Key to healthcare PE: specialised knowledge

Healthcare and M&A specialist Richard Zall, a partner at New York-based law firm Proskauer Rose, says PE fund managers need to develop networks of advisers with specialised knowledge if they want to outmanoeuvre strategic buyers.

Proskauer Rose partner Richard Zall, who specialises in healthcare and M&A, tells Private Equity International that the complexity of the Affordable Care Act (ACA), passed in 2010, and the changes in the law since then have created opportunities for private equity investors.

What does it take to be a successful private investor in an industry that is heavily regulated?

The most successful and thoughtful investors are spending a lot of time meeting with companies, attending conferences, learning about the innovation that is going on, and finding people who have solutions that are working. We certainly spend a lot of time with our private equity clients, sometimes just sitting around a table, talking about trends that we’re seeing. Other consultants and bankers come to [these meetings] as well, and discuss companies and trends they’re seeing. This dynamic environment places a premium on specialised knowledge. Investors need to [first] develop a thesis about a problem that’s out there and a solution to that problem, and [then] find a company that understands the problem and [either has] the solutions and has or can develop the required solution.

What challenges do healthcare-focused fund managers face right now?

There are a number of challenges. In the last 6-12 months, the expectations of some companies have led to valuations that have grown substantially compared to a number of years ago. So, funds are concerned about investing at too high a valuation and not being able to get the kind of ROI they were expecting.

This is compounded by another recent trend, which is that there are strategic investors competing for the same investment opportunities as the funds. Unlike PE firms looking to generate IRR, the strategics are often willing to pay higher prices. That’s a challenge for many PE investors we work with. They deal with this situation by trying to directly source opportunities through getting out, meeting the young companies, talking to lawyers, bankers, consultants, finding situations and getting to those companies before they’re in the process of reaching out to other PE firms and strategic buyers.

It’s a relatively new phenomenon. But it is likely to change a bit, just because I think there has been discipline. So with some of these auctions, people are not getting the prices that they thought. There’s an equilibrium that sets in where prices will come down somewhat. That’s a healthy thing.

How about the concerns from LPs?

I would note two. First, LPs need to be sure that the time frame for a particular investment is appropriate to their objectives. Given the degree of change in the marketplace now, many companies face a longer time horizon for a potential liquidity event, so LPs need to align their expectations with their portfolio companies’ realistic business plan.

Secondly, the current environment has heightened regulatory and reimbursement risk for many health services companies. Healthcare is a highly regulated industry and the ACA made it even more so, and there’s also a lot of state regulation and a lot of public funding through Medicare and Medicaid. As a consequence, investors need to do a ‘gut check’ and determine how much of this risk they are prepared to tolerate. Some get comfortable with where the government is going in terms of regulation and payment in various sectors, but other investors stay away from more directly regulated sectors or any companies that are directly dependent on third-party reimbursement because they aren’t prepared to roll the dice on how government agencies might act. So I think LPs really have to gauge their tolerance for risk.

Where in the healthcare sector is private capital flowing into?

Healthcare IT or digital health is an area of increasing activity because technological change has begun to transform the healthcare industry and there’s much that can be done electronically now. There is a lot of data available to analyse, and that helps various players in the industry, as well as the consumers, manage their healthcare. So there’s a lot of relatively early-stage money going into that sector. There is a lot of potential payoff there.

Population health management is another growth sector. Increasingly, both public and commercial payers are expecting a better managed, more efficient delivery system, and this requires increased coordination across the healthcare spectrum. Traditional providers such as hospitals and medical groups, health plans, and standalone care management companies are all looking to guide patients across the healthcare system and integrate services and medical care. This capability is essential in order to function in a value-based payment environment.