On this episode of The Banker's Corner, McGuireWoods' Geoff Cockrell invites Raj Kothari, Managing Director at Cascade Partners, to discuss the current challenges of the healthcare investing market.

An uncertain market and disagreements on valuations have created an interesting start to 2023, which saw a decrease in transactions in the first quarter. For those looking to make larger healthcare sales, the general consensus seems to be  to wait until Q2 or Q3 and see if market conditions improve.

Raj recognizes that buyers are being more thoughtful and cautious when considering a deal. However, the lower and middle market valuations are holding up. 

“If you’re an investor, you're looking for long-term cyclical trends, and all the long-term cyclical trends say that [healthcare-related services] are going to work well,” Raj says on why he chooses to play in the healthcare sector. “If you've got a good service or technology that lowers costs or improves efficiency, and does anything to help, it's going to get more and more traction.”

Featured Guest

Name: Rajesh Kothari

What he does: Raj is the founder and managing director of Cascade Partners where he leads divestitures, recapitalizations, acquisitions, and other strategic transactions for clients in the healthcare, industrials, business services, and technology sectors. He has also co-managed multiple private equity funds and dozens of early-stage investments to buyout.

Organization: Cascade Partners

Connect: LinkedIn

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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 Banker's Corner, a McGuireWoods series exploring investment trends, solutions, and business issues relevant in today's private equity and finance 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. I'm co-chair of the firm's private equity industry group where I invest principally in healthcare transactions. And here at The Corner Series we try to bring together dealmakers and thought leaders in private equity investing in the healthcare industry and other participants at that intersection to talk through some of the current dynamics, trends and other things that we're seeing in that space.

Today I'm thrilled to be joined by my friend Raj Kothari at Cascade Partners. Cascade Partners is a phenomenal investment bank that does a lot of work in the healthcare intersection. And we're going to talk about some current investing trends, given that we're in a little bit of a challenging market. But Raj, maybe give a little introduction to yourself and to Cascade Partners.

Geoff, well thanks for having me here for your series. I've enjoyed listening to many of your guests and appreciate the opportunity. You did a nice job of describing Cascade and our work as investment bankers, helping organizations kind of go through the process of exploring what their options are, how to realize the value in what they've created, and in many cases help them figure out how to drive and continue to accelerate the growth.

We often work with physicians, as they're not really interested in moving on. They just want to figure out how to realize some value in what they've created and grow. And I have a lucky background having done a lot of work in healthcare, not just as an advisor but having served on the boards of payers as well as providers and actually done MSO as an investor and run a couple of different healthcare focused private equity funds. And the career really brings a different perspective and point of view as we're helping clients evaluate, "Hey, how do I get a transaction done and is the transaction the right thing for me and my practice?"

So Raj, jumping right in, from where I sit I see kind of a convergence that's really manifesting itself in deal activity. Convergence being some headwinds from a macro-economy level, challenges around availability of credit, and those have kind of collided into there being some lack of connection on pricing between what buyers are thinking companies are worth when they now have a higher cost of capital and what sellers think a company is worth. And that's translated to a pretty sharp temporary, is the expectation, temporary reduction in kind of the deals that are occurring. What does the world look like from where you sit and you advise a lot of sellers, and against that pricing dynamic, what do you tell folks?

If I would say it was interesting times, that'd be the most overplayed line for the last three years. So we'll avoid that and just create, there's a broader range of dynamics than we're seeing and clearly buyers are being far more thoughtful and cautious. So that's showing up in how are they evaluating opportunities, how are they approaching diligence, and how are they pricing. At the same time sellers are, "Hey, life's been going great. I heard what my friend did six months ago or a year ago. Why can't I get the same?" Not connecting with the reality. And then interestingly, deals that are getting done, particularly in the middle and lower middle market where it's an add-on and not a new platform, we've seen valuation holding up for the most part. A little bit of softness, but we're seeing much greater scrutiny on diligence and add backs and pro formas as buyers are a little worried about, "Hey, what's the economy and what's the world looking at?"

Without a doubt, I mean we work with a lot of buyers so I wish I could say I've never used the line myself, but at the same time buyers are like, "Hey, you said that my cost of capital's gone up and so we’ve got to adjust the price." And as I was joking with one of the CEOs of one of the platforms in the healthcare space that is going to be going to the market shortly, I'm like, "You're not going to let your buyers use that line." And the joke is they're not.

