As the market recovers, multiple trends are taking shape in the healthcare provider services industry that will affect investors in 2024.

In this episode of The Corner Series, McGuireWoods’ Geoff Cockrell welcomes two guests, Bart Walker and Matt Searles. Bart is a fellow McGuireWoods partner and co-chair of the Healthcare & Life Sciences Industry Team. Matt is the managing partner at Merritt Healthcare Advisors, a healthcare services-focused investment bank.

Tune in to hear Bart and Matt share their perspectives on private equity investing in the healthcare services space and their forecast for 2024. Their discussion includes things such as impediments to closing and active areas in healthcare investing.

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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, partner at McGuireWoods. Here at The Corner Series, we bring together thought leaders and deal makers in all facets of private equity investing in healthcare.

We're breaking form today and having two guests. One is my partner and friend Bart Walker who sits in our healthcare group, and we're thrilled to be joined by Matt Searles from Merritt Advisors, one of really the best investment bankers in provider services that we know, and we're going to have an interesting conversation of what we can expect in 2024. But Matt, if you could give a quick introduction of yourself and Merritt before we get started.

Thank you. Again, my name is Matt Searles. I'm the managing partner of Merritt Healthcare Advisors. We are a healthcare services focused investment bank. We are doing deals from sub-specialty practices to facilities to pharma to clinical research trials, just across that spectrum. We are doing those nationally. We have offices in West Coast and East Coast, and happy to be here today.

To get us started, we're here at the beginning of 2024. 2023 was a little choppy. Matt, you're a banker and so you guys have a little more forward-looking insight into the deal market. From where you sit here early in 2024, what are you seeing as far as pipeline, as far as buyer interest, seller interest? What's the landscape look like?

I think that the deal flow from all those perspectives is still strong. I do think that some of the macroeconomic forces that have come into play in the last 18 months have very likely shifted a little bit of an advantage to buyer a little bit. I don't want to say all good things come to an end, but we went through a very long period where I think that markets were shifted towards sellers. You saw certain sectors start to show multiples that were fantastic for the client, but from a banker's perspective, just concerning that they were maybe not sustainable, they would be difficult to continue.

I think that that's what we're seeing, that little bit of a regression to the mean on multiples, and from our point of view, that's not bad. I do get concerned. I mean they will go unnamed, but we can see examples of platforms that paid very high multiples during a period of low interest rates, leveraged up and had palpable and real difficulty refinancing in this environment. That has a very negative effect on our world, and so we don't like to see that happen. I wouldn't say I'm happy that multiples are lower. I don't think that's the right way to put it, but I do think that we're getting back to a more sustainable pattern that is a little bit less threatening to that, to our microeconomic environment that we operate in.

Bart, you represent a number of platforms that are doing the more multiple tuck-in acquisitions that maybe aren't banker led, so it's a little different corner of the market. What does the add-on environment look for smaller tuck-ins as opposed to the larger platform marketed sales?

Thanks, Geoff. I think it's looking up is the way I would characterize it. Last year, I think there were a couple of challenges for roll-up strategies. The first being just the cost of capital and availability of debt. A lot of the platforms when they initially do their capitalization, they've got a delayed draw term loan or line of credit that they can pull down to fund leveraged acquisitions. To the extent they were tapped out on those, it was challenging for them to do add-ons unless they were investing out of their own equity.

The second piece was really just the increasing discrepancy in value expectations, in particular between sellers and buyers. On the smaller end of the scale, in my view, it takes a bit of time for valuation changes within the market to trickle down to the roll-up size transactions. What we found there were some sellers that still had some relatively unrealistic expectations on purchase price.

I think those two things had depressed deal volume overall last year quite a bit. This year, it seems like things are right-sizing, to Matt's point earlier, definitely seems like things are on an upswing.

Matt, the high multiples were certainly a catalyst for driving seller volume, meaning those high prices sent a rush of people wanting to sell at those high prices. As the pricing has rationalized, obviously it puts pressure on some investments from a year or two ago. What has the impact been on the flow of sellers? Has it diminished the market for sellers in some of these provider services areas or not so much?

I'm sure it certainly has impacted some folks that were on the fence about whether or not it was the right time to sell, but we find just fundamentally when a practice or a service company has made the decision to sell, there is some factor that's causing them to do it, whether it's inability, margin compression, or inability to make an impact with payers, or headwinds related to scale and size and management. I think that most folks we run across are experiencing those and know it's the right time to do a deal and it maybe a little bit of a bitter pill to swallow that maybe you're not going to get a 14 or a 15 for your cardiology practice. Maybe it's lower than that, but the fundamental reasons for doing that deal are the same.

We go through a little bit of that educational process, and for all the things that we can collectively impact, the macroeconomic environment is not one of them, so it is what it is. Maybe a slight drop-off with those who were just motivated by price only, but I think it's more unusual to have somebody that's just purely money motivated. There are always other reasons for doing a deal.

