Leading investment bankers discussed the current market climate for healthcare investing coming out of the record-setting pace in 2021. They also shared their insights on hot sectors, growth strategies and the dealmaking outlook for 2022 and beyond. Fred Levenson, Partner & Co-Head of McDermott’s Private Equity Partner, hosted the panel, with insights from:

• Michael Dodds, Managing Director, Jefferies & Company
• Mark Francis, Managing Director, Head of Healthcare, Houlihan Lokey
• Simon Gisby, Principal, Life Sciences & Health Care Leader, Deloitte Corporate Finance
• Philip Pucciarelli, Partner, Perella Weinberg Partners
• Wyatt Ritchie, Managing Director, Cain Brothers

Top takeaways from the panel included:

1. All five panelists made it abundantly clear: in today’s fast-paced dealmaking landscape, the player who walks in with the work done upfront will walk away with a deal in hand. “When you make the first call be ready to run,” Simon Gisby said. Deals are happening faster than ever, especially with the convenience afforded by Zoom. Startups should invest upfront in consulting and strategy before starting any processes. Everyone involved in the dealmaking process should do as much work as possible upfront to show your organization’s seriousness and to prevent unnecessary roadblocks from cluttering your path to a deal.

2. Another point that all five panelists stressed is that healthcare will continue to be a strong sector moving forward. Everyone had a rosy outlook. Panelists pointed to the fact that even non-healthcare funds are looking to healthcare as a smart investment. The wealth curve has left many well-capitalized investors considering healthcare investments including family offices, companies like Google and private investors like Jeff Bezos. That’s a wide array of players in the field and so much interest is expected to keep things moving quickly and keep valuations elevated.

3. Large companies like Google and Amazon are investing in the healthcare space and their commitments will likely grow. Their involvement has contributed to creating a landscape where there is more venture capital rushing to invest in the sector than there are startups, allowing new companies to emerge at a fast rate. Entrepreneur investors are also chasing healthcare. However, many startups could be looking at coming into the space as disruptors, impacting investments in traditional healthcare providers. Ultimately, a wide array of players could create challenges. “There’s just a significant amount of capital chasing too few assets,” Philip Pucciarelli said.

4. Investors with ready capital are thick on the ground and will continue to be in the foreseeable future. “There is an endless supply of dry powder,” Michael Dodds said. Investors are getting creative and it will be interesting to see if megadeals continue. There will be plenty of money flowing in from myriad sources including buyout money, conveners, Amazon Care and other investors, creating an interesting confluence of capital. This atmosphere looks set to hold through 2022.

5. “There may be a day of reckoning coming in the next few years,” Wyatt Ritchie said. If the debt markets crack, valuations could come down. Rising interest rates and the ripple effect of the conflict in Ukraine could also impact valuation and dealmaking. Inflation is the biggest risk as it will increase expense ratios and that can impact valuations. However, none of these factors is expected to have a devastating impact, and the private equity market isn’t likely to see a sea change.

6. The landscape has changed for prospective buyers with the emergence of a wave of European investors on the scene. With insufficient deal flow in Europe, many funds are incentivized to deploy more capital in the US than in Europe. The fact that partners in the US are paid on a US waterfall instead of a European waterfall is a factor that creates incentives to do more and bigger deals in the US. The way that European players make deals could also influence the dealmaking landscaping, changing processes.

7. “Ask yourself, how do you buy time, how do you save time in a process?” Mark Francis posed, in order to emphasize where everyone’s focus should be going into first- and second-round negotiations. CEOs and CFOs cannot sit any part out and must make time to get the pulse of PE investors, understand what family offices think of their space and seek feedback with consultants. This gives their companies an edge. Doing the legwork in early cycles, maintaining strong interpersonal and intercompany relationships, and having your ducks in a row before you start any process is the path to victory.

