The difficulties faced by healthcare provider consolidations could be temporary or they could indicate a long-term decline in the attractiveness of consolidation. Some challenges, like high debt and labor market imbalances, are temporary and don't reflect the fundamental quality of the businesses involved. 

On this episode of The Banker’s Corner, McGuireWoods' Geoff Cockrell is joined by Mark Francis, Managing Director and Global Head of Healthcare Investment Banking at Houlihan Lokey. The two discuss the future of healthcare provider consolidations through the lens of those working in the industry right now. 

Over the past six to eight months, some larger platforms that had been acquiring smaller companies have paused their acquisition activities due to a disconnect between seller expectations and current valuations. They were also waiting for more favorable credit conditions and pricing adjustments. Now, these platforms are beginning to look to the market again and see what is available. 

Geoff and Mark discuss the healthcare sector’s resilience during economic slowdowns. Healthcare is often less volatile than other sectors, making it an attractive option for investors looking to allocate funds during economic uncertainties.

Healthcare is a mature market, but new interest in private equity has led to a reshuffling of focus within sectors. Some sectors like healthcare technology, veterinary care, and behavioral health remain highly attractive despite varying trends in their valuations.

Later on in the episode, Mark and Geoff discuss valuations and the importance of running and operating integrated businesses. “Great companies get great valuations, and we can debate what great is, but if people don't feel good about the valuations, largely they're not trading,” says Mark.

Featured Guest

Name: Mark Francis

What he does: Mark is a Managing Director and Global Head of Houlihan Lokey’s Healthcare Group. He has nearly 25 years of experience in M&A and financial operations in the healthcare industry and has managed a wide variety of projects, including divestitures, financial restructurings, joint ventures, and strategic alliance formation. 

Organization: Houlihan Lokey

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 from McGuireWoods. Here at The Corner Series, we try to bring together thought leaders and deal makers in connection with healthcare private equity transactions.

Today I'm thrilled to be joined by my good friend Mark Francis. Mark's managing director and global head of healthcare investment banking with Houlihan Lokey. Mark and I have worked on a bunch of varied deals over many years, so we go way back. Mark, I'm thrilled to have you joining. Maybe give a quick little intro, and then we can jump into some discussion.

Yeah, Geoff. Thank you and great to be here and happy to participate. Mark Francis, global head of healthcare, been in healthcare for probably 30 plus years and the firm for 26. We have a team of around 80 people in healthcare globally and are one of the most active healthcare M&A groups on the street. So, happy to be here and ready to dive in with whatever questions you have.

Maybe to start us off, I want to explore a topic that I get lots of questions about and I hear varied views. That is you and I spend a lot of time in healthcare provider consolidations across a whole bunch of different sub-sectors, and there's no denying that consolidation process has hit some headwinds when for a long time it was only tailwinds.

That raises the question of, well, what does the future look like? Is that a run that is going to wind down or be less attractive, or are the headwinds more kind of situational or temporary? I talk to some people that are very doom and gloom on the whole project now, and then other people that are much more bullish.

I will give kind of my thought on it. Then I'd love to hear yours. My thought is that some of the headwinds feel temporary in the sense that a lot of folks bought at very high multiples, very high debt, and now they have a balance sheet problem. The underlying business can be good, but they have a balance sheet problem.

And then the other big headwind that it feels these businesses have been encountering is that there's been a pretty historic imbalance in the labor market, such that labor, including these providers have had a lot of power to extract economics in ways that they hadn't historically. A lot of these businesses have pretty fixed reimbursement, and if one side of the cost is going up, the revenue side doesn't turn on a dime, so government reimbursement can't react very quickly in response to that. Similarly, commercial payer reimbursement doesn't turn that quickly, and that's put a real pinch on some of those businesses.

But to me, those in particular are not forever or really getting at the underlying businesses. So I still have a lot of confidence in the overall consolidation project. But Mark, what are your thoughts?

Sure. It is a little bit of a complicated story, but I'll try to narrow this down to a couple of minutes if that's okay. Look, on the macro trends on a longer term basis, we're very bullish on provider consolidation. If you look at the more macro mega themes of convergence, providers taking more risk, there being payers and a larger set of providers taking a broader set of different parts of the continuum and combining those, I think it's super interesting on a long-term basis. And so we like the market.

But it's also if you think five, 10 years out, there's going to be winners and losers. Not all market participants are going to win as you think about the size, scale, operating sophistication necessary to be the market leader and deploy enough technology to be efficient and play themes that are very critical, as we all know, for instance, value-based care.

So I think a lot of positive trends there, but it probably favors the slightly larger company than maybe the really small ones, but time will tell. That's good news. I think everybody sees that or most people see that.