So there is this dynamic of there's a lot of money out there, people still have to deploy it, debt has gone through the roof, so we're seeing on the very large deals or larger deals, over $125, $150 million, we're seeing much greater pricing pressure because of the impact of debt. On the sub hundred million deals, a change in a hundred, 200 basis points of debt while it sucks and it's painful, it doesn't really change the valuation dynamics in the return profile significantly enough. But if you've got a new platform and you're large, it's much greater chance that you're going to see pressure on that valuation.

Couple things, are you seeing more kind of contingency built into how purchase prices are being framed in the purchase agreement? And how do you view that as a bridge on valuation?

So I think we're seeing folks asking for it just like we saw them ask for it right after COVID, we'll see whether they hold. I think the more sophisticated sellers or sellers with more sophisticated advisors have been able to avoid those. We've, knock on wood, been able to avoid those and are trying to avoid those. The challenge is, at least in physician practice world as an example, the market isn't growing 5, 6, 8, 10% in any specialty. So those earn outs and those contingency payments become tricky. I clearly see them being proposed. I think it's too early to tell whether they'll survive into closings and purchase agreements, but there's no doubt the buyers are trying just like they tried in 2020. And we had a several that proposed that and when we got to the finish line, we didn't have that in any of the deals that we closed in 2020 or early 2021.

Right. And as you know, having contingent purchase price in a healthcare transaction poses a-

A lot of regulatory issues.

A lot of regulatory issues. Exactly. And some of those you can work around. Some of them, you can't. Also think it's a blunt instrument for bridging valuations. And that, I mean it's one thing if I'm the buyer and I think that the company would be worth more if you did X, Y, and Z and we're just not sure if you're going to be able to do that. That can be a useful bridge on valuation. But if there's just a disconnect on valuation and earn out doesn't really correct that, it just proves out some of the assumptions but doesn't kind of adjust the overall pricing metrics. So I think that's a challenging way to go about it. One other kind of related question, the discussion about extra scrutiny on due diligence, are you seeing that as a bridge to buyers translating that into making requests on pricing adjustments?

So not as much that as I think it's a reflection of their nervousness, a nervousness of what they see happening in the economy. And it's giving them time to see how the market develops. I think it's much more around nervousness than it is around how to manage or calibrate valuations. Because I don't think the dynamics they're finding are anything new, than what they found a year ago or two years ago. The practices look like what the practices look like. They don't have all the perfect systems, they're not all in compliance. Because they've been run mostly as small privately held businesses and many cases without super sophisticated business operations. They haven't needed that. They haven't been on the radar, they haven't been large enough to hit the scrutiny of regulators. We understand private equity guys much larger, much bigger target, and they want all the Is dotted and Ts crossed and they're just taking more time to evaluate that and make sure, "Hey, I checked everything out, I didn't get caught with a surprise."

Growth hides a lot of sins. And they've had very successful growth and they've had... I mean everybody says it's a three to seven year hold, it sure looked like a four-year hold for most of the late major exits in the PPM sector. And so they're able to move pretty fast. Well, everybody's worried, "Oh, are we in a recession? If we're in a recession is that going to stretch out my hold period from four years to back to six years?" That's going to change what risks they're willing to accept.

At JP Morgan I had a lot of conversations with bankers. And many of them were indicating that their view on the market, when they have kind of assets that they're thinking about timing to bring to market, their thought was to hold them until Q2. So not even bring them to market in Q1. Are you seeing similar dynamics and how are you advising your clients?

We're looking at it similarly for larger transaction opportunities, a hundred million and over. We're definitely being more thoughtful about what the right timing is, getting folks to hold off until at least Q2, see how interest rate markets and the outlook for the economy goes. We've been giving less about that guidance on smaller, because we think the impact is lower. And candidly, what we've seen and the success we've seen is when we're doing add-ons they're as aggressive and eager to do their add-ons as they were before. And so we're not having a lot of issue getting the price that we're looking for or the level of interest that we were looking for so far. Right now, subject to the sector, we're like, "Let's keep moving forward." The bigger ones are the ones that we're saying, "Eh, let's be thoughtful about the right timing and what's happening in the business to determine, 'hey, do we go to market in Q2? Do we go market Q3? Do we go market late Q1?"

