Q3 2023 Healthcare Private Equity Outlook & Trends


Look ahead to 2024 with our take on Private Equity M&A trends in strategic & private equity investing.

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As we approach the end of Q3 and look ahead to 2024, a number of factors are shaping deal making for PE firms investing in healthcare and their portfolio companies. Below we review the issues and trends to keep on your radar as you plan ahead. Scan the QR code or click below to view and download our initial 2023 Healthcare Private Equity Outlook & Trends publication released in January 2023.


1. Considerations in the Debt Markets – Current and Future Credit Facilities


As discussed in the initial 2023 Healthcare Private Equity Outlook & Trends publication released in January 2023, sponsors and company management faced a number of notable headwinds as they entered 2023, including ongoing supply chain and workforce disruptions, Federal Reserve rate hikes and continued, albeit slightly less acute, inflation pressures. Amidst this uncertain market, stories of bank failures dominated news cycles and are expected to have a lasting impact on the availability of debt financing sources for emerging companies. In addition to these larger market trends in both established banking and non-traditional financial providers, stakeholders in the healthcare sectors continue to navigate novel issues in an ever-changing regulatory landscape. Debt finance providers have understandably become more conservative in their underwriting of healthcare enterprises, which has, in turn, reduced options for would-be borrowers seeking funding. Growing concerns over cybersecurity and privacy risks, alongside increased reimbursement and billing scrutiny, have continued to impact the ability of growth-focused companies to attract and retain traditional lending sources. The collapse of Silicon Valley Bank and the related scrutiny on other regional and industry- focused traditional banks has also left a significant hole in the traditional debt financing market for venture capital-backed and low mid-market companies. As a result, non-traditional lending arrangements have continued to gain a growing share of the market in healthcare debt financing.


2. Employee Retention Tactics and Trends


Staffing shortages and the constantly evolving landscape of employment laws are current complicating factors with respect to employee retention. Many employers have become increasingly creative in their efforts toward employee retention. Below are some ideas to keep in mind when facing shortages or retention issues. 1. Benefits such as mental health days, unlimited PTO, and four-day workweeks are becoming more common. Employers are also using monetary incentives – such as rolling retention bonuses (i.e., retention payment every quarter or every month), instant reward apps and on-demand wage payments – to increase retention. However, employers should seek counsel before rolling out these types of benefits and incentives, as they may implicate state or federal laws related to wages, hours, paid time off, etc. 2. Many employers turn to the engagement of independent contractors when struggling to fill positions, but doing so can be risky. Some states – such as California, Illinois and Massachusetts – have stringent requirements to properly classify a worker as an independent contractor. Also, the U.S. Department of Labor (DOL) has issued a proposed rule to rescind the DOL’s current independent contractor rule adopted under the Trump administration. The proposed rule would restore the DOL’s prior multi-factor test, a more stringent rule when analyzing the classification of independent contractors. Legal review of any proposed engagement of an independent contractor may be helpful in avoiding potential liability, especially a wage and hour collective action. 3. Employers are using contractual obligations to combat turnover. One example is entering into an employment agreement with an employee that includes a liquidated damages provision in the event the employee fails to provide a certain notice period (i.e., 30 days, 60 days, etc.) upon resignation. Such provision provides the employer with an adequate transition period upon a resignation to recruit a replacement and engage in an orderly transition of duties. Another example is adding a liquidated damages provision to an employee non-solicitation provision in an employment agreement or restrictive covenant agreement. The goal is to prevent employee raiding by employees who leave the employer and go to work elsewhere. However, the use of these types of contractual provisions must be reviewed by legal counsel to ensure compliance with any applicable laws governing liquidated damages and restrictive covenants, which vary widely on a state-by-state basis. 4. As more states follow the trend of passing stringent non-compete laws (and as the Federal Trade Commission continues to consider the passage of its proposed ban on employment-related non- compete agreements), some employers are foregoing non-compete provisions for non-executive employees and are, instead, focusing on non-solicitation and non-interference provisions. The goal is to reduce situations in which the non-compete hinders recruitment, especially in those states in which enforcement of a non-compete would be an uphill battle and not likely worth the employer’s time and resources. There is no question that employers today must be creative and flexible in order to recruit and maintain a stable workforce, but employers should take care to do so in a manner that does not run afoul of local, state and federal employment laws.


