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EX-32.2 - EXHIBIT 32.2 - Surgery Partners, Inc.q22017exhibit322.htm
EX-32.1 - EXHIBIT 32.1 - Surgery Partners, Inc.q22017exhibit321.htm
EX-31.2 - EXHIBIT 31.2 - Surgery Partners, Inc.q22017exhibit312.htm
EX-31.1 - EXHIBIT 31.1 - Surgery Partners, Inc.q22017exhibit311.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________________________________________
Form 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2017
or
o    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number:  001-37576
Surgery Partners, Inc.
(Exact name of registrant as specified in its charter)
Delaware
 
47-3620923
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

40 Burton Hills Boulevard, Suite 500
Nashville, Tennessee 37215
(Address of principal executive offices and zip code)
(615) 234-5900
(Registrant’s telephone number, including area code) 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. 
Large accelerated filer o
 
Accelerated filer x
Non-accelerated filer o
 
Smaller reporting company o
(Do not check if a smaller reporting company)
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No  x
As of August 9, 2017, there were 48,811,091 shares of the registrant’s common stock outstanding.
 




SURGERY PARTNERS, INC.
FORM 10-Q
TABLE OF CONTENTS

 
 
Page
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
Condensed Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
Notes to Condensed Consolidated Financial Statements (Unaudited)
 
 
 
Item 2.
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
Item 4.
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
Risk Factors
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
Item 3.
Defaults Upon Senior Securities
 
 
 
Item 4.
Mine Safety Disclosures
 
 
 
Item 5.
Other Information
 
 
 
Item 6.
Exhibits





PART 1 - FINANCIAL INFORMATION
Item 1.  Financial Statements
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, amounts in thousands, except shares and per share amounts)
 
 
June 30, 2017
 
December 31, 2016
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
57,034

 
$
69,699

Accounts receivable, less allowance for doubtful accounts of $31,465 and $29,872, respectively
 
215,294

 
220,594

Inventories
 
29,680

 
28,777

Prepaid expenses and other current assets
 
42,332

 
32,014

Acquisition escrow deposit
 
7,971

 
10,871

Total current assets
 
352,311

 
361,955

Property and equipment, net
 
205,744

 
204,253

Intangible assets, net
 
43,421

 
48,023

Goodwill
 
1,569,408

 
1,555,204

Investments in and advances to affiliates
 
34,488

 
34,980

Restricted invested assets
 
315

 
315

Long-term deferred tax assets
 
80,166

 
83,793

Financing escrow asset
 
370,000

 

Other long-term assets
 
15,634

 
16,435

Total assets
 
$
2,671,487

 
$
2,304,958

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
48,210

 
$
49,766

Accrued payroll and benefits
 
27,437

 
29,273

Acquisition escrow liability
 
7,971

 
10,871

Other current liabilities
 
72,465

 
68,993

Current maturities of long-term debt
 
29,919

 
27,822

Total current liabilities
 
186,002

 
186,725

Long-term debt, less current maturities
 
1,795,265

 
1,414,421

Long-term tax receivable agreement liability
 
122,351

 
122,351

Other long-term liabilities
 
76,101

 
76,266

 
 
 
 
 
Non-controlling interests—redeemable
 
176,252

 
180,521

 
 
 
 
 
Stockholders' equity:
 
 
 
 
Preferred stock, $0.01 par value, 20,000,000 shares authorized, no shares issued or outstanding
 

 

Common stock, $0.01 par value, 300,000,000 shares authorized, 48,810,075 shares issued and outstanding at June 30, 2017; 48,488,616 shares issued and outstanding at December 31, 2016
 
488

 
485

Additional paid-in capital
 
324,340

 
320,543

Retained deficit
 
(318,576
)
 
(311,351
)
Total Surgery Partners, Inc. stockholders' equity
 
6,252

 
9,677

Non-controlling interests—non-redeemable
 
309,264

 
314,997

Total stockholders' equity
 
315,516

 
324,674

Total liabilities and stockholders' equity
 
$
2,671,487

 
$
2,304,958


See notes to unaudited condensed consolidated financial statements.


1



SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, amounts in thousands, except shares and per share amounts)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
 
Revenues
 
$
288,353

 
$
289,681

 
$
574,536

 
$
556,755

Operating expenses:
 
 
 
 
 
 
 
 
Salaries and benefits
 
90,022

 
93,791

 
179,909

 
180,677

Supplies
 
74,084

 
66,915

 
145,244

 
130,577

Professional and medical fees
 
22,577

 
20,304

 
43,702

 
39,957

Lease expense
 
13,674

 
13,074

 
27,300

 
25,508

Other operating expenses
 
16,095

 
14,768

 
32,245

 
28,836

Cost of revenues
 
216,452

 
208,852

 
428,400

 
405,555

General and administrative expenses (1)
 
18,655

 
15,023

 
34,196

 
27,220

Depreciation and amortization
 
11,417

 
9,702

 
22,525

 
19,271

Provision for doubtful accounts
 
5,788

 
3,544

 
11,463

 
7,417

Income from equity investments
 
(1,052
)
 
(1,082
)
 
(2,252
)
 
(1,840
)
Loss on disposal or impairment of long-lived assets, net
 
405

 
1,331

 
1,601

 
1,125

Gain on litigation settlement
 
(3,794
)
 

 
(3,794
)
 

Loss on debt refinancing
 

 

 

 
8,281

Merger transaction and integration costs
 
2,904

 
1,325

 
3,241

 
4,497

Electronic health records incentive income
 
(161
)
 
(2
)
 
(302
)

(95
)
Other expense (income)
 

 
40

 
(2
)
 
97

Total operating expenses
 
250,614

 
238,733

 
495,076

 
471,528

Operating income
 
37,739

 
50,948

 
79,460

 
85,227

Interest expense, net
 
(25,600
)
 
(26,235
)
 
(50,782
)
 
(48,388
)
Income before income taxes
 
12,139

 
24,713

 
28,678

 
36,839

Income tax expense
 
512

 
2,420

 
2,629

 
4,190

Net income
 
11,627

 
22,293

 
26,049

 
32,649

Less: Net income attributable to non-controlling interests
 
(16,098
)
 
(20,173
)
 
(33,274
)
 
(37,720
)
Net (loss) income attributable to Surgery Partners, Inc.
 
$
(4,471
)
 
$
2,120

 
$
(7,225
)
 
$
(5,071
)
 
 
 
 
 
 
 
 
 
Net (loss) income per share attributable to common stockholders
 
 
 
 
 
 
 
 
Basic
 
$
(0.09
)
 
$
0.04

 
$
(0.15
)
 
$
(0.11
)
Diluted (2)
 
$
(0.09
)
 
$
0.04

 
$
(0.15
)
 
$
(0.11
)
Weighted average common shares outstanding
 
 
 
 
 
 
 
 
Basic
 
48,145,729

 
48,019,652

 
48,112,909


48,018,228

Diluted (2)
 
48,145,729

 
48,129,041

 
48,112,909


48,018,228


(1) Includes contingent acquisition compensation expense of $1.8 million and $1.5 million for the three months ended June 30, 2017 and 2016, respectively, and $3.8 million and $1.5 million for the six months ended June 30, 2017 and 2016, respectively.
(2) The impact of potentially dilutive securities for the three and six months ended June 30, 2017 and the six months ended June 30, 2016 was not considered because the effect would be anti-dilutive in those periods.

See notes to unaudited condensed consolidated financial statements.



2



SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited, amounts in thousands)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
 
Net income
 
$
11,627

 
$
22,293

 
$
26,049

 
$
32,649

Other comprehensive income
 

 

 

 

Comprehensive income
 
$
11,627

 
$
22,293

 
$
26,049

 
$
32,649

Less: Comprehensive income attributable to non-controlling interests
 
(16,098
)
 
(20,173
)
 
(33,274
)
 
(37,720
)
Comprehensive (loss) income attributable to Surgery Partners, Inc.
 
$
(4,471
)
 
$
2,120

 
$
(7,225
)
 
$
(5,071
)
See notes to unaudited condensed consolidated financial statements.




3



SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited, amounts in thousands, except shares)
 
Common Stock
 
Additional
Paid-in Capital
 
Retained Deficit
 
Non-Controlling Interests—
Non-Redeemable
 
Total
 
Shares
 
Amount
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance as of December 31, 2016
48,488,616

 
$
485

 
$
320,543

 
$
(311,351
)
 
$
314,997

 
$
324,674

Net (loss) income

 

 

 
(7,225
)
 
26,165

 
18,940

Issuance of restricted stock, net of forfeitures
354,058

 
3

 
(3
)
 

 

 

Equity-based compensation

 

 
2,069

 

 

 
2,069

Cancellation of restricted shares
(32,599
)
 

 
(658
)
 

 

 
(658
)
Acquisition and disposal of shares of non-controlling interests, net

 

 
2,389

 

 
(3,238
)
 
(849
)
Distributions to non-controlling interests—non-redeemable holders

 

 

 

 
(28,660
)
 
(28,660
)
Balance as of June 30, 2017
48,810,075

 
$
488

 
$
324,340

 
$
(318,576
)
 
$
309,264

 
$
315,516


See notes to unaudited condensed consolidated financial statements.



4



SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, amounts in thousands)
 
 
Six Months Ended June 30,
 
 
2017
 
2016
 
 
 
 
 
Cash flows from operating activities:
 
 
 
 
Net income
 
$
26,049

 
$
32,649

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
22,525

 
19,271

Amortization of debt issuance costs and discounts
 
3,774

 
3,348

Amortization of unfavorable lease liability
 
(162
)
 
(216
)
Equity-based compensation
 
2,069

 
635

Loss on disposal or impairment of long-lived assets, net
 
1,601

 
1,125

Loss on debt refinancing
 

 
8,281

Deferred income taxes
 
1,894

 
3,890

Provision for doubtful accounts
 
11,463

 
7,417

Income from equity investments, net of distributions received
 
487

 
(611
)
Changes in operating assets and liabilities, net of acquisitions and divestitures:
 
 
 
 
Accounts receivable
 
(5,699
)
 
(25,902
)
Other operating assets and liabilities
 
(7,530
)
 
24,150

Net cash provided by operating activities
 
56,471

 
74,037

 
 
 
 
 
Cash flows from investing activities:
 
 
 
 
Purchases of property and equipment, net
 
(15,102
)
 
(20,350
)
Payments for acquisitions, net of cash acquired
 
(14,163
)
 
(113,017
)
Proceeds from divestitures
 
70

 

Net cash used in investing activities
 
(29,195
)
 
(133,367
)
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
Principal payments on long-term debt
 
(113,364
)
 
(424,348
)
Borrowings of long-term debt
 
119,778

 
525,422

Payments of debt issuance costs
 
(941
)
 
(12,555
)
Lender financing escrow fee
 
(6,591
)
 

Penalty on prepayment of debt
 

 
(4,900
)
Distributions to non-controlling interest holders
 
(36,841
)
 
(32,362
)
(Payments) receipts related to ownership transactions with non-controlling interest holders
 
(745
)
 
573

Financing lease obligation
 
(579
)
 
(390
)
Other financing activities
 
(658
)
 
1,556

Net cash (used in) provided by financing activities
 
(39,941
)
 
52,996

Net decrease in cash and cash equivalents
 
(12,665
)
 
(6,334
)
Cash and cash equivalents at beginning of period
 
69,699

 
57,933

Cash and cash equivalents at end of period
 
$
57,034

 
$
51,599

See notes to unaudited condensed consolidated financial statements.


