Valuation Considerations for Risk-Sharing Terms in MSO-“Friendly PC” Arrangements

How Risk-Sharing Terms Shift Risk to the MSO

A key component common to MSO–“Friendly PC” arrangements is formalized risk sharing in the management services agreement (the “MSA”). Risk-sharing terms can include a priority-of-payments waterfall, risk of deferred or unpaid fees during periods of insufficient funds, deficit-funding arrangements, guaranteed PC margins, lease-holding risk for the medical office space, etc. These terms serve to shift a substantial portion of the enterprise’s financial risk from the medical practice (the “PC”) to the management services organization (the “MSO”).

For example, a payment waterfall may prioritize the PC’s expenses so that they are paid before funds are distributed to the MSO for its costs, working capital loan repayments, and management fees. As a result, if revenues are sufficient to cover the PC’s costs to provide the clinical services (e.g., clinical salaries and benefits of the providers, malpractice insurance premiums, etc.), the PC could operate at or near breakeven even while the broader enterprise is generating a loss that the MSO incurs.

A deficit funding arrangement can further shift financial risk to the MSO by requiring the MSO to provide sufficient working capital to sustain the PC's clinical operations, often on more favorable terms than securing financing from a traditional lender. If the PC ultimately shuts down or fails to generate sufficient cash flow, the MSO may never recover deferred management fees or working capital advances. Even in the short term, if the PC is unprofitable, the MSO may not be fully compensated until sufficient revenue is generated months or years later when the PC reaches scale.

The agreement may formalize a guaranteed minimum margin for the PC. In some arrangements, the PC may also retain the right to all excess profits, in which case the PC retains all upside profit potential of the enterprise, and the MSO bears all downside risk.

The MSO may also assume other contingent obligations. For example, if the MSO is the leaseholder of the medical office space and the PC shuts down, the MSO may remain responsible for lease payments, termination costs, or other contractual obligations associated with the provision of that space.

Table 1. Summary of Common Risk-Sharing Provisions

Provision	How it works	Risk shifted to the MSO	Valuation consideration
Priority-of-payments waterfall	PC clinical costs are paid first; MSO costs, loan repayments, and fees are paid from what remains.	Deferral or nonpayment of fees when cash is insufficient	Collection risk and timing of the management fee
Deficit funding	MSO advances working capital to sustain PC operations	Capital at risk, often on terms more favorable than a traditional lender would offer	Implied financing subsidy; recoverability of advances
Guaranteed PC margin	PC receives a minimum margin regardless of enterprise results	Enterprise-level losses	Supports a lower-end benchmark for the PC’s retained return
Lease obligations	MSO holds the lease for the medical office space	Remaining lease payments and termination costs if the PC shuts down	Contingent liability over the remaining lease term

What Is the Risk Worth?

Collectively, these provisions shift a substantial portion of the enterprise's financial risk from the PC to the MSO. The MSO is therefore assuming contractual obligations that extend beyond the provision of administrative and management services. The burden falls on the MSO to efficiently manage the PC's operations, or the MSO could be left holding the bag if the enterprise is not profitable. In the universe of sellers of similar management services, no partner would agree to these risk-sharing terms without some consideration or remuneration. To only consider the scope of management services and the associated costs would fail to capture everything the MSO is providing under the arrangement. From a valuation perspective, this begs the question: what is that risk worth? It, of course, depends on the specific facts and circumstances of the arrangement. Relevant components may include the implied financing subsidy of deficit funding, the collection risk on deferred or unpaid fees, and the contingent exposure under lease obligations. There is no universal formula for quantifying the value of this risk sharing, but there are some useful reasonableness checks to consider.

Check 1: Sustainable PC Profitability

The first is whether the management fee and practice economics allow the PC to achieve a sustainable level of profitability once the enterprise reaches normalized operations. It’s not uncommon for de novo or startup arrangements to operate at a loss in the initial ramp-up period. However, as the PC scales and reaches normalized operations, the enterprise should demonstrate profitability at the PC level. Having said that, a persistent PC-level loss does not, in isolation, imply that the management fee is excessive. The PC’s profitability can be affected by many factors unrelated to the management fee, such as provider compensation, clinical productivity, and local market conditions. Nevertheless, a persistently unprofitable PC can be an important indicator that the arrangement's economics warrant further analysis.

Check 2: Residual Profit Sweep and the PSA Analogy

If the implied management fee sweeps all residual profit to the MSO after the PC’s costs are covered, that does not necessarily indicate that the management fee is inappropriate. It may not be appropriate in all circumstances. Still, we can consider this scenario in the context of valuing a traditional professional services arrangement (“PSA”) in which a hospital contracts with a physician practice to provide hospital-based clinical services. Under this common arrangement, the hospital provides all non-clinical administrative functions and assumes responsibility for the operational performance of the specialty service line. The practice, meanwhile, is compensated for the clinical staffing services regardless of whether the broader service line is profitable. In this sense, the hospital occupies a position similar to that of the MSO, and the practice a position similar to that of the PC. When valuing these PSAs, it is generally unusual to add a separate provision for practice-level profit to the value of the clinical services. The fair market value analysis would generally focus on the value of the clinical services and, where appropriate, allocable practice overhead and back-office support. Adding such a provision could result in overpayment for clinical services and, in the PSA context, be interpreted by regulatory authorities as an inducement to make referrals.

Check 3: PC Markup Relative to Staffing Benchmarks

However, in many cases, it may be appropriate for the PC to retain a portion of the enterprise’s margin. The clinical providers of the PC are a major driver of revenue and profitability, as well as the operational risks associated with leased clinical staffing services (e.g., compliance with healthcare and labor laws, malpractice claims, workers’ comp, provider recruitment and retention, clinical oversight, etc.). In these cases, it may be appropriate to compare the implied return retained by the PC with the observed margins or markups of comparable providers of leased staffing services. However, because the MSA insulates the PC from significant downside risk that market comparables typically bear, this may warrant an adjustment to the comparable market benchmarks, as, all else equal, a lower level of risk would generally support a lower required return. Therefore, the selected markup on PC costs may need to align with the lower end of observed market profitability ranges to reflect the minimized financial risk exposure to the PC.

Reasonableness Checks at a Glance

1. Sustainable PC profitability. Once operations normalize, the management fee and practice economics should allow the PC to achieve a sustainable level of profitability. A persistent PC-level loss is not conclusive on its own but warrants further analysis.

2. Residual profit sweep. A fee that sweeps all residual profit to the MSO is not necessarily inappropriate. In a comparable hospital, PSA, the practice is generally compensated for clinical services, with no separate provision for practice-level profit.

3. PC markup relative to staffing benchmarks. Where the PC retains a portion of the margin, its implied return can be compared with the markups of comparable leased staffing providers, with selection toward the lower end of the range to reflect the PC’s reduced risk exposure.

Conclusion

Ultimately, the economics of an MSO-“Friendly PC” model should consider all that the MSO provides under the arrangement and not just the management services and associated costs. No arrangement is the same, and there is no “one-size-fits-all approach” or silver bullet to valuing these arrangements. They require consideration of the arrangement's economics from multiple perspectives, including the scope of services and associated costs, capital commitments, risk allocation, projected profitability, and market benchmarks, to ensure the management fee is appropriate.

Reach out to BFMV

BFMV works with MSO entrepreneurs to structure fair market value and commercially reasonable management fees. Reach out to taylor@buckheadfmv.com to set up a consultation.