Private equity funding can be a winning strategy for successful imaging entrepreneurs.

“It was the best of times, it was the worst of times.” Dickens’ memorable line might be applied to today’s outpatient imaging centers in the wake of the reimbursement cuts mandated by the 2005 Deficit Reduction Act (DRA). While it may be the worst of times for some operators, it is perhaps the best of times for outpatient imaging entrepreneurs looking for market consolidation prospects. Take, for example, the recent merger of RadNet Inc, Los Angeles, with Dallas-based Radiologix Inc.

Bigger is better—and more profitable—in today’s post-DRA imaging marketplace. However, acquiring multiple diamonds in the rough requires a solid business plan and many millions of dollars. Relying on loans to fund acquisitions can be costly and add payments to existing capital debt, tightening profits even further. As an alternative, some imaging entrepreneurs may consider funding their acquisitions through private equity firms willing to bet their dollars on those who have already proven themselves by surviving—and thriving—despite the DRA and a competitive referral climate.

Today’s Investment Environment

Tor Valenza
Craig Frances, MD, partner, Summit Partners.

Craig Frances, MD, is a partner at the Palo Alto, Calif, office of private equity firm, Summit Partners, which is headquartered in Boston. Frances analyzes the health care industry for Summit, spotting market trends and opportunities for investment.

Now is a robust time for fund-raising in the overall health care market, says Frances. “The environment for fundraising in health care services companies—of which imaging would be considered one—is very good,” said Frances. “That’s fueled by the perception of what the macro demographics are going to be: A relatively stable reimbursement environment and the fact that the pharmaceutical industry isn’t doing so well, so people tend to invest more in health care services.”

Of the outpatient imaging market, however, Frances believes that equity investors are somewhat cautious, especially with smaller operators. “If you believe there is going to be a cut in the industry, then there’s an advantage to choosing companies with large scale,” he said.

A case in point is RadNet’s merger with Radiologix Inc, which resulted in the largest outpatient imaging provider in the United States, with 129 facilities. Since the merger, the company has grown to 134 freestanding centers. The deal was partly financed with private equity money as well as loans. (For more on RadNet’s merger and growth philosophy, see the March 2007 issue of Axis Imaging News.) Summit made its own investment in the radiology industry when it placed $25 million private equity in NightHawk Radiology Holdings Inc, Coeur d’Alene, Idaho, and eventually helped the company with an initial public offering to expand further.

While opportunities like RadNet and NightHawk Radiology may be few, Frances believes that imaging companies with demonstrated successful results are in a good position to find equity partners to help finance smaller consolidations.

David Varhol, managing director of the Corporate Finance Group at GE Healthcare Financial Services (HFS), Chicago, analyzes the imaging market and also sees equity investment opportunities in imaging—perhaps even for GE.

“As a leading provider of capital to the health care market, we have more than $16 billion invested in the industry. To maintain and grow this commitment, we are utilizing both a defensive and offensive strategy as it relates to private equity in the diagnostic imaging space,” said Varhol. “The DRA has forced valuations down, causing some facilities to struggle financially from the significant revenue reduction. Yet despite these market shifts, the fundamentals remain and scan volumes continue to grow. Therefore, we can selectively choose where to invest our equity.”

Jim Sadowski, marketing programs manager at HFS, says that part of GE’s interest in investing equity into the imaging sector stems from its experience with imaging clients that were at risk for default for their imaging equipment loans or leases. Some of these notes were restructured to include converting the debt into equity.

“We’ve taken that experience as well as the experience that we’ve had in related sectors, like senior housing, and said, ‘Why not?’,” said Sadowski. “There’s a need and there’s an opportunity for us to help our customers and for GE to make a return doing it.” (For more on how imaging companies are surviving the DRA, see the April 2007 issue of Axis Imaging News.)

There is another current trend in the industry. Consultants are partnering with private equity groups to consolidate multiple imaging centers to drive increased operating performance. Daniel Mahoney, president of Vendor Healthcare, Specialty Finance group of New York-based CIT Group, has been working with such consultants, who are also seeking new equipment financing. These groups typically aim to consolidate six or seven imaging centers in a specific region and reconfigure those units onto the same equipment, billing centers, and maintenance contracts, and achieve other savings through economies of scale.