5

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)


1. Organization
Surgery Partners, Inc., a Delaware corporation (together with its subsidiaries, the “Company”), was formed on April 2, 2015, as a holding company for the purpose of facilitating an initial public offering (the “IPO”) of shares of common stock. Prior to September 30, 2015, the Company conducted business through Surgery Center Holdings, Inc. and its subsidiaries. Surgery Center Holdings, LLC was and is the sole indirect owner of the equity interests of Surgery Center Holdings, Inc. and has no other material assets. On October 1, 2015, the Company completed its IPO of 14,285,000 shares of common stock at an offering price of $19.00 per share.
On September 30, 2015, Surgery Partners, Inc. became the direct parent and sole member of Surgery Center Holdings, LLC (the "Reorganization"). In the Reorganization, all of the equity interests held by the pre-IPO owners of Surgery Center Holdings, LLC were contributed to Surgery Partners, Inc. in exchange for 33,871,990 shares of common stock of Surgery Partners, Inc. and certain rights to additional payments under a tax receivable agreement. After giving effect to the Reorganization, Surgery Partners, Inc. is a holding company, and its sole material asset is an equity interest in Surgery Center Holdings, LLC.
On May 9, 2017, the Company entered into a series of transactions pursuant to which the Company agreed (i) to acquire NSH Holdco, Inc. (“NSH”), an owner and operator of surgical facilities, for approximately $760 million through a merger of SP Merger Sub, Inc., a wholly owned subsidiary of the Company, with and into NSH (the “NSH Merger”), pursuant to an Agreement and Plan of Merger, by and among the Company, SP Merger Sub, Inc., NSH, and IPC / NSH, L.P., solely in its capacity as sellers’ representative (as amended by that certain Letter Amendment, dated July 7, 2017, the “NSH Merger Agreement”) and (ii) to issue to BCPE Seminole Holdings LP (“Bain Capital”), an affiliate of Bain Capital Private Equity, up to 320,000 shares of the Company’s preferred stock, par value $0.01 per share, to be created out of the authorized and unissued shares of the Company’s preferred stock and designated as 10.00% Series A Convertible Perpetual Participating Preferred Stock at a purchase price per share of $1,000 (the “Preferred Private Placement”), pursuant to a Securities Purchase Agreement by and among the Company and Bain Capital (the “Preferred Purchase Agreement”). In connection with the NSH Merger and the Preferred Private Placement, on May 9. 2017, the Company also entered into (i) a Stock Purchase Agreement, by and among the Company, H.I.G. Surgery Centers, LLC (“H.I.G.”), the Company’s controlling stockholder, H.I.G. Bayside Debt & LBO Fund II L.P. (for the purposes stated therein) and Bain Capital (the “Common Stock Purchase Agreement”), pursuant to which H.I.G. agreed to sell all of its 26,455,651 shares of the Company’s common stock to Bain Capital at a purchase price per share of $19.00 (together with the NSH Merger and the Preferred Private Placement, the “Transactions”) and (ii) an amendment to that certain Income Tax Receivable Agreement, dated September 30, 2015, by and between the Company, H.I.G. (in its capacity as the Stockholders Representative) and the other parties referred to therein (the “TRA Amendment”). The Transactions have not yet been consummated and the TRA Amendment has not yet become effective. Following the consummation of the Transactions, NSH will be a wholly-owned subsidiary of the Company, and Bain Capital will be the controlling stockholder of the Company.
As of June 30, 2017, the Company owned and operated a national network of surgical facilities and ancillary services in 29 states.  The surgical facilities, which include ambulatory surgery centers ("ASCs") and surgical hospitals, primarily provide non-emergency surgical procedures across many specialties, including, among others, gastroenterology ("GI"), general surgery, ophthalmology, orthopedics and pain management. The Company's surgical hospitals provide services such as diagnostic imaging, laboratory, obstetrics, oncology, pharmacy, physical therapy and wound care. Ancillary services are comprised of a diagnostic laboratory, multi-specialty physician practices, urgent care facilities, anesthesia services, optical services and specialty pharmacy services.
As of June 30, 2017, the Company owned or operated a portfolio of 103 surgical facilities, comprised of 98 ASCs and five surgical hospitals. The Company owns these facilities in partnership with physicians and, in some cases, healthcare systems in the markets and communities it serves. The Company owned a majority interest in 73 of the surgical facilities and consolidated 93 of these facilities for financial reporting purposes. In addition, the Company owned or operated a network of 59 physician practices.
The foregoing description of the Transactions, the NSH Merger Agreement, the Preferred Purchase Agreement, the Common Stock Purchase Agreement and the TRA Amendment do not purport to be complete and is subject to, and qualified in its entirety by, the full text of the respective agreements and any amendments thereto, copies of which are filed as Exhibit 2.1, Exhibit 10.1, Exhibit 10.2 and Exhibit 10.3, respectively, to the Company’s Current Report on Form 8-K filed with the SEC on May 11, 2017. A copy of the amendment to the NSH Merger Agreement is filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on July 11, 2017.
2. Significant Accounting Policies
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, as well as interests in partnerships and limited liability companies controlled by the Company through its ownership of a majority voting interest or other rights granted to the Company by contract to manage and control the affiliate's business. All significant intercompany balances and transactions are eliminated in consolidation.
The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation of the Company's financial position and results of operations have been included. The Company’s fiscal year ends on December 31 and interim results are not necessarily indicative of results for a full year or any other interim period. The condensed


6

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

consolidated balance sheet at December 31, 2016 has been derived from the audited financial statements as of that date. The information contained in these condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the fiscal year ended December 31, 2016. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Non-Controlling Interests
The physician limited partners and physician minority members of the entities that the Company controls are responsible for the supervision and delivery of medical services. The governance rights of limited partners and minority members are restricted to those that protect their financial interests. Under certain partnership and operating agreements governing these partnerships and limited liability companies, the Company could be removed as the sole general partner or managing member for certain events such as material breach of the partnership or operating agreement, gross negligence or bankruptcy. These protective rights do not preclude consolidation of the respective partnerships and limited liability companies.
Ownership interests in consolidated subsidiaries held by parties other than the Company are identified and generally presented in the condensed consolidated financial statements within the equity section but separate from the Company's equity. However, in instances in which certain redemption features that are not solely within the control of the Company are present, classification of non-controlling interests outside of permanent equity is required. Consolidated net income attributable to the Company and to the non-controlling interests are identified and presented on the condensed consolidated statements of operations; changes in ownership interests in which the Company retains a controlling interest are accounted for as equity transactions assuming the Company continues to consolidate related entities. Certain transactions with non-controlling interests are classified within financing activities in the condensed consolidated statements of cash flows.
The condensed consolidated financial statements of the Company include all assets, liabilities, revenues and expenses of surgical facilities in which the Company has sufficient ownership and rights to allow the Company to consolidate the surgical facilities. Similar to its investments in non-consolidated affiliates, the Company regularly engages in the purchase and sale of ownership interests with respect to its consolidated subsidiaries that do not result in a change of control.
Non-Controlling Interests — Redeemable. Each of the partnerships and limited liability companies through which the Company owns and operates its surgical facilities is governed by a partnership or operating agreement. In certain circumstances, the partnership and operating agreements for the Company's surgical facilities provide that the facilities will purchase all of the physicians’ ownership if certain adverse regulatory events occur, such as it becoming illegal for the physicians to own an interest in a surgical facility, refer patients to a surgical facility or receive cash distributions from a surgical facility. The non-controlling interests - redeemable are reported outside of stockholders' equity in the condensed consolidated balance sheets.
A summary of activity related to the non-controlling interests—redeemable follows (in thousands):
Balance at December 31, 2016
 
$
180,521

Net income attributable to non-controlling interests—redeemable
 
7,109

Acquisition and disposal of shares of non-controlling interests, net—redeemable
 
(3,197
)
Distributions to non-controlling interest—redeemable holders
 
(8,181
)
Balance at June 30, 2017
 
$
176,252

Variable Interest Entities
The condensed consolidated financial statements include the accounts of variable interest entities in which the Company is the primary beneficiary under the provisions of Accounting Standards Codification Topic ("ASC") 810, Consolidation. As of June 30, 2017, the variable interest entities include five surgical facilities, three anesthesia practices and three physician practices. At December 31, 2016, the variable interest entities included five surgical facilities, three anesthesia practices and two physician practices. The change is due to a physician practice acquired during the three months ended June 30, 2017. The Company has the power to direct the activities that most significantly impact the variable interest entity's economic performance. Additionally, the Company would absorb the majority of the expected losses of these entities should they occur. As of June 30, 2017 and December 31, 2016, the condensed consolidated balance sheets of the Company included total assets of $93.3 million and $99.5 million, respectively, and total liabilities of $9.5 million and $10.7 million, respectively, related to the Company's variable interest entities.
Equity Method Investments
The Company has non-consolidating investments in surgical facilities and management companies that own or manage surgical facilities. These investments are accounted for using the equity method of accounting. The total amount of these investments included in investments in and advances to affiliates in the condensed consolidated balance sheets was $34.5 million and $35.0 million as of June 30, 2017 and December 31, 2016, respectively.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and footnotes. Examples include, but are not limited to, estimates of accounts receivable allowances, professional and general liabilities and the estimate of deferred tax assets or liabilities. In the opinion of


7

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

management, all adjustments considered necessary for a fair presentation have been included. All adjustments are of a normal, recurring nature. Actual results could differ from those estimates.
Fair Value of Financial Instruments
The fair value of a financial instrument is the amount at which the instrument could be exchanged in an orderly transaction between market participants to sell the asset or transfer the liability. The Company uses fair value measurements based on quoted prices in active markets for identical assets or liabilities (Level 1), inputs other than quoted prices in active markets that are either directly or indirectly observable (Level 2), or unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions (Level 3), depending on the nature of the item being valued.
The carrying amounts reported in the condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, restricted invested assets and accounts payable approximate their fair values.
A summary of the carrying amounts and fair values of the Company's long-term debt follows (in thousands):
 
