December 4, 2023

When independent medical groups enter into a real estate project, it is not uncommon that some practice partners cannot afford to fund their full portion of the equity. That is, a portion that would create equality of ownership among all the partners.

In such cases, there are several sources that may be accessed to backfill the individual or aggregate equity needed. These equity sources should only be used after accessing traditional sources of real estate financing to fund the bulk of the investment, assuming the terms of repayment allow for reasonable, sustainable cash flow and do not contain unusual loan covenants that could negatively impact other sources of income or the partners personally.

These backfill equity sources include:

I. Bank loans to the individual doctors,
II. Other doctors within the practice taking on greater ownership in the real estate,
III. Loans (internal financing) from the real estate entity,
IV. Injection of equity by the CPOMP Physicians’ Equity Fund, and
V. Injection of equity by other outside investors (e.g., developers)

I. Bank Loans to the Individual Doctors

Personal bank loans to individuals with equity shortfalls may be the easiest and most efficient method of solving the shortfall so long as the doctors individually and collectively are able to accept the disadvantages that may accompany this source. Those disadvantages may include:

  1. An outcome where all doctors may not receive loan approval or favorable terms because each must be underwritten personally in accordance with their own creditworthiness. Should that occur, this method will not have fully resolved the shortfall and may create some discomfort among the partners.
  2. Personal loans may impact the borrowing doctors’ personal financial statements and credit ratings, which, in turn, might negatively affect other planned borrowing or purchases.
  3. The borrowing doctors wishing to pay back their personal loans from real estate investment disbursements may need to limit their loan amounts so that after-tax disbursement income will fully cover the personal loan principal and interest payments. Any borrowing in excess of that amount will create an initial negative cash flow.
  4. That cash now obligated for personal loan payments may otherwise have been deployed personally in other investments (opportunity cost).

II. Other Doctors Within the Practice Taking on Greater Ownership in the Real Estate

The advantage to this method, assuming the other doctors within the practice have sufficient capital, is that the wealth stays within the practice and those doctors who can afford a greater investment stand to make a greater return.

However, this method also creates its own set of disadvantages, which are likely to grow and will impede sustained growth and an alignment of objectives between the partners. Those include:

  1. A Creation of “Haves and Have Nots” in the Partnership. Since the Haves get a larger share of the disbursements and equity gain, there may be no clear path for those receiving a smaller share to later purchase their way to equality.
  2. An Inability to Fund Partner Buyouts at a Later Date. This buyout problem can be exacerbated and remain concealed for years, only becoming apparent when those having a larger interest reach retirement. When those retiring partners seek their buyout, many groups realize the entity doesn’t have the cash flow necessary, and the remaining partners don’t have the equity to facilitate the buyout. Even with a refinance, there is often not enough cash out to the remaining shareholders to fund the buyout of the retired partners having the largest shares.
  3. Partner Divisiveness. Unequal ownership positions lead to unequal outcomes for owners; decisions made by the group will impact owners differently. This misalignment can result in contentious issues, as doctors with larger ownership may be incentivized to capitalize on the lease through a sale, or increase rents to increase real estate entity distributions, while those with less ownership request lower rents to benefit from reduced practice expenses.

Without having some sort of equalization plan in place, the challenges of unequal ownership are likely to amplify and result in an unsustainable ownership model that triggers fractures among the group.

III. Loans (Internal Financing) from the Real Estate Entity

Some groups admit new partners by internally financing the new shareholders’ purchases. This approach may be favorable for incoming shareholders but quite costly for those already invested. The cost to existing shareholders is not readily apparent and, for that reason, overlooked. However, it can be significant and will occur in two forms:

Assuming the cash-on-cash returns are in excess of the interest rate charged to the purchasing partner, that difference is lost to the other owners who are redirecting a portion of what would be their distributions in exchange for some lesser interest income, and

The appreciation of the shares the other owners are giving up ahead of receiving the equity from the loan payment to purchase those shares.

Depending upon the configuration of the partnership, the difference can amount to hundreds of thousands of dollars and is accompanied by a significant reduction in the ROE (Return on Equity).