Entrepreneurs Wanted

No doubt, health care is attracting the time and money of private equity players. Even so, it is not easy for just any operator with a couple of imaging centers to woo millions from a major player. In general, private equity and venture capitalists want to wager their investment dollars on larger operators that will reap larger returns, such as the RadNet merger. In addition—no matter how many units a company owns and operates—private equity firms typically invest in highly successful businesses with a proven track record. While there are early-stage venture capitalists who seek to invest in young companies with little experience or cash flow, these situations are rarer in health care than in other industries, such as Internet start-ups.

Summit Partners is a late-stage investor that solely invests in operators that are already profitable with significant cash flow. Even so, Frances says that under the right circumstances Summit would consider investing in a middle market operator with as few as four to 12 centers.

“The critical factor for us would be finding people who have done [acquisitions] a handful of times, so they can at least demonstrate that they know how to do acquisitions, put together a thoughtful plan, and then build that company with scale,” Frances said. “Even with that, we’d want to start with a platform that owns several [imaging centers.]”

Finding an Equity Partner

Finding a list of these private equity and venture capital firms can be as simple as going to the Web site of the National Venture Capital Association at Here you can research specific information about member firms, their funds, the sectors in which they invest, as well as their organization and structure. Ideally, you will want to target private equity firms that have experience in investing in health care services—and even better, radiology services.

But word-of-mouth remains your best source. The primary way entrepreneurs learn about venture capital firms is from other professionals, such as by talking with contacts at high-powered law firms and getting their recommendations.

After creating a list of private equity prospects, Frances recommends that entrepreneurs look up each prospect’s portfolio and ask questions, such as whether the company invests in similar types of companies. If so, get to know those companies personally and learn how that private equity firm thinks and operates.

At Summit, the entrepreneur is viewed as the eternal client, because the truly successful ones can go anywhere. “That’s been our philosophy and the brand of our company for 23 years. We invest in people that don’t need our money. That’s our mantra,” Frances said. “We are trying to help the entrepreneurs get to where they want to go, but we do not mandate how they do it. We’re a minority investor about half the time, and that means we don’t control these types of investments.”

Due Diligence

Entrepreneurs should be prepared for a thorough due diligence by the private equity firm, and have several things prepared to show investors. These include:

  • A written business plan or executive summary that elucidates the strategy of the company going forward.
  • Historical financial information that has been audited. If it has not been audited, expect that the investor will perform some kind of audit or, at the very least, a quality of earnings study that reviews the financials.
  • Financial projections going forward. Private equity and venture capital firms generally build a cash flow model for the endeavor, which is typically a 4- to 5-year model going forward. If the private equity firm does not actually generate this model, it will usually ask the entrepreneur to build a conservative model.

“It’s important to have realistic projections,” Frances advised. “Part of what you’re doing by creating the [financial projection] is earning credibility as a manager. A lot of people make the mistake of projecting something that’s overly aggressive. Instead, they shoot themselves in the foot, because it would have been better to be more realistic and start earning credibility with that investment partner.”

In addition to financial due diligence, private equity firms also perform their own business due diligence about the imaging sector and the strategy for investing at this time. Business diligence looks at customer concentration, market concentration, and supplier concentration. Naturally, the firm also assesses the entrepreneur’s management team and its business history.

Finally, expect some type of legal due diligence, which will investigate any legal risk that the company or its officers may present. This process may include confirming that the company is compliant with all city, state, and federal government regulations, as well as regulations involving independent diagnostic testing facilities.

Valuing the Company

All private equity and venture capital firms are exchanging capital dollars for some kind of ownership stake in the company. How much equity is given for that investment—and risk—will largely depend on the value of the entrepreneur’s company.

There are several ways to value a company. Perhaps the most common method is to use the cash flow model, which can help determine what the company is valued at today and project what it will be worth in 4 to 5 years. Frances says that Summit expects to see numbers corresponding to a return of three to five times the investment.

Another method for valuing the company is relative valuation, where one compares the value of other comparable businesses and their earnings multiple and cash flow models. One can find this information from public companies, where the valuations are made available to investors, or sometimes, if available, through information about companies that were recently acquired.

