Business Model Of Physician Groups

Over the last several years, we have rated about nine physician groups that primarily provide physician services such as anesthesiology, radiology, emergency medicine, or hospitalists at acute care hospitals. These groups manage the staffing (including hiring and scheduling) and have greater flexibility to address fluctuating needs and employee turnover by moving physicians between hospitals. These groups are generally reimbursed directly by patients and health insurers (government or commercial payors) for their services.

The business model benefits from a cost structure that is primarily labor with limited fixed costs, and limited needs for capital expenditure and working capital. We believe the market for these physician services is highly fragmented, with only modest barriers to entry, and limited product differentiation. These groups compete intensely for staff and hospital contracts. They usually have margins that are below average relative to other health care services companies. They also often focus on a single medical specialty (such as anesthesia or radiology).

The groups we rate are mostly owned by private-equity sponsors, which typically have higher levels of leverage (above 5x), focus on near-to-medium term shareholder returns, and prioritize rapid growth.

Industry Pressures Have Been Mounting Since 2022 And Show Limited Signs Of Improving

With the exception of the disruption from the COVID-19 pandemic in 2020, our ratings on this group of companies were relatively stable in 2021 with one upgrade and no downgrades. Moreover, even at the end of 2021, of the nine companies we rated in this space, five had a stable outlook, two had a positive outlook, and two had a negative outlook.

In 2022, two material challenges arose that impacted many of these companies. The No Surprises Act (NSA), which went into effect in January 2022, introduced the requirement for an independent dispute resolution (IDR) process to settle the reimbursement rates providers could charge commercial insurers and their patients, when medical services were provided out-of-network. Several factors led to a very slow processing of these claims, delaying payments, and weighing on liquidity at some of these physician groups.

Separately, benchmark interest rates rose sharply during 2022 as the Federal Reserve sought to tamp down inflation, leading to a significant rise in interest expenses for these typically highly leveraged companies. This greatly reduced free cash flow generation and led to rating pressure during the year.

Table 1

Chart 1

These pressures were compounded by significant physician labor inflation in 2022 and especially 2023, when procedure volume rose with the easing of the pandemic and physician burnout and retirements surged. Indeed, the pace of inflation for physician labor has been meaningfully exceeding the trend in reimbursement rates from both government payors (Medicare and Medicaid), which have been down modestly, and from commercial insurers, which have generally increased only modestly.

Although these pressures have had a significant impact on margins and free cash flow generation, some groups have been able to partly offset them by negotiating subsidy payments from hospitals, exiting supply contracts with hospitals that were no longer sufficiently profitable, and introducing variable compensation models for doctors. These companies are also benefitting from improving utilization of labor given rising hospital patient volume and by improvements into streamlining the IDR process.

Ultimately, these pressures led to two downgrades in 2022; five downgrades in 2023, including a bankruptcy; and two downgrades in 2024 related to a debt modification and proposed debt restructuring transaction (table 1). In addition, three of the eight companies that we rate today have a negative outlook and one is on CreditWatch with negative implications, which reflects uncertainty around whether these pressures will ease, remain in place, or intensify over the next 12 months.

Chart 2

Table 2

Physician Wage Inflation Is A Major Headwind

The current shortage of physicians, especially those active in hospital settings, is occurring in the wake of the COVID-19 pandemic, when physicians faced extraordinary pressures, sparking a wave of physicians pursuing early retirements and recalibration of work-life balance. Indeed, some health systems are still struggling to keep up with increased demand for procedures, resulting in extended waitlists for elective procedures. We believe this supply and demand imbalance has been a primary contributor to the inflation in physician labor.

While it is difficult to predict wage inflation, our base case assumes labor inflation for physicians will continue, albeit at a slower pace, in the mid-single-digit percent area in 2024, compared to about 10% in 2023. We see the pace of inflation slowing as companies increase their focus on the efficient utilization of available labor via technology solutions and greater reliance on nurses, CRNAs (certified registered nurse anesthetist) and other less-expensive health care professionals, where feasible. We believe the physician shortage is more pronounced among anesthesiologists and radiologists and less so for emergency medicine physicians and hospitalists.

That said, we view the physician shortage as a longer-term issue. According to the latest estimate by the Association of American Medical Colleges (AAMC), the U.S. will have a physician shortage of about 86,000 physicians by 2036--almost half of which are primary care physicians. This is in part due to an aging population (including an expected increase in the proportion of the population above the age of 65, who use more health care services) and increasing rates of chronic illnesses.

The AAMC also projects a decline in the supply of physicians, given the proportion of doctors who will be approaching retirement age by 2034. As per latest data from Bureau of Labor Statistics (BLS), physicians aged 65 or older are 20% of the clinical physician workforce, and those between age 55 and 64 are 22% of the clinical physician workforce.

Table 3

Reimbursement Likely To Remain A Headwind

Whereas physician groups are price takers with regard to reimbursement from government payors, providers can negotiate rates with commercial insurers. We believe the insurers generally have more negotiating power given their larger scale, though physician groups who have a significant market share in a specific geographic area can also have substantial negotiating power, because leaving the provider out of network could significantly lower employee and employer satisfaction with the insurer's health plan.

