M&A activity in the healthcare space has slowed since 2022, but with stable interest rates and creative deal structuring, M&A activity should increase going forward.

Host Geoff Cockrell is joined by James Heidbreder, managing director in Fifth Third’s Healthcare Investment Banking group, to discuss challenges faced in healthcare M&A since 2022, the factors leading to an uptick in healthcare M&A activity, and how balancing scrapes, income repair, and other factors can lead to more M&A deals being made. Tune to learn how healthcare M&A, especially in middle markets, should be on the rise for the rest of 2024 and into 2025 and beyond!

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Corner series, a McGuireWoods series exploring business and legal issues prevalent in today's private equity industry. Tune in with McGuireWoods partner, Geoff Cockrell, as he and specialists share real-world insight to help enhance your knowledge.

Thank you for joining another episode of The Corner series. I'm your host, Geoff Cockrell, a partner at McGuireWoods. Here at The Corner Series, we try to bring together deal makers and thought leaders at the intersection of healthcare and private equity. I'm thrilled to be joined by my good friend, Jamie Heidbreder, at Fifth Third Healthcare M&A.

Jamie's a managing director and has helped many, many buyers and sellers navigating the landscape of doing M&A transactions in healthcare. Jamie, maybe you could give a quick introduction of yourself and Fifth Third Healthcare M&A, and then we can jump into some discussions of the current healthcare M&A trends and climate here in the mid-part of 2024.

Great, thanks Geoff. I appreciate the opportunity to be on this podcast. I've certainly been at admirer for a long time. So I'm Jamie Heidbreder. I'm, as you mentioned, a managing director at Fifth Third Healthcare. I've been a healthcare M&A banker for almost 25 years, most of the time or almost all the time, focused on healthcare services M&A, but across a range of different sub-sectors.

I live in New York City, work in New York City healthcare at Fifth Third, we have about 30 healthcare M&A bankers that cover the spectrum of healthcare services. So we have a sizable team that covers real estate, sizable team that covers hospital systems, and sizable team that covers a range of other sub-sectors from multi-site to post-acute to healthcare IT, et cetera, et cetera. So we're a scale group within Fifth Third, and again, excited to be here today.

So Jamie, when I talk to people and they ask me, "How's the M&A market been in healthcare provider services?" I always say it's been a little choppy. Some things are getting done, some things are not. There's a number of headwinds, there's still a number of tailwinds. What do you think the market looks like here in the midway point of 2024?

We spend all of our time focused on what we call middle market healthcare services M&A, which can mean a lot of different things. People can define that differently. And one of the hardest parts of citing where the market is, where it's been and where it's going, is just how do you get really good data on middle market M&A? And it can be challenging because these transactions are generally all private. And by definition, by their nature, they're not supposed to have information that is knowable to discern deal trends where valuations are going, et cetera.

That said, when we think about the market, we think about middle market healthcare services, and there are organizations that aggregate data for this purpose. And so folks like PitchBook and GF Data, Healthcare Dealflow, which is aggregated by one of your competitors and one of ours, Irving Levin, the deal flow that we're working on and other types of sources are all imperfect, but together can paint a picture as to the overall status of the market. And while the market has been challenging since the second half or maybe the second quarter of 2022, there are reasons to believe that it is hit an inflection point and it will start to pick up and has started to pick up throughout 2024 and into 2025. And I'm happy to expand on that.

Yeah, I'd love to hear how you're handicapping some of the headwinds, whether that is maybe more optimism around interest rates coming down, optimism around labor markets, which impacts provider services in particular. What is kind of shifting the landscape?

Yeah, so think about 2022, in March of that year, interest rates started to pick up to move up. The Fed started to increase rates. That has been the most meaningful driver of the slowdown in the middle market M&A world. A lot else has been going on, whether it's global things going on in Ukraine or the Middle East, or domestic macroeconomic headwinds like the supply chain disruption or labor cost challenges like you just cited. There's a lot more than just the interest rates that have constrained M&A over the last couple of years, but the interest rates increase has been a significant driver of slowdown. And there are reasons to believe that that dynamic has played out enough where people are now accepting of the new norm.

Interest rates now suffers in mid-fives and probably isn't going to go up much more at all and likely will come down at some point. And there are some real important themes and dynamics in the financing markets that lead us to believe that there's a real favorable environment for financing transactions. And so that, we think, is going to coupled with the long-tenured nature of some of the deals that have not yet gone to market. We think that's going to really start to accelerate M&A as a go forward matter, and I'm happy to be more specific about some of the things we specifically monitor.