The pricing shifts that you've seen are obviously driven by supply and demand, but is that spread out evenly across the spectrum of sizes of platforms? Because I can see the desires you're describing of say, a physician owned practice, why they might want to be making a transition to a platform. But it's a little more opaque to look in the future and say, okay, what is the growth strategy of a large platform where you can't keep getting more and more economies of scale? Maybe focusing a little on the high end of the market, are you encountering headwinds in that part of the market?

I mean, from the platform perspective, I think it's like the straw house, stick house, brick house analogy. There are some brick houses out there that have been fundamentally disciplined about how they've approached acquisitions, not over-leveraged, whether it was consciously or unconsciously preparing for those shifts in the market in the last few years. I think that those types of entities are always going to have a strong market and trade in higher multiples because of their scale and do well.

I think the straw house would be folks that have been paying a lot, and I get it, you're out there, you're trying to grow your platform, the pressure's on to do that, and sometimes it seems like a good idea. But you pair that up with leverage and I think that's a recipe for a platform that's going to wind up trading at a discount. But there's certainly a lot of just very well put together larger entities that I think will continue to have success in the secondary market.

One of the difficulties in 2023 was just getting a deal to closing. I'll be curious on both of your perspectives, and Bart, maybe start with you of what some of the impediments of getting all the way to a closing have been?

In the healthcare services space, increasingly we're seeing regulatory issues of some, to be clear, not all bad actor type events, but it's unusual not to have some sort of regulatory turbulence around these deals. I mean, no one's doing anything perfectly, quite frankly, and there's always things you can improve. It just seems like that's more and more ordinary course. Again, not an obstacle to actually getting the deal done or closing the deal, but something that you just have to deal with and bake into the closing timeline these days.

The other thing that I've seen that's just been an increasing functionality amongst multi owner practices or multi owner businesses in the sense that as the deals get somewhat skinnier from a valuation perspective, you're starting to see some stratification along things like specialties or sub-specialties, seniority, revenue producers. There seems to be, again, anecdotally that there's a bit more infighting amongst the sellers about who gets what, who takes what away from the table, and what the go forward relationships look like. Sometimes I think sellers or founders can be their own worst enemies in that regard, so we've been doing a lot of herding of cats on the seller side.

Bart, on your first point that regulatory issues arise. Is the issue that the problems are larger or that the tolerance or anxiety around that from either buyers or lenders is higher, such that it has to be more ironed out or the solution clearer and more certain? What's been the pressure point on that?

I wouldn't say that the magnitude has increased of the regulatory issues. It's more a question of frequency. We're just seeing something on just about every deal. Nothing serious, nothing deal threatening, but something you have to deal with.

I think there's an increased amount of activity coming out of State Attorneys General, out of the Department of Justice in the form of civil investigative demands, subpoenas, things like that where it could very easily be innocent folks who have no ill intent at all, who are receiving these requests or subpoenas and being asked about financial relationships that may or may not be problematic. Again, there may not be anything there. It could be a tempest in a teacup, but you still have to respond to these things. It's something to work through, so that's been a bit of a hurdle to clear.

Listen, that's an opportunity for buyers. I don't mean to sound pessimistic when I say this, but I always joke internally in our firm that at what point did quality of earnings studies get weaponized for? I feel like they were a little bit easier to get through years back, but now it's not uncommon to do a deal and have 10 different consultants come in and attack 10 different aspects of the business, regulatory and otherwise. It's an opportunity for buyers to improve their terms, and I'm not saying those problems don't exist, but we've seen that also, I agree with Bart, become more acute and difficult to manage.

Some of those things can give rise to actual concerns where a revisiting of the price is a natural outflow of the issue, something that is concrete and affecting future earnings is going to impact the price. But Matt, to what extent have you seen buyers really leveraging into re-trading on pricing in ways that you feel is a bit of a reach?

I mean, I can think of deals recently where there were measurable differences of opinion on coding audits and carrying those forward in terms of extrapolating what those differences might be. I think just objectively with some of these deals that have closed, there's a spectrum of views that you can take that are credible. That's one area where if the buyer pool isn't as deep or if there's been some shift a little bit towards buyers in terms of advantage in certain types of deals, then it can be an avenue to do that.

I do think, listen, most buyers don't. It's got to be real incredible. No one wants to go into a deal with a price change at the end and upset their partners, but that's an example of what we've seen. Then on the regulatory stuff, just wind up getting layered with escrows and special indemnity items, things of that nature as a result of these really deep dives that are happening over multiple aspects of these businesses.

Matt, following up on that, as the market continues to shift, are you seeing any movement in the sub-sector areas where there's more activity? There have been some real consistent driving sub-sectors for a while. From my view, there's been a move towards some of the more deeper specialties. What are you seeing in the evolution of the movement of the different sectors?

Right now, some of your more mature platform businesses, DERM or Eye, you already have large platforms out there. Multiples are generally lower. They're being more selective about what they pick up growing organically, and that can contrast to, I always pick on cardiology a little bit, but we've been very active. We've had a half a dozen deals.

I think the sense in that specialty is that there's, I believe that there are a hundred practices of 20 or more, and that's it in the whole country. There's been a real land grab for that. So multiples higher. I think orthopedics is somewhere in between, maybe GI just below that. I think it depends on the life cycle and the age of that particular roll-up, and the newer they are, I think the more aggressive they tend to look. With cardiology being a good example of that.