3. The Rise of ESG in Healthcare Private Equity


Despite potential headwinds from recent environmental, social and governance (ESG) marketing or product initiatives that received highly publicized backlash earlier this year, private equity (PE) firms remain under increasing pressure from their limited partners to integrate ESG matters into their operations and investment practices at the fund- and the portfolio company-level. Many funds continue to engage consultants and/or employ dedicated ESG specialists within their management companies to support these efforts and related limited partners (LP) communications and reporting. Q4 2023 and looking ahead into 2024 should see increased adoption of ESG practices and initiatives throughout the PE community.

ESG priorities for healthcare investors should include the following:

• Define and understand the “ESG end goals” for your portfolio, and be sure those are aligned with your LP base and other key stakeholders. This focus should include identifying your key ESG-related LP priorities, such as reducing carbon footprints within your portfolio, diversity initiatives at board and portfolio company levels, and employee retention and wellness. • Assemble the right team and resources to better understand and analyze where your funds and portfolio presently sit relative to your end goals and define priority ESG action plans for the coming year. • Enhance ESG-related diligence policies and procedures (in coordination with outside lawyers and advisors), both for new investments and your existing portfolio. • Collect and analyze your ESG data, including tracking key performance indicators and implementing common policies at the portfolio level. • Assess your areas of ESG weakness and prepare for the eventuality of reporting and disclosing your successes (and failures) and quantifying financial costs and impacts. • Consider how to positively impact the community and regional economic development. For those healthcare services companies in particular that include multi-location and jurisdiction physician practice management organizations and that have a broad reach across numerous local communities, these focused efforts could have a tangible impact if coordinated at the management level and benefit the many geographies serviced by the larger organization. You could also consider how your healthcare organization could benefit under-served geographies and populations. • Have your management teams share in the implementation and “accountability” for the achievement of your goals, especially starting with your C-suites – i.e., from the top down. The PE funds that are best positioned to lead the market will have a developed internal ESG expertise or function; actionable and appropriate ESG objectives; a demonstrated ability to acquire, analyze and report their ESG data; and portfolio company top-down buy-in and participation. The funds with these attributes should be able to garner the attention of the LPs with these priorities.


4. Considerations in Physician Practice Transactions


With choppy debt markets, 2023 has proven to be the “year of the tuck-in” for PE buyers. PE firms largely have looked to shore up their existing physician practice platforms while seeking opportunistic acquisitions of smaller practices, in some cases bolting on to practices in existing markets. Although some buyers have looked to availability under their existing credit facilities to finance acquisitions, others have looked to non-traditional financing, including seller financing and earnouts, similar to the early days post-COVID-19. Buyers also continue to navigate physician alignment issues, such as division of proceeds among selling physicians, participation of junior physicians in transactions, structures for rollover equity, and the ability to use incentive equity as a retention tool. In addition, buyers are now navigating new state filing requirements for certain healthcare transactions, including physician practice transactions, with a number of states having enacted or considering legislation in the double digits. And, with the pause button pressed on many platform exits earlier this year, existing sponsors have looked to special-purpose vehicles as a potential avenue for liquidity for their LPs. All of this points toward a pent-up supply of smaller physician practice platforms that will be looking for exit opportunities with upstream PE buyers or their portfolio companies as debt markets stabilize and PE firms continue to seek to deploy capital. With multiples reported to have peaked, those buyers will be placing additional scrutiny on the financial and operational aspects of potential targets. Existing platforms looking for exits in 2024 should use the remainder of 2023 to get their house in order in these five key areas:

• Scrub current financials and/or consider engaging in sell-side Q of E in preparation for future buy- side Q of E.

• Evaluate staffing levels, expertise and needs to determine where certain areas need to be bolstered or where operational efficiencies can be achieved.

• Evaluate progress on the integration and implementation of synergies for recent acquisitions.

• Ensure that the platform is operating under a cohesive and comprehensive compliance program.

• Consider a select internal billing and coding audit now to surface any billing issues that can be corrected prior to a sell-side process.

Evaluating these key areas now can help existing physician practice platforms prepare for future scrutiny from discerning buyers.