Yeah. Do you think that some of what makes M&A more feasible, I know it helps that interest rates have stabilized, but do you think that sellers have acquiesced to the pricing implications of those rates?

We do. When you talk about sellers, let's bifurcate into sellers that are physician, family and entrepreneur-owned, and sellers that are owned by private equity firms that can have more pressures to think about when to sell assets. But going back last year around this time, we did an analysis of the large consolidators across healthcare services. And so we looked at a couple of dozen companies that are all have term loan Bs the trade, and then are all reported on by Moody's and S&P.

And so these are businesses in the physical therapy space, the dental space, vet, behavioral health, hospital staffing, et cetera, et cetera. And if you look at the analysis of where their term loan Bs were trading and where their debt levels were at, it was pretty negative. So a lot of these businesses, and I won't mention specific company names, but a lot of these businesses had their term loans trading at 60, 70 cents on the dollar.

A lot of these businesses took on full leverage when they got their buyout done, call it at six or six and a half times. But because of the labor issues that you cited, because of the interest rate increases because of their debt is generally floating rate, that six to six and a half times leverage profile spiked to 9 or 10 times. And a lot of the cashflow that these businesses generated was not driving growth, it was going to service debt, and that really constrained the M&A markets. That was one element of what really constrained M&A markets quite dramatically.

You fast-forward here to July of 2024, looking at those same companies, there's been quite an improvement where their loans trade and where their balance sheets are. And part of that is because if a business had 8 or 9 or 10 times levered and was challenged to refinance and extend those maturities out or otherwise improve their balance sheet, the financing markets today are about as good as they've been in the last five or six years.

And that has enabled a lot of the businesses that were constrained by their financial situation, we're constrained by their over-levered balance sheets, to refinance and to improve their profile so that they can go back to the market and continue to be aggressive from a growth perspective. And we've seen that across the spectrum of healthcare services consolidators, and that manifests itself to an improvement at some level in the middle market M&A sell side environment.

I can see the improvement in balance sheets of those large consolidators. One of the questions I still have, is what the business proposition for those very large consolidators is, and who do they sell to or those terminal ownership positions? How would you describe what the game plan is for the largest consolidators?

Yeah, so at some point, these businesses get large enough where there are only so many private equity firms, only so many Canadian pension funds and other types of large institutional buyers to buy them. At some point, you'll see that across healthcare services, whether it's large physician practices in eyecare and GI, dermatology, et cetera, whether it's in physical therapy or dental, at some point it's going to be difficult to continue to trade these to the next private equity firm.

And at some point, there'll be an acceleration of IPOs and other exits, public exits for these businesses. We're already hearing one of the largest dental businesses in the country, a very high profile name. I'd hired an advisor to go out and find a buyer, and I don't have the specifics as to the interest they received or didn't receive, but I was told at a conference last week that that business is now pivoting toward exploring a public offering. And that's not novel. The idea of these large dental businesses going and finding public exits has been something people have been talking about for years, and it's not just dental. But at some point, Geoff, the businesses get large enough where you're going to have to look for a public exit.

The other side of that, we worked on a transaction a couple of years ago in the GI space where we sold it to a urology consolidator, which at the time and still is, was a very novel transaction. Two very successful, large, single specialty businesses came together to create a urology GI consolidator. And I think at some point, with some of these PPM models, not all of them lend themselves to combining with each other, but at some point you're going to start to see some of the PPM models from different specialties coming together to drive scale, to leverage ancillaries and so forth. And you haven't seen a significant amount of that happening yet, but at some point, because of the size that some of these they're going to get to, are already at, I think you're going to see an acceleration of that as well.

What do you see happening on the antitrust front? That's another area where there's been headwinds. Some of the rhetoric coming from elected officials has been pretty dark and I think pretty excessive and painting with a wildly overly broad brush. Do you think that some of the level of heat around that will die down and that'll become a little bit less of a headwind, or how do you see that playing out?

I hope so, and I think so. You are seeing a real acceleration of headlines coming from federal and state regulatory bodies around the role of private equity investment in healthcare. I do think that that, at some point, hopefully is transient. You saw if you've been doing this long enough, have been in the healthcare space long enough, you'll know that the PBM industry has been under a negative microscope from the beginning almost, dating back to the '90s and 2000s. And just this last couple of weeks, you've seen the PBM industry under a negative spotlight again.

There's always going to be concern that the healthcare industry is not focused on clinical outcomes first and foremost, that people are trying to make money off healthcare at the expense of clinical care, the expense of patient care and patients' ability to fund care. But I do think that the value of private equity in healthcare is immeasurable.