 
Carrying Amount
 
Fair Value
 
 
June 30,
2017
 
December 31,
2016
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
 
 
 
 
2014 First Lien Credit Agreement, net of debt issuance costs and discount
 
$
909,410

 
$
911,784

 
$
911,120

 
$
917,528

Senior Unsecured Notes due 2021, net of debt issuance costs and discount
 
$
389,095

 
$
387,942

 
$
420,223

 
$
412,189

Senior Unsecured Notes due 2025, net of debt issuance costs
 
$
367,100

 
$

 
$
367,100

 
$

2014 Revolver Loan
 
$
91,000

 
$
85,000

 
$
91,000

 
$
85,000

The fair values of the 2014 First Lien Credit Agreement and the 2021 Unsecured Notes (in each case, as defined in Note 4, "Long-Term Debt") were based on a Level 2 computation using quoted prices for identical liabilities in inactive markets at June 30, 2017 and December 31, 2016, as applicable. The carrying amounts related to the Company's other long-term debt obligations, including the 2025 Unsecured Notes issued on June 30, 2017 and the 2014 Revolver Loan (in each case, as defined in Note 4, "Long-Term Debt"), approximate their fair values.
The Company maintains a supplemental executive retirement savings plan (the "SERP") for certain executive officers. The SERP is a non-qualified deferred compensation plan for eligible executive officers and other key employees of the Company that allows participants to defer portions of their compensation. The fair value of the SERP asset and liability was based on a quoted market price, or a Level 1 computation. As of June 30, 2017 and December 31, 2016, the fair value of the assets in the SERP were $1.8 million and $1.7 million, respectively, and were included in other long-term assets in the condensed consolidated balance sheets. The Company had a liability related to the SERP of $1.8 million and $1.7 million as of June 30, 2017 and December 31, 2016, respectively, which was included in other long-term liabilities in the condensed consolidated balance sheets.
Revenues
The Company recognizes revenues in the period in which the services are performed. Patient service revenues and receivables from third-party payors are recorded net of estimated contractual adjustments and allowances, which the Company estimates based on the historical trend of its cash collections and contractual write-offs, accounts receivable agings, established fee schedules, contracts with payors and procedure statistics.
A summary of revenues by service type as a percentage of total revenues follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Patient service revenues:
 
 
 
 
 
 
 
 
   Surgical facilities revenues
 
90.5
%
 
90.0
%
 
90.1
%
 
90.6
%
   Ancillary services revenues
 
7.9
%
 
7.7
%
 
8.3
%
 
7.2
%
 
 
98.4
%
 
97.7
%
 
98.4
%
 
97.8
%
Other service revenues:
 
 
 
 
 
 
 
 
   Optical services revenues
 
1.0
%
 
1.2
%
 
1.0
%
 
1.3
%
   Other
 
0.6
%
 
1.1
%
 
0.6
%
 
0.9
%
 
 
1.6
%
 
2.3
%
 
1.6
%
 
2.2
%
Total revenues
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%


8

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

Patient service revenues. The fee charged for healthcare procedures performed in surgical facilities varies depending on the type of service provided, but usually includes all charges for usage of an operating room, a recovery room, special equipment, medical supplies, nursing staff and medications. The fee does not normally include professional fees charged by the patient’s surgeon, anesthesiologist or other attending physician, which are billed directly by such physicians to the patient or third-party payor.  However, in several surgical facilities, the Company charges for anesthesia services. Ancillary service revenues include fees for patient visits to the Company's physician practices, pharmacy services and diagnostic tests ordered by physicians. Patient service revenues are recognized on the date of service, net of estimated contractual adjustments and discounts from third-party payors, including Medicare and Medicaid.  Changes in estimated contractual adjustments and discounts are recorded in the period of change. During the three and six months ended June 30, 2017, the Company recognized an increase to patient service revenues as a result of changes in estimates to third-party settlements related to prior years of approximately $128,000 and $506,000, respectively.
The following table sets forth patient service revenues by type of payor and as a percentage of total patient service revenues for the Company's consolidated surgical facilities (dollars in thousands):
 
 
Three Months Ended June 30,
 
 
2017
 
2016
 
 
Amount
 
%
 
Amount
 
%
Patient service revenues:
 
 
 
 
 
 
 
 
Private insurance
 
$
140,922

 
49.6
%
 
$
145,211

 
51.3
%
Government
 
118,381

 
41.7
%
 
113,971

 
40.2
%
Self-pay
 
5,760

 
2.0
%
 
4,766

 
1.7
%
Other (1)
 
18,771

 
6.7
%
 
19,263

 
6.8
%
Total patient service revenues
 
$
283,834

 
100.0
%
 
$
283,211

 
100.0
%
Other service revenues:
 
 
 
 
 
 
 
 
Optical service revenues
 
$
2,903

 
 
 
$
3,395

 
 
Other revenues
 
1,616

 
 
 
3,075

 
 
Total net revenues
 
$
288,353

 
 
 
$
289,681

 
 
 
 
Six Months Ended June 30,
 
 
2017
 
2016
 
 
Amount
 
%
 
Amount
 
%
Patient service revenues:
 
 
 
 
 
 
 
 
Private insurance
 
$
279,925

 
49.5
%
 
$
277,426

 
50.9
%
Government
 
235,259

 
41.6
%
 
219,774

 
40.3
%
Self-pay
 
11,831

 
2.1
%
 
8,479

 
1.6
%
Other (1)
 
38,465

 
6.8
%
 
39,092

 
7.2
%
Total patient service revenues
 
$
565,480

 
100.0
%
 
$
544,771

 
100.0
%
Other service revenues:
 
 
 
 
 
 
 
 
Optical service revenues
 
$
5,724

 


 
$
7,019

 


Other revenues
 
3,332

 


 
4,965

 


Total net revenues
 
$
574,536

 
 
 
$
556,755

 
 
(1) Other is comprised of anesthesia service agreements, auto liability, letters of protection and other payor types.
Other service revenues. Optical service revenues consist of product sales from the Company's optical laboratories as well as handling charges billed to the members of the Company's optical products purchasing organization.. The Company's optical products purchasing organization negotiates volume buying discounts with optical products manufacturers. The buying discounts and any handling charges billed to the members of the buying group represent the revenue recognized for financial reporting purposes. Revenue is recognized as orders are shipped to members. The Company bases its estimates for sales returns and discounts on historical experience and has not experienced significant fluctuations between estimated and actual return activity and discounts given. The Company's optical laboratories manufacture and distribute corrective lenses and eyeglasses to ophthalmologists and optometrists. Revenue is recognized when product is shipped, net of allowance for discounts.
Other revenues include management and administrative service fees derived from the non-consolidated facilities that the Company accounts for under the equity method, management of surgical facilities in which it does not own an interest, and management services provided to physician practices for which the Company is not required to provide capital or additional assets. The fees derived from these management


9

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

arrangements are based on a predetermined percentage of the revenues of each facility or practice and are recognized in the period in which services are rendered.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.  The Company maintains its cash and cash equivalent balances at high credit quality financial institutions.
Accounts Receivable and Allowances for Contractual Adjustments and Doubtful Accounts
Accounts receivable are recorded net of contractual adjustments and allowances for doubtful accounts to reflect accounts receivable at net realizable value. Accounts receivable consists of receivables from federal and state agencies (under the Medicare and Medicaid programs), managed care health plans, commercial insurance companies, employers and patients. Management recognizes that revenues and receivables from government agencies are significant to the Company's operations, but it does not believe that there is significant credit risk associated with these government agencies. Concentration of credit risk with respect to other payors is limited because of the large number of such payors. As of June 30, 2017 and December 31, 2016, the Company had a net third-party Medicaid settlements receivable of $1.1 million and $454,000, respectively.
The Company recognizes that final reimbursement of accounts receivable is subject to final approval by each third-party payor. However, because the Company has contracts with its third-party payors and also verifies insurance coverage of the patient before medical services are rendered, the amounts that are pending approval from third-party payors are not significant. The Company's policy is to collect co-payments and deductibles prior to providing medical services. It is also the Company's policy to verify a patient’s insurance 72 hours prior to the patient’s procedure. Patient services of the Company are primarily non-emergency, which allows the surgical facilities to control the procedures for which third-party reimbursement is sought and obtained. The Company does not require collateral from self-pay patients.
The Company analyzes accounts receivable at each of its facilities to ensure the proper aged category and collection assessment. At a consolidated level, the Company's policy is to review accounts receivable aging, by facility, to determine the appropriate allowance for doubtful accounts. Patient account balances are reviewed for delinquency based on contractual terms. This review is supported by an analysis of the actual revenues, contractual adjustments and cash collections received. An account balance is written off only after the Company has pursued collection with legal or collection agency assistance or otherwise has deemed an account to be uncollectible.
The receivables related to the Company's optical products purchasing organization are recognized separately from patient accounts receivable, as discussed above, and are included in other current assets in the condensed consolidated balance sheets. Such receivables were $9.0 million and $7.0 million at June 30, 2017 and December 31, 2016, respectively.
Inventories
Inventories, which consist primarily of medical and drug supplies, are stated at the lower of cost or market value. Cost is determined using the first-in, first-out method.
Prepaid Expenses and Other Current Assets
A summary of prepaid expenses and other current assets follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
Prepaid expenses
 
$
19,178

 
$
11,158

Receivables - optical product purchasing organization
 
8,964

 
7,042

Insurance recoveries
 
2,305

 
2,476

Other current assets
 
11,885

 
11,338

Total
 
$
42,332

 
$
32,014

Property and Equipment
Property and equipment are stated at cost or, if obtained through acquisition, at fair value determined on the date of acquisition. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets, generally three to five years for computers and software and five to seven years for furniture and equipment. Leasehold improvements are depreciated on a straight-line basis over the shorter of the lease term or the estimated useful life of the assets. Routine maintenance and repairs are expensed as incurred, while expenditures that increase capacities or extend useful lives are capitalized.


