Do’s and Don’ts in Physician-Hospital Alignment, Part 1

Part 1 of this 3-part series focuses on pretransactional due diligence and structural design processes as they pertain to physician–hospital alignments. Part 2 of this series will address governance and compensation plans; the final installment will discuss ongoing relationships and planning for a potential “divorce.”


The alignment of physicians with hospitals and health systems is increasingly challenging in today’s healthcare climate. In the past, many physicians viewed hospitals as potential partners with endless channels of money by which they could augment their previous private practice incomes. Notwithstanding the compliance concerns with this approach, the economic realities are that hospitals do not have excess funds to pay physicians—at least not at the levels that many physicians expect. Moreover, the regulatory requirements of paying at fair market value and commercially reasonable rates prevail in every instance.

Despite these challenges, interest in alignments continues to expand. And the necessity of maintaining a strong and diverse medical staff versus the threat of losing critical team members and the subsequent closure of a business line often results in hospitals/health systems making de­cisions and promises they may not otherwise make. Accordingly, let’s briefly examine some of the key areas of consideration that must occur to prevent hospitals and physicians from falling into arrangements that are unlikely to succeed.

Pretransactional Due Diligence

Before formulating the transaction, both the hospital and the physician group must be reasonably certain that they are comfortable with partnering. Often, this results from an initial review of the landscape (stage 1). Hospitals will engage consulting firms to complete a landscape review, which involves nonthreatening in­teractions between the physicians and hospital leadership in exploratory discussions. It is at this stage that specific issues are identified; even more importantly, an exact model is designed. That model could range from limited to moderate to fuller forms of alignment.

The initial review of the landscape should encompass some basic financial analysis to consider the historical performance of the practice. The analysis should also begin to explore what the practice will look like posttransaction through a financial pro forma, which will have a great deal to do with the model that has been selected. If multiple models are under consideration, each should have its own financial pro forma.

Once the basic analysis is completed and the decision is made to move forward into transactional development (stage 2), a more detailed financial analysis should be prepared; this could be prepared by an independent party. That independent party should also be knowledgeable in fair market value testing for commercially reasonable rates of compensation for physicians employed by nonprofit hospitals or integrated delivery systems. The financial analysis will ultimately lead to a completed pro forma. The pro forma analysis will address many things, not the least of which will be the hospital or delivery system’s return on investment. The full-fledged pro forma analysis will lead to the development of a term sheet that memorializes (not legally binding) the key financial terms of the transaction.

Assuming the processes continue to go well, an independent appraisal will also be needed in order to determine the fair market value of the assets and other related items of value that are included in the transaction. Depending upon the structure of the transaction, the areas of consideration could range from the entire practice entity to certain components of the practice, such as physician and staff workforce remaining in place. The independent appraisal should be specific in response to the actual structure of the proposed transaction. For example, if the transaction is a joint equity model, the appraisal would only be for a minority interest (assuming that the hospital is only buying a minority interest) of the practice. If it is a professional services agreement, there will likely be very little upfront value exchange, with the exception of the ancillary assets, which are often purchased by the hospital.

Finally, as a part of the pretrans­actional due diligence, the hospital/health system should complete an operational assessment of the practice or other healthcare entity. This would only be needed if they are acquiring all or most of the practice or the related ancillary service, such as an ambulatory surgery center. Typically, a hospital/health system will be equipped with its own internal resources to review all areas of operations, or they will engage an independent expert to complete that operational assessment; the operational assessment often will include a procedural coding audit.

The pretransitional due diligence process involves many facets to allow the hospital and health system to gain full undersactional of what they are getting into. From there, the parties can move toward a well designed and legally compliant alignment transaction.

Structural Design

Another key facet toward the successful development of a physician–hospital alignment relationship is the actual design of the model. As briefly discussed, there are myriad models; each has its pros and cons, from both the hospital and physician perspectives. It is the job of the experts (often independent consultants and attorneys) who are assisting the practice and the hospital to point out the pros and cons of each model and, ultimately, to build consensus as to the best model for the particular transaction. Flexibility in model development is a key overarching point of view in achieving a positive result. Although employment is often the preferred model and is the outcome of the majority of transactions, this arrangement should not be forced on the physicians.

Key economic and noneconomic terms and conditions should be considered. Ultimately, these will be formalized in the definitive agreements; prior to that, a term sheet or letter of intent (LOI) or memo of understanding should detail these terms and conditions. Often, we separate these into 3 major classifications:

  • Economic
  • Governance/leadership
  • Unwind provisions

With the term sheet and LOI draft in place, these major areas of review have been considered and are a significant part of the overall foundation that is being formed. (It should be noted that several of the items discussed under pretransactional due diligence would be completed simultaneously with the matters we are discussing at this point under structural design.)

Next, an additional financial analysis should be considered. While analysis under pretransactional due diligence is absolutely essential, another financial analysis—the “impact analysis”—should be completed by the hospital. This is done by the hospital as an internal document that incorporates the overall contributions that the transaction will entail—meaning that there are some portions of the transaction that will likely not appropriately (or legally) be considered within the pro forma process. For example, if the hospital acquires the ancillary services from the practice as a part of the alignment transaction and they choose to convert these to hospital outpatient department (HOPD) billing structure for Medicare and Medicaid, and they move these out of the actual integrated entity, those performance results cannot be considered in order to determine the physicians’ compensation within the alignment model. However, the hospital should certainly consider the impact of having these assets and being able to realize this revenue going forward. It should also be noted that often this revenue (under HOPD rates) is much better than that paid to private practices. In short, the overall return on investment (“downstream revenue”) is better for the hospital. Although this should be considered in the overall impact analysis, it cannot be a part of the actual direct transaction for legal and compliance purposes.

Finally, within the structural design and assuming all of these prior analyses have been thoroughly reviewed, and both parties are still interested in proceeding (note that at any point during this process either party can drop out or change the transaction structure), the definitive agreement drafting should be completed. This should include utilization of legal counsel and the consultant’s support to formulate the actual legal documents that will be executed at closing. Such legal documents will vary, but usually will include an asset purchase agreement, or, if the entity (or a part of the entity) is being purchased, a stock purchase agreement. Other agreements could be tied to management services, operating agreements, employment agreements, professional services contracts, etc. Again, these are all a part of the definitive agreement process that must be ultimately decided upon and responded to, based upon the actual model structure.

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