The Future of PE Healthcare Investments
In 2020, deal volume fell when compared to 2019. However, while most industries experienced heavy losses, it was the healthcare industry that saw an overall increase of 21% in spite of a significant reduction in patient volume. We discussed this new frontier of investment opportunity with three leading private firms and got their insight into new possibilities in the healthcare industry.
Participants
Patrick Watkins, Principal
Osceola Capital Management
Matt Blevins, Partner
Clearview Capital
JJ Carbonell, Principal
Northlane Capital Partners
Where does your firm see the greatest potential in healthcare today?
Matt:
We tend to focus primarily on healthcare services due to the large size of the various sub-markets within that segment of healthcare as well as the fragmentation which lends itself well to Clearview’s proven ability to execute an aggressive buy-and-build strategy. Behavioral health, home health (skilled and unskilled) and hospice continue to be attractive markets from a demand standpoint, but valuations are frothy, so investors have to balance the market opportunity relative to what’s already priced into the valuations of those businesses. We believe outpatient diagnostic imaging is an interesting place to invest as payors continue to push volumes away from hospitals to free-standing centers to bend the cost curve, while at the same time the outpatient setting is preferred by the patient. We also like outsourced revenue cycle management focused on the more complicated end markets in healthcare, as payor complexity continues to increase resulting in significant back office burdens for many providers.
JJ:
The healthcare sector has been a longstanding area of focus for Northlane largely due to the recession resistant demand drivers and the mission critical nature of the services and products. We have several targeted subsectors within healthcare that are supported by favorable industry tailwinds and sector-specific investment theses. Examples of our targeted subsectors include: healthcare IT, medical device outsourcing, behavioral health, life sciences tools and consumables, regulatory and compliance services, and pharmaceutical services. The central themes that these subsectors have in common are the continued trend toward outsourcing (usually driven by cost and/or quality improvements), strong margin profile driven by a differentiated, value-added service, and a stable regulatory outlook.
Patrick:
As we evaluate healthcare investments, we have focused on the following major trends in the industry: (a) value-based care and population health, (b) personalized care and patient engagement, (c) chronic care management, (d) home and community-based services, and (e) consumerism and affordability. We are always flexible and creative in evaluating new opportunities, but these trends provide a great baseline lens through which to look at new deals.
“Trying to follow the crowd into the myriad of over-saturated specialties with overheated multiples is a recipe for overpaying.”
Patrick Watkins
With the rising competition for healthcare investment opportunities, has your firm changed its approach for deal sourcing and lead generation?
Matt:
We’ve always had an intense focus on deal origination at Clearview and continue to evolve our strategy as market forces change over time. We’ve recently made a more concerted effort to leverage our historical experience with portfolio companies in specific healthcare end markets that we still have an interest in, to appeal to potential sellers in a more targeted way.
JJ:
Our general strategy in terms of company characteristics, target subsectors, and industry growth drivers has remained consistent over the last 15+ years. In fact, many of our portfolio companies are businesses that we have tracked for a long period of time. Northlane’s approach to deal sourcing and lead generation has remained thematically consistent but has become more refined in recent years. With the added competition for new deal execution, we have accelerated our market research into our target subsectors, which resonates with intermediaries and management teams. Key initiatives that we have executed recently have included formalizing sector specific theses, augmenting our executive network in specific areas within healthcare, and increasing the level of proactive company outreach as a result of our market mapping and industry research. In addition to improving our sourcing capabilities, the combination of the above factors has helped our due diligence efficiency and portfolio company strategies post-close.
Patrick:
We’ve taken a much more proactive, thesis-led approach. Trying to follow the crowd into the myriad of over-saturated specialties with overheated multiples is a recipe for overpaying. We are always actively looking for new specialties or sub-specialties that would be supportive of a roll-up. Osceola creates relationships with executives, physicians, and advisors to source and close businesses with a like-minded approach to growth.