In this session, Ian Schwartz, Partner and Head of McDermott’s Investment Funds Practice, moderated a discussion that explored fundraising strategies and transaction structures that optimize liquidity and long-term returns from private equity funds’ strongest assets. Session panelists included:

• Rob Campbell, Managing Director, Co-Head of Americas, Intermediate Capital Group
• Tim Fitzsimmons, Managing Director, Lorient Capital
• Garrett Hall, Managing Director, Secondary Investments, AlpInvest Partners
• Ryan Rohloff, Senior Managing Director, Evercore

Top takeaways from the panel included:

1. To help ensure that the audience was speaking the same language, Ryan Rohloff offered a brief description and overview of continuation funds and why they have become so popular in recent years. “A continuation fund, effectively, is a better mousetrap than doing a fund-of-funds sale or selling one of your best companies to another sponsor. You take an asset of any vintage and move it into a continuation fund that typically has a new lease on life from a duration perspective, follow-on capital, etc.” Rohloff also noted that continuation funds have been around for several decades, but for much of that time continuation funds were only applicable to sponsors as their funds reached 10 years old or were going into extensions. 2021 was the first year in which more than half of the continuation deals, or half of the overall market, were transacted out of funds that were six years old or younger.

2. Rob Campbell described the types of deals that his company is looking for, where they can act as the secondary player, and what they are looking for in terms of alignment with the general partner (GP): “We are very focused on alignment. We want to see evidence that the GP is a buyer alongside of us in the asset.” He also described what they don’t want to see: They are not pursuing transactions where the GP tested the M&A market and failed, and therefore pivoted to a continuation vehicle. On the other hand, the list of favorable elements that Campbell’s team looks for include a great management team in place, strong organic growth within the asset, and M&A serving as a catalyst (in the sense that the asset may have outgrown the size for portfolio construction within the flagship fund, they don’t have the dry powder to support that asset, or they’re out of their investment period).

3. Tim Fitzsimmons provided the GP/sponsor’s perspective on reasons to pursue a continuation fund rather than a traditional sale. Noting that his company operates in a smaller end of the market, he said that his company takes a two-fold approach to making the decision to pursue a continuation fund: “We look at it at the company level and at the portfolio, or fund, level.” As examples, Fitzsimmons mentioned multi-site healthcare services, clinical businesses focused on value-based care, and others, always with a view toward realigning investors for the next stage of growth and development of the company. He emphasized the importance of being clear about expectations for the next stage (e.g., duration or term of the investment opportunity, new exit strategy).

4. Ian Schwartz suggested that a continuation fund can help strengthen existing relationships between private equity sponsors and portfolio company management teams. Fitzsimmons concurred, saying “Many of these bubble up from the management team dynamic; they’re good assets and really good management teams, and as everyone knows, management teams are a leading indicator of the success of an investment.” A continuation fund allows that relationship and bond to continue. Rohloff noted that, from a process perspective, many of these transactions are relatively frictionless for management and allow them to continue executing on the plan. “These transactions allow you to provide management liquidity, reload them with a new management incentive plan, and really realign all constituents on the new cost basis, without having them go through the exercise that they would with a traditional exit.”

5. Garrett Hall pointed out a distinction between the continuation fund and M&A processes, noting that his firm spends a lot of time speaking with GPs in order to get a sense of the quality of the business so they can de-risk the process and build collaboration. Campbell underscored the importance of frank, early discussions so that investors can be pointed to appropriate opportunities and transactions that satisfied all players. Hall reiterated that multi-asset deals are much easier to negotiate and close than single-asset deals, and that secondary market demand is much deeper for the former—therefore, you should think more holistically and package multiple deals together, rather than pursuing a series of one-offs.

6. Fitzsimmons noted that healthcare has always been a specialist strategy and must respond to unique regulatory and other dynamics. That said, he added that the market is jam-packed, including new funds, spinouts, re-ups and more, so limited partners (LPs) are feeling strained right now. The public markets are likely to have an effect on fundraising and capital availability, and many LPs are waiting to see how things play out. Hall suggested that people open their minds to the new ways that capital is raised today (blindfold capital, secondary capital, etc.) and that these methods operate on different cycles. Continuation fund opportunities are worth exploring and, as Schwartz concluded, the area is only going to grow.