The lack of readily available debt for larger transactions has certainly been having kind of the effect that you're talking about. Where that has started to catch up to the smaller end of the market is that a lot of the add-ons are done through kind of delayed draw term loans with some of those platforms, and you can do that for a while without reopening your credit facility but you hit a point where that kind of runs out of steam. And for some, there's ways to work around that. Some equity funds will continue their acquisition strategy using equity for a while. But I feel like those are kind of a safety hatch on the small end is it might have limited duration as well.

You hit the nail on the head exactly why on the smaller ones we're like, "We probably should go, if it makes sense to go let's go now." Collapsing of that capital facility and the cost hasn't flown through the system yet in a significant way in the lower end of the market. Luckily it doesn't have as much of an impact either, but at some point folks are going to get more thoughtful and more cautious – at the end of the year, I think.

We're relatively optimistic. We think the environment that we're in is not a long duration pullback. I have a friend that I think classified it really well is this is much more of a consumer recession. And so that has a lot more psychological impact than it does actual impact on businesses. Non-consumer, consumer-related businesses. We'll see if that plays out for the year but we have, as historically have been, pretty optimistic about what the economy is going to look like. And I'm hoping that plays through and that people are going to get more optimistic as the year progresses. As you're going into those closings, people are going to be eager to get them done because they're going to see, "Oh, we're coming out of this already."

On the availability of credit, I'm probably the most bullish on that I understand why lenders who are making longer term credits have anxiety in an uncertain rate environment when the rates are rising and they can't often just keep raising their rates as well. I do believe that we're going to here pretty quickly hit kind of the terminal rate increase for a while, and once there's some certainty in kind of going forward rates, I think that the higher end credit market will start to open up, which will then trickle down. I'm bullish on that dynamic. And then the other part that makes me think that this will turn around is that if 2020 and the pandemic taught us anything is that when there are deals that are wanting to happen, they're often not lost, they're just delayed. And some of that pent-up demand for activity gets pushed into just the later part of the year. So I'm optimistic on both of those fronts.

At the end of the day, there's still $2 trillion of overhang between private equity and private debt in the marketplace. 2022 was not a record year, but 2021 was a record capital raising year. So there's still lots of dry powder, new money coming in, and folks still have to deploy this capital. There's going to be demand for deals, and so I remain very optimistic that their deals are going to get done. I'm still going to have a business, you're going to still have a business, and clients are going to get to be able to realize the value. This is all about expectations. You've done this long enough, their expectations get unrealistic when valuations get real unrealistic. And buyers are like, "Oh, I think I've got the advantage. I can pull that expectation back," and some deals will get done at a lower price because people are like, "Okay, I want to get it done," or, "I don't know any better." And so educated buyer, educated seller makes for more educated decisions.

Right. And some of those kind of heady valuations, maybe those are gone and that wouldn't be necessarily a bad thing. The new normal may be just fine.

Valuations aren't going back to where they were 10 or 15 years ago. There is a new level, there is a new norm, but that's because of the velocity that you see happening. And part of setting that valuation is supply and demand and that we're in a very different supply demand and dynamic than we were 10 or 15 years ago. That is a factor that people will sometimes forget. And for guys like us have been around the block a few times, there's a whole generation of executives and CFOs and others that have never experienced near double-digit cost of capital, and that is going to take some time to reconcile and process and understand how does that really affect how I run, finance, and operate my business?

Absolutely. Maybe shifting a little bit, Raj you have your pulse on the supply side of these transactions. What sectors do you see heating up here for the balance of the year? I'm definitely seeing interest in some specific ones, but curious on what you're seeing.

Yeah. Our physician practice management side continues to be very busy. Seeing a lot of activity still in ophthalmology and GI and many others... Orthopedics and behavioral health are probably the four specialties that we're seeing the most activity, but you're continuing to see podiatry. ENT is an interesting market with some of the changes in the rules. I think that's softened, but people are still looking at it. We're continuing to remain optimist, but we're actually seeing a lot of activity in other parts of the healthcare world, including the regulatory consulting side. That has been an area where there were lots of consolidation, then there was lots of disintegration, and now we're back into a consolidation phase where these middle tier regulatory, whether they're CMC or CROs or other consultants are now getting rolled up and consolidated in the marketplace. So as we look at 2023 and 2024, it's an area we expect a lot more activity in the healthcare world.

