When Private Equity Meets the False Claims Act
The United States recently filed a False Claims Act Complaint in Intervention against Florida-based compounding pharmacy Patient Care America (“PCA”), two PCA employees, as well as Riordan Lewis & Haden, Inc. (“RLH”), the private equity (“PE”) firm that acquired PCA and helped manage the company. United States ex rel. Medrano, et al. v. Patient Care America, et al., 15-62617 (S.D. FL.) The scheme alleged by the government was a common one: the payment of kickbacks for referrals of expensive compound drugs, which were often paid for by TriCare. What was uncommon was the government’s focus on a PE firm. Following the filing of the Complaint in Intervention, RLH, along with other defendants, filed Motions to Dismiss. The government’s recently filed response brief opposing the Motions to Dismiss provides further insight into the interplay between the FCA and private equity investments in healthcare.
In opposing RLH’s Motion to Dismiss, the government focused on the fact that RLH was not a “passive investor,” but rather an active participant in PCA’s management, involved in PCA’s move to the compounding pharmacy space, and even oversaw PCA’s CEO. RLH was also an experienced healthcare investor. RLH quickly became aware of how much of PCA’s revenue came from TriCare and that much of PCA’s revenue was paid out in the form of commissions to independent contractor sales representatives, a violation of the Anti-Kickback Statute.
While the facts in the PCA matter may seem unique, they may be more common than a financial layperson would expect. Private equity transactions nearly always operate under a “buy to sell” model. The PE firm (or a consortium of firms investing together) effectuate a leveraged buyout (“LBO”) of the target company, using massive amounts of debt to finance the acquisition. The cash flow from the acquired company is then expected to service the debt from the LBO.
PE firms believe that by acquiring the company and taking over its management they can drive profitability, allowing them to sell the company at a later date (typically around four to six years after the LBO) at a substantial profit. The problem with the managerial facet of the private equity model is that the more the PE firm takes over operations, the more likely it is that they may face FCA liability. The risk is particularly acute in highly regulated industries like healthcare.
As noted above, PE firms operate under a “buy to sell” model. They are, virtually by definition, not passive investors; to the contrary, PE firms are usually highly active managers of their portfolio companies. This is not a mutual fund but a company taking over equity and management. These sorts of transactions are called “takeovers” for good reason. PE firms do not just pore over balance sheets but often get involved in various managerial tasks, from marketing strategy to compliance oversight. By providing managerial knowhow, the PE firm can take the reins and build a more profitable company that can then be sold at a handsome profit.
Either individually or with partner PE firms, a PE firm will tend to own a majority of the company’s equity. Few PE firms will take the risk of such a sizable investment in an illiquid asset unless they hold a controlling portion of the company’s voting shares. Accordingly, PE firms tend to have multiple seats on the acquired company’s board, have full power (given their equity stake) to hire and fire executives, and may also take part in management decisions outside the scope of the board.
Individual PE firms also frequently focus on certain industries. As the RLH matter shows, if a PE firm is familiar with a certain industry it will be difficult for the firm to claim that it was ignorant of the regulatory mandates governing that industry, either in relation to its pre-LBO due diligence or its subsequent managerial role. That is likely to be particularly apt in the case of healthcare and the Anti-Kickback Statute, a broad law that any healthcare investor would be expected to be intimately familiar with.
Given that the lifeblood of private equity is the LBO, the financial structure at play makes a PE firm an attractive target for FCA enforcement. PE firms may siphon off much of a company’s profits in the form of distributions (e.g., dividends) and fees (e.g., monitoring fees paid to the PE firm for advising and managing the company). As the PCA matter shows, at least in some cases, the government may think twice about allowing PE firms to profit off of fraud without facing liability.
Further, in light of the substantial debt service from an LBO (which commonly involves interest rates from 6% to 15%) much of the remaining cash flow from an acquired company is sent to debt investors. This creates a dynamic where the target company may be unable to fund anything approaching a fair settlement with the government. The ill-gotten gains have already been funneled out of the company to investors. Perhaps more obviously, PE firms tend to have deep pockets and access to additional capital, making them particularly appealing targets when damages are substantial and the entity in which they have invested is strapped for cash.
Ultimately, as private equity continues to invest in industries which have high FCA exposure like healthcare, it may be that cases like PCA become more common. More robust due diligence by private equity firms should be the norm moving forward. After all, once the PE firm takes over and enters the company’s driver’s seat, it should come as no surprise if the government seeks to hold the driver liable.