I think the more headwinds are more recent things. It's the things that you mentioned, inflationary pressures on clinical wages. By the way, those haven't totally gone away. In some pockets, we definitely are seeing above normal wage inflation, particularly in the Northeast. I think hospitals are still having a tough go of it in certain clinical categories. Even some practice managements are having difficult time.

And so you have a definitely labor issue there that I think is subsiding mostly, but it's still a little bit elevated. What you've had is really margin compression over the last couple of years. You had COVID issues, you've had margin compression issues, and the reimbursement has just quite frankly on the government side, not kept up with it.

And so you've seen a real differentiation in companies and management teams on the positive end. The really strong teams at scale that had technology that used the last couple of years to reimagine their business, I think are coming out of this much stronger with better margins than others and a lot more growth.

And then I think you have others who maybe didn't have the level of sophistication and technology and scale have compressed margins and aren't doing as well. And then you overlay on that balance sheets in terms of where you were in leverage coming into the last couple of years. I think you're ending with some companies that are actually in distress and need to be restructured.

And so I think you're seeing probably more of those situations that we are tracking and keeping track of because we also have one of the largest restructuring groups in the world. There are more of those today than there was pre-COVID, just as a broad indicator.

It's also been interesting. I do a lot of work for large platforms that for a long time were just running on a steady drumbeat of tuck-in acquisitions. It's been interesting to see their response over the last six, eight months. A number of them who had been very active acquirers have used the last six months to kind of take a deep breath.

They were experiencing a real pricing disconnect with seller expectations, not realigning to the reality of valuations right now. And then frankly, many of them had done a bunch of acquisitions that were not fully integrated and consolidated within themselves.

Especially when they ran out of DDTL on their credit facility, it is felt like a good time to take a deep breath, consolidate themselves operationally, and wait for credit to become a little bit looser, for pricing to become more rationalized. Just now I'm seeing those platforms starting to come back awake and start looking at things. Has that been a similar experience for you?

Well, I think so. Certainly some are coming back into the fold in terms of being a pace of acquisition similar to what they were before. However, we do see a lot of companies, and I'll call them hung for lack of a better term, where the DDTL is maxed out. You're three years into an equity fund investment and where the private equity fund doesn't want to put in new capital. And so they're kind of not really that acquisitive and they're just kind of doing what you said they're doing things that can't be efficient, through integration, those kinds of things.

We see that persisting for a little bit while longer. I mean within practice management there's probably 40 or 50 of those that are just kind of in limbo for now in terms of financing for growth. And so we're working through a number of those with our capital markets group to try to expand the financing base, the DDTLs, and ready to get them back on the right track.

Because otherwise, you have periods, and look, we saw some of this in COVID for private equity firms, you have a year of lost IRR. If you do this in the provider market and don't grow through acquisition or de novo, you somewhat are losing pace to the IRR.

One of the ways to think about where the market's going to be heading that you hear discussed quite a bit is kind of overhang. Sometimes it's discussed in terms of this overhang of dry investor powder, which can be instructive as to what to expect over the next 6, 12, 18 months.

But another overhang that I feel like we're experiencing right now is kind of portfolio company overhang where a lot of private equity funds have held platform investments longer than is their natural intuition and are holding more of them than is their natural intuition.

As an investment banker in that space, do you feel that, and do you think that that is going to start driving a lot more activity as those private equity funds are not built to hold that many portfolio companies for that long?

Sure. Maybe take those in reverse order. On the whole period, look, in peak markets, which if you go back to '18, '19 and early parts of '20, hold periods had been accelerating and you saw most people in the three, three and a half year range for companies that were really growing doing well because multiples were somewhat expansionary and at a peak during that period. Even in '21, we saw that, kind of the last half of '21.

And so hold periods contracted now. When there's times like the last year you see hold periods for private equity funds look more like five or six years until they can get the MOIC that they're looking for. And so I think that's a trend that we see play up and down as markets accelerate and decelerate to where we are today. That's kind of a natural process we think.

I do think though what you saw a lot of people, particularly late last year, early this year, just be risk off. They were taking books, they were taking meetings, but they really weren't fully engaged in investing. I think that's a big sea change from where it is today. The vast majority of private equity funds and strategics are, it's definitely game on. They're very engaged. They want to fulfill their investment goals and strategic initiatives.

And so I think today is a dramatically different and better environment than we saw six months ago for sure. We're pretty optimistic that it's going to get better through the balance in the second half of this year. And so we feel pretty good about the market.

But maybe two points to talk about. One is as we think about healthcare's resiliency in a slowdown, if you look at the economic indicators, up until recently, people were calling for a recession either late this year or early next year. I think the temperament or the discourse has been more of a slowdown, but regardless, healthcare, which is the area you and I are totally focused on, is more resilient than other sectors. It's not as impacted as others.

