Ostensibly, the purpose of an individual buying into a medical group is to capitalize it. Normally, stock and voting rights in the group are issued in exchange. The buy-in money is kept by the organization until the relationship terminates, then the stock is re-purchased.

The tithe is analogous to a "second buy-in" through an income-deferral program. Thus, when the tithing person terminates, his/her stock is re-purchased and the tithe amount is repaid as compensation, and the group takes the tax deduction. Groups may consider the time/value of the tithe, and include it in its re-purchase agreement with the tithing participants.

Consider the tax consequences
The most common objection to a tithe strategy is its tax consequence. Simply, if a company leaves money (profit) on the books at its tax year end - which a tithe will do - then the profit is subject to corporate tax. However, there are other considerations why showing profit may be better than commonly thought by those in our business.

In most cases, the marginal tax rate for individuals is about 5 percent greater than it is for professional corporations. Thus, if a physician leaves money in his professional corporation, 5 percent less tax is paid on it. Further, if the group's strategic plan is rigorously thorough, then it should sufficiently demonstrate that by leaving money in the company, each physician will personally benefit from better insurance contracts, added ancillaries, more satellite offices, more providers sharing call, access to sophisticated information systems, more autonomy and greater stability.

It is entirely possible for the tithing group to plan its use of tithe money so well that the only amounts subjected to corporate tax would be depreciable capital items or investments in outside businesses. The tithe money used for fully deductible items would not be taxed.

Also consider that each time a PPMC declares dividends, it pays out these dividends after paying corporate tax on them. This means that the management fees they collect from their client-physicians are used to pay those taxes. Ironically, many PPMC client-physicians have stridently refused over the years to pay tax on earnings in their practices before affiliating with a PPMC, yet support the payment of corporate taxes with the management fees that they pay to the PPMC after their affiliation. The lesson here is that most mainstream businesses accept paying corporate tax as routine, so why should your group be any different?

One step at a time
There is intrinsic value in organization. The larger the organization, the greater its value. PPMCs attempted to create national providers from a cottage industry. Unfortunately, such a consolidation takes more time and many more (smaller) steps than the PPMCs envisioned.

The group that chooses to assume local leadership in a consolidation effort must believe that by this effort it will create greater intrinsic value. Further, it should be the group's belief that when the next step in consolidation of our industry comes, and neighboring locales begin to amalgamate, the group will be in a position to reap the rewards of the value it created in its own locale.

If your group has community-recognized physician and business leadership, develops a detailed strategic plan and supporting budgets, adopts a method of leveraged financing through the use of tithing, and creates an "entity vehicle," then you can successfully lead and implement a local consolidation and growth. Your group can do this without giving up as much autonomy as with any other model for growth and consolidation, and the group will be able to ensure a more stable future as well.

Michael J. Pulaski, FACMPE, is an MGMA member and CEO, Peachtree Orthopedic Clinic, and may be contacted at mjpulaski@earthlink.net