Need for Greater Investment in California Healthcare and Behavioural Healthcare Must Contend With California Regulatory Headwinds

While healthcare and behavioural health M&A activity during the past 12 months is down from 2021‒22 levels, there is still strong investment interest in the space. For healthcare, key drivers include the need for greater access to care for chronic conditions, potential profits related to certain physician practices, ambulatory surgery centre and other outpatient services, and IT-related developments to better support clinical decision-making. Key investment drivers in behavioural health include unmet social need for behavioural health treatment, expanded third-party reimbursement, and evolving business models that create opportunity for established providers and new market participants alike.

Notwithstanding the foregoing, headwinds for healthcare and behavioural health include capital constraints, higher interest rates, inflation, ongoing staffing challenges and lingering economic uncertainty ‒ all of which have made buyers more selective. This has also placed an even greater emphasis on due diligence and vetting applicable regulatory/third-party reimbursement issues. Some sellers have elected to defer a sale process, awaiting improved market conditions and/or stronger financial performance to maximise exit value; parties seeking to transact in current market conditions are well advised to prepare for a thorough diligence process to avoid disruption or delay on the path to closing. Market conditions along with heightened regulatory scrutiny place a premium on close alignment between business and legal teams on both sides of the table to support a timely and successful transaction.

Layers of Restriction and Scrutiny

California corporate practice of medicine

Various states have differing degrees of what is popularly known as the prohibition of the corporate practice of medicine (CPOM). California counts itself among the most restrictive CPOM states. Although many levels of healthcare and behavioural healthcare fall under a state agency licence, certain levels of care may only be rendered by a professional corporation (PC) owing to CPOM. Often this is the case for physician practice clinics, urgent care clinics and related ancillary services lines, outpatient mental health and/or certain clinician-provided services within a residential setting. All of this can impact legal structure in varying degrees of scope and scale. Where CPOM exists, depending on its nature and degree and in the absence of an applicable exception, certain clinical services may only be provided through a physician-owned PC. As those who practise, operate and invest in related affected areas, this often leads to structuring and investment in a “friendly professional corporation” and Management Services Organisation (MSO) arrangement in order to facilitate needed investment in healthcare by private equity investors, hospitals, health systems and laypersons while remaining compliant with applicable CPOM parameters.

California Attorney General notice and approval

For years, non-profit corporations that own and operate certain healthcare facilities and other healthcare services have been subject to either pre-closing notice to or review and approval by the California Attorney General (AG). In these cases, required submissions by the parties can be burdensome to produce and voluminous (some submissions being hundreds or several thousands of pages in length). Following sufficient notice, the AG has 90 days in which to respond as to whether it will grant consent, grant conditional consent or withhold consent for the transaction. This time period can be subject to an extension under certain circumstances.

Licensing, certification, accreditation and other regulatory approvals

As in other states, parties to many healthcare transactions in California must also navigate an array of state- and federal-level change of ownership licensing, certification and accreditation requirements, each potentially requiring notice and/or approval. Some of these may involve lengthy pre-closing filing and approval requirements, some may require short pre-closing filing requirements, and some may require notice (and potentially even approval) requirements within some prescribed period after the deal closes.

Heightened antitrust-related scrutiny

In addition to the above-mentioned structure and approval issues, buyers and sellers should take notice of new antitrust and similar review and approval requirements at the federal and state level. These requirements are separate from and additional to the licence and certification approvals noted earlier. Assessment and preparation for applicable filings early in a transaction process, with the help of qualified and experienced healthcare transaction counsel, is recommended.

Heightened federal antitrust scrutiny

At the federal level, the US Department of Justice (DOJ) and Federal Trade Commission (FTC) have withdrawn long-standing healthcare merger guidance that they viewed as outdated and overly permissive. New merger and consolidation guidelines have now been developed. The new guidelines reflect the Biden Administration’s view that decades of industry consolidation have often led to excessive market consolidation across multiple sectors, including healthcare. The new guidelines focus on additional theories of competitive harm, as well as lower thresholds at which certain transactions will be presumed illegal under antitrust laws.

By way of example, the new guidelines presume that a deal is anti-competitive if it results in a post-transaction market share greater than 30% together with an increase of 100 or more in the so-called Herfindahl-Hirschman Index (HHI) (a measure of market concentration commonly used by antitrust enforcers and the courts). By lowering the threshold percentage of market share and levels of market share concentration, several healthcare transactions ‒ including potentially behavioural health transactions that would likely have been presumed lawful under the former merger guidelines of 2010 ‒ may now be presumed unlawful under the new guidelines.