Although commercial insurance payors' rates may be influenced by government payors' reimbursement rates, commercial insurers generally pay much more--often three to four times more than the government rates--effectively subsidizing the only marginally profitable or even unprofitable patients covered under Medicare and Medicaid (see chart 3).

Chart 3

Reimbursement pressures from government payors and large commercial payors is a key risk for physician groups, with reimbursement from government payors even declining in recent years. Most recently, the Centers for Medicare and Medicaid Services (CMS) finalized the 1.76% reduction to the Medicare Physician Fee Schedule conversion factor for 2024 (effective March 9, 2024, a decrease from the 3.37% cut initially announced Jan. 1, 2024).

More broadly, according to the AMA, Medicare physician payments increased only about 10% over 2001-2024, compared to inflation in physician practice costs of above 50% over the same period.

Our base case assumes big commercial payors, such as Blue Cross, United Health, Cigna, and Aetna (BUCA) limit annual increases in reimbursement to low-single-digit percent or flat rate. We also assume overall reimbursement (collectively across all payors) continues to rise more slowly than inflation, acting as a headwind to profit margins for these physician groups.

Interest Rates Will Decline Only Modestly Over The Next 12 Months

The Federal Reserve increased interest rates significantly over 2022-2023, in an effort to tamp down an increase in inflation. This increased interest expense is weighing on free cash flow and liquidity for some companies.

Table 4

The companies we rate in this space have predominantly issued floating rate debt, though several of them have some interest rate hedges in place.

Table 5

The No Surprises Act Continues To Hinder Free Cash Flow Generation And Liquidity

Congress passed the NSA on Dec. 22, 2020, and it went into effect on Jan. 1, 2022, with the goal of protecting patients with commercial insurance from unexpected (surprise) medical bills, which arise from using out-of-network providers. While the act has helped reduce unexpected out-of-pocket costs for patients, various developments have arisen in the implementation of the mandatory IDR process that have led to significant delays in payments to providers on these claims. This includes a backlog relating to the unexpectedly high volume of claims and several legal challenges that led to temporarily putting the IDR process on hold to implement certain changes. Some of the medical specialties with the highest rate of out-of-network billing are emergency medicine, anesthesiology, radiology, pathology, and air medical transportation companies.

As per data released by CMS in February 2024, three physician companies, Schumacher Group of Delaware Inc., Team Health Holdings Inc. (both focused on emergency medicine and hospitalist medicine), and Radiology Partners Holdings LLC (focused on radiology) together represented 58% of the total claims under the IDR process. We believe this proportion likely reflects the fact that many of the smaller physician groups (unrated) have chosen, at least for now, to accept the reimbursement rates being proposed by payors and are not pursuing the IDR process for additional amounts. CMS also indicated that the IDR process has more often ended in favor of providers, with a 77%-win rate for providers for the first half of 2023.

While exposure to out-of-network billing for patients covered by commercial insurance varies significantly across these companies (see table 2), these delays have had a material impact on collections, cash flows, and liquidity for some. For example, we believe this development along with others contributed significantly to the debt modification transaction for Radiology Partners Holdings LLC and default at Envision Healthcare Corp.

Tangentially, the NSA contributed to financial distress at the emergency air transport companies, Air Methods Corp. and Global Medical Response Inc. Air Methods filed for bankruptcy in October 2023, and Global Medical Response Inc. recently completed a debt modification transaction that we treated as a distressed exchange (see "Global Medical Response Inc. Downgraded To 'SD' From 'CC' On Distressed Debt Exchange", published May 20, 2024 on RatingsDirect). We expect the pace of the IDR settlements will improve gradually over the coming year and that physician groups with exposure to these claims will benefit from improving cash flow relating to the unpaid portion of these claims.

As the outcomes of these IDR settlement process gain predictability, we expect it will influence reimbursement rates for in-network contracts, though we are uncertain how that will evolve given shifting dynamics in the negotiating power of commercial insurers and providers. We also expect that over time payors and providers will reduce their exposure to the IDR process by moving more services in-network to avoid IDR-related administrative costs.

FTC Bans Noncompete Agreements

In April 2024, the FTC announced a final rule banning noncompete agreements (in employment contracts) that prevent workers from switching jobs. We do not yet have clarity on whether the non-solicit agreements (which prevent hospitals from hiring the same group of doctors as part of an effort to insource these services) are also banned as part of this rule. Moreover, while the rule is scheduled to go into effect as of September 2024, we expect it will be challenged in court, potentially delaying, limiting, or preventing implementation.

Still, this law could be another headwind for some physician groups who currently use these agreements with their employees, because it may increase wage inflation or staff turnover, especially given the tight labor markets, in our view.

Positive Patient Volume Trends Will Continue In 2024 And 2025

During the COVID-19 pandemic (primarily in 2020 and 2021), hospitals saw fewer elective procedures for fear of exposure to COVID-19, while staffing shortages also forced hospitals to turn away patients, decreasing volume.

