Healthcare sea change

The mid-term election in the US Tuesday could have major effects on healthcare reform and the opportunities for private equity in the sector, writes Dan Mendelson.

Government reimbursement is the single greatest source of revenue for most healthcare investments in the US.

For this reason, successful private equity healthcare investing rests on an accurate understanding of the impact government healthcare regulation and reimbursement has on investment returns.

In addition, these investments are highly sensitive to the political process and can be greatly affected by significant “sea change” elections – like the one the US faces Tuesday.

The prevailing belief in Washington is that Republicans will take back legislative control. Rightfully, everyone is questioning how this will affect the implementation of healthcare reform begun by the Democrats. By extension, private equity investors are wondering what effect this political shift will have on current private equity healthcare investments and the healthcare industry as a target for successful private equity investment.

Dan
Mendelson

To properly address this issue, we must first look at the likely near term effects of the Healthcare Reform Bill and then anticipate how a Republican victory in the US House of Representatives and/or Senate would repeal, replace or alter the implementation of the bill.

As reform is currently contemplated, the industry will experience phases of change relevant to private equity over the next four to five years.

The first phase, government reimbursement reduction, will be marked by margin compression and rate reduction at companies within the healthcare space. The second phase, risk transfer, will further pressure healthcare providers as the government attempts to push down cost accountability. Finally, around 2014, the industry will begin to see significant volume expansion as more patients enter the system. Throughout this period, enforcement and fraud detection have been on the rise, with the Justice Department and Medicare stepping up activities to identify and eliminate system abuse.

As the voters return some level of political balance to Washington and the states, we’ll see changes to healthcare reform but perhaps less than one might think.

Full repeal of the Healthcare Reform Bill won’t happen. That said, dominance in the House will enable Republicans to shape the substance and pace of reform. Many important payment systems, including rates for Medicare Advantage health plans, will be modified through Republican engagement in regulation. Newly created healthcare agencies will be called to task through contentious hearings. In some cases, Republican members will move to slow down or prevent activity by withholding funding.

By contrast, the implementation of cost control measures will continue. Reform is meant to create local health care delivery systems that are more efficient and force a focus on healthcare quality. Republicans will influence these developments but are unlikely to disrupt them. In fact, cost reduction proposals such as the activities of the Center for Medicare and Medicaid Innovation are likely to get more urgent and more innovative.

Given the above, what are the healthcare investment opportunities for private equity firms going forward?
There are several. Companies specialising in cost reductions, evidence-based medicine, and reimbursement management will be attractive investment targets. As government pushes cost and risk onto providers, there will be opportunities for consolidation in local provider markets. Finally, government reimbursement reduction has hit certain healthcare sub-sectors disproportionately hard over the last few years. Many of these sub-sectors have nowhere to go but up.

Of course, every healthcare investment opportunity is unique.  While Reform has complicated the diligence environment with some reform activities slowing down and others accelerating, careful analysis can still result in good projections of likely changes in revenue flows for healthcare companies.  

Private equity firms must understand how their portfolio companies and investment targets will be affected by regulatory change, cost pressures, reimbursement reduction and enforcement activities and work these into their investment modeling and expectations for future returns.

Dan Mendelson is chief executive officer and founder of Avalere Health, which provides consulting, due diligence and policy guidance for clients in industry, government and the not-for-profit sector.