Additionally, there is an acute focus on “roll-ups” in the new guidelines. When a transaction is a part of a series of acquisitions, the revised guidelines indicate that the agencies will examine the current transaction along with all of the prior acquisitions, even if no single transaction would be considered anti-competitive on its own. This will likely increase the risk of antitrust scrutiny for entities such as private equity firms and health systems that engage in multiple acquisitions of various healthcare providers. Healthcare and behavioural health industry participants should be mindful of plans to acquire multiple practices and clinics and that relatively small transactions that would not by themselves be subject to HSR (Hart-Scott-Rodino Antitrust Improvements Act of 1976, or the “HSR Act”) reporting requirements could be subject to scrutiny.

The new guidelines also reflect a focus on impacts on labour markets. Notwithstanding the ongoing staffing shortages that have plagued the behavioural healthcare and healthcare sectors for some time, the FTC and the DOJ indicated that they are concerned that some transactions may reduce demand for workers and suppress wages and other compensation.

Many market observers are expecting a more hostile regulatory reception to healthcare M&A transactions. These federal developments influence many related state legal developments and are important in understanding the objectives and potential enforcement climate of many states, including California. However, it remains to be seen how agency application of the new rules and any related legal challenges may play out over time.

Rise of “mini-HSR” legislation in California and elsewhere

During the past few years, several states have enacted legislation and promulgated regulations to subject various healthcare transactions to review that often were not subject to material review before. Parties to a given transaction may be compelled to make detailed submissions for prior review ‒ and, in some cases, approval ‒ before a given deal can be completed. Some commentators observe that this new series of requirements somewhat resembles submissions that must be made for certain healthcare (and other) deals under the HSR Act, but often for far smaller dollar values than the HSR reporting threshold. Lower dollar reporting thresholds have in part given rise to the label “mini-HSR” legislation, involving healthcare market review for certain transactions with thresholds driven by provider size and type and revenue source (as opposed to transaction value) capturing deal values far below HSR requirements.

Relatively recent examples of mini-HSR legislation include notice requirements for certain healthcare entity transactions that may constitute material change transactions meeting certain dollar, property or other prescribed thresholds that, as noted earlier, often capture relatively small healthcare deals that would not have been subject to sometimes onerous notice, review and/or approval requirements in the past. There is significant range in these kinds of mini-HSR requirements, including without limitation 30-day advance notice for certain defined transactions in New York, 30 days’ advance notice for certain defined transactions in Illinois, and 90 days’ advance notice for certain defined healthcare transactions in California. More on such developments in California follows immediately below.

California’s new OHCA notice and review requirements

Final regulations implementing the healthcare transaction reporting requirements of the new California Office of Healthcare Affordability (OHCA) were approved in late 2023 and took effect on 1 January 2024. These new requirements impact several healthcare transactions closing on and after 1 April 2024. Members of the healthcare and behavioural health industry should give careful and early consideration to whether the OHCA regulations impact any of their respective transactions. Required submissions are burdensome and the OHCA review process can be lengthy.

The OHCA’s transaction notice requirements apply if the transaction meets the following three requirements.

• At least one party to the transaction must be a “healthcare entity”. The OHCA’s implementing statute defines “healthcare entity” as a “payer, provider, or fully integrated delivery system.” Each term is further defined in the statutes and regulations to include a broad range of health facilities, provider organizations, health insurers, and others. The transaction notice requirements may also apply to affiliates of healthcare entities in certain instances.
• The healthcare entity must meet certain thresholds for California assets or revenue. The OHCA’s notice requirements only apply to:
1. healthcare entities that have at least USD25 million in California-derived assets or annual revenue;
2. healthcare entities with at least USD10 million in California-derived assets or annual revenue when another party to the transaction is a healthcare entity with USD25 million in California-derived assets or annual revenue; and
3. healthcare entities located in a designated primary care Health Professional Shortage Area (HPSA) in California.
• The transaction must constitute a “material change transaction”. The OHCA’s regulations list and define seven types of transactions that constitute material change transactions, including transactions with a proposed fair market value of at least USD25 million that concern the provision of healthcare services, transactions involving the sale of 25% or more of the submitter’s total California assets, transactions involving a change of control of the submitter, and other prescribed types of transactions.