In this session, Stephanie McCann, Partner and Co-Head of McDermott’s Finance Practice, led a wide-ranging discussion of critical strategies for investors to consider as they seek sources of capital to finance healthcare deals. Session panelists included:

• Javier Casillas, Chief Credit Officer & Managing Director, WhiteHorse Finance
• Matthew Evans, Managing Director, Head of Healthcare Finance, Monroe Capital
• Scott Gallin, Partner, Linden Capital Partners
• Aman Malik, Managing Director, HPS Investment Partners
• Bryan Rupprecht, Managing Director & Head of Healthcare, MidCap Financial

Top takeaways from the panel included:

1. Although 2021 was not without its issues, the first quarter of 2022 has already provided a long list of challenges for healthcare markets: geopolitical uncertainty (including US and global sanctions on Russia), rising interest rates, increasing prices for energy and other goods and services, ongoing COVID disruptions and the LIBOR transition, to name just a few. Despite the expected bumps, Scott Gallin noted that his company is “absolutely expecting 2022 to be as busy as the last couple of years have been.” With many companies coming to market, Gallin noted, “we are fortunate that healthcare, despite all these macro-pressures, is still pretty resilient.” He added, “We just have to incorporate those macro-vectors into our models to ensure that we are doing sound underwriting.”

2. The energy industry may seem distinct from the healthcare industry, but, said Aman Malik, rising fuel prices will have an impact on certain activities such as home healthcare services. “Reimbursement doesn’t flex up immediately,” he noted, it is typically set at the start of the year. Regarding inflation, Malik said “If you have interest rates go up by a point and you have growth slow down a little bit, you’re going to be in a world where interest payments and everything could be [an issue].” On the subject of rising wages, Bryan Rupprecht said, “I would emphasize that there are certain subsectors—say, skilled nursing homes—where the model literally is not going to work. Wages are such a high percentage of the total costs that, when the pandemic is over and they stop getting the increased payments from the government and they have this new cost structure, every nursing home in the country is bankrupt.”

3. Stephanie McCann noted a number of issues underwriters must consider, including timing and diligence, loan to value (i.e., purchase price), sponsor-backed versus non-sponsor-backed options, sector/industry differentiation, and asked the panelists for their thoughts. From an investment committee perspective, Javier Casillas said, “Aside from obvious credit criteria, we are focused the enterprise value of the firm and its resilience and sustainability.” Rupprecht added, “What’s unique to today, relative to history, is the COVID bump stuff. Every company that we invest in that’s doing super well, the management teams and the equity firms are saying that ‘this is the new normal,’” while the companies that are not doing well, “say ‘This is a COVID hit and we’re going to bounce back as soon as COVID is over.’”

4. McCann posed a question about EBITDA adjustments and company valuation and wondered if the panelists gave any consideration to whether the company is sponsor-backed or non-sponsor-backed, and whether there was any leniency for sponsor-backed companies. Casillas pointed out that there is now a third category: independent sponsors. “We find that to be a very fruitful and interesting place to play. You have a lot of institutional sponsors that have spun off funds that have very smart and experienced people who are buying companies, and there’s good business there and there are good fits—we are very actively in that market.” Matthew Evans noted that, “At the end of the day, if you have the majority of your underwritten EBITDAs in adjustment, there still needs to be cash flow at some point.” He said that his firm is looking “at 13-week cash flows at a close to make sure we’re going to have cash to service the debt.”

5. When asked about a growing tendency for lenders to go “capless,” Rupprecht noted that a large majority of deals have no covenants. “These companies are going to run out of money before they trip a covenant,” he said, “that’s just the straight-up reality. What we try to do is keep the revolvers small, because a) they’re extremely expensive for us, and b) when you run out of money, we don’t want you to go hit a $40 million revolver and just keep bleeding this company for the next two years because I know you’re not going to trip the covenant.”