I think investors kind of know that, and so there's been a little bit of pivot to, hey, I'm trying to allocate dollars to different sectors in the next year. There's some risk, whether it's a slowdown or a recession, healthcare is a good place to be. So I think that's one.

The other is a lot of people did studies in the great recession and in other recessions, and they looked at investments across their portfolio and actually their healthcare investments seemed to do better in times of slowdown or distress. That's another feather in the cap for healthcare more broadly is that it just does better in tougher times.

We have higher IRRs and MOICs than other sectors on occasion and private equity firms know that. It's no wonder that there's an enormous amount of time and attention spent on healthcare broadly. And then within that, private equity funds and strategics will figure out where within that they want to play.

As a banker, you have better kind of forward or exactly current visibility than I as a lawyer do. I enter deals later than obviously you do, and so I've got a little bit of lagging visibility. But from where you sit, I would be super curious to hear what your assessment of the pipeline of deals is for things that you can touch and see.

And then a couple sub-questions. What do those look like from a size perspective? Is there more small, medium-sized deals or are larger deals coming back online? And then within provider services in particular, are there some sectors where you're seeing more activity as opposed to others?

Sure. Yeah, no, definitely have a stronger confidence level for activity in the second half. I would say our pitch activity on a relative basis is pretty good. And definitely I would say the last 90 days pitch activity, people trying to make decisions whether to sell companies or make investments or not are much better.

If you look at the number of deals, both us and other firms like us that are launching in September and October is very high relative to the balance of 2023. And so all that gives us confidence that both the supply of good companies that need partners or strategic exits are going to be much higher in the second half than the first half.

Also, that there's strong demand for private equity funding strategics with private equity funds. It's a dry powder conversation. Strategics, it's more of a cash on balance sheet and financing conversation. Both those are in really good shape in the vast majority of instances. The conditions are really right for a great second half, and we're definitely seeing the early phases of that.

Now, if you look at the M&A stats, you're not seeing that in closed deals yet, but my sense is you will start to see them pick up appreciably in announcements in October, closings in November, December, January at a much higher rate than we've seen earlier this year.

Yeah, there's no rest for the wicked. It's uncomfortable when things are a little bit slower, and then correcting that is bad as well. We're sure being punished for something.

What about sector bias of those? And maybe two parts, one is within provider services and then some other sectors where you're seeing a lot of activity moving towards transactions.

Sector bias, it's interesting. Healthcare is a fairly mature market, so we don't see new sectors emerging, but we do see new interest in private equity emerging. One of those would be in the last year, cardiology within practice management, we definitely have seen sectors come back, things like imaging and HME and other sectors. And so we see a little bit more of a reshuffling than anything else.

But the things that are extremely attractive, healthcare technology, vet, behavioral, minus maybe autism, part of that, which has had a tough time on the labor side, a lot of those are still very attractive. Now, some parts of those evaluation have come in. Other parts they haven't.

It's been interesting on the size commentary, which you mentioned. It's been our thesis through this time based on a lot of years of doing this, that premium companies do get premium valuations. I think that's definitely been true over the last year, but I think it's been a little bit of the tale of two cities in that yes, great companies get great valuations, but companies that maybe aren't as strong with management, with growth, all the things people look at, those deals have really struggled.

I think that's been the difficult part of it. If you go back to really peak market, there was more of a scenario where high tides raises all boats. I think this year has been not that, and I think it's been more difficult to navigate, quite frankly.

But in terms of size, we've got, I would say anything if the credit facilities under a billion dollars, we can get done with private credit, which has been incredibly strong in this market. A syndicated market still is mostly for refinancing and less more LBO activity, but private credit is definitely filling the gap today. We definitely see the syndicated market warming up, but it's not as functioning today as, say, the private credit. You probably see the same thing from your seat too.

For sure. The availability and the way in which money has kind of poured into that perceived gap, you can see the smart money leaning heavily into the private credit market, and I think that's going to continue for sure.

One area where I think it's a bit of the canary in the coal mine kind of test case for the entire provider consolidation arena is to watch carefully the performance and success of the larger kind of big box buyers, because if those much larger transactions are not being as successful, those headwinds there will trickle down.

What's your assessment of the big deals performance through now and what's your assessment of how those larger buyers are going to perform? Because I think that will drive this market. They need to be successful.

Yeah, no, totally. Look, I think the mega deals have really been constrained given the cost of capital and the availability of financing, particularly for these multi-billion dollar transactions. And so I think that's been tough. It's really cash on the balance sheet and financing capability and really using stock as currency.