If all three requirements are met, the healthcare entity must provide the OHCA with notice of the transaction at least 90 days before the expected closing date of the transaction. The notices will require extensive information and documentation concerning the transaction and the transaction’s potential impact on healthcare services in California. The OHCA will conduct an initial review of the notices and determine whether to conduct a more intensive and lengthy Cost and Market Impact Review (CMIR), which will open the transaction to public comment. Even though the regulations establish timelines for the OHCA’s review process, the review process can take anywhere from a few months to nearly a year depending on the circumstances. Although the OHCA does not have approval power over a given transaction, the transactions that are subject to such notice and review requirements cannot take effect until after the OHCA has completed its review of the transaction.

The OHCA’s notice and review requirements do not apply to the following types of transactions:

• transactions involving healthcare service plans that are subject to review by the Department of Managed Healthcare for cost impact or market consolidation under the Knox-Keen Healthcare Service Plan Act;
• transactions involving health insurers that are subject to review by the California Insurance Commissioner;
• transactions where a county is acquiring or taking control of an entity to ensure continued access in that county; and
• transactions involving the sale of health facilities by non-profit corporations that are subject to review by the AG.

Although these new legal requirements appear more aimed towards the broader healthcare sector, many have the potential to directly impact the behavioural health sector as well, depending on the state law at issue, how the deal is structured, how the behavioural healthcare providers are structured, and the size of the transaction (among other things).

All of the foregoing, including potential application of OHCA notice and review requirements, depends upon understanding the nuances of the law, regulations and exceptions. Each analysis will be unique and depend heavily on the particular parties, facts and circumstances of each deal. As of the date of this publication the OHCA has issued proposed amendments to OHCA regulations which may further broaden the scope of OHCA requirements in certain circumstances. Stakeholders should continue to monitor related legal and regulatory developments closely.

Potential additional California law on horizon to increase review and approval power of the California AG

The California legislature is considering a bill that could severely impact the ability of private equity companies and hedge funds to operate in the California healthcare industry. California Assembly Bill 3129 (AB 3129) would:

• require notice to and approval by the AG prior to a change of control or acquisition between certain healthcare entities and private equity groups or hedge funds; and
• limit the ability of private equity companies or hedge funds to exercise managerial authority over physician and psychiatric practices.

As noted earlier, this bill follows an intensifying trend for adding layers of scrutiny by state and federal enforcement agencies of private equity investments in the healthcare industry, including the new California OHCA notice and review process for several of the above-mentioned healthcare transaction. If passed, this new law would take effect as of 1 January 2025.

Notice and approval of certain private equity and hedge fund deals in healthcare

AB 3129 would require a private equity group or hedge fund to notify and obtain written consent from the AG prior to a change of control or an acquisition between the private equity group or hedge fund and a healthcare facility or provider group. A “healthcare facility” generally includes facilities where healthcare services are provided (eg, hospitals, clinics, long-term healthcare facilities, ambulatory surgery centres, treatment centres, laboratories, or physician offices). “Provider group” means:

• a group of ten or more individual providers; or
• a group of between two and nine individual providers with at least USD10 million in annual revenue.

The applicable providers include individuals providing physician, psychiatric, surgery, or laboratory services to consumers, as well as licensed dentists, optometrists, and pharmacists providing health-related surgery or laboratory services.

The notice must be submitted at the same time as any other state or federal agency is notified of the transaction under law, or 90 days before the change of control or acquisition (whichever is earlier). The AG may extend the review period by 45 days if necessary to obtain additional information, if the proposed transaction is substantially modified, or if the proposed transaction involves a multi-facility or multi-provider health system serving multiple communities. The review period may also be extended by 14 days if a public meeting is held to receive public comment on the proposed transaction. The time period for review may also be stayed pending review by another state or federal agency.

The AG would also be empowered to impose conditions on the transaction if the transaction has a substantial likelihood of anti-competitive effects or the transaction may create a significant effect on the access to or availability of healthcare services in the affected community. When reviewing transactions, the AG would consider the interests of the public in protecting competitive and accessible healthcare markets for prices, quality, choice, accessibility, and availability.

AB 3129 would also authorise the AG to grant a waiver of the review process upon written request in certain cases. The waiver would require a finding by the AG that:

• the requesting party is in financial distress or at risk of filing for bankruptcy;
• the transaction would ensure healthcare access in the relevant markets; and
• the party made commercially reasonable best efforts to elicit reasonable alternative offers that would keep its assets in the relevant markets and that would pose a less severe danger to competition and to access to care than the proposed transaction.