6. At the mid-cap level, said Rupprecht, regulatory enforcement and qui tam issues have traditionally been a major concern, but that this was not unique to the healthcare environment. The big challenge today, he said, is “trying to figure out what is the new normal.” He mentioned telehealth as something that is here to stay, but added that this wasn’t true of all companies that experienced revenue growth during the pandemic. Gallin elaborated on the new normal and questioned whether some of the changes in consumer behavior are a result of the pandemic only, or because of better marketing or information sharing. Evans noted that underwriting processes have accelerated and that deals are being negotiated very quickly—a compression of timeframes that makes it very difficult to conduct appropriate due diligence, and an issue that doesn’t appear to be going away very soon.

The kick-off session of HPE Miami 2022 focused on the latest trends causing the most disruption in healthcare investing and forecasted what the healthcare investing landscape could look like moving forward. Ira Coleman, McDermott Partner & Chair, moderated the panel featuring insights from:

• Alex Albert, Founding Partner, Patient Square Capital
• Alex Carles, Managing Partner & Co-President, Wellspring Capital Management
• Paige Daly, Partner, Harvest Partners
• Jeremy Gelber, Senior Managing Director, Centerbridge Partners
• Curtis Lane, Founder, WindRose Health Investors & Founding Partner, MTS Health Partners

Top takeaways from the panel included:

1. Burnout, staffing shortages and inflation are creating continued pressure. The threat of employees leaving the workforce should be a top-of-mind concern for investors, Alex Carles noted. “We’ve never seen a greater need for really sophisticated human resources performance to both recruit talented individuals and also to manage through this compression.”

2. Private equity sponsors are uniquely positioned to offer support and leadership around talent management issues. “During the pandemic, a lot of us built up some muscles around employee support networks, really trying to think about ways that we could make sure that we were building companies that people were excited to say they worked at and that they were proud of,” Paige Daly said. “One of the things that we think about a lot on the private equity side is how we can use our lens looking across companies to share capabilities, strengths and innovations.”

3. Participating in companies that are making a meaningful difference in patients’ lives is increasingly important. “There’s an incredible war for talent, and at every level we’re seeing not just challenges with compensation, but a real demand to be part of something that’s having an impact,” Alex Albert said. “As private equity healthcare investors, we do this because we think we can improve patient lives.” The adoption of remote work arrangements during the COVID-19 pandemic has facilitated this focus on impact,” he said. Five years ago, having a management team located in different offices might have signaled instability, but today’s more flexible work arrangements can help gather the best talent available with a strong focus on mission.

4. The robust pace of healthcare investing activity seems set to continue through 2022, even amid current geopolitical uncertainty. “The good news for us is that healthcare is always there and it is always changing,” Curtis Lane said. “There are always transactions to do—to build out a portfolio company, to add to a portfolio, to sell out a portfolio. That’s always going to be there, particularly with the amount of capital that’s behind the industry.” While appetite for transactions remains strong, there is some question regarding pricing trends, Lane said. The market has shifted in the past three to six months, Daly agreed, resulting in a greater emphasis on business model fundamentals and likely a reversion to more traditional ways of valuing businesses. “That’s a big change that’s going to create business model shakeout and opportunities on the investment side,” she said.

5. As healthcare services companies consider going public, management teams must be realistic about the related operating challenges. Many healthcare companies that went public between 2019 and 2021 haven’t performed as well as expected, Jeremy Gelber said. “A lot of them just didn’t remember that you actually have to be able to forecast your business in a granular or quarterly way, and hit your numbers or exceed your numbers,” he said. “That takes a lot of infrastructure and it takes the right, predictable business model.” A management team may be highly talented and producing well, but operating effectively as a public company requires an additional core skillset.