10

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

A summary of property and equipment follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
Land
 
$
8,082

 
$
8,082

Buildings and improvements
 
123,106

 
118,172

Furniture and equipment
 
16,234

 
14,670

Computer and software
 
33,238

 
29,902

Medical equipment
 
136,149

 
117,418

Construction in progress
 
4,333

 
2,396

Property and equipment, at cost
 
321,142

 
290,640

Less: Accumulated depreciation
 
(115,398
)
 
(86,387
)
Property and equipment, net
 
$
205,744

 
$
204,253

The Company also leases certain facilities and equipment under capital leases. Assets held under capital leases are stated at the present value of minimum lease payments at the inception of the related lease. Such assets are depreciated on a straight-line basis over the lesser of the lease term or the remaining useful life of the leased asset. The carrying values of assets under capital lease were $15.9 million and $15.4 million as of June 30, 2017 and December 31, 2016, respectively, net of accumulated depreciation of $12.6 million and $11.6 million, respectively.
Intangible Assets
The Company has indefinite-lived intangible assets related to the certificates of need held in jurisdictions where certain of its surgical facilities are located. The Company also has finite-lived intangible assets related to physician guarantee agreements, non-compete agreements, management agreements and customer relationships. Physician income guarantees are amortized into salaries and benefits costs in the condensed consolidated statements of operations over the commitment period of the contract, generally three to four years. Non-compete agreements and management rights agreements are amortized into depreciation and amortization expense in the condensed consolidated statements of operations over the service lives of the agreements, typically ranging from 2 to 5 years for non-compete agreements and 15 years for the management rights agreements. Customer relationships are amortized into depreciation and amortization expense in the condensed consolidated statements of operations over the estimated lives of the relationships, ranging from three to ten years.
A summary of the activity related to intangible assets for the six months ended June 30, 2017 follows (in thousands):
 
 
Physician Income Guarantees
 
Management Rights
 
Non-Compete Agreements
 
Certificates of Need
 
Customer Relationships
 
Other
 
Total Intangible Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
 
$
813

 
$
21,290

 
$
16,457

 
$
3,780

 
$
3,704

 
$
1,979

 
$
48,023

Additions
 
175

 

 
92

 
14

 

 

 
281

Recruitment expense
 
(284
)
 

 

 

 

 

 
(284
)
Amortization
 

 
(865
)
 
(2,843
)
 

 
(550
)
 
(341
)
 
(4,599
)
Balance at June 30, 2017
 
$
704

 
$
20,425

 
$
13,706

 
$
3,794

 
$
3,154

 
$
1,638

 
$
43,421



11

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

Goodwill
Goodwill represents the fair value of the consideration provided in an acquisition over the fair value of net assets acquired and is not amortized. Additions to goodwill include amounts resulting from new business combinations and incremental ownership purchases in the Company's subsidiaries.
A summary of activity related to goodwill for the six months ended June 30, 2017 follows (in thousands):
Balance at December 31, 2016
 
$
1,555,204

Acquisitions
 
13,137

Divestitures
 
(175
)
Purchase price adjustments
 
1,242

Balance at June 30, 2017
 
$
1,569,408

Impairment of Long-Lived Assets, Goodwill and Intangible Assets
The Company evaluates the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist in accordance with Accounting Standards Codification (ASC) 350, Intangibles- Goodwill and Other. The Company performs an impairment test by preparing an expected undiscounted cash flow projection. If the projection indicates that the recorded amount of the long-lived asset is not expected to be recovered, the carrying value is reduced to estimated fair value. The cash flow projection and fair value represents management’s best estimate, using appropriate and customary assumptions, projections and methodologies, at the date of evaluation. The Company tests its goodwill and intangible assets for impairment at least annually, or more frequently if certain indicators arise. 
Restricted Invested Assets
Restricted invested assets of $315,000 as of both June 30, 2017 and December 31, 2016 were related to a requirement under the operating lease agreement at the Company's Chesterfield, Missouri facility. In accordance with the provisions of the lease agreement, the Company has a deposit with the landlord that shall be held as security for performance under the Company's covenants and obligations within the agreement through January 2024.
Other Long-Term Assets
A summary of other long-term assets follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
Notes receivable
 
$
817

 
$
716

Deposits
 
3,284

 
4,196

Assets of SERP
 
1,834

 
1,725

Debt issuance costs
 
1,199

 
1,488

Insurance recoverable
 
6,835

 
6,835

Other
 
1,665

 
1,475

Total
 
$
15,634

 
$
16,435

Other Current Liabilities
A summary of other current liabilities follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
Interest payable
 
$
11,771

 
$
19,206

Current taxes payable
 
3,408

 
2,622

Insurance liabilities
 
6,814

 
6,625

Amounts due to patients and payors
 
14,660

 
12,221

Tax receivable agreement liability
 
999

 
999

Contingent acquisition compensation liability
 
6,555

 
4,589

Other accrued expenses
 
28,258

 
22,731

Total
 
$
72,465

 
$
68,993



12

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

Other Long-Term Liabilities
A summary of other long-term liabilities follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
Facility lease obligations
 
$
51,904

 
$
52,653

Medical malpractice liability
 
10,453

 
10,453

Liability of SERP
 
1,834

 
1,725

Unfavorable lease liability
 
1,509

 
1,671

Other long-term liabilities
 
10,401

 
9,764

Total
 
$
76,101

 
$
76,266

The Company has facility lease obligations in connection with the surgical hospital located in Idaho Falls, Idaho and with a radiation oncology building at this facility. The obligation is payable to the lessor of this facility for the land, building and improvements. The current portion of the lease obligation was $1.3 million and $1.1 million at June 30, 2017 and December 31, 2016, respectively, and was included in other current liabilities in the condensed consolidated balance sheets. The long-term portion of the lease obligation, included in the table above, was $48.3 million and $48.9 million at June 30, 2017 and December 31, 2016, respectively.
Additionally, the Company has a facility lease obligation in connection with a surgical facility in Ocala, Florida payable to the lessor of this facility for the building. The current portion of the lease obligation was $189,000 and $182,000 at June 30, 2017 and December 31, 2016, respectively, and was included in other current liabilities in the condensed consolidated balance sheets. The long-term portion of the facility lease obligation, included in the table above, was $3.6 million and $3.7 million at June 30, 2017 and December 31, 2016, respectively.
Operating Leases
The Company leases office space and equipment for its surgical facilities, including surgical facilities under development. The lease agreements generally require the lessee, or the Company, to pay all maintenance, property taxes, utilities and insurance costs. The Company accounts for operating lease obligations and sublease income on a straight-line basis. Contingent obligations of the Company, as defined by each lease agreement, are recognized when specific contractual measures have been met, typically the result of an increase in the Consumer Price Index. Lease obligations paid in advance are recorded as prepaid rent and included in prepaid expenses and other current assets on the condensed consolidated balance sheets. The difference between actual lease payments and straight-line lease expense over the initial lease term, excluding optional renewal periods, is recorded as deferred rent and included in other current liabilities and other long-term liabilities on the condensed consolidated balance sheets.
Equity-Based Compensation
Transactions in which the Company receives employee and non-employee services in exchange for the Company’s equity instruments or liabilities that are based on the fair value of the Company’s equity securities or may be settled by the issuance of these securities are accounted for using a fair value method. The Company applies the Black-Scholes-Merton method of valuation in determining share-based compensation expense for option awards. 
The Company’s policy is to recognize compensation expense using the straight line method over the relevant vesting period for units that vest based on time. In connection with the Reorganization, the Company’s board of directors and stockholders adopted the Surgery Partners, Inc. 2015 Omnibus Incentive Plan from which the Company’s future equity-based awards will be granted.
Professional, General and Workers' Compensation Insurance
The Company maintains general liability and professional liability insurance in excess of self-insured retentions through third party commercial insurance carriers in amounts that management believes is sufficient for the Company's operations, although, potentially, some claims may exceed the scope of coverage in effect. The professional and general insurance coverage is on a claims-made basis. Workers' compensation insurance is on an occurrence basis.
The Company expenses the costs under the self-insured retention exposure for general and professional liability and workers compensation claims which relate to (i) claims made during the policy period, which are offset by insurance recoveries and (ii) an estimate of claims incurred but not yet reported that are expected to be reported after the policy period expires. Reserves and provisions are based upon actuarially determined estimates. The reserves are estimated using individual case-basis valuations and actuarial analysis. Reserves for professional, general and workers' compensation claim liabilities are determined with no regard for expected insurance recoveries and are presented gross on the condensed consolidated balance sheets. Total professional, general and workers' compensation claim liabilities as of June 30, 2017 and December 31, 2016 are $13.5 million and $13.8 million, respectively. The balance includes expected insurance recoveries of $9.1 million and $9.3 million as of June 30, 2017 and December 31, 2016, respectively.
Income Taxes and Tax Receivable Agreement
The Company uses the asset and liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets


13

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If a net operating loss carryforward exists, the Company makes a determination as to whether that net operating loss ("NOL") carryforward will be utilized in the future. A valuation allowance is established for certain net operating loss carryforwards when their recoverability is deemed to be uncertain. The carrying value of the net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to adjust its deferred tax valuation allowances.
The Company, or one or more of its subsidiaries, files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations for years prior to 2013 or state income tax examinations for years prior to 2012.
As part of the Reorganization that was effective September 30, 2015, the Company entered into a Tax Receivable Agreement (“TRA”), the terms of which required the Company to pay to its stockholders as of immediately prior to the IPO 85% of the cash savings, if any, in U.S. federal, state or local tax that the Company actually realizes (or is deemed to realize in certain circumstances) as a result of (i) certain tax attributes, including NOLs, capital losses, charitable deductions, alternative minimum tax credit carryforwards and federal and state tax credits of Surgery Partners, Inc. and its affiliates relating to taxable years ending on or before the date of the Reorganization (calculated by assuming the taxable year of the relevant entity closes on the date of the Reorganization) that are or become available to the Company and its wholly-owned subsidiaries as a result of the Reorganization, and (ii) tax benefits attributable to payments made under the TRA, together with interest accrued at a rate of LIBOR plus 300 basis points from the date the applicable tax return is due (without extension) until paid.
As described in Note 1, "Organization," on May 9, 2017, the Company entered into the TRA Amendment. The TRA Amendment, which will become effective immediately prior to (but contingent upon) the consummation of the NSH Merger, provides for a fixed payment schedule.
Prior to the effectiveness of the TRA Amendment, the amounts payable under the TRA vary depending upon a number of factors, including the amount, character and timing of the taxable income of Surgery Partners, Inc. in the future. The Company estimates the total amounts payable would be approximately $123.4 million, if the tax benefits of related deferred tax assets are ultimately realized. The amounts payable were recognized during 2015 in conjunction with the release of the Company's valuation allowance recorded against the deferred tax assets.
After the effectiveness of the TRA Amendment, the amounts payable will be related to the projected tax savings to be realized by the Company over the next five years and are not dependent on actual savings. The Company estimates that the total amounts payable under the TRA, as amended, may be as high as $120.5 million.
The Company and its subsidiaries file a consolidated federal income tax return. The partnerships, limited liability companies, and certain non-consolidated physician practice corporations file separate income tax returns. The Company's allocable portion of each partnership's and limited liability company's income or loss is included in taxable income of the Company. The remaining income or loss of each partnership and limited liability company is allocated to the other owners.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09, "Revenue from Contracts with Customers," along with subsequent amendments, updates and an extension of the effective date (collectively the “New Revenue Standard”), which outlines a single comprehensive model for recognizing revenue and supersedes most existing revenue recognition guidance, including guidance specific to the healthcare industry. This five-step process will require significant management judgment in addition to changing the way many companies recognize revenue in their financial statements. Additionally, and among other provisions, the New Revenue Standard requires expanded quantitative and qualitative disclosures, including disclosure about the nature, amount, timing and uncertainty of revenue. The provisions of the New Revenue Standard are effective for annual periods beginning after December 15, 2017, including interim periods within those years by applying either the full retrospective method or the modified retrospective approach upon adoption. The Company will adopt this ASU on January 1, 2018. Upon the continued evaluation of the New Revenue Standard, the Company currently plans to adopt using the modified retrospective method, including providing all requisite disclosures under such method.
In preparation for the adoption of the New Revenue Standard, the Company continues to evaluate and refine its estimates of the anticipated impacts the New Revenue Standard will have on its revenue recognition policies, procedures, financial position, results of operations, cash flows, financial disclosures and control framework. Specifically, the Company is continuing to evaluate its accounting policies and internal controls under the New Revenue Standard, as well as analyzing all of the potential effects of the New Revenue Standard, particularly with respect to non-patient service revenue sources. Upon further evaluation, the Company anticipates that the majority of its provision for doubtful accounts will continue to be recognized as an operating expense rather than as a direct reduction to revenues, given the Company’s practice of assessing a patient’s ability to pay prior to or on the date of providing healthcare services.
In February 2016, the FASB issued ASU 2016-02, “Leases,” which will require, among other items, lessees to recognize most leases as assets and liabilities on the balance sheet. Qualitative and quantitative disclosures will be enhanced to better understand the amount, timing and uncertainty of cash flows arising from leases. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The Company believes the primary effect of adopting the new standard will be to record right-of-use assets and obligations for current operating leases.


14

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

In March 2016, the FASB issued ASU 2016-07, “Investments- Equity Method and Joint Ventures,” which allows investments that now meet equity method treatment that were previously accounted for under a different method to apply the equity method prospectively from the date the investment qualifies for equity method treatment. ASU 2016-07 is effective prospectively for fiscal years beginning after December 15, 2016, including interim periods within those years. Early adoption is permitted. The Company adopted this ASU on January 1, 2017. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operations, cash flows and financial disclosures.
In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments,” which clarifies the classification of certain cash receipts and cash payments on the statement of cash flows. ASU 2016-15 is effective retrospectively for fiscal years beginning after December 15, 2017, including interim periods within those years. Early adoption is permitted. The Company is currently evaluating the impact this new guidance may have on the condensed consolidated cash flows.
In October 2016, the FASB issued ASU 2016-17, “Interests Held through Related Parties That Are under Common Control,” which modifies existing guidance with respect to how a decision maker that holds an indirect interest in a VIE through a common control party determines whether it is the primary beneficiary of the VIE as part of the analysis of whether the VIE would need to be consolidated. Under the ASU, a decision maker would need to consider only its proportionate indirect interest in the VIE held through a common control party. Previous guidance had required the decision maker to treat the common control party’s interest in the VIE as if the decision maker held the interest itself. As a result of the ASU, in certain cases, previous consolidation conclusions may change. ASU 2016-17 is effective prospectively for fiscal years beginning after December 15, 2016, including interim periods within those years. The Company adopted this ASU on January 1, 2017. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operations, cash flows and financial disclosures.
In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows: Restricted Cash, which will require the reconciliation of restricted cash in the statement of cash flows. ASU 2016-18 is effective retrospectively for fiscal years beginning after December 15, 2017, including interim periods within those years. Early adoption is permitted. The adoption of this ASU will not have a material impact on the Company's condensed consolidated cash flows.
In January 2017, the FASB issued ASU 2017-01, “Business Combinations – Clarifying the Definition of a Business,” which narrows the definition of a business when evaluating whether transactions should be accounted for as asset acquisition or business combination. ASU 2017-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. Early adoption is permitted. The Company is currently evaluating the impact this new guidance may have on the condensed consolidated financial position, results of operations and cash flows.
In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment,” which eliminates the requirement to calculate the implied fair value of goodwill (i.e., Step 2 of the current goodwill impairment test) to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value (i.e., measure the charge based on the current Step 1). ASU 2017-04 is effective for fiscal years beginning after December 15, 2019, including interim periods within those years. Early adoption is permitted for annual and interim periods after January 1, 2017. The Company early adopted this ASU on January 1, 2017. The adoption of ASU 2017-04 only impacts the Company's financial statements in situations where an impairment of a reporting unit’s assets is determined.
3. Acquisitions and Developments
The Company accounts for its business combinations in accordance with the fundamental requirements of the acquisition method of accounting and under the premise that an acquirer can be identified for each business combination. The acquirer is the entity that obtains control of one or more businesses in the business combination and the acquisition date is the date the acquirer achieves control. The assets acquired, liabilities assumed and any non-controlling interests in the acquired business at the acquisition date are recognized at their fair values as of that date, and the direct costs incurred in connection with the business combination are recorded and expensed separately from the business combination. Acquisitions in which the Company is able to exert significant influence but does not have control are accounted for using the equity method.
2017 Transactions
During the six months ended June 30, 2017, the Company completed acquisitions in existing markets of three physician practices for a combined purchase price of $14.2 million. The acquisitions were funded through cash from operations and proceeds from the Revolver (as defined in Note 4, "Long-Term Debt").


15

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

The aggregate amounts preliminarily recognized as of the acquisition date for each major class of assets and liabilities assumed in the acquisitions closed during the six months ended June 30, 2017 are as follows:
Cash consideration
$
14,163

Fair value of non-controlling interests
105

Aggregate fair value of acquisitions
14,268

Net assets acquired:
 
Accounts receivable
871

Other current assets
18

Property and equipment
622

Intangible assets
92

Accounts payable
(99
)
Other current liabilities
(187
)
Long-term debt
(186
)
     Net assets acquired
1,131

Excess of fair value over identifiable net assets acquired
13,137

The fair values assigned to certain assets and liabilities assumed by the Company have been estimated on a preliminary basis and are subject to change as new facts and circumstances emerge that were present at the date of acquisition.
4. Long-Term Debt
A summary of long-term debt follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
 
 
 
 
 
2014 Revolver Loan
 
$
91,000


$
85,000

2014 First Lien Credit Agreement
 
927,250


932,000

Senior Unsecured Notes due 2021

400,000


400,000

Senior Unsecured Notes due 2025
 
370,000

 

Subordinated Notes
 
1,000


1,000

Notes payable and secured loans
 
52,793


42,521

Capital lease obligations
 
14,787


13,996

Less: unamortized debt issuance costs and discount
 
(31,646
)

(32,274
)
Total debt
 
1,825,184

 
1,442,243

Less: Current maturities
 
29,919

 
27,822

Total long-term debt
 
$
1,795,265

 
$
1,414,421

2014 Revolver Loan
The 2014 Revolver Loan (“Revolver”), entered into on November 3, 2014, is a revolving credit facility used for working capital, acquisitions and development activities and general corporate purposes and matures on November 3, 2019. On October 7, 2015, the Company entered into an amendment to the 2014 First Lien Credit Agreement to increase certain lenders’ commitments under the Revolver from $80.0 million to an aggregate principal amount at any time outstanding not to exceed $150.0 million.
The Company has the option of classifying borrowings under the Revolver as either Alternate Base Rate ("ABR") loans or Eurodollar ("ED") loans. The interest base rate on an ABR loan is equal to the greatest of (a) the Prime Rate in effect on such day, (b) the Federal Funds Effective Rate in effect on such day plus 0.50% and (c) the adjusted LIBO Rate for a Eurodollar Borrowing with a one-month interest period plus 1.00%. In addition to the base rate, the Company is required to pay a 3.25% margin for ABR loans. The interest base rate on an ED loan is equal to (x) the LIBO Rate for such Eurodollar borrowing in effect for such Interest Period divided by (y) One minus the Statutory Reserves (if any) for such Eurodollar Borrowing for such interest period. In addition to the base rate, the Company is required to pay a 4.25% margin for ED loans. The Company must also pay quarterly commitment fees of 0.50% per annum of the average daily unused amount of the Revolver. As of June 30, 2017, the Company's availability on the Revolver was $55.9 million (including outstanding letters of credit of $3.1 million).