5. Structuring Earnouts


With the mergers and acquisitions (M&A) activity no longer at its peak, parties are still utilizing various tools to close the valuation gap. Those tools include, among others, the following:

1. Seller notes.

2. Equity grants that are subject to vesting based on the future financial performance of the target business.

3. Earnouts.

In some transactions, parties must use all three of these tools in order to make the economics/risk allocation ultimately work for the parties.

We are seeing increased frequency with which earnouts are being used in 2023 will as compared to the early part of 2022 when we were still in a seller’s market. This trend can also be attributed to the cost of financing for private transactions.

When structuring, drafting and negotiating earnouts, consideration should be given to the following:

• Earnouts are prone to disputes, so clarity around the applicable earnout metrics (revenue, EBITDA, etc.), earnout period (1-3 years), payout formula and measurement standard (i.e., GAAP and exceptions to GAAP) is very important. Bloomberg researchers have already picked up a significant increase in the number of earnout disputes filed in federal and state courts – see this Bloomberg Law article.

• If applicable, consider expressly addressing any potential Medicare/Medicaid recoupment issues and their effect on the achievement and payment of the earnout.

• For businesses that derive revenue directly or indirectly from federal healthcare programs, earnouts should be carefully structured, considering applicable healthcare laws and regulations, including the federal Anti-Kickback Statute, preferably at the LOI stage. Guardrails should be employed mainly if any business derived from the referrals of physician owners is being considered in the calculation of the earnout.


6. Section 220 Demand Considerations – Updates from Delaware Chancery Court


Section 220 books and records demands remain popular, especially from minority shareholders in healthcare PE post-closing disputes. While recent decisions from the Delaware Court of Chancery may help portfolio companies limit the scope of informal communications like email data, management materials, or investor communications sought pursuant to these demands, other recent opinions provide a cautionary tale for companies that fail to respond to 220 demands in good faith or engage in unnecessary dilatory tactics.

The Delaware Chancery Court has issued recent opinions that, among other things, do the following:

• Make it tougher for a demanding shareholder to obtain such communications if formal board materials are available, comprehensive and consistent with shareholder communications.

• Limit the shareholder’s request for additional materials if they are not essential to the admittedly proper investigative purpose under Section 220.

• Praise companies for responding to – rather than rejecting outright – the shareholder’s demand and providing relevant, formal board materials in its response.

• Awarded sanctions and/or attorneys’ fees in two separate 220 cases this year where companies refused to produce any documents or engaged in dilatory or “egregious” litigation conduct.

Moving forward in the healthcare PE context, these cases underscore the importance of:

• Maintaining corporate formalities – including clear distinctions between the PE firm’s work and the management and board work of the target healthcare entity.

• Taking the time to formally document board agendas, meetings and other board-level materials and communications so that the healthcare company is well-situated and prepared to respond to an inspection demand, no matter the context. • Responding to any shareholder demand that arguably states a proper purpose by providing well- documented, formal board materials to fulfill the company’s information-sharing duties under Section 220.


