Critical conditions for healthcare sector

Few managers would call this a golden era for private equity in healthcare. The media has highlighted cases of mismanagement and bankruptcies, with The Wall Street Journal reporting that doctors are pushing back on “private equity takeovers” in their industry and even Forbes asking in a headline, “Is private equity a villain in healthcare?” To be fair, several outlets don’t even bother posing it as a question.

Now it is true the mainstream press has rarely worn rose-colored glasses when covering private capital, but regulators are applying new pressure to healthcare transactions as well. The Federal Trade Commission, Congress and state governments are acting in ways that might materially change how managers can create value in a sector that represents an estimated 17 percent of the American economy. However, this hasn’t dissuaded GPs from hunting for opportunities.

On the contrary, firms are responding by avoiding the physician group plays that have underwhelmed of late and shrinking their strike zone for new investments. The focus tends to be subsectors where technology plays a big role, including medtech, medical devices and pharma services. In some ways, managers are entering the “helper” era of healthcare investment, where they’re looking at the broader ecosystem and hunting for chances to improve some stage along the vast value chain that sits well outside a doctor’s office. It’s a move that might prove to the press, regulators and the public that GPs can actually deliver lower costs, better outcomes and a windfall to LPs.

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Regulatory hunts

That’s a tall order, given recent events. The state of California proposed AB 3129 that would require GPs to notify and obtain consent from the Attorney General for healthcare transactions. And part of the Inflation Reduction Act (IRA) allows the government to negotiate for lower drug prices in some cases but is widely seen as the first step in stiffer price controls.

“The IRA’s provision around the government’s ability to negotiate prices may seem modest since it only applies to a limited number of drugs and includes multiple restrictions, but there is certainly the potential for the purview to significantly expand over time to include a lot more,” says Robert Girardi, a partner with Avista Healthcare Partners. “So, pharma companies are paying close attention to the political landscape and working to ensure that they get a proper return on investment for their drug development costs.”

$410.5m

Average size of healthcare-focused PE funds last year, up from $215.4m in 2022
Source: Buyouts

This kind of change is in line with past regulatory risks when one of an industry’s main customers is the government. What about the new activist bent among regulators in California and the FTC? What caused these crackdowns?

“Regulators just want to make sure that PE investors aren’t just piling on debt to these companies, but investing to add value to the system, in lower costs and higher quality care of patients,” says Steven Yecies, a managing partner at Kain Capital. “And since we don’t rely on leverage to invest in growth opportunities, we don’t see that additional regulatory scrutiny as a problem.”

Bring it on

Many GPs aren’t discouraged by these developments. “The regulatory posture around private equity in healthcare today certainly involves more scrutiny, but candidly, we welcome that because we’re investing in companies that we believe are doing things the right way,” says David Nguyen, the managing partner and co-head of healthcare at Court Square Capital Partners.

Others are adding even more rigor to their review process. Managers are becoming more cautious with debt levels for investments, double-checking recruiting and retention metrics and triple checking just how defensible the profit margins are before pulling the trigger.

Jackie Peradotto is a principal at HarbourVest Partners and stresses they partner with GPs that strenuously review any potential government policies and trends that might impact any pay dynamics. “We closely evaluate the compliance standards, history and go-forward monitoring plan to ensure patients are treated in the right way.”

That’s not to say that the backlash to transactions involving provider businesses hasn’t changed behavior. “There’s been a pronounced and across-the-board pullback from provider businesses, which include both physician practice management companies and non-physician businesses,” says Nguyen. “But that isn’t just due to additional regulatory scrutiny, since they’re often buy and build strategies that require low interest rates to fund the velocity of M&A.”

Silver linings

However, there are positive developments in the market for healthcare deals. “We’re seeing an uptick in transactions in the second half of this year that we think will start to accelerate,” says Yecies. “And the opportunities that are coming to market are of premium quality, with consistency of operations, no material compliance issues and prices based on the last 12 months of performance.”

Managers also find sellers have more realistic expectations, with prices to match. “The multiples in the healthcare sector have come back to levels that make investing very interesting right now, even if there are segments, we still tend to avoid,” says Vaishnavi Katamreddy, director of Investments at Golding Capital Partners, a Germany-based asset manager active in healthcare co-investments.

