Spotlight on Healthcare M&A in the Middle Market

By Bill Kane

Healthcare – broadly defined – has been a very active area for merger & acquisition activity throughout 2014, measured in both number of deals and dollars. In addition to a number of billion-dollar-plus strategic acquisitions, healthcare has been an active area for private equity investment. According to  , there were 271 healthcare private equity deals in the first three quarters of 2014, up from 264 in the first three quarters of 2013. With a median deal size range of $100-160 million during 2010-2014 YTD, it’s clearly part of the middle-market buyout industry. As such, several middle-market private equity firms have built successful franchises in various sectors of healthcare.

Healthcare is a huge part of the U.S. economy – almost $3 trillion and approaching 20 percent of GDP – and historically has been growing. It consists of several sectors, each of which has several segments, the majority of which are quite fragmented and comprised of mostly private companies. Furthermore, its growth rate has appeared counter-cyclical to overall GDP (or at least has lagged GDP change by a couple of years). Finally, it has had a huge increase in “air time” in the popular press over the past few years due to discussion of the Affordable Care Act (“ACA”, a.k.a. ObamaCare).

So, why doesn’t every generalist private equity firm and middle market lender expand into healthcare?

Most generalist private equity firms – ones that target a few verticals, as opposed to those with a singular or twin focus, each of which requires substantial domain expertise – have probably looked at expanding into healthcare at one time or another, particularly during economic downturns. Many middle-market generalist lenders also claim to do healthcare deals, or at least have looked at the possibility of doing so. In both the private equity and lender cases, at least initially, “healthcare” rarely includes providers of healthcare, due to concerns over reimbursement – so-called “stroke of the pen” risk. On the other hand, outsourced services (e.g. revenue cycle management), low-tech medical products, and medical product distribution are common areas for such investment.

While these areas – outsourced services, medical products, and distribution – appear to have less reimbursement or regulatory risk, that doesn’t mean that there is none. For example, there is usually some reimbursement risk in revenue cycle management (formerly known as medical billing and collection). These companies usually charge a percentage of the collections, which are typically dependent on third-party payments. An example: If provisions of the Balanced Budget Act of 1997 (BBA ’97) ever come into full effect, i.e. Congress fails to pass the so-called “doc fix”, then Medicare physician fees would decline by over 20% on average. The Medicare reduction would presumably also have a negative effect on private insurance reimbursement rates.

Medical products and their distribution don’t escape regulatory concerns. Some examples include::

  • Changes in regulations have increased the cost of compliance for the manufacturers of even non-invasive so-called “510k” devices, such as diagnostic instruments, which has dramatically increased the time and cost of new product introduction (probably bolstering the competitive position of existing devices).
  • The ACA’s medical device tax still hangs over the industry, although there’s a chance of bi-partisan change or repeal.
  • The ACA has accelerated hospitals’ acquisition of physician groups and urgent care centers, partly due to a perceived shortage in primary care resources. To the extent that hospital purchasing departments and group purchasing organizations (GPOs) exercise greater control over office-based physicians, then product selection will likely change, as will distribution networks, say from alternate site to hospital distributors. Average unit prices and gross margins will likely decline from such a shift.

Healthcare services is actually the most active sector for healthcare private equity investment, and accounts for 50-60 percent of total healthcare investment, according to a recent Pitchbook study . Given the fragmented nature of this sector, and increased valuations of platform acquisitions, add-ons now represent about 70 percent of total private equity change-of-control transactions.

Despite fears of “stroke of the pen” risk, “overnight” adverse regulatory or reimbursement are relatively uncommon in healthcare services – although some management teams and their investors sometimes offer them as scapegoats. There is usually a fairly lengthy period of trial balloons, lobbying, comment, and implementation that give companies a fair amount time to respond strategically and tactically, provided that they’re not hamstrung by excessive leverage. (BBA ’97, however, had an adverse affect on nursing homes and Medicare home nursing. It blew up both industry segments by changing the way it paid providers from cost-plus to a more traditional revenue model, which companies without strong management teams and access to capital had a difficult time navigating.)

Poor management execution is actually a more typical cause of unhappy investment results in healthcare services, again often compounded by excessive leverage. Two common areas of poor execution are billing & collection and regulatory compliance.

  • Billing & collection problems, often stemming from weak internal processes, result in cash collections that fall significantly short of net revenue (less bad debt expense) – and ultimately lead to lower-than-expected EBITDA and big accounts receivable write-offs.
  • Regulatory compliance problems, on the other hand, mean billing – and getting paid – for services for which the company shouldn’t bill, due to existing regulatory or contractual requirements. At a minimum, revenues and EBITDA are higher than they should be. In addition to suffering reduced profits and cash flow, restitution may include repayment of improper collections, payment of penalties, and/or other negative consequences.

Usually an informed and experienced due diligence effort will uncover billing & collection and compliance issues (which a properly drafted purchase agreement should backstop). For example, a prior portfolio company routinely killed 50 percent of add-on acquisitions already under letter of intent due to these two issues.

It  makes sense to work with experienced healthcare investors or lenders, whether on the payroll, as co-investors in the deal, or as consultants. They will have better idea of whom to call to bolster areas they don’t know as well, or to get valuable viewpoints on where the industry segment in question is likely to go in the future.

Bill Kane, Senior Managing Director of Redborn Capital Partners, LLC, is a board director of the ACG’s New York chapter, and chairs its annual Healthcare Conference in February. He has over 25 years of healthcare private equity investment experience.

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