Advisory Resources For Physicians

Dermatology from Private Equity's Perspective: Rationale, Risk and Reward

Posted by Eric J. Yetter on Mar 28, 2019 10:14:12 AM
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Many interested physicians ask me how private equity investments in dermatology will play out over the coming years. We now know that consolidation is happening, but how will it work? Why are PE firms interested? What kind of return on investment are they looking for? And what will it take to achieve that objective? This article will look at those items in detail and explore the financial mechanics from a PE firm's perspective.

Some Background on How Private Equity Firms Work

Essentially, PE firms are all trying to do the same thing - raise money, invest it, sell their assets, and return more money to their investors. Private equity managers have an incentive to produce high returns due to their compensation structures.

Typically, managers earn a "management fee" of 2% of assets under management. The management fee goes to paying operating expenses, base salaries, rent, etc. Managers make the big bucks through "carried interest", a portion of the profits they earn (typically 20%) above a specified "hurdle rate". A common hurdle rate for PE is 8%. So, if a PE manager earns her investors an 8% annualized return on their money, she would not earn any carried interest, just the management fee. But, if she earned her investors 10% on their money, she would earn carried interest on the 2% excess gain that exceeds her 8% hurdle rate. Let’s say she earned her investors $20 million in returns above the hurdle rate. She would then keep 20% of that amount ($4 million) as carried interest.

The Desired Return

Average returns for private equity during the last five years were 11%. That is typical, and slightly lower returns (10%) are anticipated in the next five years for macroeconomic reasons.

A 15% targeted rate of return is a good example. It would be an above market target that allows for some margin of error and under-performance in other investments. Truthfully, I believe most of PE would be happy with a 10% or 11% return over the life of their dermatology investment.

Those returns are very achievable at the rates firms are buying dermatology practices (3x to 10x EBITDA). Let me demonstrate how.

A Hypothetical Private Equity Investment in Dermatology 

The basic factors that go into determining what rate of return is achieved are:

  1. Purchase Price for Practices (and other companies) Acquired
  2. EBITDA Growth (through revenue gains and expense savings)
  3. Transaction and Management Costs, including corporate overhead
  4. Selling Price (as a multiple of EBITDA) for the Whole Company
  5. Leverage (Debt)

Let's look at a hypothetical example. Assume a PE firm starts a portfolio company to acquire and operate dermatology practices. For this example, we will consider “practices” to include the practice, ASC, laboratory, and other income sources acquired. We make the following assumptions by category above -

  1. Purchase Price
    1. The average acquired practice will have $2m in EBITDA (after paying the owners normalized compensation post-sale)
    2. The acquisition price will be 8x EBITDA
    3. The PE firm will acquire 80% of the practices it transacts with (selling physicians will retain the remaining 20%) [note that alternatively, physicians often “roll” equity in exchange for ownership in the global management company]
    4. The firm will acquire sixteen total practices as follows:
      1. 1 acquisition in year 1
      2. 3 acquisitions in year 2
      3. 4 acquisitions per year in years 3 through 5
  2. EBITDA Growth
    1. Assume practice EBITDA will stay constant
      1. No revenue growth assumptions
      2. No cost savings assumptions
    1. Corporate overhead at the management company will be
      1. $500,000 in year 1
      2. $1,000,000 in year 2
      3. $2,000,000 in year 3
      4. $3,000,000 in year 4
      5. $4,000,000 in year 5
    2. There will be transaction costs (legal fees, etc.) for each transaction of $100,000
    3. Effective income taxes are assumed at 15%
  3. After five years, the whole company can be sold for 14x EBITDA
  4. Leverage
    1. The PE firm will fund acquisitions with 50% equity and 50% debt, borrowed at 5% interest

Building a financial model with these assumptions, we generate the following outputs -

  • Management company EBITDA will reach $21.6 million annualized by the end of year five
  • The PE firm will have invested a total of $74 million in cash over five years
  • The sale price of the total company (not including physicians’ interest) would be $302.4 million
  • After paying off total debt borrowed ($103.2 million), the firm retains $199.2 million

Thus, the firm has earned $199.2 million on its total investment of $74 million.