We ask this question every year, but do we ever run out of green space for consolidation? Does this idea run out of legs?

I think that fundamentally there's a real bipartisan effort to lower healthcare costs and consolidation's part of it. The first part of that question, do we run out of practices? There's a million physicians and a little less than half of them work for hospitals. I think as they fall under price pressure because they are just generally a more expensive provider, and I don't say that to harm hospitals. They just are vis-a-vis fee schedules. I think there's a pretty good wellspring of even in cardiology of people coming out of those environments.

I'm sure at some point, I mean, Optum's done an amazing job. I think they're up to 6% of all physicians in the country. Sure, I mean at some point you run out, but I think it's pretty fertile ground into the foreseeable future, and when I say that, I mean three, four or five years.

You mentioned the idea that consolidation gives opportunity for reducing costs. Obviously, it can be leveraged in an inappropriate way that antitrust investigators will have issues with, but it can also be leveraged into value-based contracting. That has felt like a ship that has been always just over the horizon and never quite here. Bart, what are you seeing with some of these larger practices moving into more value-based contracting?

That's an excellent question, and you're right. It has always seemed to be just barely out of reach for the last 10 years. It's been a long time coming. I think there were a couple of things that people needed before that could be a real driver of revenue.

One is just the ability to track things and to code things properly in a way that you can actually measure outcomes, measure cost savings in a way that's somewhat standardized so you can scale across a payment mechanism. I think we're starting to see that, especially with consolidation amongst payers and blurring of the lines between payers and providers like Matt just alluded to. I think you're starting to make that possible just by having the infrastructure in place.

The deals I'm working on, there is definitely more of a tone of those conversations now than there ever was. The fee for service, I think generally is what it is, and you're going to verify that, you're going to look at that through a quality of earnings. But a lot of the vision for the future is how much can you turn value-based care into greater margins and taking more risk on the provider side. I think that's where people see an awful lot of opportunity.

Matt, other than primary care and Medicare Advantage contracting, what sectors have been most ready to engage in value-based contracting?

I think the ones that are, and Bart, I couldn't agree more with that. You have to invest literally tens of millions in systems to be able to track this properly to go at risk. I think that, Geoff, to your question directly, I think it has really started with some of the higher acuity, higher costs orthopedic, cardiology cases for sure.

Look, there's half a dozen really solid orthopedic platforms out there. I can think of maybe two that are doing anything really significant in the value-based care space, and both have invested really heavily in their IT systems and it's real. We just closed a deal up in this neck of the woods with an orthopedic group, and we did a fair amount of diligence on the buyer and are watching these real palpable benefits and related to value-based care.

But I'd say it's more like, it's not the norm. I think they're all going to move in that direction, but you don't see it occurring with every platform. But the ones that have been able to do it effectively, I think have really been able to move the needle. To your point earlier, I think the days are gone where, not that it ever should have been happening, but people were gaming the system without a network and things of that nature that weren't good for anybody but the doctor's bank account. Here I think these types of efforts and they're private equity driven are absolutely lowering costs, and that's a good thing for everybody.

It is frustrating that, and there certainly can be bad actors that are leaning heavily into leveraging market power against payers, but the pathway for as a country to lowering cost has got to be leaning more heavily into this value-based contracting idea. You just have to have scale for that to even be a viable idea. It's frustrating that more of the dialogue around, in particular, private equity investing in healthcare is not driven by the need for scale to do the things that can actually make a real difference. We'll see if that narrative is able to change.

Coming out of the choppy environment in provider services investing over the last 12 months, investors have diversified either to balance out their portfolios or maybe push a little bit of distance from as much direct reimbursement exposure. Matt, what areas have been key growth areas as people might be looking at healthcare investing beyond provider services?

I think that the broader the spectrum that you can impact as a provider, the better off you're going to be. We've seen people branch off into, sure we talked about value-based care. We talked about Managed Medicaid, other types of ancillaries that are tangential and meaningful to the different sub-specialties that we work around. All those things I think are, it makes sense for folks to invest in to the extent that it's not diluting their focus on their primary goals.

Bart, from where you sit, as folks look to diversify their healthcare investing, what have been some of the active areas?

I've seen a ton of interest in pharma services, which is the constellation of companies that provide outsource services to big pharma and to biotech. Things like clinical research organizations, CDMOs, clinical distribution and manufacturing organizations, for sure. Anything that serves that sector without actually being a pharmaceutical company has been seen as a gateway to tiptoe into the life sciences field from somebody who's already a seasoned healthcare investor.

There's a lot of commonalities there, the issues they deal with and the deal structures, and notably, it doesn't have the direct reimbursement risk that healthcare provider businesses have. That's always been a big challenge with healthcare services businesses, but it's also been the factor that separates the healthcare tourists from the healthcare seasoned veterans in terms of who gets access to deals and so forth.

With that, I think we'll bring this episode to an end. Matt and Bart, thanks for joining. It's always a ton of fun to chat with you guys, and here's to a strong 2024.

All right, great. Thanks boys.

Thanks, Geoff.

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.