16

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

The 2014 First Lien Credit Agreement governs the Revolver and contains various covenants that include limitations on the Company's indebtedness, liens, acquisitions and investments. It additionally includes the requirement that, if triggered, the Company maintain a net leverage ratio within a specified range. As of June 30, 2017, the Company was in compliance with the covenants contained in the 2014 First Lien Credit Agreement.
2014 First Lien Credit Agreement
The 2014 First Lien Credit Agreement (“2014 First Lien”), entered into on November 3, 2014, is a senior secured obligation of Surgery Center Holdings, Inc. and is guaranteed on a senior secured basis by certain subsidiaries of the Company. The 2014 First Lien matures on November 3, 2020. On March 24, 2016, Surgery Center Holdings, Inc. and certain subsidiaries of the Company entered into an amendment to the 2014 First Lien to obtain an incremental term loan in an aggregate principal amount of $80.0 million, which increased the total term loan obligation under the 2014 First Lien to $950.0 million. On September 26, 2016, the Company entered into an amendment to the 2014 First Lien to reduce the interest margins for an ABR loan to 2.75% and for an ED loan to 3.75%.
The Company has the option of classifying the 2014 First Lien as either an ABR loan or an ED loan. The interest base rate on an ABR loan is equal to the greatest of (a) the Prime Rate in effect on such day, (b) the Federal Funds Effective Rate in effect on such day plus 0.50%, and (c) the Adjusted LIBO Rate for a Eurodollar Borrowing with a one-month interest period plus 1.00%; provided that the base rate shall not be less than 2.00% per annum. In addition to the base rate, the Company is required to pay a 2.75% margin for ABR loans. The interest base rate on an ED loan is equal to (x) the LIBO Rate for such Eurodollar borrowing in effect for such Interest Period divided by (y) One minus the Statutory Reserves (if any) for such Eurodollar Borrowing for such interest period; provided that the rate shall not be less than 1.00% per annum. In addition to the base rate, the Company is required to pay a 3.75% margin for ED loans. Accrued interest is payable in arrears on a quarterly basis. Within five business days after the earlier of (i) 90 days after the end of each fiscal year or (ii) the date on which financial statements have been delivered, the Company is required to make mandatory prepayments in amounts calculated in accordance with the excess cash flow provisions of the 2014 First Lien Credit Agreement. There were no excess cash flow payments required as of June 30, 2017.
The 2014 First Lien Credit Agreement governs the 2014 First Lien and contains various covenants that include limitations on the Company's indebtedness, liens, acquisitions and investments. As of June 30, 2017, the Company was in compliance with the covenants contained in the 2014 First Lien Credit Agreement. The 2014 First Lien is collateralized by substantially all of the assets of the Company.
2014 Second Lien Credit Agreement
The 2014 Second Lien Credit Agreement (“2014 Second Lien”), entered into on November 3, 2014, was prepaid in full on March 31, 2016. The 2014 Second Lien was a senior secured obligation of Surgery Center Holdings, Inc. and was guaranteed on a senior secured basis by the Company and certain of its subsidiaries. On March 31, 2016, the Company repaid the remaining principal of the 2014 Second Lien of $252.8 million with the proceeds of the issuance of the 2021 Unsecured Notes, defined below, of which $1.3 million was accrued interest. In connection with the prepayment, the Company incurred a loss on the extinguishment of debt of $8.3 million which included the write-off of loan costs and the original issue discount and a prepayment penalty for the six months ended June 30, 2016.
Senior Unsecured Notes due 2021
Effective March 31, 2016, one of the Company's subsidiaries, Surgery Center Holdings, Inc., issued $400.0 million in gross proceeds of senior unsecured notes due April 15, 2021 (the "2021 Unsecured Notes"). The 2021 Unsecured Notes bear interest at the rate of 8.875% per year, payable semi-annually on April 15 and October 15 of each year. The 2021 Unsecured Notes are a senior unsecured obligation of Surgery Center Holdings, Inc. and are guaranteed on a senior unsecured basis by each of Surgery Center Holdings, Inc.'s existing and future domestic wholly owned restricted subsidiaries that guarantees the Revolver and the 2014 First Lien (subject to certain exceptions).
The Company may redeem up to 35% of the aggregate principal amount of the 2021 Unsecured Notes, at any time before April 15, 2018, with the net cash proceeds of certain equity offerings at a redemption price equal to 108.875% of the principal amount to be redeemed, plus accrued and unpaid interest to, but excluding, the date of redemption, provided that at least 50% of the aggregate principal amount of the 2021 Unsecured Notes remain outstanding immediately after the occurrence of such redemption and such redemption occurs within 180 days of the date of the closing of any such qualified equity offering.
The Company may redeem the 2021 Unsecured Notes, in whole or in part, at any time prior to April 15, 2018 at a price equal to 100.000% of the principal amount to be redeemed plus an applicable make-whole premium, plus accrued and unpaid interest, if any, to, but excluding, the date of redemption. The Company may redeem the 2021 Unsecured Notes, in whole or in part, at any time on or after April 15, 2018, at the redemption prices set forth below (expressed as a percentage of the principal amount to be redeemed), plus accrued and unpaid interest, if any, to the date of redemption:
April 15, 2018 to April 14, 2019
106.656
%
April 15, 2019 to April 14, 2020
104.438
%
April 15, 2020 and thereafter
100.000
%
If Surgery Center Holdings, Inc., experiences a change in control under certain circumstances, it must offer to purchase the notes at a purchase price equal to 101.000% of the principal amount, plus accrued and unpaid interest to, but excluding, the date of repurchase.


17

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

The 2021 Unsecured Notes contain customary affirmative and negative covenants, which among other things, limit the Company’s ability to incur additional debt, pay dividends, create or assume liens, effect transactions with its affiliates, guarantee payment of certain debt securities, sell assets, merge, consolidate, enter into acquisitions and effect sale and leaseback transactions.
In connection with the offering of the 2021 Unsecured Notes, the Company recorded debt issuance costs of $8.4 million.
Senior Unsecured Notes due 2025
Effective June 30, 2017, SP Finco, LLC, a wholly owned subsidiary of Surgery Center Holdings, Inc., issued $370.0 million in gross proceeds of senior unsecured notes due July 1, 2025 (the "2025 Unsecured Notes"), which gross proceeds were deposited in an escrow account (the “Escrow Account”) established at Wilmington Trust, National Association (in such capacity, the “Escrow Agent”) in the name of the trustee under the indenture governing the 2025 Unsecured Notes (the “2025 Unsecured Notes Indenture”) on behalf of the holders of the 2025 Unsecured Notes. The 2025 Unsecured Notes bear interest at the rate of 6.750% per year, payable semi-annually on January 1 and July 1 of each year, commencing on January 1, 2018. The 2025 Unsecured Notes are a senior unsecured obligation of SP Finco, LLC.
In connection with the closing of the NSH Merger and the release of the proceeds from the Escrow Account (the “Escrow Release”), SP Finco, LLC will be merged with and into Surgery Center Holdings, Inc., with Surgery Center Holdings, Inc. surviving such merger (the “Initial Issuer Merger”) and assuming the rights and obligations of SP Finco, LLC under the 2025 Unsecured Notes and the 2025 Unsecured Notes Indenture by operation of law. From and after the release of the proceeds from the Escrow Account, the Initial Issuer Merger and the consummation of the NSH Merger, the 2025 Unsecured Notes will be guaranteed on a senior unsecured basis by each of Surgery Center Holdings, Inc.’s domestic wholly owned restricted subsidiaries that guarantees Surgery Center Holdings, Inc.’s senior secured credit facilities (subject to certain exceptions).
At June 30, 2017, the Company included the escrowed proceeds as a long-term asset in its condensed consolidated balance sheets.
The Company may redeem up to 40% of the aggregate principal amount of the 2025 Unsecured Notes at any time prior to July 1, 2020, with the net cash proceeds of certain equity issuances at a redemption price equal to 106.750% of the principal amount to be redeemed, plus accrued and unpaid interest to, but excluding, the date of redemption, provided that at least 50% of the aggregate principal amount of the 2025 Unsecured Notes remain outstanding immediately after the occurrence of such redemption and such redemption occurs within 180 days of the date of the closing of the applicable equity offering.
The Company may redeem the 2025 Unsecured Notes, in whole or in part, at any time prior to July 1, 2020, at a price equal to 100.000% of the principal amount to be redeemed plus the applicable premium, plus accrued and unpaid interest, if any, to, but excluding, the date of redemption. The Company may redeem the 2025 Unsecured Notes, in whole or in part, at any time on or after July 1, 2020, at the redemption prices set forth below (expressed as a percentage of the principal amount to be redeemed), plus accrued and unpaid interest, if any, to, but excluding, the date of redemption:
July 1, 2020 to June 30, 2021
103.375
%
July 1, 2021 to June 30, 2022
101.688
%
July 1, 2022 and thereafter
100.000
%
If the NSH Merger does not occur on or prior to the applicable date set forth in the 2025 Unsecured Notes Indenture or, if earlier, the Company notifies the Escrow Agent that the NSH Merger will not be closed, then SP Finco, LLC will be required to redeem the 2025 Unsecured Notes within three business days at a price equal to 100.000% of the initial issue price of the 2025 Unsecured Notes, plus accrued and unpaid interest, if any, to, but excluding, the date of such redemption.
If Surgery Center Holdings, Inc. experiences a change in control under certain circumstances, it must offer to purchase the 2025 Unsecured Notes at a purchase price equal to 101.000% of the principal amount, plus accrued and unpaid interest to, but excluding, the date of repurchase.
The 2025 Unsecured Notes contain customary affirmative and negative covenants, which, upon consummation of the Initial Issuer Merger, among other things, will limit the Company’s ability to incur additional debt, pay dividends, create or assume liens, effect transactions with its affiliates, guarantee payment of certain debt securities, sell assets, merge, consolidate, enter into acquisitions and effect sale and leaseback transactions.
In connection with the offering of the 2025 Unsecured Notes, the Company recorded debt issuance costs of $2.9 million.
Subordinated Notes
As of June 30, 2017, the Company had a subordinated debt facility ("Subordinated Notes") of $1.0 million. The Subordinated Notes, owed to H.I.G. Surgery Centers, LLC, had a maturity date of August 4, 2017 and had the interest rate of 17.00% per annum. As described in Note 8, "Subsequent Events," on August 3, 2017 the Company redeemed the Subordinated Notes, in whole, at a price equal 100% of the $1.0 million principal amount redeemed, plus accrued and unpaid interest.
Notes Payable and Secured Loans
Certain of the Company’s subsidiaries have outstanding bank indebtedness, which is collateralized by the real estate and equipment owned by the surgical facilities to which the loans were made. The various bank indebtedness agreements contain covenants to maintain certain


18

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

financial ratios and also restrict encumbrance of assets, creation of indebtedness, investing activities and payment of distributions. At June 30, 2017, the Company was in compliance with its covenants contained in the credit agreement. The Company and its subsidiaries had notes payable to financial institutions of $52.8 million and $42.5 million as of June 30, 2017 and December 31, 2016, respectively. The Company and its subsidiaries also provide a corporate guarantee of certain indebtedness of the Company’s subsidiaries.
Capital Lease Obligations
The Company is liable to various vendors for several equipment leases classified as capital leases. The carrying value of the leased assets was $15.9 million and $15.4 million as of June 30, 2017 and December 31, 2016, respectively.
5. Earnings Per Share
Basic and diluted earnings per share are calculated in accordance with ASC 260, Earnings Per Share, based on the weighted-average number of shares outstanding in each period and dilutive stock options, unvested shares and warrants, to the extent such securities exist and have a dilutive effect on earnings per share. The following is a reconciliation of the numerator and denominator of basic and diluted earnings per share for the three and six months ended June 30, 2017 and 2016 (in thousands except share and per share amounts):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
Numerator:
 
 
 
 
 
 
 
Net (loss) income attributable to Surgery Partners, Inc.
$
(4,471
)
 
$
2,120

 
$
(7,225
)
 
$
(5,071
)
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average shares outstanding- basic
48,145,729

 
48,019,652

 
48,112,909

 
48,018,228

Effect of dilutive securities (1)

 
109,389

 

 

Weighted average shares outstanding- diluted
48,145,729

 
48,129,041

 
48,112,909

 
48,018,228

 
 
 
 
 
 
 
 
(Loss) earnings per share:
 
 
 
 
 
 
 
Basic
$
(0.09
)
 
$
0.04

 
$
(0.15
)
 
$
(0.11
)
Diluted (1)
$
(0.09
)
 
$
0.04

 
$
(0.15
)
 
$
(0.11
)
 
 
 
 
 
 
 
 
Dilutive securities outstanding not included in the computation of (loss) earnings per share as their effect is antidilutive:
 
 
 
 
 
 
 
Stock options
1,312

 

 
1,056

 

Restricted shares
209,858

 

 
188,342

 
100,560

(1) The impact of potentially dilutive securities for the three and six months ended June 30, 2017 and the six months ended June 30, 2016 was not considered because the effect would be anti-dilutive in those periods.
6. Commitments and Contingencies
Professional, General and Workers' Compensation Liability Risks
The Company is subject to claims and legal actions in the ordinary course of business, including claims relating to patient treatment, employment practices and personal injuries. To cover these claims, the Company maintains general liability and professional liability insurance in excess of self-insured retentions through third party commercial insurance carriers in amounts that management believes is sufficient for the Company's operations, although, potentially, some claims may exceed the scope of coverage in effect. The professional and general insurance coverage is on a claims-made basis. Workers' compensation insurance is on an occurrence basis. Plaintiffs in these matters may request punitive or other damages that may not be covered by insurance. The Company is not aware of any such proceedings that would have a material adverse effect on the Company's business, financial position, results of operations or liquidity.