“The multiples in the healthcare sector have come back to levels that make investing very interesting right now”

Vaishnavi Katamreddy  
Golding Capital Partners

Beyond an aversion to provider businesses, where are managers finding opportunities to fuel this modest recovery? “GPs are more focused on the larger ecosystem that surrounds care points,” says Kevin Desai, the PwC advisory private equity leader. “They’re looking for ways to add value to the system without putting themselves in between providers and patients.” And that naturally demands deep sector knowledge to find those opportunities.
And LPs appear to be bullish towards the sector. In total, healthcare funds gathered $26.7 billion between them in 2023, according to Buyouts data, up from $14 billion the prior year. The average size of the 65 healthcare-focused funds ballooned from $215.4 million in 2022 to $410.5 million in 2023.

Indeed, a survey of LPs conducted by Adams Street Partners found that 40 percent of respondents cite healthcare and technology among the top three investment opportunities for 2024, second only to ESG and impact themes.

Nooks and crannies

“We’re starting to see a structural change in the market,” says Ray Hill, an operating partner at Arsenal Capital Partners. “It’s going to be challenging to find those traditional up and to the right investments in healthcare, so you’ll need operational expertise to discover those untapped spaces, which we’d call a nook and cranny approach.”

65

Number of healthcare-focused PE funds that closed in 2023, per Buyouts data

This was a recurring theme among the managers we spoke with, this dedication to finding unique angles that court less risk while offering real upside.

“Our view is that the product and technology segments are particularly attractive, and we’ve defined six core subsectors that we focus on,” says Girardi. “This approach gives us access to those appealing tailwinds of the industry as a whole while also avoiding the headline risk, reimbursement pressure and margin compression that comes with provider businesses.”

Technology was by far the most popular and common refrain among managers touting their current priorities, especially around those subsectors, which includes pharma services and medtech.

“We are looking at companies that can bring, ideally, technology-enabled solutions to create efficiencies to the major areas of spend like clinical trials and then the commercialization of new therapies,” says Gene Gorbach, an investment partner at Arsenal Capital Partners. “We’re also spending a lot of time with companies that can leverage data insights to improve drug discovery, development and commercialization.”

“Time after time, we’re seeing that the winners are those that live and breathe the healthcare sector”

Kapila Ratnma
NewSpring

In short, managers are looking for opportunities where tech can “help” improve some aspect of the healthcare value chain, including providers. “GPs are really thinking about how to better these businesses,” says Katamreddy. “For example, harnessing today’s tech to alleviate admin work so caregivers can spend more time with patients, and this in turn helps generate more revenue and leads to greater job satisfaction – a win-win for all stakeholders.”

AI to the rescue?

These days, there is no talk of technological progress without mention of AI and machine learning “AI and language models are already transforming R&D,” says Hill. “There are estimates that they could produce a 40 percent reduction in R&D spend over the next 10 years, so we’ve built a team of AI experts that are looking at the entire industry’s value chain.”

Some are already backing AI-driven enterprises. This past September, GI Partners made a majority investment in eClinical Solutions, which offers ­AI-enabled data products and biometric services to help life science firms accelerate their research process and produce more therapeutic breakthroughs. “We’ve been excited by healthcare data management and analytics,” says Dave Kreter, a managing director with GI Partners. “It’s particularly attractive because healthcare’s tech adoption is only in the early innings.”

But tech advancements are also reigniting interest in medical devices. And progress in robotics is part of that story. “For the last few years, we’ve been very bullish on robotic assisted surgery, for both soft tissue and in the ortho end market,” says Girardi. “We have a med tech contract manufacturing business called GCM, whose largest customer is in the robotic assisted surgery market, and we feel there’s tremendous runway for further penetration here.”

Specialists still matter

Even as tech plays a bigger role in the sector, managers are staying healthcare investors first, and judging tech plays through the unique lens of the sector. “Time after time, we’re seeing that the winners are those that live and breathe the healthcare sector,” says Kapila Ratnam, a general partner with NewSpring. “These are the people who understand the regulatory risks and can navigate the pitfalls. Now, we see a lot of tech investors come in and promise to fix a particular problem, but they don’t see the checks and balances, and honestly, they’re there for a good reason. They’re there to protect the patient.”

“If you’re a tourist in this space and look at these opportunities while the market is hot, you’ll never learn,” says Nguyen. “But I wouldn’t be surprised in three or four years if more generalist firms don’t start exploring the sector again, if and when the world seems more certain.” And when they do, there’s a chance that mistakes will be made, that scrutiny will return, and the specialists will be left to make the most of what that they find.