The healthcare market may be tumultuous these days, but deals are still happening. 

On this episode of The Professor’s Corner, Diwakar Sinha of Polaris Healthcare Partners joins McGuireWoods’ Geoff Cockrell to discuss how practices can prepare to sell, what specialties are especially attractive, and how the search for investors varies from practice to practice.

According to Diwakar, the same volume of deals are occurring, but the number of A-grade deals may be fewer. Currently, most A-grade deals exist in certain specialties. 

Diwakar recommends that group practices run a quality of earnings (QOE) analysis to firm up their EBITDA projections. This eliminates some of the doubt for investors and makes a deal more appealing.  

Diwakar also predicts that the cost of capital will come down mid-2024, which is a good reason to start planning from the sell-side now. 

On the consulting side of Polaris Healthcare Partners, Diwakar shares that for a practice to engage Polaris Healthcare Partners, it typically needs seven to 10 locations with aspirations to grow. At that point, the leadership team needs to expand to include a CFO and a more robust accounting team.

Tune in for more on current trends in healthcare group practice investing.

Featured Guest

Name: Diwakar Sinha

What he does: With about 22 years of experience in healthcare lending and transaction services, Diwakar is a Co-Founder and Partner at Polaris Healthcare Partners. Polaris provides consulting services to healthcare group practices across all specialties, as well as capital and sell-side advisory. 

Organization: Polaris Healthcare 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 Professor's Corner, 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, partner at McGuireWoods. Here at The Corner Series, we try to bring together thought leaders and deal makers in investing in healthcare. It's been a tumultuous time in the market, but deals are still happening. Today, I'm thrilled to be joined by Diwakar Sinha from Polaris Healthcare Partners. Diwakar, maybe give a brief introduction of yourself and Polaris. I know that Polaris does a bunch of different things and would love to kind of cover that waterfront.

Sure, Geoff. Thanks for having me on. My name is Diwakar. I've had about 22 years in healthcare lending and transaction services, one of the co-founders and partners of Polaris Healthcare Partners. We provide consulting services to group practice healthcare across the healthcare spectrum, group practices looking to scale from 3, 5, 10 locations to 30, 50, a hundred locations, in all healthcare verticals, from dental to urgent care to plastic surgery and [inaudible 00:01:22]. We also provide capital advisory services for lower middle market and middle market lending transactions, and also going along with that, provide sell-side advisory as established platforms who want to go to market and look at different capital and equity investments.

So, Diwakar, I think we'll spend a little time in a little bit talking about some of your consulting work, but maybe starting on what you're seeing in the market. Transactions have been choppy, valuations have been choppy. What has that looked like from your perspective, and what are you seeing both companies looking to sell and buyers doing in response to some of that choppiness?

Sure. I think coming into 2023, the parties going to market, the flow is approximately the same. It's a little bit lower than it was in '22 or '21 for sure, but as far as valuation expectations, from a sell-side perspective, I think clients are looking to hold the valuation of their businesses. So, we're having become creative in how to make sure the valuation stays consistent to previous years. As far as how buyers are looking at it, I think buyers are a little more selective. They're looking to understand what the leverage ratio is going to be, what the geographic footprint's going to be, what kind of growth rate the business has had. They are looking for a better quality deal or overall a holistic platform in 2023, versus in 2022, we saw a little more openness as far as a overall credit box from a investor's perspective.

So, a little bit of a tightening of the box. We've seen a transaction that we would've taken to market in 2022 have seven to eight different LOIs come in above market, to what we would consider above market, to where we're now seeing those three to five a little bit lower in the number of LOIs being issued, three to five LOIs being issued at market, some below what we would've expected in the transaction. So, we are seeing a little bit of softening in valuation that could be related to obviously the amount of capital available in this space, and also the cost of capital going up several hundred basis points.

There are a lot of ways to kind of push down pricing and still hold a valuation multiple, and I see that happening on the front end where add-backs have gotten a lot skinnier. But also I see it on a much more rigorous Q of E process that is really leaning into looking at recurring revenue, looking at different aspects of the business that may be a little bit less recurring, and putting a lot of pressure on what the actual EBITDA is for purpose of the valuation. Are you seeing similar dynamics, and to what extent is that kind of yielding trades on pricing partway through the process?

Yeah, so I agree with you. I think going through a quality of earnings, try to go through any anomalies, any quarters or months that were outliers to really understand what they are. All of our transactions are typically about one and a half to $2 million in EBITDA. We're doing a sell-side Q of E, so we're trying to be forward-thinking about those issues going to market. So, when we're going to market, majority of our transactions do have a sell-side Q of E going into it.

