David Ivill, Felicia Perlman, and Andrea Zazulia, McDermott Will & Emery LLP06.06.23
It has been a challenging start to 2023 across all sectors of the U.S. economy, including in the historically recession-proof healthcare space. Healthcare investing and overall deal activity have slowed from the frenetic pace of activity seen throughout 2021 and into Q1 2022, thanks to economic headwinds such as inflation, interest rate hikes, recession fears, and geopolitical uncertainty. Against this backdrop, healthcare companies and investors are reframing their expectations for the year ahead. Opportunities remain for companies willing to step outside their typical investment spaces, get creative with deal structures, and keep an open mind to distressed assets.
Price, speed, and certainty are fundamental to making prospective buyers stand out, followed by experience in the sector and relationships. However, this is complicated by heightened risks in the diligence and regulatory approval processes and a general sentiment of risk aversion. Other factors that will affect valuations in 2023 include financing, fundamentals and creativity.
Given today’s debt market, creative deal structures are making a real difference in closing a transaction. Buyers and sellers have proceeded cautiously over the last few quarters because of fluctuating interest rates and limited debt financing availability. Although the hesitancy of debt providers and the uncertainty surrounding interest rates has made it harder to negotiate and conduct transactions, deals have not stopped altogether, and the market is still hot for the right targets. Parties are finding innovative ways to address valuation issues, including using seller notes, earnouts, and creative structures that benefit all stakeholders. These strategies are becoming more common in bridging valuation gaps.
For example, certain provider services, such as physical therapy, hospitals, and large corporate and strategic businesses have suffered disproportionately, largely from upward wage pressure, burnout and turnover.
Conversely, there are plenty of opportunities in the cash-pay elements of healthcare, such as fertility services, aesthetics, and veterinary, due in part to payor rates trailing inflation. Other areas of opportunity include home health, ambulatory health, and digital health and health tech solutions that address staffing and burnout issues by streamlining workflows.
Diversification is also trending. Sponsors who previously operated exclusively in the physician practice management space are now diversifying and investing in other subsectors. This has led to a significant increase in transactions in health IT, pharmaceutical services, and technology-driven healthcare services, including revenue cycle management, educational training, and staffing. Transformative transactions are indicative of—and a further driver for—rethinking healthcare, including as a great deal of optionality for investors.
Distressed transactions continue to increase in frequency. Precursors for distress, including divestitures, will become more common, particularly on the hospital side. Private equity can often solve for distressed businesses in attractive sectors because of a weak balance sheet or poor management.
In determining whether to invest in a distressed healthcare company, it is important to conduct sufficient diligence and analyze (1) existing and go-forward liquidity issues, as well as additional capital needs; (2) current liabilities and whether they can be disposed and (3) the company’s existing capital structure. Investors will want the restructured company to be successful on its own following the proposed transaction, and every dollar counts—so understanding the company’s cash flow, liabilities, and capital structure at the outset is essential. Additionally, healthcare is a “people business” at its core, and there is a certain standard of care that must be maintained regardless of how the transaction is implemented. As such, distressed investors must determine whether the company is able to maintain patient care continuity, both while the transaction is implemented and following consummation.
It is critical for any potential investor to evaluate the distressed company’s existing management to determine whether to maintain the same team or bring in new management to fix existing issues. Analyzing how the company became distressed in the first place can facilitate this evaluation, including determining (1) whether current management took missteps, (2) whether current management can be trusted or properly incentivized to implement the proposed process successfully in good faith or (3) whether a new management team is necessary to facilitate the restructuring process.
David Ivill is practice area leader for the Healthcare Private Equity practice at McDermott Will & Emery LLP. He has built a strong profile in advising private equity clients active in the healthcare market, both in New York and nationally. He is a highly sought-after advisor providing innovative and insightful advice on operational and management issues in the context of complex regulatory frameworks. David has extensive experience in the regulatory issues affecting the provision of healthcare services, particularly with respect to both hospital mergers and acquisitions and large practice group mergers and affiliations with hospitals in New York state. Prior to practicing law, David was a podiatric surgeon.
Felicia Gerber Perlman is the global head of the McDermott Will & Emery’s Business Restructuring Practice Group. She focuses her practice on complex business reorganizations, debt restructurings, and insolvency matters, advising debtors, creditors, lenders, investors, sellers, purchasers, and other parties-in-interest in all stages of restructuring transactions, from Chapter 11 reorganizations to out-of-court negotiations, workouts and acquisitions.
Andrea Zazulia is a partner in McDermott Will & Emery’s Healthcare Private Equity practice, advising clients through the full lifecycle of complex transactions, including M&A, private equity investments, restructurings, and transformational ventures. She has advised on transactions in various specialized areas, including dermatology, ophthalmology, and radiology, and brings a nuanced understanding of healthcare clients’ practice-specific needs to her transactions counsel. Andrea is also experienced in providing regulatory and due diligence advice to clients as they navigate compliance issues at the federal and state levels.
Creativity as a Differentiator
While strong businesses continue to sell at a premium price despite the economic headwinds, there are now fewer of those businesses compared to a year ago. The current market largely consists of buyers and sellers with a business need to conduct deals (due to economic conditions or otherwise) and best-in-class acquisition targets. Strategic buyers have become bifurcated, with large retail pharmaceutical companies, retail care companies, and similar strategic buyers continuing to embrace the risky environment while others pull back.Price, speed, and certainty are fundamental to making prospective buyers stand out, followed by experience in the sector and relationships. However, this is complicated by heightened risks in the diligence and regulatory approval processes and a general sentiment of risk aversion. Other factors that will affect valuations in 2023 include financing, fundamentals and creativity.