19

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

Laws and Regulations
Laws and regulations governing the Company's business, including those relating to the Medicare and Medicaid programs, are complex and subject to interpretation. These laws and regulations govern every aspect of how the Company's surgical facilities conduct their operations, from licensing requirements to how and whether the Company's facilities may receive payments pursuant to the Medicare and Medicaid programs. Compliance with such laws and regulations can be subject to future government agency review and interpretation as well as legislative changes to such laws. Noncompliance with such laws and regulations may subject the Company to significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal healthcare programs. From time to time, governmental regulatory agencies will conduct inquiries of the Company's practices, including, but not limited to, the Company's compliance with federal and state fraud and abuse laws, billing practices and relationships with physicians. It is the Company's current practice and future intent to cooperate fully with such inquiries. The Company is not aware of any such inquiry that would have a material adverse effect on the Company's business, financial position, results of operations or liquidity.
Acquired Facilities
The Company, through its wholly-owned subsidiaries or controlled partnerships and limited liability companies, has acquired and will continue to acquire surgical facilities with prior operating histories. Such facilities may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws. Although the Company attempts to assure that no such liabilities exist, obtain indemnification from prospective sellers covering such matters and institute policies designed to conform centers to its standards following completion of acquisitions, there can be no assurance that the Company will not become liable for past activities that may later be asserted to be improper by private plaintiffs or government agencies. There can be no assurance that any such matter will be covered by indemnification or, if covered, that the liability sustained will not exceed contractual limits or the financial capacity of the indemnifying party.
The Company cannot predict whether federal or state statutory or regulatory provisions will be enacted that would prohibit or otherwise regulate relationships which the Company has established or may establish with other healthcare providers or have materially adverse effects on its business or revenues arising from such future actions. Management believes, however, that it will be able to adjust the Company's operations so as to be in compliance with any statutory or regulatory provision as may be applicable.
Potential Physician Investor Liability
A majority of the physician investors in the partnerships and limited liability companies which operate the Company's surgical facilities carry general and professional liability insurance on a claims-made basis. Each partnership or limited liability company may, however, be liable for damages to persons or property arising from occurrences at the surgical facilities. Although the various physician investors and other surgeons generally are required to obtain general and professional liability insurance with tail coverage that extends beyond the period of any claims-made policies, such individuals may not be able to obtain coverage in amounts sufficient to cover all potential liability. Since most insurance policies contain exclusions, the physician investors will not be insured against all possible occurrences. In the event of an uninsured or underinsured loss, the value of an investment in the partnership interests or limited liability company membership units and the amount of distributions could be adversely affected.
Contingent Consideration
Pursuant to a purchase agreement dated December 24, 2009 (“the Purchase Agreement”), the Company acquired controlling interests in 36 business entities in various Florida locations which operate freestanding ASCs and provided anesthesia and pain management services (“the 2009 Acquisition”). The Purchase Agreement provided for maximum potential contingent consideration of up to $10.0 million based on operating results subsequent to the acquisition for the period from January 1, 2010 to December 31, 2010. Pursuant to the Purchase Agreement, the contingent consideration is payable as principal under a Subordinated Promissory Note, the form of which was delivered concurrent with the Purchase Agreement. The balance has remained outstanding due to ongoing litigation as a result of a civil claim. The Company has made indemnification claims against the Seller exceeding the amount of the contingent consideration liability, which the Company has a contractual right of offset against. Based on a court order in December 2016, the Company removed the contingent consideration liability on its consolidated balance sheets at December 31, 2016. On April 20, 2017, a settlement was reached between the two parties resulting in the Company receiving $3.9 million of which $2.7 million was paid from the escrow funds set up at the time of purchase and $1.2 million was paid by the seller. During the second quarter the Company recorded a gain on litigation settlement of $3.8 million for the settlement amount, net of legal costs.
In connection with an acquisition during the three months ended June 30, 2016, pursuant to the purchase agreement, the Company must pay consideration to the prior owners of the applicable facility should the requirements for continuing employment agreed to in the purchase agreement be met. As of June 30, 2017, the Company estimates it may have to pay $15.7 million in future contingent acquisition compensation expense over the remaining performance periods. The contingent acquisition compensation expense is recognized as a component of general and administrative expense in the condensed consolidated statements of operations and was $1.8 million and $1.5 million for the three months ended June 30, 2017 and 2016, respectively and $3.8 million and $1.5 million for the six months ended June 30, 2017 and 2016, respectively.


20

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

7. Segment Reporting
A public company is required to report annual and interim financial and descriptive information about its reportable operating segments. Operating segments, as defined, are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or "CODM," in deciding how to allocate resources and in assessing performance.
The Company operates in three major lines of business that are also the Company's reportable operating segments - the operation of surgical facilities, the operation of optical services and the operation of ancillary services, which includes physician practices, a diagnostic laboratory and a specialty pharmacy.
Adjusted EBITDA is the primary profit/loss metric reviewed by the CODM in making key business decisions and on allocation of resources. The segment disclosures below provide a reconciliation from adjusted EBITDA back to net income in the reported condensed consolidated financial information.
The following tables present financial information for each reportable segment (in thousands):

 
Three Months Ended June 30,

Six Months Ended June 30,

 
2017
 
2016

2017

2016
Revenues:
 
 
 
 




Surgical facility services
 
$
262,810

 
$
263,783


$
520,960


$
509,453

Ancillary services
 
22,640

 
22,503


47,852


40,283

Optical services
 
2,903

 
3,395


5,724


7,019

Total revenues
 
$
288,353

 
$
289,681


$
574,536


$
556,755

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Segment Adjusted EBITDA:
 
 
 
 
 
 
 
 
Surgical facility services
 
$
49,946

 
$
54,311

 
$
98,187

 
$
99,971

Ancillary services
 
429

 
3,068

 
4,211

 
6,568

Optical services
 
883

 
849

 
1,659

 
1,728

Total segment adjusted EBITDA (1)
 
$
51,258

 
$
58,228

 
$
104,057

 
$
108,267

 
 
 
 
 
 
 
 
 
General and administrative expenses
 
$
(18,655
)
 
$
(15,023
)
 
$
(34,196
)
 
$
(27,220
)
Non-cash stock compensation expense
 
1,435

 
502

 
2,069

 
635

Contingent acquisition compensation expense
 
1,814

 
1,530

 
3,847

 
1,530

Acquisition related costs
 
1,203

 
795

 
1,385

 
1,245

Total adjusted EBITDA (1)
 
37,055

 
46,032

 
77,162

 
84,457

 
 
 
 
 
 
 
 
 
Net income attributable to non-controlling interests
 
16,098

 
20,173

 
33,274

 
37,720

Depreciation and amortization
 
(11,417
)
 
(9,702
)
 
(22,525
)
 
(19,271
)
Interest expense, net
 
(25,600
)
 
(26,235
)
 
(50,782
)
 
(48,388
)
Income tax expense
 
(512
)
 
(2,420
)
 
(2,629
)
 
(4,190
)
Non-cash stock compensation expense
 
(1,435
)
 
(502
)
 
(2,069
)
 
(635
)
Contingent acquisition compensation expense
 
(1,814
)
 
(1,530
)
 
(3,847
)
 
(1,530
)
Merger transaction, integration and practice acquisition costs (2)
 
(4,137
)
 
(2,192
)
 
(4,728
)
 
(6,108
)
Gain on litigation settlement
 
3,794

 

 
3,794

 

Loss on disposal or impairment of long-lived assets, net
 
(405
)
 
(1,331
)
 
(1,601
)
 
(1,125
)
Loss on debt refinancing
 

 

 

 
(8,281
)
Total net income
 
$
11,627

 
$
22,293

 
$
26,049

 
$
32,649


(1) The above table reconciles adjusted EBITDA by segment to net income as reflected in the unaudited condensed consolidated statements of operations.
When the Company uses the term “Adjusted EBITDA,” it is referring to net income minus (a) net income attributable to non-controlling interests plus (b) depreciation and amortization, (c) interest expense, net, (d) income tax expense, (e) non-cash stock compensation expense, (f) contingent acquisition compensation expense, (g) merger transaction, integration and practice acquisition costs, (h) gain on litigation settlement, (i) loss on disposal or impairment of long-lived assets and (j) loss on debt


21

SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2017
(Unaudited)

refinancing. Non-controlling interests represent the interests of third parties, such as physicians, and in some cases, healthcare systems that own an interest in surgical facilities that the Company consolidates for financial reporting purposes. Our operating strategy is to apply a market-based approach in structuring its partnerships with individual market dynamics driving the structure. The Company believes that it is helpful to investors to present Adjusted EBITDA as defined above because it excludes the portion of net income attributable to these third-party interests and clarifies for investors the Company's portion of Adjusted EBITDA generated by its surgical facilities and other operations.
The Company uses Adjusted EBITDA as a measure of liquidity. It is included because the Company believes that it provides investors with additional information about its ability to incur and service debt and make capital expenditures.
Adjusted EBITDA is not a measurement of financial performance or liquidity under GAAP. It should not be considered in isolation or as a substitute for net income, operating income, cash flows from operating, investing or financing activities, or any other measure calculated in accordance with generally accepted accounting principles. The items excluded from Adjusted EBITDA are significant components in understanding and evaluating financial performance and liquidity. The Company's calculation of Adjusted EBITDA may not be comparable to similarly titled measures reported by other companies.
(2) This amount includes merger transaction and integration costs of $2.9 million and $1.3 million for the three months ended June 30, 2017 and 2016, respectively, and practice acquisition costs of $1.2 million and $867,000 for the three months ended June 30, 2017 and 2016, respectively.
This amount includes merger transaction and integration costs of $3.2 million and $4.5 million for the six months ended June 30, 2017 and 2016, respectively, and practice acquisition costs of $1.5 million and $1.6 million for the six months ended June 30, 2017 and 2016, respectively.
 