I think if you are thinking about going to market, should think about a sell-side Q of E as part of that process to address any outliers, to really identify your own EBITDA and make sure the expectations are within market with your banker, and then go to market. And I think that does create a higher level of confidence when you do run a process, and in that process, as you have a pitchbook and a full data room going to different interested parties, you have a sell-side Q of E attached to that process.

I also see bankers being a little bit more realistic in that sequence. When prices and valuations are running sky-high, I see bankers pressing their own clients or encouraging their own clients to be more aggressive in add-backs and other things, where now I see bankers being a little bit more cautious to not wind up their clients' expectations around numbers that are not going to pan out very cleanly during the Q of E. So, there's certainly a role for the bankers, both in managing the process but also managing expectations on the part of their client.

That's correct. Yeah. I think a role of a banker is obviously, provide the best valuation and structure for their client, but also to set a win-win situation for both parties. So, to educate the client on what is an add-back, what is not an add-back, what will be accepted, not just initially towards a initial diligence, but will be accepted and be defendable through a quality of our earnings process, is very important in early education of the client.

What are you seeing by way of overall supply? Everyone always says that A-grade assets will always have a market, and that will always be true, but it doesn't answer the question as to, what's the overall volume, number one, and number two, what's the ratio of A-grade assets to less than A-grade assets? Those can be very much moving targets. What are you seeing on those two questions?

Yeah, so don't have the full market spectrum, but I think as far as A-quality targets in 2022 to 2023, I think the volume's down a little bit, maybe about 10% or 15%. As far as what we're seeing compared to 2022, we are still seeing our overall volume of deal flow would be the same of coming in. So, one would argue more not as mature businesses or businesses with outlier performance that need a banker to come in and kind of look at the deal and see how to structure that deal for the right party. More of those transactions are coming up, so I would say the A- or B+ transactions are coming up in the market.

What's been your experience both in things that you've worked on and things that you've seen with transaction failures? Obviously, a failed transaction has a lot of costs, both real and kind of trajectory implications, but what's been the incidence of transaction failures that you've seen or been a part of?

As far as deals that have not consummated in the process have been where there was an initial expectation of valuation, we had a quality of earnings done, and something internally within the organization changed, that's about one out of maybe potentially 10 times that has happened. On the other side, we are starting to see more and more investors coming in issuing IOIs or LOIs, and then for some reason, the financial lending solution that's sponsor-financed or something is not there to fulfill the commitment. So that's happened once or twice. That being said, we've been able to pivot really well to another party that had good backing to still consummate the sale, but we are starting to see in 2023 more investors that are issuing IOIS or LOIs may not have the financing capital to execute on the transaction.

Diwakar, maybe shifting gears a little bit, I'd love to hear some of the view from the consulting side of your house. One of your main things that you do is help provider businesses that have gotten to a certain scale ramp up to that next level, and I'd love to hear from you where you think the break points are, or where a practice can get to a certain level and then struggle to get above that, and what are the barriers at that level?

Sure. What we see, again, we take on clients for about three locations on the entry point, and our sweet spot for clients engaging Polaris is about seven to 10 locations. So about three to five seems like a big gap or a big obstacle to overcome, because a lot of the three locations are still doctor, principal owner, still practicing a few days a week within the business, and about three to five, they have to work through that process to go from clinical to admin or bring on or build out an admin team, a leadership team, an executive team within the platform. So, that seems to be about one of the initial obstacles stages.

The next one is around 10 locations, or typically around $20 million in revenue. I kind of use those two different KPIs, and around that, again, at that point they have to build out a full leadership team and have to start thinking about different capital structures, have to think about accounting principles, typically going towards an audit. So, start to do about 15, 20 million in revenue, you're going towards audit financials. Again, if you're still privately held, not going towards a bigger process, and also bringing out a CFO, controller services if they don't bring on a CFO, setting up a back office, MSA, MSO, DSO structure. These are all the different things that a lot of these groups are having to do once they get to about seven or 10 locations. Those are the two different milestones we see, three to five, and then just about 10 locations.

Given that businesses trade on EBITDA multiples, do you get a lot of pushback on that build out? Because that is adding a lot to an executive team and other aspects create expense, which is going to be a drag on income? Do you get pushback from sellers and practices on that front?