If there is a sector of the economy that needs innovation, that needs efficiency, it's healthcare. It's particularly healthcare services. And the industrial logic around the rapid consolidation of some of the PPM models over the last dozen years hasn't gone away. While there's a headwind in PPM world today, there's a cloud over the sector, there is significant benefits that private equity has brought. And I think that you're seeing a lot of regulatory noise, that again, I hope is transit because if that was curtailed, it would take away from a lot of the efficiencies that private equity actually is driving to the industry.

And one more thing I'd mention, it was pretty interesting last week, PitchBook issued a report entitled Quantifying PE Investment in Healthcare Providers, which is just one report, one journalist's view of the world, but it was a very well done, from a data perspective, report that talked about PE backed providers represent less than 4% of US healthcare provider ecosystem by revenue. It's a lot more data in that report, but I just wanted to highlight that it's overblown to say private equity is dominating the healthcare providers and it's been the largest force within that. It's the hospital systems that are. Private equity has been a consistent force, but it hasn't been an overwhelming large force relative to other stakeholders within healthcare.

Maybe pivoting a little bit to kind of where you're seeing a lot of interest from buyers, private equity investors are always looking for the new angle or the new area, maybe for consolidation, maybe for avenues for investing in value-based care. What do you see as the new areas of interest coming here into the second half of 2024 and beyond?

There's one area that seems to be getting a lot of attention across the healthcare ecosystem as far as where investors are looking to uptick their investments, and that is pharma services. It's an area that's been around for a long, long time. I believe there's a very fragmented end market at some level within pharma services. I know from many conversations, it's an area of real increasing focus by the investment community.

That said, I would say there's a reason why it's never been an outsized area of investment for the private equity community, at least in the middle market. While there are endless number of companies that get put under the pharma services banner, outsource companies, clinical services, consulting, manufacturing, distribution, a lot of them have concentration risk in the middle market, just because of the large pharma companies that inform their customers. A lot of them are very global, which is a different investing mentality and skillset for middle market investors.

And there aren't, as a relative matter, that many middle market companies that exist within that ecosystem. There's a lot of smaller companies and a lot of bigger companies, so there's a little bit of a barbell effect. So, I think you're seeing a lot of people pivoting toward pharma services. I think there's going to be a lot of good investments, a lot of opportunities to make there, but I don't want to overstate it to say it's going to become the new PPM of the new provider services. I think it'll be an increasingly important area for investment.

But I do think that despite all of the headwinds over the last 18, 24 months, that provider services still is the largest end market for private equity investors in the middle market to deploy money. That was in 2021, '22, '23, and this year to date. So, it's got headwinds, it's got clouds over it. There has been a slowdown, but it still is a disproportionately large end market for investors. I don't think that's going to change, getting back to my comments around the reason why it accelerated so dramatically, which is the importance of consolidation and professionalization of very inefficient end markets with the provider universe.

Within the arena of investing in provider services platforms, I have endless conversations with investors and practices themselves about how to think about alignment between private equity investors and providers. As you're advising people in the sell side context, and let's think about it from the perspective of if you're representing a group of providers, so maybe a group of physicians that have built a platform or practice of sufficient size. When you're advising them, how do you advise them to think about economic alignment with a private equity fund, both from the perspective of compensation structures and from the perspective of equity ownership?

Every deal, I know this is cliche, but every transaction is completely unique for the next, but I think the theme of, for a lot of physician practice deals where there are a number of physician owners of a practice, the EBITDA is generally created by what they call compensation adjustments. So the doctors agree to take less compensation going forward than they have earned looking backward, and that creates the EBITDA that an investor invests in.

I think there's going to be more focus on smaller adjustments, to put less money in the pocket of the physicians, but still allow them some liquidity, but it has them more focused on ongoing income as well, that is closer to what they've learned historically. I think we're talking to a lot of practices over the last period of time around higher levels of equity roll forward.

And so again, every deal is different, but if there's a rule of thumb that a transaction has 70% cash and 30% equity, I think we're talking to more of our clients around, "Hey, to drive alignment, you may need to have 35, 40, 45% equity in the business." And there are a range of different structures, particularly in dental, as I reflect, that allow for JV models to be created below the parent, that align better the local practices with the corporate entity. And they take on a lot of different forms, but I think there's more of that likely to be seen in other areas of provider-based investment beyond just dental, where so far we've seen most of it in the dental space.