IV. Injection of Equity by the CPOMP Physicians’ Equity Fund

The CPOMP Physicians’ Equity Fund (PEF) differs from most traditional equity sources in that it acts as a placeholder with an agreed sale of its shares back to the doctors within two to six years from the initial injection of equity. The buyout return is set at the time of the investment and approximates what the typical buyout might be for any other physician partner at termination. It is structured with the anticipation that a refinancing within six years of the initial equity injection would produce sufficient cash out to fund PEF’s buyout.

The risk is that a downturn in the market would result in a value not able to produce enough cash out and the shareholders would need to come out of pocket or find other sources to replace that portion of the equity not paid for in the refinance.

The advantages of the PEF source are:

  • The pre-set buyout assures a capping of the payout to PEF in the case of a sale or other liquidity event with 100% of the remaining upside going to the doctors.
  • The doctors maintain control of all major decisions (sale, refinance, etc).
  • It allows new partners to buy in more affordably and not forego distributions to repay personal loans, because the subsequent refinancing should buy out PEF and bring all physicians to a position of full and equal partnership.
  • Upon buyback from PEF, shareholders will see 100% of distributions from operations and liquidity events.

The disadvantage of the PEF source is:

  • Risk that a refinancing will not produce sufficient cash to fund a full PEF buyout and that partners will have to negotiate an extension, come out of pocket or seek other equity sources to fund the remaining portion.

VI. Injection of Equity by Other Outside Investors (e.g. Developers)

The CPOMP Physicians’ Equity Fund (PEF) differs from most traditional equity sources in that it acts as a placeholder with an agreed sale of its shares back to the doctors within two to six years from the initial injection of equity. The buyout return is set at the time of the investment and approximates what the typical buyout might be for any other physician partner at termination. It is structured with the anticipation that a refinancing within six years of the initial equity injection would produce sufficient cash out to fund PEF’s buyout.

The risk is that a downturn in the market would result in a value not able to produce enough cash out and the shareholders would need to come out of pocket or find other sources to replace that portion of the equity not paid for in the refinance.

The advantages of the PEF source are:

  • The pre-set buyout assures a capping of the payout to PEF in the case of a sale or other liquidity event with 100% of the remaining upside going to the doctors.
  • The doctors maintain control of all major decisions (sale, refinance, etc).
  • It allows new partners to buy in more affordably and not forego distributions to repay personal loans, because the subsequent refinancing should buy out PEF and bring all physicians to a position of full and equal partnership.
  • Upon buyback from PEF, shareholders will see 100% of distributions from operations and liquidity events.

The disadvantage of the PEF source is:

  • Risk that a refinancing will not produce sufficient cash to fund a full PEF buyout and that partners will have to negotiate an extension, come out of pocket or seek other equity sources to fund the remaining portion.

VI. Injection of Equity by Other Outside Investors (e.g. Developers)

Consideration of other outside equity sources should be weighed against what is received or given up in the JV agreement. The typical JV Agreement calls for a proportionate level of risk / reward for the investment partners. If a JV partner puts in 50% of the equity, they expect 50% of the upside and downside.

The differences between this source and the PEF mentioned above are: 1) the PEF lets the physicians keep the upside in exchange for limiting downside risk with an agreed takeout, 2) the PEF agrees to give up its ownership in the buyout, and 3) all control stays with the physicians.

Often, a JV Agreement with someone like a developer is a requirement rather than an option. As an example, a developer might own the land and only agree to sell it if it can be an equity partner with the doctors. Under those circumstances, it is important to recognize that an equity partner may have different objectives that are averse to the sustainability of the investment.

The practice group should keep these suggestions in mind when negotiating the JV agreement and seek to:

  • Attribute Fair Market Value, not an inflated value, to any non-cash contribution such as land or development fees.
  • Receive additional equity for the value of the brokerage fees that would have been due for bringing in any other but your own lease.
  • Maintain control over decisions of financing or sale/leaseback.
  • Limit the payment to the equity partner of the incremental value created in a sale/leaseback, since that extra value is solely attributable to the practice’s lease and ongoing payment obligation.

If there is no consideration (such as control of the land) that would tie a group to this category of equity, it is recommended that other sources be considered first, because the negatives are less detrimental. For additional information on equity sources, reach out to solutions@cmacpartners.com.