Has COVID-19 affected your firm’s company valuations? If so, how?
Matt:
Certainly our valuations were not immune to the initial shock of COVID-19, including the initial drop in the public markets, followed by the quick recovery, both of which reverberated through private company valuations, but at this point I believe the impact of COVID-19 on company valuations is much more company-specific, with some companies still trying to find their way due to a variety of challenges, including labor shortages; some companies doing relatively well despite the pandemic’s impact; and some companies doing incredibly well, potentially with the pandemic serving to accelerate their growth.
JJ:
Northlane’s portfolio has performed very well during the pandemic, with significant overall earnings growth and portfolio value appreciation over the past year and a half. We target healthcare investments in businesses that typically have inelastic demand drivers, so any negative COVID-19 impact across our portfolio was short-term.
Patrick:
COVID-19 has not affected our valuations as much as it’s affected our structures. Operating in the lower end of the lower middle-market shielded our target companies from the dramatic drop in valuation that middle-market or mega funds saw. We remained flexible and creative in forming deal structures that worked well for both sides, and took a pragmatic approach to those temporary headwinds from COVID. We also take a conservative approach to leverage, so our companies did not face trouble with lenders. Rather, we used COVID as an opportunity to accelerate acquisition growth.
“Targeting companies that fit within our sector specific theses, have long-term industry growth tailwinds, and dynamic management teams gives us the confidence to invest through different economic cycles.”
JJ Carbonell
Rising healthcare company valuations may have created a Bull Market. How is your firm responding to these circumstances?
Matt:
I’m not sure rising healthcare company valuations have created a Bull Market, as much as overwhelming liquidity from every corner – consider the Federal Reserve, an explosion in private credit, continued money flowing to private equity firms – combined with an optimistic economic outlook has, but certainly healthcare company valuations are very frothy. That said, valuations across most sectors are frothy right now. As a private equity firm, our job is to find attractive places to invest our limited partners’ capital across any economic cycle. In a hot market, we remain cautious overall while still aggressively pursuing investment opportunities in which we have a high degree of conviction, which often means investing in industries with which we have prior experience.
JJ:
While always taking relative price into consideration, we do not base our investments on attempting to time the market. Targeting companies that fit within our sector specific theses, have long-term industry growth tailwinds, and dynamic management teams gives us the confidence to invest through different economic cycles. We believe Northlane’s continued focus on the lower middle market also provides an advantage relative to larger funds as we can acquire smaller companies that may be sub-scale or in need of a management transition at lower prices than larger, more professionalized companies. In addition, these smaller companies tend to operate in fragmented markets with ample add on opportunities which can help us enhance value post-closing.
Patrick:
We have stayed disciplined both in our valuations and in our sector selection. We identified opportunities where we had an angle and were uniquely positioned to be a value-added partner, and did not pursue opportunities that were on the fringes of our investment criteria. Most importantly, we continued to prioritize partnerships with entrepreneurial founders who aligned well with Osceola’s approach to growth and operations.
Given the varying impact the pandemic has had on the healthcare industry, what factors have contributed to such an increase in deal volume?
Matt:
We believe the three largest drivers of healthcare deal volume right now are certainty, valuations and taxes. Volume dried up considerably from March – May of last year simply because no one had any idea what the future would hold. Now, while we don’t have complete certainty, there’s clearly a light at the end of the tunnel and that certainty breeds confidence in the M&A market. Second, high valuations will always attract more sellers and valuations are at or near an all-time high across just about every segment of healthcare. Third, the potential for changes to capital gains rates is obviously driving a lot of sellers to seek an exit in 2021, potentially prior to the effective date of any legislative change.
JJ:
Healthcare is generally one of the more recession resistant end markets. While some pockets, especially on the provider side, were impacted by COVID-19, the majority of sectors where Northlane sees deal flow were relatively unaffected or quickly returned to pre-pandemic levels. We believe the resiliency of the sector during a pandemic provides investors with added conviction regarding the appeal of investments in the near and long-term.