As COVID-19-related hospitalizations decreased and the availability of nurses and physicians improved (relative to 2020 and 2021 levels), hospitals saw a rebound in patient volumes. Indeed, most of the physician groups had very favorable volume trends in 2023 (high-single-digit percent growth, on a same-site basis) with patient visits broadly returning to pre-pandemic levels; this is notwithstanding some pockets of demand softness in certain geographies, including certain rural areas.

Longer term, we expect the aging population will be a tailwind for volumes because people tend to need more medical care as they age. Positive trends in life expectancy will also boost volumes. The Bureau of Labor Statistics projects that the number of people in the U.S. aged 65 and older will increase to 82 million by 2050 from 58 million in 2022 (a 42% increase). We project annual growth in patient volumes in the low- to mid-single-digit percent area for 2025 and beyond.

That said, with an aging population comes an adverse shift in payor mix, including a gradual increase in the proportion of patients covered by Medicare. This could pressure margins long term because Medicare rates are generally much lower than that of commercial payors, often only about one-third of the level of commercial rates.

Hospitals Are Providing Subsidies To These Groups, At Least For Now

In many cases, the health systems that rely on these physician groups have been helping to offset the rising cost of labor, and thereby supporting the viability of these physician groups, with substantial financial subsidies (also referred to as stipends). These subsidies are separate from the primary revenue that these physician groups earn from patients and the insurers.

While the concept of subsidies is not new, these subsidies are becoming more common and increasing in size. In some instances, these agreements are being revised with a cost-plus structure that provides a modest profit margin for the physician group and leaves the hospital bearing the uncertainty around the trends in physician wages and reimbursement.

However, other hospitals have been more resistant to providing subsidies, choosing to insource these functions instead. This could result in revenue contraction, pressure on profit margins, and weaker negotiating power with the payors for some physician groups.

Over the past several years, revenue from subsidies for many physician groups have increased significantly and now represents a sizeable portion of total revenue-and an even larger portion of profits. For example, subsidy revenue at ASP NAPA Intermediate Holdings LLC (NAPA), represented about a third of total revenue in 2023 (up from about 20% or below in 2020-2022). Importantly, the subsidy revenue far exceeds the group's entire EBITDA, which highlights both the necessity for these subsidies and the extent to which the companies rely on it for their continued viability (see table 2 for subsidies revenue by company)

While we expect these subsidies will persist and even grow in 2024, we expect hospitals will seek to reduce them as reimbursement catches up with wage inflation, which would likely limit the potential for improvement in financial performance at the physician groups over the next one to two years.

Regulatory Scrutiny Will Likely Slow The Pace Of Acquisitions

Many private-equity owned health care service companies, including physician groups, have grown rapidly through acquisitions (sometimes referred to as a roll-up strategy). This strategy provides economies of scale (because fixed costs are spread over a larger revenue base) and improves the dependability of services (via a larger pool of physicians that can be moved around when needed). It also often provides physician groups with more power when negotiating reimbursement rates with commercial insurers.

This strategy has been criticized by lawmakers such as the FTC and the Department of Health and Human Services (HHS). More specifically, in September 2023, the FTC sued USAP and private-equity sponsor Welsh, Carson, Anderson and Stowe (WCAS), alleging they engaged in an anticompetitive scheme to consolidate anesthesiology practices in Texas, drive up the price of anesthesia services, and boost their own profits. The complaint also alleges they drove up prices through price-setting agreements with independent practices and that USAP made a deal with a significant competitor to keep it out of USAP's territory. USAP and WCAS filed motions to dismiss the case in November 2023. In May 2024, the judge allowed the case against USAP to proceed but dismissed the case against 23% owner WCAS, concluding that a minority holder cannot be held responsible for allegations of an anticompetitive behavior by a company it only partially owns.

In addition, in April 2024, the Senator of Michigan sent letters requesting information from three investment firms that focus on private equity and some of the highly leveraged, distressed, or bankrupt emergency-medicine-focused physician groups they control or invest in, including Envision Healthcare Corp. (not rated), Team Health Holdings Inc., and U.S. Acute Care Solutions Inc. (see table 2). The letters highlight concerns about anticompetitive practices, cost cutting and staffing levels, and the potential impact on patient care and emergency preparedness. While this was a request for information and not a lawsuit or subpoena, given the breadth of the regulators' and lawmakers' interest, we expect the scrutiny on this industry to persist over the coming year, which adds to the reputational risks for private-equity owned companies in this space.

In our view, greater scrutiny by the FTC and lawmakers will likely dampen the pace of acquisitions and consolidation. Fewer acquisitions could lead to lower leverage, which would be credit positive. Alternatively, fewer acquisitions could also lead sponsors to increase spending on dividends, which could be a credit negative. In addition, reduced growth prospects could lower the valuations of physician groups, limiting exit opportunities for the sponsor and increasing refinancing risk.

Given the turbulence and uncertainty in the industry, we see elevated risk of continued pressure on ratings in this space over the next year, absent more favorable conditions. This is consistent with the high proportion of negative rating outlooks in the space.