A rare confluence of factors is generating great opportunities for private equity and strategic buyers in the healthcare industry. These factors have buyers lining up at the gate, resulting in unprecedented (and often double digit) multiples and enterprise valuations, which have positioned physicians and other healthcare entrepreneurs to reap significant financial rewards.
Median EBITDA multiples for healthcare M&A in 20151
ASCs, Diagnostics and other Ancillary Services 6-8 x
Healthcare Services 9+x
Healthy valuations are not the only reason that physician owners and other healthcare founders/entrepreneurs are increasingly attracted to the possibility of partnering with private equity and other buyers. Partnering with a strategic or financial sponsor allows sellers to access capital to grow or to acquire or implement innovative technologies and enhanced infrastructure. Partnering with the right sponsor also affords physicians and healthcare companies an alternative pathway to maintaining independence from hospitals and health systems and a more strategic outlook with regard to their participation in accountable care organizations, clinically integrated networks, and other types of joint ventures and arrangements. Selling a meaningful interest can also reduce a seller’s overall exposure to future reimbursement decreases. Finally, with proper structuring, these partnerships typically allow the sellers to benefit from long-term capital gains tax rates on the sale proceeds in lieu of substantially higher ordinary income rates applicable to compensation and profit distributions.
However, opportunities in the healthcare sector come with a corresponding degree of risk, given healthcare’s highly regulated market, ever-changing reimbursement dynamics, and unique operational requirements. So it is important to understand both the market forces and the business and legal requirements in order to mitigate risk and maximize return.
Extraordinary volume of activity
Healthcare M&A had a record year in 2015, with nearly 1,500 deals worth more than $560 billion2 – though simply noting that last year broke records may be understating the trend. To understand the extraordinary volume of activity in the healthcare sector over the last two years, consider this: 2015 marked the second consecutive year in which M&A deal value over a 12-month period was more than double the annual average from the previous decade.
A number of factors are driving this increased level of activity, including a macro environment that has been favorable to M&A due to the inexpensive cost of capital and an inbound flow of capital from outside the United States. And the healthcare sector in particular has attracted investors with the prospect of higher valuations, while sector-specific market forces and regulatory pressures – two things we will examine in greater detail below – are encouraging consolidation.
Following the record levels reached in 2015, expectations for this year are high.3 The ingredients that have powered the healthcare M&A market over the past few years remain in place, and early analysis suggests the pace of activity remains brisk, with activity in the first half of the year outpacing the same period in 2015.4
There are two subsectors of the broader healthcare industry where we have seen particularly strong activity: healthcare services and information technology (IT). Current conditions point to continued opportunities in both sub-sectors for a range of interested players, from venture capital (VC) and private equity (PE) to strategic buyers at multiple levels. Let us explore both in some greater detail.
Healthcare services: ACA sets the stage for M&A opportunity
Since its passage in 2010, the Affordable Care Act (ACA) has served as a catalyst for many changes within the broader healthcare industry, and the consolidation of healthcare services businesses is one of them. How has this legislation set the stage for greater M&A opportunity?
For many years, complex payment systems and the industry’s multiple levels of regulation and governance served as a protective shield for healthcare providers against certain market fluctuations. Yet they also created a barrier to growth and innovation within the industry.
One of the most fundamental changes to the operations of our healthcare system – stemming from the ACA – is the evolution of the way doctors and hospitals are paid. Reimbursement for healthcare services is moving away from a fee-for-service model to one that is value-based. The bottom line for providers is that revenue will depend on multiple factors, including the overall outcome and quality of experience for each patient and broader population health management.
In a value-based payment system, quality, efficiency, transparency, and coordination are rewarded, while waste and inefficiencies are penalized. Vertical integration enables healthcare providers to coordinate care across specialties, allocate resources more efficiently, and manage the most expensive chronic health conditions with greater success. Larger size and greater geographical coverage also allow service providers to leverage new data analytics tools more effectively. And while a change in the White House Administration could lead to significant ACA reform and challenges, the commercial payor and private markets seem to be embracing a need for change and will likely continue to move away from a strictly fee-for-service system and continue to seek more opportunities to shift risk onto providers, irrespective of the outcome of the election.
Different types of buyers are moving to acquire healthcare services businesses for different reasons. Private equity is attracted to the opportunity to create new value by improving management effectiveness and eliminating operational inefficiencies, along with the potential to grow a platform business and take it to the next level. Strategic buyers, primarily health systems and insurance companies, understand that acquisitions in the healthcare services sector will put them in a better position to compete and operate in healthcare’s brave new world, improving their long-term revenue sustainability and overall value.
Spurring growth in healthcare technology
Technology has always played a role in healthcare, and today great attention is focused on the impact (current and potential) of technology on care management and delivery. Just as the ACA’s fundamental tenets of quality, efficiency and transparency are transforming the services landscape, they are spurring growth in the healthcare technology sector.
For instance, the digital health landscape includes the rapid integration of mobile computing, wearables, and the Internet of Things to enable new, more cost-effective “care anywhere” services that allow patients to get care at (or closer to) home. New digital tools support smarter patient loading, registration, and treatment adherence systems for those who do require hospitalization. Databases and high-powered analytics will allow industry players, from providers to medical devices makers and biotech, to analyze data from many sources in novel ways, unlocking insights embedded in the patient information being collected.