Given today’s debt market, creative deal structures are making a real difference in closing a transaction. Buyers and sellers have proceeded cautiously over the last few quarters because of fluctuating interest rates and limited debt financing availability. Although the hesitancy of debt providers and the uncertainty surrounding interest rates has made it harder to negotiate and conduct transactions, deals have not stopped altogether, and the market is still hot for the right targets. Parties are finding innovative ways to address valuation issues, including using seller notes, earnouts, and creative structures that benefit all stakeholders. These strategies are becoming more common in bridging valuation gaps.
Hot Subsectors in the Current Market Dynamics
Changes in market dynamics are creating opportunities for new healthcare subsectors and driving sponsors to diversify their platforms. Healthcare services continues to be a complex, multifaceted industry that encompasses a broad range of services; the current environment has enabled certain pockets of the industry to experience significant growth, while other areas have been hit harder by macroeconomic challenges.For example, certain provider services, such as physical therapy, hospitals, and large corporate and strategic businesses have suffered disproportionately, largely from upward wage pressure, burnout and turnover.
Conversely, there are plenty of opportunities in the cash-pay elements of healthcare, such as fertility services, aesthetics, and veterinary, due in part to payor rates trailing inflation. Other areas of opportunity include home health, ambulatory health, and digital health and health tech solutions that address staffing and burnout issues by streamlining workflows.
Diversification is also trending. Sponsors who previously operated exclusively in the physician practice management space are now diversifying and investing in other subsectors. This has led to a significant increase in transactions in health IT, pharmaceutical services, and technology-driven healthcare services, including revenue cycle management, educational training, and staffing. Transformative transactions are indicative of—and a further driver for—rethinking healthcare, including as a great deal of optionality for investors.
Distressed Assets Present New Opportunities
Increased leverage, margin pressures, and more than $20 billion of debt coming due in the next three years are top concerns for many healthcare companies. These severe liquidity constraints are driving many to look for innovative ways to obtain additional capital, either from their existing lenders or from new financing sources in the market.Distressed transactions continue to increase in frequency. Precursors for distress, including divestitures, will become more common, particularly on the hospital side. Private equity can often solve for distressed businesses in attractive sectors because of a weak balance sheet or poor management.
In determining whether to invest in a distressed healthcare company, it is important to conduct sufficient diligence and analyze (1) existing and go-forward liquidity issues, as well as additional capital needs; (2) current liabilities and whether they can be disposed and (3) the company’s existing capital structure. Investors will want the restructured company to be successful on its own following the proposed transaction, and every dollar counts—so understanding the company’s cash flow, liabilities, and capital structure at the outset is essential. Additionally, healthcare is a “people business” at its core, and there is a certain standard of care that must be maintained regardless of how the transaction is implemented. As such, distressed investors must determine whether the company is able to maintain patient care continuity, both while the transaction is implemented and following consummation.
It is critical for any potential investor to evaluate the distressed company’s existing management to determine whether to maintain the same team or bring in new management to fix existing issues. Analyzing how the company became distressed in the first place can facilitate this evaluation, including determining (1) whether current management took missteps, (2) whether current management can be trusted or properly incentivized to implement the proposed process successfully in good faith or (3) whether a new management team is necessary to facilitate the restructuring process.
Proper Positioning Imperative for Potential Sellers
Currently, any company looking to sell in the next 12 to 18 months should begin preparing for the transaction process now and ensure they are aligned with their advisors. Organizations that do not spend enough time preparing for a transaction and understanding key value drivers often experience significant issues. Steps companies can take to best position themselves for a potential sale include (1) ensuring the company is clean from a compliance and financial perspective, (2) conducting billing and coding audits (as applicable) and completing the Quality of Earnings process early and (3) getting ahead of any potential or known issues, including addressing any labor shortages or other areas of concern that arise in the due diligence process. Companies should also consult with tax and accounting advisors regarding the organization’s current structure and take any restructuring steps necessary prior to going to market.Closing Prognosis
Dealmaking is still possible for the right partners that prioritize creativity, but timelines to close may be longer than anticipated. As parties come together and apply their unique strengths to overcome challenges, we expect to see creative collaborations and deal structures designed to deliver transformative solutions despite the year’s challenges to date.David Ivill is practice area leader for the Healthcare Private Equity practice at McDermott Will & Emery LLP. He has built a strong profile in advising private equity clients active in the healthcare market, both in New York and nationally. He is a highly sought-after advisor providing innovative and insightful advice on operational and management issues in the context of complex regulatory frameworks. David has extensive experience in the regulatory issues affecting the provision of healthcare services, particularly with respect to both hospital mergers and acquisitions and large practice group mergers and affiliations with hospitals in New York state. Prior to practicing law, David was a podiatric surgeon.
Felicia Gerber Perlman is the global head of the McDermott Will & Emery’s Business Restructuring Practice Group. She focuses her practice on complex business reorganizations, debt restructurings, and insolvency matters, advising debtors, creditors, lenders, investors, sellers, purchasers, and other parties-in-interest in all stages of restructuring transactions, from Chapter 11 reorganizations to out-of-court negotiations, workouts and acquisitions.
Andrea Zazulia is a partner in McDermott Will & Emery’s Healthcare Private Equity practice, advising clients through the full lifecycle of complex transactions, including M&A, private equity investments, restructurings, and transformational ventures. She has advised on transactions in various specialized areas, including dermatology, ophthalmology, and radiology, and brings a nuanced understanding of healthcare clients’ practice-specific needs to her transactions counsel. Andrea is also experienced in providing regulatory and due diligence advice to clients as they navigate compliance issues at the federal and state levels.