Opinion – Why Lower Mid-market Healthcare M&A Is Poised For Growth

By: Dana Pawlicki, Published in Mergers & Acquisitions

It is without question that the private equity healthcare sector is storming into 2018. Extremely robust deal activity continues from 2017’s momentum in all size levels of the market, ranging from the lower middle-market to large buyout.

Driven by healthy valuations in the public markets and funds flush with new capital, Stonington Capital Advisors fully expects these forces to continue to drive frenzied deal activity through 2018. Healthcare generally has returned to being the highest returning sector of the broader market (one only need look at United Health Group’s share price to evidence the sector’s recent success on the large public company level), and after a few years of relative softness, biotechnology has bounced back in a big way.

According to the McKinsey Global Institute: “Healthcare has led all sectors in total returns to shareholders; with returns of 15 percent annualized over the period of 2010-2015, which would suggest this is a long-term trend. While biotechnology remains the strongest sub-sector, the market outside of biotech has also created more consistent value for investors as of late, with successful deals in payors, IT, medical devices, and general services opportunities. There remains one noted sub-sector with weakness in deal volume, as the pharmaceutical space continued its recent trends to record low deal volume for 2017. That said, outside of that area, there are many reasons for continued enthusiasm and activity in healthcare private equity.

Specifically, lower-middle market healthcare buyout has been a very active space with recent successful fundraises concluding in 2017, including Shore Capital, DW Healthcare Partners, and others. In a fundraising market, where many smaller funds have struggled on their raises, these healthcare specialists have prevailed to continue to grow their capital base. Boston consultant NEPC estimated that there are now approximately “325 healthcare-only firms across the private equity spectrum” (although noting the vast majority of these are more venture focus.) Even within a year of record private equity fundraising ($453 billion, according to Preqin), healthcare specialist firms stood out.

Another very active area of the lower-middle market that Stonington has been involved in has been working with independent sponsors pursuing healthcare deals. The appetite for direct healthcare deal flow has never been stronger amongst institutional investors, as LPs seek to look beyond established private equity firms for access to unique deal flow, and we expect this to continue to be a growing area over the next few years. As healthcare private equity firms continue to grow, and as healthcare private equity sector teams at more generalist firm out- perform, there is bound to be more executives seeking to “go it on their own.”

Secondly, in the middle-market, aside from traditional specialist healthcare firms such as Spanos, Barber, Jesse & Co,. Linden, Riverside, MTS and DW, several larger private equity generalist shops have recently created specific strategies targeting the space such as KKR’s Health Care Strategic Growth Funds. Many of these specialists firms create and pursue niche opportunities within healthcare sub-sectors; growing and consolidating previously fragmented activities.

With respect to the larger end of the private equity market, 2017 witnessed Clayton, Dublier & Rice’s acquisition of Envision Healthcare and TPG’s purchase of Par Pharmaceutical to name a few large private equity transactions. Perhaps most notable was TPG, WCAS and Humana’s taking the lead on 2017’s largest healthcare private equity investment in home healthcare provider Kindred Healthcare in a $4.1 billion take-private deal. It seems home healthcare continues to see strong tailwinds with an aging population looking to stay in their homes. These larger deals further promote activity lower into the middle-market by paving the way to larger valuations with continued growth. Stonington witnessed the larger end of the market intersect with the mid (and even sometimes lower middle market) on a number of roll-up transactions in physician specialties such as dermatology, dental, pain management, and other specialist practices.

Corporate strategic investors have also been as active as ever in acquiring competitors and new business lines for strategic growth initiatives. In 2015, corporates divested $115 million of healthcare assets, which was double the rate of just years before. Speaking United Health Group, after recently buying DaVita Medical Group (NYSE: DVA) for $4.9 billion, on December 22, 2017, the quickly turned around to purchase Chilean Banmedica SA (SSE: GO) for $2.8 billion. KKR also executed a successful turnaround of former Pfizer pill manufacturer Capsugel, doubling its money in a sale to strategic Lonza for $5.5 billion. Corporate acquirer INC Research also purchased contract researcher inventive Health for $4.6 billion from Advent International and Thomas H. Lee Partners. Finally, while not a traditional acquisition, 2018 has already brought in an alliance between Amazon, Warren Buffet’s Berkshire Hathaway, and JP Morgan Chase. While early days, given the parties involved, industry experts are viewing this a potential market shift in its creation of an alignment between insurance coverage and healthcare distribution/ access.

The momentum with respect to large private equity deals continues. In late February, Cerberus backed grocery chain Albertsons abandoned its IPO plans in favor of acquiring already public Rite Aid. Observers believe this was partly in response to CVS’ nearly $70 billion merger with Aetna. The interesting twist on the CVS deal is that in addition to cost savings on the prescription/ insurance reimbursement side, is Aetna’s believe that the chain retailer will become a gateway for additional health insurance customers. Aetna CEO Mark Bertolini stated; “Call it 10,000 new front doors to the healthcare system.” Many believe that this deal was also a competitive response to the Amazon/ JP Morgan/ Berkshire Hathaway alliance noted above.

Another data-point suggesting the environment continues to bode well for 2018, in a recent survey of 150 CEOs by Capital One, 33 percent of healthcare chiefs surveyed said their capital needs would be higher in 2018 vs. 2017. Along those lines, the same survey reported that 48 percent of CEOs anticipated more hiring in 2018 than 2017. This could represent a massive hole to be filled by private equity firms.

Skeptics are quick to correctly point out two clouds in an otherwise bright blue sky. First, the obvious conclusion that all of the activity noted above continues to drive acquisition multiples upwards. That said, private equity firms are looking beyond their basic playbooks to find value. There is little doubt for example that within the roll-up space that by creating platform
companies and then buying smaller practices continues to create a multiple arbitrage between the lower and mid to upper segments of the market.

PE firms are also getting creative by combining multiple diverse practices under the same payor umbrellas which create additional value from cross-selling and customer convenience. Corporate divestitures also provide a second hunting group where values can be less exuberant, recognizing these transactions can typically take more time to source and execute on. Secondly, while the Affordable Care Act (ACA) looms in the background, there seems to be enough friction on both sides of the aisle, particularly around an area as sensitive as this to many Congressmen’s constituents to keep change from being too radical or cataclysmic. In fact, many private equity firms see potential revisions to ACA as a potential driver of new opportunities and needed capital requirements to fund them.

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