Healthcare technology is also unlocking new levels of transparency within the system, enabling different specialists working on the same patients to communicate and share information. Transparency tools are also a boon for patients, who can make more informed choices about care options and the costs involved.
Finally, technological advances are also playing a role in the overhaul of chronic disease management and prevention. Caring for patients with chronic conditions now consumes a major percentage of healthcare costs, so any efficiencies here can generate disproportionate financial rewards for healthcare providers and payors. Success in preventing the growth of chronic diseases will pay dividends through improved population health management and future cost savings.
A notable trend in this area is that some of the larger payors and health systems have established their own venture capital arms or are partnering with venture capital firms. These tend to act like traditional corporate VCs, with a twist. They are expected to yield returns in the traditional way: established organizations assisting new ventures by developing and implementing their business plans, then achieving growth and value upon exit. In addition, these strategic healthcare VCs are seeking to harness the value of new health IT innovations and efficiencies, bringing the best elements of those benefits back into their health systems, insurance companies, or other parent organizations to improve operational performance and returns. They also typically offer the benefit of a ready-made “incubator” or laboratory where the innovations can get plugged in and fast-tracked for beta testing in the VC’s sponsor’s systems or facilities.
Consumer driven dynamic
Another important factor in healthcare that did not originate with the ACA, but has certainly been propelled by it, is the push toward consumer-driven healthcare. The rise of high-deductible health plans, greater access to individual insurance plans through the healthcare exchanges, an increased level of transparency (both in quality and in pricing), the proliferation of retail-style health clinics, and a growing patient expectation for customer service based on a generation of digitally-enhanced services have all contributed to healthcare becoming a much more consumer-driven sector.
Healthcare businesses that can leverage scale, capabilities, and synergies will be in a better position to meet the demands of the next generation of patients who are more informed and discerning consumers.
There is tremendous opportunity in the healthcare sector during this period of rapid evolution, as the record level of M&A activity attests. That opportunity comes with elevated risks in certain areas, some of which are unique to the sector.
Potential pitfalls include an increased level of antitrust scrutiny as consolidation within the sector continues. Indeed, the US Department of Justice has become increasing vigilant in its challenges, as evidenced by its scrutiny over the consolidation of four of the biggest health insurers. Don’t think for a moment, however, that antitrust scrutiny is reserved for only the biggest players. Even smaller regional systems like Carolinas HealthCare System are at risk. In what appears to be a first-of-its-kind antitrust complaint, the DOJ has alleged that Carolinas improperly prevented insurers from steering patients to lower-cost hospitals. The outcome of such closely watched cases is likely to have significant implications for insurers and providers that are pursuing growth strategies through mergers and acquisitions as well as through the development and advancement of clinically integrated networks and bundled payment arrangements, cost containment strategies and the design of provider networks.
In addition, many healthcare transactions are subject to the Stark Law and the federal Anti-Kickback Statute, which bars certain healthcare referrals. Understanding the application of these laws to the varying relationships that a company may have with its referral sources is absolutely critical to avoiding potential liability and ensuring the viability and stability of a healthcare company’s relationships with key referral (and revenue) sources.
2015 marked the fourth consecutive year in which the US Department of Justice exceeded $3.5 billion in settlements and judgments involving fraud and abuse, more than half of which involved healthcare. Importantly, several federal investigations in 2015 concerned violations of the Stark Law, with settlements ranging from $11.5 million to $69.5 million. With more expansive False Claims Act enforcement efforts involving Stark Law violations, healthcare organizations need to be highly vigilant. Of particular concern for the healthcare sector is that the complexity of these rules creates an uncertainty in how they will be enforced, a situation that is affecting what would normally be non-issue business transactions.
A wide range of state laws also come into play with many healthcare companies. For instance, there are laws in many states that virtually prohibit a non-physician from owning a medical practice, which means PE and VC funds along with many strategic players need to be mindful. It may well be necessary to structure deals involving medical practices in a non-traditional (or at least non-traditional outside of the healthcare space) manner through the use of a management company or other contractual arrangements.
Those involved – or seeking to become involved – in healthcare M&A require more support in structuring and executing deals than those in other sectors; generic experience in M&A will not cut it. Working with partners and professional advisors who understand the intricacies of the market and the forces at work, the potential pitfalls and unique legal risks associated with the market, and how these can be addressed are highly valued in driving a successful outcome both in terms of the closing and the ongoing stability and compliance of the healthcare company.
Taking advantage of opportunities
The healthcare industry is ripe with opportunity. Funds and strategic buyers are aggressively pursuing opportunities with an increasing emphasis in healthcare services and healthcare IT. Physicians and other healthcare entrepreneurs are drawn by the high valuations and multiples that these new potential partnerships offer as well as the opportunity to be well positioned for continued independence and future growth. Investing in the healthcare industry, however, is also filled with both operational and legal challenges. Understanding a company’s relationships with payors and referral sources, its commitment to healthcare compliance, and the implication of federal and state laws on both the operations of the company as well as the transaction structure are key considerations to maximize value and minimize risk in a healthcare transaction.