Healthcare is a capital intense industry: facilities, technologies, workforces, infrastructures and clinical breakthroughs require access to funding from banks willing to lend and investors willing to bet.
For most, being a limited partner in a private equity fund is an attractive hedge against inflation, especially a fund that targets healthcare wherein demand is increasing and shifting, costs are soaring and consumers are receptive to new alternatives.
Private equity is big business:
Private equity funds have nearly $2 trillion in dry powder to invest. The Securities and Exchange Commission (SEC) recently reported that private funds’ gross assets now surpass those of the commercial banking sector at more than $25 trillion–up from $9 trillion in 2012. And the American Investment Council reports that…
· 12 million are employed at Private Equity-Backed Companies.
· 32,041 Private Equity-Backed Businesses have been funded since 2017.
· 34 million Americans Depend on Private Equity to Support Their Retirements.
And healthcare is a prime target:
According to data compiled by Pitchbook, “private equity invested more than $206 billion in U.S. health care throughout 2021 to fund research into deadly diseases like Alzheimer’s and Parkinson’s, expand and renovate facilities, modernize medical records and health care data, and make other needed investments.” Bain reported “Despite the slowdown in healthcare private equity deal flow in the second half of 2022, firms continued to create healthcare-focused funds and raise near-record levels of capital in 2022. Data from Preqin suggests that firms raised more than $15 billion in new buyout capital for funds where healthcare is the exclusive or core focus, which has happened in only two other years in the last two decades—2019 and 2021.”
In 2021, the Medicare Payment Advisory Commission (MedPAC) released a report affirming that private equity investments “play an important role providing hospitals, nursing homes, and physician practices with capital and expertise to navigate an increasingly complex health care landscape” but offered Congress no recommendations about how to navigate its growing role.
The playbook for PE investing in healthcare services is widely-known:
· Thesis: Healthcare is expensive, wasteful and unsustainable in its current structure: Incumbents in healthcare services, especially hospitals and physicians, need capital to survive and are receptive to private money.
· Strategy: Land, Expand, and Exit in 5-7 years: Leverage debt at competitive rates to fund most of the deal; operate aggressively by lowering operating costs; grow revenue aggressively thru adjacency acquisitions and partnerships; price aggressively and avoid compliance penalties associated with safety or quality issues.
· Keys to success: Timing, attractive deal terms, a scalable operating platform, exceptional CEO and dispassionate exit strategy. And for navigating expectations of limited partners (high net worth individuals, pension funds, et al), the General Partner gets a 2% management fee and 20% of the value created in the enterprise at exit.
My take:
For the past decade, PE investments in distressed hospitals, medical specialties (radiology, dentistry, dermatology et al), outpatient surgery/ diagnostic facilities and logistics solutions have been popular targets. Going forward, opportunities in services will increasingly center on business models that produce significant, near-term cost-reduction compared to alternative solutions as issues around affordability and employer health costs mount. But three issues will impact the role and success of PE investing in healthcare services looking ahead:
1-Heightened Regulatory Scrutiny: There’s growing concern in Congress and among regulatory agencies about the role of private equity in healthcare services.
· In Congress and in some states, ownership restrictions and added disclosure requirements are being considered.
· The SEC is advancing changes to require added protections for investors in PE funds.
· The FTC is examining the correlation between PE ownership and business practices and consumer choices.
· CMS is considering analyzing the association between PE ownership and prices.
2-The Maturity Wall: “A maturity wall is fast approaching for PE funds that are nearing the end of their term life to distribute their capital back to investors through exits. PE investors will need to pick up their exit pace or will be confronted with 20% to 26% of the capital initially invested by funds to hit the maturity wall. The cumulative amount of still- held investments could grow to over $360 billion in the next 12 years.” (Pitchbook June 30, 2023). The maturity wall will be especially problematic in communities where medical practices and/ancillary services providers acquired thru PE-sponsored deals are forced to switch owners necessitating possible disruptions in care.
3-Heightened Competition among PE Funds: PE funds compete for good deals and satisfied investors. Bigger funds have advantages over smaller funds i.e., domain expertise, analytic models and access to effective executive talent. The deal landscape in healthcare services has slowed though opportunities remain. It’s a buyer’s market prompting intensified competition between funds and aggressive negotiations between buyers and sellers. Qualified investors are comparing fund performance and moving funds to the most successful.
The healthcare services market in the U.S. is worth $3.5 trillion and is forecast to increase at 5%/yr. for the next decade. It’s traditionally dominated by nonprofit operators and market conditions that favor incumbents over newbies, bigger over smaller and business to business (B2B) models over business to consumer (B2C). That’s changing. Investor-ownership in healthcare services is increasing. Distinctions between privately operated PE owned hospitals and services providers and investor-owned publicly traded operators are being scrutinized by regulators even as the tax-exempt status enjoyed by not-for-profits is under the microscope.
Access to capital that’s cost-effective is critical to the future of health services providers. PE will be increasingly part of that discussion and with it, added risk.
HENRY KOTULA 