Yeah on the physician side, seeing the same sectors that you're seeing without a lot of decrease in desire to be in those spaces. One of the things we're following pretty closely are the FTC proposed rules on non-competes going away in the employment context and maybe materially limited in the sale of business context. So there's a lot of focus on that as it relates to provider services, given that you kind of need those people to stick around for this model to work. So a lot of interest in how that plays out. Are you hearing that from your clients as well?

Probably not from the clients because they don't get it as much. I mean, I think our sell side clients would be all excited because their biggest sticking issue is non-competes. But the ramification is it's really going to change the risk profile for the buyers. I think that'll be an issue if it develops. I don't think it's really on most sellers' radar screens yet. I think the level of increasing regulatory scrutiny... So you talked about the FTC, New York is talking about making a regulatory requirement to approve any M&A transactions, change of control provisions related to providers and physician practices, which is really odd. The regulators think there's some insider perspective they can do with. There's a lot of misconception, as you know, in the marketplace of the evil of private equity as opposed to some of the positive things that we see happen when they're done right and successfully.

Yeah, definitely an uptick in antitrust enforcement and intervention at the state level. You mentioned New York looking at this. We've seen actual measures in Oregon, Washington. And they can throw a wrench into the process, might be as much as like a 60-day review period that you got to account for. And you never quite know what, maybe there's going to be an approval that comes with some conditions that you're going to have to work around. It'll be interesting.

I mean, it's frustrating because when you look at the reality, the world of the five doc practice group isn't, it's not a sustainable model. If in 2019, from AMA data, the majority of practice flipped for the first time to being more than 10 providers. It's a fixed cost business, and those costs are going up and revenue is not going up. I mean, everybody's cutting reimbursement or changing delivery models to lower cost. And as a result, the ability to be a successful two, three doc practice is nearly impossible in the regulatory, the level of payer scrutiny, reimbursement system investments.

It's not a viable business strategy, and eventually those type of things that are preventing these consolidations are going to hurt patients because those practices will not be able to keep up with the latest and best technology and they're going to deliver subacute care. Or physicians are going to just say, "Well, I’ve got to go to the hospital," or they're going to retire. We already have a huge shortage of physicians as you look out into the future. Folks have to look at more than just, "Hey, are people billing more and what's happening there," I believe.

Definitely. Another area that I'm seeing a lot of investment interest in is healthcare related services, which the confluence there in my mind is for a lot of the healthcare investors that have done a ton of provider services, consolidation, investing, they're looking to diversify a little bit. You've got other investors that may not be kind of peer play healthcare investors that are looking for exposure to the healthcare industry, but are wanting to avoid the direct reimbursement and government reimbursement risks that are harder to dabble in. And so these services related to healthcare, which some of them are massive sectors and to themselves are getting a lot of interest in, whether that's kind of pharma services, pharmacy services, payer services, those are enormous business segments that are getting a ton of interest. Are you seeing the same?

Oh, yeah. I think this trend has been going on since 2008 when everybody said, "Whoo-hoo! Hey look, this whole healthcare thing is not cyclical," and so there's been a lot more excitement. Amazing how many people that had never been in healthcare, private equity funds, they're like, "Oh, no, no, no. We're now playing healthcare." I'm like, "Okay. It's a whole 'nother world." I think the growth, the lack of cyclicality has gotten a lot of folks excited and interested. They might not be up for dealing with kind of the dynamics of a physician practice management, or as you said the reimbursement elements and they're like, "Hey, here's a way for us to play the sector," really through a more traditional business that we're used to.

Yeah, which that is translated to still pretty frothy pricing and I think that'll probably continue. You put your finger on part of it that as we head into a potentially recession-oriented economy at some level, having an investment exposure into an area that is much less connected to kind of economic performance in the sense that people are going to need healthcare services regardless of the nature than the economy, it's way more resilient. That's going to keep pricing pressure in the healthcare area in general for a while.

Right? If they're an investor, you're looking for long-term cyclical trends and all the long-term cyclical trends say, "This is going to work well," and if you've got a good service or technology that lowers costs or improves efficiency, does anything to help, it's going to get more and more traction. So that's why you and I like to play in the healthcare sector.

Raj, we'll probably end it there. It's always great to hear your insights and your thoughts on healthcare investing and hope to see you soon here in Chicago, and thanks again for joining.

Thanks, Geoff. Really appreciate the chance to be here and catch up with you.

Thank you for joining us on this installment of The Banker's Corner. To learn more about today's discussion, please email host Geoff Cockrell, 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.