Yes and no. Initially I think there's questions around, why are we building out the team? And it comes down to their goals. If they're looking to be an add-on or a bolt-on to an established platform, they may not need to build out a full executive team or a platform. But if they want to be an initial investment into a geography or be an initial investment from a private equity, then we need to start building out the team and all the systems and infrastructure to facilitate that. So, I think it comes down to what their goals are and where they want to be in three to five years. We work towards the ROI they have, setting up an MSA agreement in full. Those things are time-intensive and capital-intensive, but I think they're well worth it, depending on your goals. So, we work through that process.

And do you find that a lot of practices, at least initially in thinking about it, are viewing themself as the platform target, and then modify their expectations? Or do a lot of practices right out of the gate think of themselves as best suited to be an add-on acquisition to an existing platform?

I think when there are about three to five locations are engaging us, they're typically looking as a bolt-on, and haven't identified what their vision may be. And when we go through that process in our engagement, we will identify, work with them to identify if their long-term goal is a bolt-on or to be a true platform and work through that process. If they're engaging us around seven or 10 locations, they initially start off with the vision of being an initial private equity investment or platform investment, and we work through that process, or we again, work through the exercise to understand, did they really understand that, what that means for them, what the investment may be, and could we figure out a strategic partner for them that might be better suited on to be a bolt-on?

Maybe switching back to the market side of this, you touch a lot of different provider services sectors. Are there any that you are relatively more bullish on or relatively more bearish on? How would you handicap some of the different sectors?

That's a great question. I think I'm very optimistic on the dermatology, med spa space, the behavioral health space. I think there's significant opportunity in those spaces. Urgent care is making a big resurgence, so really optimistic about those spaces. As far as bearish, I think vet's been high valuation for a very long time. I think it's had significant consolidation, so a little bit ... We're not concerned about the run rate in that space, but exclusive of the vet space, I think ... I mean the overall, the dental space, as I said, the med spa, dermatology, and the behavioral health space I think have a significant opportunity.

Diwakar may be pulling the lens back a little bit and looking at the broader market. Obviously, the cost and availability of capital and credit in particular has been a driver of some of the choppiness and a driver on some of the pressure on valuations. When you're advising practices and clients that are thinking about a sale transaction, while nobody has a crystal ball, what's your prognosis for some of those key driver areas?

So our recommendation to our clients is to prep a business for sale or process about six to 12 months out. So, we already have clients that we're working with that are Q1, Q2 2024. We do believe that our goal, or our hope, is that over the next six months, we start to see some drop in cost of capital. We do think, hopefully, Q1, Q2, we're going to see some level of economic resurgence that should hopefully get the Fed funds rates to slowly come down, hopefully towards Q2, Q3, and hopefully normalize towards middle to end of next year. We're somewhat optimistic about middle of next year being a turning point in the cost of capital, so we're working with clients now or engaging clients now to start prepping the market, prepping their business, understanding, working through a Q of E to what would be necessary for Q2, Q3 next year.

And talking specifically about companies at that stage where they're just dipping their toe in, what would you say is the volume at that stage? Meaning, folks that are still a year away, but are you seeing a lot of interest in activity at that stage? Where you sit, you guys are very much kind of leading indicators, or at least have visibility further down the road. What does the market of potential sales candidates six, nine months from now look like from your perspective?

From the clients we're looking at, they're anywhere from 10 to 25 locations, revenues anywhere from about 20 to 40 million in revenues, depending on the industry vertical. And working through those executive teams to clean up their organization, work towards what their expectations are, getting them into a sell-side Q of E into Q1, and really getting the business ready to where we can go to market in Q2, Q3 next year. That is a process in making sure that the client understands what they're looking for, and that allows us to understand their goals, and also work with potentially interested parties to see how their capital positions are, how they're looking at different businesses, understand the moving box that different parties have as they're going through different capital constraints over the next three to six months.

When you're talking with potential sale candidates, how often do you have kind of a very, very short list of likely acquirers, and how often do those processes get kind of preempted or truncated by those key most likely buyers?

I think most often, if we understand the client's goals, we are in active dialogue with different parties, and if we understand that there's a good fit, then we'll go to typically three to five interest parties in a process. We don't believe it's productive to go out to a mass process. That said, there's some deals that do need a bigger, broader process, but if we can initially go to three to five interested parties that we've identified through our active dialogue, most of the times, the deals can happen fairly quick with the right parties there.

Diwakar, I want to thank you for joining us. This has been a ton of fun. You've got a lot of insights in market visibility, and I wanted to thank you for joining us.

Geoff, thank you for having me.

Thank you for joining us on this installment of The Professor's Corner. 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.