The AG would have 60 days to grant or deny the waiver.

A private equity group or hedge fund would also be required to provide notice to ‒ but not receive consent from ‒ the AG prior to a change of control or acquisition of:

• a “non-physician provider” with more than USD4 million in annual revenue; or
• a provider consisting of between two and nine providers with between USD4 million and USD10 million in annual revenue.

“Non-physician provider” includes a group of between two and nine individuals who are licensed to treat patients (eg, optometrists and nurses) but do not provide health-related physician, surgery, or laboratory services to consumers.

Limitations on management services agreements

As at least some readers will know, as a result of CPOM restrictions in several states (including California), many investments and transactions in healthcare and physician practices in particular involve the use of what is often referred to as the “friendly professional corporation” and MSO model. In addition to the above-mentioned notice and consent requirements, AB 3129 would also restrict many of the management services agreements currently used in these typical “friendly professional corporation” and MSO arrangements. This would likely be very disruptive to a large number of such healthcare-related arrangements and investments across the state.

In addition to all the foregoing, AB 3129 would also have the following effects.

• Private equity groups and hedge funds will be prohibited from “control[ling] or direct[ing]” a physician or psychiatric practice, including through:
1. influencing or entering into contracts on behalf of the practice with third parties;
2. setting rates; or
3. influencing policies relating to patient admission, referrals, or provider availability.

How the government will permissibly prohibit a physician group from consulting with other individuals or entities for advice on running its business ‒ whether contracts, policies or otherwise ‒ is unclear.

• Physician or psychiatric practices will be prohibited from entering into agreements with any entity controlled by a private equity group or hedge fund for the provision of management services in exchange for a fee. Notably, this prohibition does not bar “revenue sharing” between the practice and any private equity group or hedge fund. It is unclear at this time exactly what kind of “revenue sharing” arrangement would be permissible under AB 3129. It is also unclear at this time how AB 3129, if it became law, would be reconciled with other sections of long-standing California law that expressly permit management services agreements with many healthcare providers (including physicians and psychiatrists) in exchange for a fee.
• Management services agreements, real estate purchase agreements, and asset purchase agreements between physician or psychiatric practices and private equity groups and hedge funds would not be allowed to include non-compete clauses and non-disparagement clauses.

The AG would have the authority to enforce these restrictions through injunctive relief and other equitable remedies.

What Should Healthcare and Behavioural Health Providers, Investors and Other Stakeholders Do Now? 

As discussed previously, current market conditions warrant special attention to legal structure and regulatory considerations in planning and execution for a successful transaction. Those same considerations ‒ along with a healthcare and behavioural health M&A market that remains somewhat unpredictable at this time ‒ place a premium on advance preparation in the early stages of a transaction process. Careful attention to structure, notice, review and approval processes that may be implicated can help keep a transaction moving and avoid surprise and/or delay on the path to closing. Similarly, increased regulatory scrutiny for healthcare and behavioural healthcare transactions may create new substantive barriers to investment at a time when healthcare and behavioural health providers are in need of investment to meet challenges posed by long-term increased demand and more complex business model, operating and reimbursement challenges.

As healthcare and behavioural healthcare providers, private equity investors, health systems and other stakeholders consider and plan for investment and transaction activity in California, the authors recommend:

• getting started on the legal and regulatory assessment of deals and the above-mentioned issues early, as the novelty and complexity of these issues and the “one size fits few” nature of certain healthcare and behavioural health providers mean that early assessment may pay dividends in avoiding surprises and helping expedite closing;
• being mindful that transaction structure can significantly impact necessary transaction approvals and related processes ‒ along with substantive regulatory compliance risks ‒ and, therefore, involving experienced healthcare transaction counsel in the early stages of developing the transaction blueprint;
• strategising early in an attempt to pre-emptively address agency antitrust-related enforcement concerns as well as to limit follow-up questions/request and a potentially more lengthy review (where applicable) ‒ given that co-ordination among buyers and sellers in preparing for such notice and review can help manage and mitigate timing and substantive process considerations; and
• monitoring evolving legal and regulatory standards applicable to healthcare and behavioural health providers, including ongoing changes to federal and state antitrust and mini-HSR requirements as more becomes known about how heightened scrutiny, review processes and/or legal challenges to same take hold.