Patrick:
COVID provided a bit of a shock to the system for privately-held targets, especially because the 10+ year bull market has generated high and consistent growth for their owners. COVID showed us again that few businesses are truly bulletproof (whether it be from an economic downturn, pandemic, national emergency, etc.), and that (along with a potential increase in capital gains taxes) has caused many companies to think hard about strategic alternatives.
“We believe the three largest drivers of healthcare deal volume right now are certainty, valuations and taxes.”
Matt Blevins
It seems that a higher volume of larger healthcare transactions have become more frequent. In terms of deal multiple, do you believe that larger transactions might have been postponed previously in hopes of larger valuations in the future?
Matt:
We deal exclusively in the lower middle market, so probably not the best to opine here, but I believe this is likely due simply to those sellers taking advantage of high current valuations – potentially pulling deals forward because of the high valuations – rather than smart sellers “knowing” valuations would rise and waiting until this year now that they have. Of course, most owners weren’t selling in the first half of last year due to the pandemic, so there’s a natural increase in volume this year as a result.
Patrick:
I’m sure COVID caused a pause in innumerable sales processes due to business disruption. That being said, once offices accepted patients again and operations returned to normal, seller and buyer valuations seemed to converge again (often through reasonable COVID-related add-backs). I don’t think there are any macro changes towards longer hold periods in healthcare private equity. We continue to have the same demands for returns from LPs, and the ever-expanding universe of buyers typically facilitates a smooth path to exit for performing companies.
Will rising healthcare valuations lead to more frequent fundraising and M&A activity?
Matt:
I believe rising healthcare valuations are going to make a great deal of GPs look really good with attractive exits and returns, which likely will result in more fundraising by GPs. The question for discerning LPs will be whether the GP produced those returns or the market? Multiple arbitrage can be an important part of the equation in generating above average returns to a GP’s investors, but sometimes it can be difficult to distinguish between what portion of the multiple arbitrage was driven by the GP helping management build and grow a better business versus what portion simply came from an improving overall market.
JJ:
That is probably a fair assumption in the near-term. Favorable capital markets dynamics should encourage groups to raise debt and equity capital at attractive terms, in addition to M&A. However, the higher valuations and levels of fundraising will place added pressure on investment returns. Healthcare generally has numerous long-term growth drivers, so we feel confident in our strategy to invest through all points in the economic cycle.
Patrick:
In some sectors, an extended period of rapid consolidation and rising valuations lead to an eventual slow-down in M&A activity (albeit with significantly larger assets trading hands). Healthcare remains uniquely fragmented despite multiple decades of consistent M&A.
Favorable capital markets dynamics should encourage groups to raise debt and equity capital at attractive terms, in addition to M&A.
JJ Carbonell
Is your firm considering any or more investment opportunities overseas or in other countries? If so, what is the catalyst for the shift in strategy?
JJ:
Northlane invests in new platform assets that are headquartered in North America. Our investments overseas are to expand the geographic presence of our existing portfolio to increase the addressable market and open additional avenues for growth. We plan to continue international investments and expansion initiatives across the portfolio where the strategy is appropriate.
Patrick:
While Oscoela focuses on platform opportunities headquartered in the US, we’ve prioritized gaining international exposure through add-on acquisitions. During our investment hold, those acquisitions provide attractive diversification and growth opportunities. Equally as important, it increases the total addressable market for the next owner and offers more pathways for organic and inorganic growth.
The next year or two will serve as a “make or break” time for SPACs, which typically are allowed two years to deploy their capital. While they have become a popular exit-channel, how will this time limit affect the deal making process in the near future?
JJ:
From Northlane’s perspective, the portion of the market that is seeking potential investment from SPACs is less relevant to our strategy, so we do not anticipate this dynamic having a material impact on our future deal execution.
