US mid-market: investing in healthcare

No country matches the US for spending on healthcare. Investment in the medical industry accounts for 17.1 percent of GDP, while its nearest major rival, the Netherlands, invests 12.9 percent, according to the World Health Organisation.

For companies in the multi-trillion-dollar industry, the arrival of the Affordable Care Act (better known as Obamacare) heralds more change and a wave of consolidation in the mid-market.

“I think as long as healthcare remains 16-18 percent of the GDP, there’ll be a significant amount of private equity deals, which will be very active in the foreseeable future,” says John McKernan, vice-president of mid-market firm The Riverside Company. “There’s been an uptick recently in mid-market PE deals.”

The US healthcare landscape is shifting, with emphasis on the consolidation of large insurance companies resulting in mega-cap deals, he says. Last year, the industry saw Starr Investment and Partners Group buy MultiPlan, the healthcare cost-management provider, for $4.4 billion and The Carlyle Group acquire Ortho-Clinical Diagnostics, the medical testing company, for $4 billion.

While these were the only two deals worth more than $1 billion in the US in 2014, the increase in upper-market consolidation is creating a “tremendous opportunity” for the mid-market to create meaningful growth through consolidation.

“We see mid-sized companies initiating M&A more frequently, not just for growth, but also to sustain their defence against bigger companies who themselves are consolidating at a more rapid rate,” says Matt Evans, healthcare managing director of Monroe Capital.

According to a report by CIT, the mid-market lender, 83 percent of healthcare executives thinks consolidation helps keep revenue up for companies in their market.

In the upper mid-market in 2014, Cinven acquired clinical trial services company Medpace for $915 million, Clayton Dubilier & Rice bought wound-healing services firm Healogics for $910 million and Ares Management spent about $900 million on National Veterinary Associates.

Overall, there were 80 healthcare deals worth $15.6 billion last year, compared with 90 for $9.8 billion in 2013, according to Bain & Company.

Reform caused by Obamacare is a key driver of this consolidation. Bain says many funds invested in healthcare IT as companies dove into new payment models and population health management, two issues addressed in the legislation.

“The trend toward consolidations across specialisation – whether it’s hospitals buying out large general practitioners, partnering with PE firms – is a response to an increasingly complicated regulatory environment,” says McKernan. “What we see as investors at Riverside is, because of the increasingly complicated landscape and trend toward consolidation, there are opportunities to help the smaller practitioners focus on medicine and patient-care.”

The biggest challenge, he says, is to determine what the landscape will look like in the next five to 10 years and the potential transition from “fee-for-service”, where patients are charged for separate, unbundled services, to a “fee-for-value” system that would emphasise quality over quantity of care provided. “It’s more of a conversation rather than reality today; I haven’t seen a meaningful impact on businesses,” McKernan says. “Not many networks have figured out the appropriate way to go about the fee-for-value formula.”

Monroe’s Evans agrees. “At this point most healthcare related entities realise a value-based system makes sense, but it’s very difficult to shift healthcare sectors and their reimbursement methodologies overnight,” he says.

“For investors like us, predominantly on the debt side of the capital structure, we don’t want to get involved in a model that hasn’t been able to prove itself over a number of years.”

He adds that healthcare has moved more slowly than other sectors as far as model-restructuring is concerned. With Obamacare, experts are expecting higher volumes at lower margins as more patients enter the system and more events trigger reimbursement. But, Evans says, there is a finite amount of dollars which creates an anticipation of lower margins.

In a report on the mid-market, CohnReznick, the accountant, concluded that “exit and acquisition opportunities are likely to remain robust throughout 2015 as the industry continues to consolidate”.

It said private equity firms in this sector should target growth companies in the mid-market focused on business infrastructure.

Nine PE funds, ranging between $100 million and $1 billion, have closed in the US this year, including RoundTable Healthcare Partners IV on $650 million and Flare Capital Partners I on $200 million, according to PEI Research & Analytics.

Meanwhile, three healthcare funds with targets in the same range have launched in 2015: Visium Asset Management’s Visium Healthcare Partners targeting $500 million; Heritage Group’s Heritage Healthcare Innovation Fund II targeted at $200 million; and Capital Royal’s CRG Partners III, which had raised $515 million as of 8 September.

Consolidation and reform can create an environment with plenty of opportunities, but, as McKernan says: “All healthcare is local so the opportunity set can differ by country.”