7. Maximizing the Value of Equity for Employees

BY: BRITTANY MCCANTS For many employees, equity – as a component of their compensation package – is as valuable to them as their ability to access the equity’s value. For private companies, valuation and tax issues present unique challenges for employees in accessing the value of their equity awards. As valuations increase for companies, executives and board members may broach pathways for employees to utilize their equity. Below are a few conceptual ways to frame the conversations around two popular avenues companies may consider to create liquidity opportunities for their employees holding equity awards with significant value: (1) the extension of employee loans and (2) launching tender offers. • Employee Loans – When companies reach a certain valuation, employees (including senior executives) may find it cost-prohibitive to pay the taxes on restricted stock grants and/or pay the exercise price and taxes upon the exercise of a stock option. One solution is for the company to extend an employee loan to an employee to assist in one of the aforementioned transactions. Employee loans must include certain terms in order to avoid the IRS making a later determination that the loan value was disguised compensation that was immediately taxable upon its issuance. Most practitioners take the position that the employee loan must be at least 50% personal recourse to the employee and/or secured by collateral, which is two to three times the value of the loan. In addition, the terms of the loan must provide for interest to accrue at the then applicable federal rate compounded semiannually if the value of the loan is in excess of $10,000 and includes a specified repayment schedule. Other standard provisions include requiring the purchased shares to serve as collateral for the loan, a fixed maturity date, and includes certain maturity events such as a termination of employment, IPO or sale transaction. If either the company or employee is audited by the IRS, documentary evidence establishing these required terms will be critical. To that end, we recommend seeking legal counsel to structure the loans and draft the requisite promissory note and pledge agreements to limit any potential tax exposure due to the mischaracterization of any such loan. There are a number of drawbacks for companies and employee executives to consider when a company is deciding to extend an employee loan. A key limitation is that, generally, this mechanism is only available for private companies because the Sarbanes Oxley Act of 2002 bars loans between a company and its directors or executive officers (i.e. , the specific class of service providers who hold equity awards with significant value necessitating a loan). In addition, the recent increases in the applicable federal rates may make loans an unattractive vehicle for employees until there are significant reductions in the rates. Companies should also seek legal counsel to understand how a significant depreciation in the value of the collateral securing the loan due to market conditions or otherwise is likely to impact repayment of the loan and other risks to the company in the event of an employee’s failure to make timely repayments. Since loan forgiveness results in taxable compensation to the employee, tax withholding obligations and possibly adverse accounting consequences for the company, weighing these factors should be part of the decision-making process when establishing any policies or practices around extending loans to employees.


• Tender Offers – Private company equity awards can be a meaningful component of employee compensation, but one of the key drawbacks of such awards is their illiquidity unless and until a liquidity event occurs, which may take several years (if such event occurs at all). However, late-stage start-ups can create opportunities for employees to participate in liquidity events that allow shareholders to monetize their equity compensation without waiting for the company to undergo an IPO or sale transaction via a tender offer. A tender offer is a transaction in the secondary market in which employees and/or early investors can sell their vested shares to the company. Typically, tender offers are transactions that are only available for late-stage companies that have issued outstanding equity awards with imminent expiration dates, but such a company is not in the process of undergoing a sale or IPO. Companies set the price, terms and eligibility requirements of the offering and distribute offering documents detailing such key terms. The disclosure documents require legal review since the decision to participate in the tender offer is an investment decision, which will raise securities law considerations. Further, the transaction will result in a variety of tax consequences for both the company and the employees, including, but not limited to, different tax treatment for different types of equity awards and forfeiture of certain potential tax benefits for tax-qualified stock options. Employees will need to weigh various factors in their decision. For example, does the immediacy of the access to liquidity presented by the tender offer outweigh the potential future increases in the value of the equity awards if they continue to remain outstanding or forfeiture of the favorable tax treatment of tax- qualified stock options if certain applicable holding period requirements are not met? Employees who opt to participate need to understand the financial and tax implications of their participation and that the company is not offering any professional advice on their decision to participate or not participate in any capacity.


AUTHORS & CONTACT INFORMATION Lymari Cromwell 615.742.6219 | lymari.cromwell@bassberry.com

Tatjana Paterno 615.742.7928 | tpaterno@bassberry.com

Katie Day 615.742.7891 | kday@bassberry.com

Sehrish Siddiqui 901.543.5979 | ssiddiqui@bassberry.com

Margaret Dodson 615.742.7712 | margaret.dodson@bassberry.com

Katie Smalley 615.742.7709 | katie.smalley@bassberry.com

Angela Humphreys 615.742.7852 | ahumphreys@bassberry.com

Ryan Thomas 615.742.7765 | rthomas@bassberry.com

Britt Latham 615.742.7762 | blatham@bassberry.com

ABOUT THE BASS, BERRY & SIMS HEALTHCARE PRIVATE EQUITY TEAM: The Healthcare Private Equity Team at Bass, Berry & Sims has advised in more than 200 private equity transactions in the healthcare industry over the past two years, including The M&A Advisor’s M&A Deal of the Year (Between $1B-$5B) for its involvement in Tivity’s $2 billion sale to Stone Point Capital in 2022. The firm is ranked the #5 Most Active in Healthcare Private Equity Deals by PitchBook. As the fourth largest healthcare law firm in the U.S. (as ranked by American Health Law Association in 2023), with deep corporate and healthcare regulatory experience, Bass, Berry & Sims has long been recognized as the go-to law firm for private equity funds investing in healthcare.


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