Patrick:
SPACs do not have a huge impact on Osceola’s exit-channel, as we focus on the lower end of the lower middle market. That being said, multiple of our portfolio companies have been approached as add-ons once an SPAC made its initial acquisition. Just as we’ve seen with the influx of capital and M&A interest from direct investing arms of the family, more buyers and liquidity in the market generally benefits good companies at exit.
Do you have any advice for healthcare companies who may be seeking investment capital?
Matt:
There are a lot of private equity firms entering the healthcare market due to the demographic tailwinds and overall positive outlook for the sector, so our advice for management teams would be to look for a partner with prior healthcare investment experience that truly understands the business, the industry, the payor dynamics, and not only the potential opportunities, but also the potential pitfalls, as the partnership between management and the private equity firm is truly tested when it hits the proverbial bump in the road.
Patrick:
There is an incredible amount of capital and M&A interest where a high-quality healthcare company will always have options. Fundamentally, an owner has two options: (a) sell to a strategic buyer and become a small part of a large platform, or (b) sell to a financial sponsor and be the platform. Those are two very different types of deals, so it is best to do some soul-searching prior to launching a sale process about what you really want to accomplish and then targeting one of those two options.
“Obviously every owner is looking to maximize the value for their company, and that should absolutely be a priority when looking for a partner. But do not underestimate the “fit” aspect of the selection process.”
Patrick Watkins
Are there any considerations that such companies should make when selecting the right partner in this market?
Matt:
Price is incredibly important and all firms realize that, but it’s very important for sellers not only to look at the economics of a transaction, but also the various buyers’ long-term track records and the people with whom management will be working for the next several years, as that period can either “fly by” or feel like a lifetime.
JJ:
A crucial piece of advice for groups looking to raise capital is to understand the strategy, capabilities, and investment style of the new partner - and to compare that with their desired outcome from the investment. There is a wide range of investment structures, all of which have different impacts on corporate governance, operations, go forward growth strategies, and eventual exit paths. When management teams and shareholders are at odds regarding some of these fundamental concepts, it can create friction and inefficient performance. Northlane’s strategy is to partner with industry leading companies and excellent management teams, aligning incentives to accelerate growth and build value. We do not make an investment unless we are aligned with management on the go forward strategy.
Patrick:
Obviously every owner is looking to maximize the value for their company, and that should absolutely be a priority when looking for a partner. But do not underestimate the “fit” aspect of the selection process. You will be interacting with this person or group constantly through weekly calls, quarterly board meetings, acquisition diligence, new location openings, new leadership team hires, etc. Not to mention that you will often retain some amount of equity in your company, and you are looking to maximize the value of that “second bite at the apple” as well. Ensure that diligence is a two-way street when evaluating strategic options, and make sure you select the right “fit”.
About Our Participants
Patrick Watkins, Principal
Osceola Capital
Patrick is responsible for originating, evaluating, and executing new investment opportunities, as well as partnering with portfolio companies to develop and execute strategic and operational initiatives. Patrick currently serves on the boards of Avision Sales Group, Central Medical Supply Group, Industry Services Co., and Top Gun Facility Services. Patrick's previous board participation includes Direct Travel, GKIC, Hero Practice Services, iSystems, and Tranzonic.
JJ Carbonell, Principal
Northlane Capital Partners
JJ Carbonell joined the team in 2013 as an Associate. Prior to joining the team, he was an analyst in the Leveraged Finance Group at Wells Fargo Securities. JJ received a B.S. in Business Administration from Washington & Lee University.
Matt Blevins, Partner
Clearview Capital
Matt joined Clearview in 2007 from Deloitte & Touche USA, LLP, where he worked as a Senior Consultant in the corporate strategy group in their New York office. In that role, Matt assisted Fortune 500 clients in identifying and implementing strategic initiatives in order to maximize cash flow and enhance shareholder value. Matt graduated with a B.S.B.A. in Accounting & Finance from Central Michigan University.