Financing Growth in a Changing Imaging Environment
Practices, imaging centers, and hospital radiology departments continue to keep an eye on expanding their service lines and market reach. In part, this expansion is an effort to counteract the negative effects of declining reimbursements while meeting demands to provide better care. Mergers and acquisitions, as well as the procurement of equipment, are the catalysts for such growth—and players are looking at myriad ways to finance their endeavors.
Joseph White, MBA, is a principal with CliftonLarsonAllen, an accounting and financial advisory company with operations in 13 states. He says that hospitals currently enjoy a tremendous ability to raise capital, assuming that their cash on hand and profit margins are good. In addition to bank debt, for-profit institutions have the option of tapping into the bond market or issuing stock. Interest paid by hospitals on bonds issued to procure capital is contingent upon the bond rating assigned them by Moody’s Investors Service and Standard & Poor’s.
For example, White reports, hospitals with the best (AA) rating can now finance projects via 30-year bonds at the extremely low interest rate of about 4%. For hospitals with poor ratings, interest rates can approach the 8% mark.
White adds that one key advantage of issuing bonds (rather than stock) is that the interest on bonds is tax deductible. Dividends on stock do not qualify for such deductions. It’s just as significant that while stockholders are given ownership status in the institution and benefit from it financially, bondholders do not have such status—meaning a lesser degree of control for them.
Moreover, White says, just as banks have relaxed their criteria on the mortgage side of lending, they are viewing hospitals’ loan requests more favorably. He explains, “They aren’t retaining capital as much as they were before and have built up reserves. It’s not as easy as it once was to secure a bank loan, but it’s easier now than it was a year ago or six months ago. This is a positive thing.”
He notes that in determining whether to grant financing to imaging centers with partial hospital ownership, to their independently owned counterparts, or to radiology practices, banks carefully evaluate the entity’s market dominance, whether it is exhibiting any growth or has viable growth potential, and the solidity of its management. Current compensation levels are also assessed.
“With radiology groups, the issue of high physician compensation comes into play; banks like to see that there is flexibility to reduce compensation so as to make the debt payments,” White says. “Smaller groups may be asked for personal guarantees by their partners.”
The Private-equity Path
Mark Stolper, executive vice president and CFO of RadNet, Inc, corroborates White’s comments on bank financing for imaging centers and radiology groups, observing that local banks with which operators already have relationships are becoming amenable to granting financing. “I would venture to say, though, that floating stock—while fine for hospitals—is not an option for 99.99% of imaging-center chains,” he says, despite some having probably contemplated it briefly. He adds, “To go public, you need north of $100 million in annual sales.”
RadNet has 237 owned or operated freestanding imaging centers, including 23 joint ventures. It has typically executed acquisitions using $25 million to $40 million in cash flow per year, but it also has a revolving credit line totaling $121 million. “We are somewhat unusual in that we have such a substantial credit line, but because it is a less expensive way to go in the long run, we always look to cash reserves first when making an acquisition,” Stolper says.
For its part, CDI has successfully accessed bank debt multiple times to meet financing needs, according to Robert Baumgartner, CEO of the newly merged company. The imaging-center chain recently followed another approach, however, harnessing private-equity capital in its merger with Insight Imaging.
As a result of the merger, the combined company maintains a footprint of 116 fixed imaging centers (in 25 states) and 90 mobile MRI and PET/CT units. CDI partnered with Black Diamond Capital Management, LLC, an alternative asset-management company with more than $11 billion in assets under management across four investment platforms, including private-equity funds. Black Diamond (through funds that it manages that collectively own a majority interest in Insight Imaging) led an investment in Insight Imaging that bought out the owners of CDI.
Private-equity capital is unlike traditional venture capital in that the latter is traditionally a financing option for startup or early-stage companies. In a private-equity scenario, investor groups and funds make investments directly into companies that have significant operating history. Capital for private equity is raised from retail and institutional investors.
“Our intent, in working with private equity for the merger with Insight Imaging, was to provide liquidity for the previous majority owner—which is a big benefit,” Baumgartner says. In his experience, private-equity capital is easier to obtain when there is a solid five- to 10-year earnings history.
Baumgartner concedes that prior to taking the private-equity route with Black Diamond, CDI considered going in two other directions—allying itself with a strategic investor or taking the organization public. A strategic investor can be an entity or an individual (CDI considered an entity).
Unlike a financial investor, a strategic investor not only takes ownership, but the strategic investor also typically becomes involved in the operation of the business. Involvement might include day-to-day operation of the imaging center/practice, or it could entail higher-level decision making about its direction, service lines, and the like.
CDI did not see a logical match with a strategic investor, Baumgartner says, noting that candidates lacked a cultural fit, managerial synergy, and agreement about business strategies (such as future growth and geographic markets). “With Black Diamond there is strong alignment in these key areas,” Baumgartner adds. Going public, he adds, was determined to be a poor idea (in part, because it would have meant making significant additional expenditures). Another strike against such a move was that similar radiology entities currently were not being valued at strong multiples in the stock market.
