By David S. Ivill, partner-in-charge of the McDermott New York healthcare practice, and Kristian (Krist) Werling, co-head of the McDermott’s Private Equity Practice Group
When it comes to the US economy, newspaper headlines over the past year have been grim. While inflation rates have been steadily decreasing—during April 2023, the Consumer Price Index climbed “just” 4.9%, the tenth monthly decline in a row—they remain well above the pre-pandemic rate of approximately 2% per year. US stock markets have begun a cautious shift upward, but labor and supply shortages, the debt-limit debate in Washington, DC, and other forces have continued to put downward pressure on industries across the spectrum. Except, with caveats, for the healthcare industry.
In its twelfth annual Global Healthcare Private Equity and M&A Report, Bain & Company noted that, despite the slowdown in the latter half of the year, 2022 was the second-best year for healthcare private equity (PE) on record, according to a number of measures. While disclosed deal value was, at $90 billion, lower than in 2021, the amount was still more than $10 billion over the third-best year. Deal volume in North America, as well as in China and Europe, was also higher than usual.
All of which raises important questions: Is the healthcare investment marketplace a temporary outlier? Or do systemic strengths and broader trends exist that will continue to support growth in this sector, despite slumps in other areas of the economy? After conversations with leading investment bankers focused on healthcare, we offer the following thoughts:
Economic headwinds have bifurcated the investment market
Rather than affecting the marketplace as a whole, the current round of inflation, interest rate hikes, recession fears and geopolitical uncertainty have had differing impacts on specific industries, and on investment activity within those industries. Many private equity groups have become less active in certain sectors, such as banking and financial services, and have become more disciplined. There has, for example, been a renewed focus on due diligence and cautiously pessimistic number crunching.
Within the healthcare space, in general, the opposite appears to be true. According to KPMG’s report on 2022, M&A trends in private equity, “Moving forward, looking inward,” healthcare and life sciences professionals had the most favorable view of their companies’ deal activity, with 53% of PE survey respondents indicating that they expect an increase in buy-side deals in 2023 (as compared to 71% of corporate respondents who anticipate that deal activity will decrease or remain the same).
Not unexpectedly, when it comes to private equity investment, not all participants in the healthcare sector are created equally. Partly due to payor rates trailing inflation, strategic buyers have shifted their attention toward large retail pharmaceutical companies, retail care companies, and cash- and private-pay entities such as providers of fertility, anesthetics, veterinary, radiology, home health and ambulatory health services. Dental services have seen particular growth, with nearly two-dozen transactions reported in January 2023 alone. Likewise, healthcare information technology (HCIT)—especially in areas such as workflow management, revenue cycle management, and clinical and life sciences data—also show strong upward potential.
On the other hand, hospitals, health systems, physical therapy providers, and other large corporate and strategic businesses have suffered disproportionately due to upward wage pressure and employee burnout and turnover.
Great businesses are still selling at a premium
Despite the economic headwinds, business with solid fundamentals continue to sell apace. However, there are fewer such businesses now as compared to a year ago. Many sponsors are holding onto their businesses in the face of current, broader economic challenges, which is likely to further reduce deal volumes. Today’s market largely consists of buyers and sellers who either need to do deals (because of economic conditions or otherwise) or involve best-in-class acquisition targets.
Within the payer space, in particular, Bain & Company also noted in its report that, in 2022, corporate buyers made 3.7 acquisitions for every sponsor buyout, as compared to 1.6 acquisitions by corporate buyers for every sponsor buyout in 2021. If this imbalance continues through 2023, sponsors will face greater competition for scale assets and tuck-in acquisition targets. It may also give rise to opportunities for sponsors to position assets for exit or to partner as co-investors with corporations.
Interest rates are restricting healthcare valuations and financings
Other factors that will affect valuations in 2023 include financing, fundamentals, and the ability of sponsors and investors to pursue and close deals creatively. Although the Federal Reserve has indicated that it intends to halt interest-rate increases for the foreseeable future, uncertainty remains, making it difficult for buyers to price deals appropriately.
Where possible, clarity around margins, wage inflation and recessionary risk can help separate best-in-class management teams from the rest of the pack. To bridge these uncertainties—as well as valuation gaps—PE investors are looking at structured notes and other creative forms of financing to take deals to the finish line.
Price, speed and certainty can help prospective buyers stand out—to a point
Even in a down market, buyers must make a strong case to potential attractive targets. In addition to quickly establishing clear deal terms and starting the bidding at relatively higher prices, experience in the sector and a strong network of industry relationships can go a long way toward improving the odds of closing any particular deal. However, buyers can only do so much—heightened external oversight in the diligence and regulatory approval processes, as well as a general sense of risk aversion, may present difficult-to-surmount barriers.
Among other issues, the Biden administration has made it clear that the healthcare sector is a primary target for federal antitrust regulatory scrutiny. Since issuing Executive Order 14036 (EO 14036), Promoting Competition in the American Economy, in July 2021, the administration has not stepped back from its assertion, in the fact sheet accompanying the order, that reduced access to healthcare in rural areas and increased costs for hospital services can, in large part, be blamed on “unchecked mergers.” With this in mind, PE investors cannot assume that they will be able to explain their way out of potential antitrust scrutiny—they may, early in the process, establish clear, convincing arguments as to how the deal will promote healthcare access and equity.
Distressed transactions will increase in frequency
The growth of distressed transactions will in part be due to the fact that precursors for distress, including divestitures, will become more common, particularly on the hospital side. That said, “distressed transaction” does not mean “unattractive opportunity” for either buyers or sellers. For distressed businesses in attractive sectors—including the almost-evergreen healthcare industry—private equity can help solve problems arising from a weak balance sheet or poor management.
Given all of these factors, it would be a stretch to say that the healthcare private equity market is looking at its best times ever. On the other hand, it would be an even greater stretch to say that the bottom is falling out of the healthcare marketplace. In the happy middle lie significant opportunities for acquirers and targets alike.
As partner-in-charge of the McDermott New York healthcare practice, David S. Ivill has built a strong profile in advising private equity clients active in the healthcare market, both in New York and nationally. He advises PE firms such as The Riverside Company, Quad-C Management, Beecken Petty O’Keefe & Company, and Deerfield Management in multi-faceted transactions.
Kristian (Krist) Werling is a co-head of the McDermott’s Private Equity Practice Group. He represents private equity and strategic investors in a wide variety of transactional matters in the healthcare and life sciences industry.