In this segment, Alex Clavero and Bernie Grondin, partners in McDermott’s Healthcare Services Private Equity Practice, moderate a discussion on the demand drivers, challenges and investment opportunities in the current landscape of the behavioral health services sector.

Participants

• Alex Clavero, Partner, McDermott Will & Emery
• Bernie Grondin, Partner, McDermott Will & Emery
• L.A. Galyon IV, Managing Director and Partner, Brentwood Capital Advisors
• David Peterson, Managing Director, NMS Capital
• Kiel Rager, Founder and Chief Executive Officer, InBloom Autism Services

Key Takeaways

• Growth of the behavioral health sector is gaining momentum, as providers strive to meet rapidly increasing demand for behavioral health services. Competition for clinical staff has been and remains one of the biggest challenges across the numerous specialties that fall under the “behavioral health” umbrella. Given the shortage of clinicians compared to the demand, providers and payors have started to focus on new models to deliver treatment.
  • Demand in the autism sector, for example, can be attributed to a higher prevalence of children being diagnosed with autism today than in the past. In the current market, it is estimated that only 30% of demand is being met. The biggest challenge to optimizing outcomes for kiddos (the autism sector’s term for pediatric patients) is the competition for high-quality staff. Payors are starting to focus on new models to deliver care to kiddos, including parent-led programming, a model in which providers are, effectively, training the parent to provide the services, given the lack of clinicians to meet demand.
• In the mental and behavioral health sector, there are a number of challenges that arise in the context of the traditional third-party payor model. Chief among these is a general lack of access to the mental health system. With a community-based care model, these challenges could be addressed by providing a more comprehensive approach to treatment and reimbursement.
  In the current mental health landscape, the majority of outpatient psychiatrists do not take insurance, which is a product of the reimbursement rates for covered services and the types of services covered.
  • At current reimbursement rates, there are few psychiatric practices that can make money at the gross-profit level. To the extent insurance plans have in-network providers in a geographic area, the wait to get an appointment with one of those providers is often too long (ranging from months to years), leaving patients with out-of-network care as the only timely alternative. Furthermore, the system in place today is set up to provide acute care to psychiatric patients while they are at a facility, but not after they are released. In most other aspects of medicine, a patient receives acute care during their stay at a hospital and receives stepped-down levels of care after discharge. Psychiatry does not have an equivalent model, with inpatient acute care provided at the facility and stepped-down care delivered once a patient is released, which makes it difficult for such patients to see lasting or meaningful improvements.
  • To address these challenges, payors must be educated on the need for better reimbursement and more thoughtful approaches to utilization and authorization. As an alternative service model, a community-based care approach takes a longer-term view, helping coordinate between acute-care providers and the therapists, counselors, social workers and other professionals who support patients in their efforts to achieve stability in daily life following acute-care treatment. Thus, there is an opportunity to be an early mover in the less-acute care segment of the industry and—by using a mix of telehealth, mid-level providers, ancillaries and other modalities that will be covered in-network—to create a scalable model.
• The increased prevalence of employee assistance programs (EAPs) in recent years has been a contributing factor in the rising demand for mental and behavioral health services, and has also presented a service model that has attracted considerable investment.
  • On the mental health and addiction-treatment sides of the industry, particularly during the COVID-19 pandemic, there has been an increase in care provided, whether through an increased number of employers offering EAPs and/or similar benefits, more employees utilizing those resources, and the proliferation of mental health clinics and mental health support.
  • Mental health has become one of the top five reasons for staff resignations in the behavioral therapy space since 2020, which underscores the importance of the new role of EAPs from a provider/operational perspective. Some companies are implementing EAPs that provide unlimited access to telehealth psychology appointments, even if they do not have insurance through the company. Given how much companies are now spending on EAPs to provide mental health and wellness resources outside of traditional health insurance, EAPs present an interesting opportunity in response to both the shortage of behavioral and mental health services covered by insurance, and the general shortage of clinical providers.