Angels and Other Avenues
On a smaller scale, some radiology players might want to consider courting angel investors—wealthy individuals or groups acting as a source of financing. This is especially true for smaller imaging centers, chains, and practices.
Jennifer DePalma is a partner in O’Melveny & Myers LLP, a law firm with practice areas that include health care. She says that the practice now is working with a physician group that has found an angel investor willing to provide partial funding for a potential acquisition.
“The deal with angel investors is that they not only want to relate to or understand what they are investing in—meaning that a wealthy patient may make a good investor for a radiology group—but they like to put their money into local entities,” DePalma says. “More than that, they crave involvement: They want to sit on the board and make their opinions known.”
Another smaller-scale alternative—usually (but not always) an adjunct to a bank loan—is requesting a capital infusion from radiologists within the practice. White deems this a somewhat difficult proposition, as few physicians are accustomed to investing in their own organizations, and many will not (or cannot) put up as much money as outsiders might. He says, however, that the radiologists’ returns on investment can be great: 5% on a five-year debt and 6% on a six-year debt.
Still, identifying viable sources of capital for mergers, acquisitions, and other growth initiatives represents only half the battle. Several issues merit investigation before proceeding with the application process. It is critical to ascertain that the lender being considered understands imaging services.
Stolper says, “If the bank (or other type of lender or investor) is familiar with at least the basics of imaging—and possibly, where the specialty is headed—all the better. Any entity that isn’t will set up more barriers.”
For technology acquisitions, hospitals, imaging centers, and practices can arrange bank loans; these, however, traditionally require a down payment of 15% of the total price of the equipment, involve high initial out-of-pocket costs, and tie up valuable working capital that might be better earmarked for other purposes. Other options exist, including signing lease agreements with (or securing financing from) one of many equipment-financing companies. Such organizations are generally bank affiliated, and they work with several different equipment and software vendors.
Stephen J. Jasiukiewicz is vice president of sales at Key Equipment Finance, a company that offers equipment leasing and financing to clients in a variety of industries. He says, “From a pure money standpoint, both choices afford distinct advantages over bank loans. Since a lease frequently does not call for a down payment, it can be equivalent to 100% financing.”
He continues, “Imaging providers can take the capital they would have used as a down payment and reinvest it somewhere else in the business. In addition, it’s possible to forecast the cash requirements for equipment accurately because the amount and number of required lease payments is preset—and with leases, there are no floating fees.”
Each option also presents its own set of benefits and drawbacks. Lease payments, Jasiukiewicz notes, are a minimum of 10% lower than payments made on financing agreements, with the difference varying by equipment type. The more long-lived the equipment is (and the less likely it is to become obsolete), the higher its residual value—and the smaller the payment will be. Jasiukiewicz cites ultrasound and MRI equipment as examples that fall into the category of extended life, high residual value, and small payments.
The IRS considers certain leases, including imaging-equipment leases, to be tax-deductible expenses, rather than purchases. Monthly payments, therefore, may be deducted from overall income, reducing the net cost of leasing.
Flexibility, too, comes into play here. Should an imaging provider’s needs change during the term of the lease, other types of equipment can be added, and/or upgrades to existing modalities can be executed. At the end of the term, lessees may renew the lease or return the equipment, but they can also purchase it at fair market value.
Moreover, leasing simplifies asset management. The leasing company, rather than the lessee, assumes and manages the risk of technology ownership, including the cost of any necessary repairs. If the equipment is returned at the end of the lease, responsibility for its disposal lies with the company alone.
On the other hand, imaging providers that finance their equipment acquisitions own the assets outright at the conclusion of the financing contract. They can also deduct equipment depreciation from their organizations’ incomes.
For small organizations, two short-term tax breaks favor prompt equipment acquisition. The section 179 IRS deduction permits small businesses to deduct the cost of equipment in the year of acquisition (instead of depreciating it). For 2011, the maximum up-front deduction was $500,000; for this year, it will be reduced to $139,000.
A second break, bonus depreciation, allows exceptions to the standard depreciation formula and rules. Under the bonus-depreciation umbrella, small businesses are permitted equipment-expense deductions that exceed the amount allowed under section 179. In 2011, the deduction was 100% of these expenses; for 2012, it will phase out at 50%.
Jasiukiewicz notes that while the decision of whether to follow the leasing or financing route can involve subjective elements, Key Equipment Finance typically advocates leasing if the equipment in question could quickly depreciate. This limits the risk of being stuck with technology that is obsolete (or close to it). “Hospitals tend to lease for this reason, and so do imaging centers and practices that compete on the basis of having cutting-edge technology,” he observes.
Clearly, hospitals, imaging centers, and radiology practices will need to address financing avenues repeatedly as the industry itself changes. Those that remain open to multiple options stand the best chance of success.