Given those assumptions, the internal rate of return on funds invested is 38%, well over the PE firm’s target rate of return (closer to 10%). If you assume the full equity investment of $74 million was set aside in year one, the internal rate of return drops to 22%. (Which case applies depends on the individual PE firm’s arrangement with investors.) Of course, this is a simplified model and certain items such as capital expenditures are not included, but you can see how dermatology can be an attractive investment even with conservative growth assumptions.

Physician “Participation” – Joining-in on the Upside

An exciting note for selling physicians – many firms are offering the opportunity to retain equity in the practice, or exchange it for equity in the global dermatology company, and sell that remaining equity when the whole PE-back company is sold. This is called “participation” because the physicians participate in the PE firm’s investment gains.

 Using the example above, a physician who sold his $2 million EBITDA practice at 8x earnings for $16,000,000, but retained 20% ownership (making the purchase price for an 80% interest $12.8 million), could sell that remaining 20% when the full PE company is sold at 14x EBITDA, for an additional $5,600,000. This assumes no EBITDA growth at the practice during those five years. Note also that physicians participating through equity ownership at the whole-company level may receive even more. In this way, participation can offer big upside to physicians who wish to sell and remain with their practices during the PE investment lifecycle.

Risk Factors

My partner and I have experience acquiring and operating ophthalmology and gastrointestinal practices and surgery centers as part of a private equity backed company. We have seen deals go very well and others go poorly, but the biggest risk factors are not always what physicians expect.

There are two major risk factors facing private equity's investments in dermatology. The first is a large Medicare reimbursement cut on the professional- or facility-side for common CPT codes. Widespread commercial cuts would also be a significant problem.

The second is physician engagement post sale. I believe this is the single biggest risk factor - that key producers will lose interest in the practice and unexpectedly decrease their performance after the deal is closed. Like any business, practices are highly dependent on revenue generation. For most, a small decrease in revenue can wipe out profits completely.

Key Takeaways

In closing, many people assume practices must have potential for extensive operational improvements and organic growth. While PE firms do like to see potential, they can’t afford to acquire problem facilities. The major keys to their success are: 

  1. Buying the largest, strongest practices they can that will maintain or grow their current EBITDA
  2. Buying enough practices quickly to reach a whole-company sale
  3. Keeping corporate overhead low

 That is why this industry is so competitive – private equity investors are looking to quickly acquire practices that meet these criteria. Premium prices are available for larger practices that don’t need a lot of management help and can absorb smaller ones acquired later.


This article is an excerpt from our New, Comprehensive 30-Page White Paper: The Current State of Private Equity in Dermatology Practices and Surgery Centers.

This White Paper contains:

  • An in-depth discussion of private equity as a dermatology buyer
  • A history of private investments and consolidation
  • A discussion of the key considerations important to physician sellers
  • Components of a deal
  • Multiples and Valuation
  • Legal and Tax issues
  • And much more ...

Click the link below to download a copy now.

Request Copy


Want to learn more? Contact our Leadership at PhysiciansFirst Healthcare Partners, read our blog or listen to our podcasts for more information about practice and surgery center acquisitions. We’re one of the few investment banks devoted entirely to physicians. 


Physicians interested in understanding what elements drive private equity transaction prices and seeking a shorthand estimate of what buyers are likely to offer for their practice and post-sale preferences should contact me directly with no obligation. See contact info below.


nullEric Yetter is Managing Partner at PhysiciansFirst Healthcare Partners - a boutique investment bank focused on physician-owned assets. He can be reached at (615) 647-6805 or via e-mail at

Topics: Private Equity, Physician Practice Mergers and Acquisitions, Dermatology