Summit tends to be flexible on how much of a stake it buys into a company. “It’s often driven by what the entrepreneur is interested in,” Frances said. “We’re also flexible in that some entrepreneurs have already built some good value into their business, and we have no problem having our capital go into their pockets. In fact, I would say that personal liquidity is part of almost every deal that our firm does here.”

According to Frances, Summit generally wants to own at least 20% of a company and no more than 80%, preferring some form of partial ownership with incentives for the entrepreneur.

A Tight or a Loose Hand

Some entrepreneurs wonder how much control they will be sacrificing by inviting in a private equity player and, as a result, keep equity investors as minority stakeholders. However, Frances says that the size of Summit’s stake does not correspond to its level of active participation in the company.

“We always view the companies as our client, and we try to help them,” Frances said. “The CEO would never know the difference whether we were a minority or a majority owner. It doesn’t matter. We almost always have a board seat, probably 95% of the time or more.”

Frances says Summit’s board seat is not a way to dictate to its new partner, but rather a way to guide that entrepreneur to build the company that they want.

Window of Opportunity

Because outpatient imaging is currently such a fragmented market, with declining reimbursements, there is certainly a risk to pouring tens of millions of dollars or more into a regional—or larger—consolidation business plan. However, with many imaging centers struggling under the present environment, it will be difficult for investors to resist taking that risk for future rewards. Even so, these opportunities may not last long.

Sadowski says that GE has created proprietary business models of the imaging market and determined that the consolidation will probably continue until the end of 2008. After that time, the market will have stabilized, and there will be fewer opportunities for both entrepreneurs and their private equity investors.

Tor Valenza is a staff writer for Axis Imaging News. For more information, contact .

Navigating the financing maze

Financing imaging equipment, particularly MRI, can be expensive. But it doesn’t have to be painful. Various equipment financing options are available, though some are better suited than others to meet the needs of outpatient imaging centers. According to Chuck Rubin, senior vice president at LFC Capital in Chicago, equity, though one obvious choice, should be considered last because it is one of the most expensive options. “If you raise equity,” said Rubin, “you not only give up ownership of the business, you also surrender part of the ongoing profits.”

A bank loan may seem like the next best option, but, according to Rubin, that too could be problematic. “A bank loan may curtail your ability to borrow for other capital needs. So, if you need credit for your day-to-day exposure, you might find yourself constrained.” Rubin adds that because banks are generalists by trade and not specialists, they also may have to go through a lengthy process of due diligence and analysis before approving a loan. In the end, they may not even understand the market value of the equipment.

“As a result,” said Rubin, “they may come back and say they’ll loan you only 70% when you’re looking for 100%.” Furthermore, in the current market climate, banks may look at a reduced revenue trend and mistakenly read it as a business in decline. As a result, the cost of the loan may go up, or the loan may be denied altogether.

According to Rubin, the preferred option for an outpatient imaging center would be to work with an independent financing company that specializes in health care. Working with a company that understands the industry and the equipment makes it easier to get a much better deal on equipment.

“A finance company that understands the market and the equipment is in a better position to take the credit risk,” said Rubin. “They also know how to liquidate the asset better, which further enhances their ability to put the risk in context.”

Jim Sadowski, marketing programs manager at GE Healthcare Financial Services, confirms Rubin’s assessment. Sadowski says his team is particularly sensitive to current trends in the market for imaging equipment and is trying to make it work for the independent imaging client.

“Lots of imaging centers are wrestling with the question of whether they should go with 3T or I5 in a post-DRA environment,” said Sadowski. “We’re putting together a program where the cash outlay for 3T looks just like I5 for the first 24 months.”

According to the GE plan, in month 25 the client gets an enhancement package, which includes a coil upgrade, a day of training, and the opportunity to upgrade the image quality for $4,500 per month for the remaining 36 months of the lease.

“We’ve structured the rates so that they’re very aggressive,” Sadowski, said, adding that the sum of the payments during the full lease is less than the original equipment cost. “That kind of return or upgrade after 2 years wouldn’t be possible with a bank loan or other sources of financing.”

—Nikos Valance