 
June 30, 2017
 
December 31, 2016
Assets:
 
 
 
 
Surgical facility services
 
$
1,912,913

 
$
1,914,842

Ancillary services
 
185,195

 
184,002

Optical services
 
23,604

 
22,478

Total
 
2,121,712

 
2,121,322

 
 
 
 
 
General and administrative
 
$
549,775

 
$
183,636

Total assets
 
$
2,671,487

 
$
2,304,958

 
 
Six Months Ended June 30,
 
 
2017
 
2016
Supplemental Information:
 
 
 
 
Cash purchases of property and equipment, net:
 
 
 
 
Surgical facility services
 
$
11,266

 
$
14,745

Ancillary services
 
1,740

 
2,951

Optical services
 
68

 
96

Total
 
$
13,074

 
$
17,792

 
 
 
 
 
General and administrative
 
$
2,028

 
$
2,558

Total cash purchases of property and equipment, net
 
$
15,102

 
$
20,350

8. Subsequent Events
On August 3, 2017 the Company redeemed the Subordinated Notes (as defined in Note 4, "Long-Term Debt"), in whole, at a price equal 100% of the $1.0 million principal amount redeemed, plus accrued and unpaid interest.



22

SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
JUNE 30, 2017

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report and included in our Annual Report on Form 10-K for the year ended December 31, 2016. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those estimated or projected in any of these forward-looking statements. Unless otherwise indicated or the context otherwise requires, references herein to the “Company”, “Surgery Partners”, “we”, “us” and “our” refer to, (i) Surgery Center Holdings, LLC and its consolidated subsidiaries, including Surgery Center Holdings, Inc., immediately prior to the Reorganization and (ii) Surgery Partners, Inc. and its consolidated subsidiaries, including Surgery Center Holdings, LLC and Surgery Center Holdings, Inc., immediately following the Reorganization. Unless the context implies otherwise, the term “affiliates” means direct and indirect subsidiaries of Surgery Center Holdings, LLC and Surgery Partners, Inc., as applicable, and partnerships and joint ventures in which such subsidiaries are partners. The terms “facilities” or “hospitals” refer to entities owned and operated by affiliates of Surgery Partners, and the term “employees” refers to employees of affiliates of Surgery Partners.
Cautionary Note Regarding Forward-Looking Statements
This report contains forward-looking statements, which are based on our current expectations, estimates and assumptions about future events. All statements other than statements of current or historical fact contained in this report are forward-looking statements. These statements include, but are not limited to, statements regarding our future financial position, business strategy, budgets, effective tax rate, projected costs and plans and objectives of management for future operations, as well as our expectations regarding the Transactions, the benefits of the Transactions, the anticipated timing of the Transactions, the expected closing of the Transactions and the actions contingent thereon, the performance of our business and other non-historical statements. The words “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “plan,” “will,” and similar expressions are generally intended to identify forward-looking statements. These statements involve risks, uncertainties and other factors that may cause actual results to differ from the expectations expressed in the statements. Many of these factors are beyond our ability to control or predict. These factors include, without limitation: (i) reductions in payments from government healthcare programs and managed care organizations; (ii) inability to contract with private third-party payors; (iii) changes in our payor mix or surgical case mix; (iv) failure to maintain relationships with our physicians; (v) payor controls designed to reduce the number of surgical procedures; (vi) inability to integrate operations of acquired surgical facilities, attract new physician partners, or acquire additional surgical facilities; (vii) shortages or quality control issues with surgery-related products, equipment and medical supplies; (viii) competition for physicians, nurses, strategic relationships, acquisitions and managed care contracts; (ix) inability to enforce non-compete restrictions against our physicians; (x) material liabilities incurred as a result of acquiring surgical facilities; (xi) litigation or medical malpractice claims; (xii) changes in the regulatory, economic and other conditions of the states where our surgical facilities are located; (xiii) substantial payments we expect to be required to make under the TRA; (xiv) the risk that the regulatory approvals required for the Transactions are not obtained; (xv) the risk that other conditions to the consummation of the Transactions are not satisfied; (xvi) the occurrence of any event, change or other circumstance that could give rise to unexpected liabilities, delays or the termination of any or all of the Transactions; and (xvii) other risks and uncertainties described in this report, including under the heading “Risk Factors,” and discussed from time to time in the Company's reports filed with the SEC.
In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur, and actual results could differ materially from those anticipated or implied in the forward-looking statements. When you consider these forward-looking statements, you should keep in mind these risk factors and other cautionary statements in this report.
These forward-looking statements speak only as of the date made. Other than as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Executive Overview
As of August 9, 2017, we owned and operated a national network of surgical facilities, physician practices and a suite of ancillary services in 29 states. Our surgical facilities, which include ASCs and surgical hospitals, primarily provide non-emergency surgical procedures across many specialties, including, among others, gastroenterology ("GI"), general surgery, ophthalmology, orthopedics and pain management. Our surgical hospitals provide services, such as diagnostic imaging, laboratory, obstetrics, oncology, pharmacy, physical therapy and wound care. Our portfolio of outpatient surgical facilities is complemented by our suite of ancillary services, which support our physicians in providing high quality and cost-efficient patient care. These ancillary services are comprised of a diagnostic laboratory, multi-specialty physician practices, urgent care facilities, anesthesia services, optical services and specialty pharmacy services. As a result, we believe we are well positioned to benefit from rising consumerism and payors’ and patients’ focus on the delivery of high quality care and superior clinical outcomes in the lowest cost and care setting.
As of August 9, 2017, we owned or operated, primarily in partnership with physicians, a portfolio of 103 surgical facilities comprised of 98 ASCs and five surgical hospitals across 29 states. We owned a majority interest in 73 of the surgical facilities and consolidated 93 of these facilities for financial reporting purposes. In addition to surgical facilities, we owned or operated a network of 59 physician practices as of August 9, 2017. For the six months ended June 30, 2017, approximately 221,000 surgical procedures were performed in our surgical facilities, generating approximately $521.0 million in revenue.
As described in Note 1 of our condensed consolidated financial statements included previously in this report, on May 9, 2017, we entered into a series of transactions pursuant to which we agreed (i) to acquire NSH Holdco, Inc. (“NSH”), an owner and operator of surgical facilities, for approximately $760 million through a merger of SP Merger Sub, Inc., a wholly owned subsidiary of the Company, with and into NSH (the


23

SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
JUNE 30, 2017

“NSH Merger”), pursuant to an Agreement and Plan of Merger, by and among the Company, SP Merger Sub, Inc., NSH, and IPC / NSH, L.P., solely in its capacity as sellers’ representative (as amended by that certain Letter Amendment, dated July 7, 2017, the “NSH Merger Agreement”) and (ii) to issue to BCPE Seminole Holdings LP (“Bain Capital”), an affiliate of Bain Capital Private Equity, up to 320,000 shares of our preferred stock, par value $0.01 per share, to be created out of the authorized and unissued shares of our preferred stock and designated as 10.00% Series A Convertible Perpetual Participating Preferred Stock at a purchase price per share of $1,000 (the “Preferred Private Placement”), pursuant to a Securities Purchase Agreement by and among the Company and Bain Capital. In connection with the NSH Merger and the Preferred Private Placement, on May 9, 2017, we also entered into (i) a Stock Purchase Agreement, by and among the Company, H.I.G. Surgery Centers, LLC (“H.I.G.”), our controlling stockholder, H.I.G. Bayside Debt & LBO Fund II L.P. (for the purposes stated therein) and Bain Capital, pursuant to which H.I.G. agreed to sell all of its 26,455,651 shares of our common stock to Bain Capital at a purchase price per share of $19.00 (together with the NSH Merger and the Preferred Private Placement, the “Transactions”) and (ii) an amendment to that certain Income Tax Receivable Agreement, dated September 30, 2015, by and between the Company, H.I.G. (in its capacity as the Stockholders Representative) and the other parties referred to therein (the “TRA Amendment”). The Transactions have not yet been consummated, and the TRA Amendment has not yet become effective. Following the consummation of the Transactions, NSH will be a wholly-owned subsidiary of the Company, and Bain Capital will be our controlling stockholder. In addition to the planned acquisition of NSH, we continue to focus on improving our same-facility performance, selectively acquiring established facilities and developing new facilities. During the six months ended June 30, 2017, we completed acquisitions of three physician practices in existing markets, for an aggregate investment of $14.2 million.
Revenues
Our revenues consist of patient service revenues and other service revenues. Patient service revenues consist of revenue from our surgical facility services and ancillary services segments. Specifically, patient service revenues include fees for surgical or diagnostic procedures performed at surgical facilities that we consolidate for financial reporting purposes, as well as for patient visits to our physician practices, anesthesia services, pharmacy services and diagnostic screens ordered by our physicians. Other service revenues consist of product sales from our optical laboratories, as well as the discounts and handling charges billed to the members of our optical products purchasing organization. Other service revenues also include management and administrative service fees derived from our non-consolidated facilities that we account for under the equity method, management of surgical facilities and physician practices in which we do not own an interest and management services we provide to physician practices for which we are not required to provide capital or additional assets.
The following table summarizes our revenues by service type as a percentage of total revenues for the periods indicated:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Patient service revenues:
 
 
 
 
 
 
 
 
Surgical facilities revenues
 
90.5
%
 
90.0
%
 
90.1
%
 
90.6
%
Ancillary services revenues
 
7.9
%
 
7.7
%
 
8.3
%
 
7.2
%
 
 
98.4
%
 
97.7
%
 
98.4
%
 
97.8
%
Other service revenues:
 
 
 
 
 
 
 
 
Optical services revenues
 
1.0
%
 
1.2
%
 
1.0
%
 
1.3
%
Other
 
0.6
%
 
1.1
%
 
0.6
%
 
0.9
%
 
 
1.6
%
 
2.3
%
 
1.6
%
 
2.2
%
Total revenues
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
Payor Mix
The following table sets forth by type of payor the percentage of our patient service revenues generated at the surgical facilities which we consolidate for financial reporting purposes in the periods indicated: