Dermatology is booming. The current size of the US dermatology market is $7.7 billion and expected to grow at a compound annual growth rate (CAGR) of 3.8% to $8.6 billion by 2026. Key demand drivers to this anticipated growth include an aging US population and an increased awareness of skin health. A dermatologist can identify and treat more than 3,000 conditions including eczema, psoriasis, and skin cancer. Skin cancer is the most common cancer in the United States and approximately. 1 in 5 Americans will develop skin cancer by the age of 70. The high prevalence of skin cancer in the US combined with the aging population has led to an increased demand in dermatological services and fueled the speculation of increased growth in the industry.
Additionally, dermatology practices are traditionally solo in nature. 40% of dermatology practices are solo practices, while 73% have less than five physicians. Furthermore, the four largest practices within the dermatology sector comprise less than 2% of market share. This has created a fragmented industry that is suitable for consolidation which has attracted the attention of private equity (PE) firms.
What is Private Equity?
Private equity refers to a fund which aggregates capital from a number of sources in order to purchase companies in whole or buy a stake in a company. PE investment sources primarily include institutional investors and accredited investors. Investors in a PE fund have no decision-making authority over the investments made by the fund and are called “limited partners.” The PE firm serves as the “general partner” and has total control over the funds’ investments. When a PE fund is formed, it has a predetermined expiration date at which time all of the money must be returned to the investors. The typical lifespan for a private equity fund is 10 years. This life cycle includes the fund formation, a fundraising period, deal sourcing and investing, and exiting from the existing investments. It is important to understand that PE funds have a limited timeframe in which they plan to own their investments. As a result of this, the fund manager tries to maximize the return on the investment over this time period. This means that PE funds typically invest in a company for an average of 4-7 years, with a goal of selling the company at the end of that period.
Types of Private Equity Funds and Strategies
Private equity firms utilize different strategies when investing. Some of the more common fund types and their characteristics include:
- Purchases a controlling stake in the business
- Typically targets more mature established businesses
- Makes small minority stake investments
- Typically targets early stage emerging businesses
- Generally minority stake investments
- Targets relatively mature companies that are going through some transformational event in their lifecycle with potential for growth
PE funds dedicated solely to health care operations raised $350 billion from investors from 2010-2020. Physician owned dermatology practices specifically have been a major focus of the PE healthcare investments over this time frame with more than 30 private equity-backed dermatology groups in the country and approximately 15% of dermatology practices being private equity-owned as of 2020. Seventeen PE-backed Dermatology Management Groups (DMGs) acquired 184 practices between May 1, 2012, and May 22, 2018 which accounted for an estimated 381 dermatology clinics.
Several factors have contributed to this trend including: (1) Growth in volume in the industry driven by the aging US population, (2) the fragmented nature of the industry, (3) the recurring nature of some of the procedures and stable reimbursement dynamics, (4) increasing proportion of physicians that are close to retirement and (5) opportunities for achieving economics of scale. All of these factors have made dermatology practices an enticing investment for PE funds.
How Does a Private Equity Firm Become Involved in Dermatology?
At a high level, a private equity firm will typically research and select potential acquisition targets for investment. Typical characteristics of a suitable acquisition target in dermatology include: (1) a larger chain with a strong presence in the regional market; (2) a diversified revenue base with exposure to several lines of business; (3) strong growth prospects and good quality patient care; and (4) businesses that are scalable. These acquisition targets can have multiple PE firms interested in investing in them. Once the target company selects a PE firm to work with, a due diligence and contract negotiation phase will then take place which involves vetting all financial, legal, and operational aspects of the target company. PE investors must be able to clearly understand the business itself, the value proposition, and the business’s vision. Once this has been successfully completed, the PE firm will then make an investment in the target practice.
For dermatology practices, this will usually be into a dermatology management group (DMG), otherwise known as a management service organization (MSO), which is the practice management company. The DMG can then be financed to increase its own operations, to acquire additional practices or to open new practices. If permitted by state law, often the DMG might own the medical entity in a separate entity, to minimize risk between the entities. In states that have robust prohibitions against the corporate practice of medicine (CPOM) the involvement of a private equity firm will usually be structured so that a physician continues to hold the practice assets while the DMG acts as operational management.
Pros and Cons of Private Equity Investment to a Dermatologist
Pros of Private Equity Dermatology
- Increased access to capital
- Unlock access to more sophisticated technology that then helps the practice grow by becoming part of a larger and better capitalized group
- Relief from the burdens of administrative paperwork and duties
- More bargaining clout with insurers, improving reimbursement
Cons of Private Equity Dermatology
Focus on short-term profits puts pressure on the practice to increase revenue.
- Higher volume of patients—one study showed the volume of patients per private equity dermatologist ranged from 4.7–17% higher than the volume of non-private equity dermatologists
- Regulatory considerations must be vetted to ensure structural control by the PE fund doesn’t infringe on prohibitions against the corporate practice of medicine. For example, private equity firms might utilize lower-paid non-physician extenders (NPs and PAs) more than most private practices in order to increase cash flow to the business while cutting costs, however, state laws typically limit the number of extenders a physician can supervise.
- Hiring and retention concerns— a study showed 65% of dermatology residents were not open to working for PE-backed practices based on negative perceptions of how PE influences quality of care, long-term salary, and physician autonomy.
Additional Considerations for Dermatology Practice Owners Considering Private Equity
Aligning yourself with the right PE fund is critical to meeting your goals. This is the time to be introspective about your own personality, how you like to operate, and what you want your future to look like. In researching and performing due diligence on the potential fund some considerations outside of price include: what key performance indicators are important to you, do you prefer a more hands-on or hands–off approach, personality type of the management of the fund, and the governance structure of the fund.
Additionally, unique to PE in healthcare is the fact that the investing firm is not practicing medicine but the doctors who work under its set-up are doing so, and they cannot cede their responsibilities to patients to the investor or a DMG. A doctor contemplating involvement with private equity must first be certain that their professional autonomy in patient care and their personal compliance with regulations and with medical ethics will not be weakened by profit goals.
There is also an issue that is unique to the private equity setting: it is not geared to long-term holdings. PE firms generally aim to drive up an asset’s value and then sell it, typically in three to seven years. A dermatologist with an equity interest at the start can ride that process to a very good outcome, but a younger physician could face the literal double whammy of losing their job and then being unable to get another because of tight non-compete clauses. A dermatologist-owner becoming involved with private equity should therefore look for an arrangement that protects both their interests and those of their staff.
The Importance of Outside Legal Counsel
Navigating the complex purchase agreements, equity structure, shareholder agreements, and employee contracts and the entire M&A process can be an overwhelming process. There are several decision points and considerations which are critical to meeting your personal and professional goals. Partnering with the right firm can help simplify this process.
At ByrdAdatto we have the experience and expertise to guide dermatologists through this process and navigate the complex purchase agreements. If you are a dermatologist interested in a private equity association or are considering employment with an equity-backed group, contact us at firstname.lastname@example.org to schedule a consultation.
We are grateful for the significant research and drafting contribution to this article from our Law Clerk, Clint Nuckolls. Clint is a second year student at SMU Dedman School of Law.