I think for the most part, a number of these bigger deals have gone well, again, more of a healthcare service commentary. But look, we haven't seen any kind of big failures, so to speak. The low end of the bookend, I don't think we've seen, but I think more than likely that what we would see with some of these big mergers is you really don't assess the success or go out of that strategy for years later.

The time the deal happens, that's not really the time to say, hey, great, this worked well or didn't. You can certainly say that on the transaction part of it, but the operational part, some of these strategies in terms of value-based care, taking risk, all the kind of mega things we've talked about, particularly that the payers are integrating, we're not going to see that really for years.

I mean, if you look at the stuff that Optum is doing in home care and hospice, for instance, if you look at CVS is doing, look, those are very long-term strategies. I think time will tell, but generally speaking, we expect a lot of those to do well. It's just a question of how well.

Maybe focus a little bit on pricing. I've seen in the middle market and lower middle market some rationalization on pricing expectations, but what's your assessment on where pricing is headed directionally, and is some of that bid-ask spread going to narrow?

It's interesting. I think we saw more bid-ask spread earlier in the year. I think as the market has heated up and accelerated, I think people are getting closer together, but it is still there. I think there are some people who looked at this year, if you're the private equity side, and were looking for more creativity, more earnouts, more valuations. I think to the extent we could bridge the gap on those, we did.

But a lot of instances, if there was too much structure in things or the valuation was too low if you were a great company, what you just said is, "Hey, look, if this is not a valuation I feel good about, I'll just wait and do this again next year or two years from now. If I don't have to do something, then let's not."

I think that's really forced counterparties and buyers to really be more fair on the valuation than maybe the capital structures or cost of money would indicate in terms of the value disparity. But again, back to this, great companies get great valuations, and we can debate what great is, right, but if people don't feel good about the valuations, largely they're not trading.

If you think about the success rate of processes this year, you probably have had more failures this year than you have in the past. That's something we track and monitor very closely in terms of failure rate of deals. That's one indication that there's a little bit of a gap between buyer and seller.

One of the ways I've seen some of the bid and ask get a little narrower is not even changing the multiple, but being a little tighter on what EBITDA means. Back in the heady days of 2021, you were doing a lot of theoretical pro forma run rate EDITDA. There's a lot less of that now. Is that consistent with what you're seeing?

Yeah. I think that's absolutely true. Part of it is experience. A bunch of people did deals where let's just say the pro forma or things that hadn't been done yet that were synergies or actions taken by the company that hadn't been done that were 50%, 60% of the EBITDA. I think there were a number of situations that people saw that the adjustments didn't bear out in terms of earnings of cashflow in the forward period and created leverage issues, created issues for the company in terms of valuation.

I think just the market is a little more sensitive to that on the investor side. And then also a lot of it is just driven by the lenders. Lenders are not getting near as much credit as they did, say, pre-COVID for adjustments. Leverage has come down in the conversation, and there's just more scrutiny around adjustments and pro forma adjustments than there used to be.

Now, there's always going to be adjustments because in fast-growing high growth businesses, whether it's acquisition or de novo or whatever it is, there's always going to be adjustments, but I think there are more scrutiny applied to those, and I think just the overall level of adjustments is less than it used to be, which I think for the overall the market is probably not a bad thing.

I also think there's been a healthy focus on realizing some of the integration that you need to do and that there was a time when you could get away with not having fully integrated pieces that have been acquired. Those days are, I think maybe appropriately over and sellers will get rewarded for having more fully integrated businesses, and a number of businesses have taken this market challenging time to do that integration. When you're talking with sellers, how much do you focus on the degree to which this acquisition strategy has been truly integrated?

I think client selection for us and for you, it's the same thing. It's about quality and probability of closing and how we add value in a process. We try to really be our client's trusted partner, and a lot of that is having conversations like this.

We're a big believer in running and operating integrated businesses. I think from the buyer's point of view, businesses that are not integrated, it feels like you're passing on risk to the next buyer or the next partner. Sometimes in a peak market that doesn't get fully realized, but I think maybe in this market, people are more focused on that. It's just a valuation discussion. If you've got a great management team that's a fully integrated business, that's a market leader, you've got more tailwinds at your back than headwinds.

It's hard to say this in every instance, but in the vast majority of instances, we're big believers in fully integrated companies all on one system, similar standards of protocols and policies and procedures, clinical care pathways, et cetera. It feels like a longer term better strategy with less variability from our perspective.

Mark, we could talk all afternoon, but I think we'll call it a wrap there. It's always fun to talk with you. Thanks for coming on the show. Hopefully we'll get to work on one down the stretch here this year.

Look forward to it, Geoff. Thank 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 at gcockrell@mccguirewoods.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.