Yeah, the JV model, where the equity is owned closer to the practice where the provider works, has been a real differentiator of dental platforms that have done well versus those that have structured. Replicating that sort of structure in other provider sectors can be difficult from a regulatory perspective, where you've got multiple sub MSOs connected to multiple practices where there's a strong desire to have those practices kind of referring between each other. That can be a real challenge. And so replicating those dynamics can be a bit tricky.

It's interesting to hear your take on maybe limiting the scrape, 'cause I'm having those same conversations. And like you said, it had become cliche to say that 30% scrape is the tolerable line of how much you could have a reduction in provider compensation to create the EBITDA for the sale transaction. Anymore, as I'm having these conversations with buyers, they're also really challenging the idea that a 30% scrape creates a stable business. Or much more now looking at the boundaries of how much compensation can be reduced in the context of a transaction, needs to have some guardrails where the main guardrail is that the compensation that the doctors are going to be making on a go forward basis, that landing spot has to be competitive with other places in the market, and that if you scrape too much, you create an unstable platform.

So it's encouraging to hear that the investment banking community is also recognizing that a more stable transaction structure may be a smaller scrape, which yields a smaller deal. 'Cause the buyers that I talked to, one of their main concerns, or a concern that they articulate, is that while they think that a smaller scrape makes for a safer investment, they're worried about competing in the marketplace of buyers when other people are still willing to offer more cash proceeds. So, it's encouraging to hear that that messaging is kind of coming from every direction.

That is a shift in the market that has happened, for sure, in the last couple of years. So, I can think of several examples, one in the plastic surgery space, where there was a scrape that was in the high 40%, and that was done by, what I understand, that was allowed by the investor to be able to win the deal. So the physicians had the power, so to speak.

A recent deal that we just announced had a scrape of 20%, and that was done because both the physicians and the investor both thought that was the right place to scrape for the purposes of achieving the goals from both sides' perspective, and it was a very successful outcome. But I do think that the idea of investors, private equity firms acquiescing to higher scrapes than they normally might to win a deal, those days are over.

What's your view on the evolution of comp models? That for a while, the darling of the industry were these income repair models, where the gist of it is, yeah, you're going to get a scrape, but on a go forward basis, your comp is going to be based on profitability. And the expectation is that profitability is going to increase over time as you expand the business, as you maybe tuck in acquisitions into the practice, and that income could be repaired. That income repair has been more difficult to deliver. And for a while, bankers in particular were very insistent that they wanted to see heavy income repair or EBPC models. Do you think that people are being a little bit more circumspect about what kind of income repair they can expect, and maybe that's playing a lesser role in how providers are thinking about comp models?

Every deal we've done, and we've been very active across a lot of the PPM specialties, the buyers, the consolidators, the sophisticated PE-backed consolidators that we've sold to have always had a very difficult time quantifying income repair. Give us a blinded case study, private equity firm, around how this has worked either within the platform that is buying my client or across other platforms that you've invested in. And it's just been a very difficult thing for folks to prove out. And not to say that income repair doesn't happen, it hasn't been successful in various geographies, various specialties with various practices, but it's been a difficult concept to prove out at times, and I think that's something that is still the case.

So income repair is still an important theme, but when we advise our clients, it's one of the many components that inform who is the right partner for our client. It's the personalities that they're going to be working with. Not so much the PE folks, but the actual management teams of the businesses that are buying them. It's the vision for growth, it's the clinical vision. It's a lot of things like that that inform, "Hey, is this the right fit?" Of course, economics are going to be an important part of that, but there's a multitude of important criteria that we advise our clients to really think through. And every deal, every client has a different priority of what those criteria are.

So income repair is on that list always, but it's not always near the top of the list. And part of it's because it can be difficult to prove out. And I think a lot of physicians, not because we're advising them this way as such, but a lot of physicians think about these transactions, whereby, "Hey, if I can find the right partner, if I can grow my market with that partner, and if I can get the right economic outcome at the transaction with the opportunity to roll equity and hopefully grow that over time, income repair is a little bit of not gravy, but like gravy, whereby that would be nice to be able to do, and if we're successful intuitively, we should be able to repair our income." But it's not usually the top of list item that drives the decisions for our clients.

Jamie, I think we'll bring this to a close. We could talk about these topics forever. It's always great to chat with you. And you guys at Fifth Third are really tremendous investment banks, and you guys do a great job.

Well, Geoff, I appreciate it. Thank you for the time there. It was great to speak as well. I really enjoyed this and hopefully we'll talk again soon.

Thank you for joining us on this installment of The Corner Series. To learn more about today's discussion, please email host, Geoff Cockrell, at gcockrell@mcguirewoods.com. We look forward to hearing from you. This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in this installment.

The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.