Host Geoff Cockrell observes that seller anxiety about the potential for broken deals seems to be high right now. A surprising number of deals, he says, are reluctant to “go out into a wider market process.” Guest Reed Van Gorden of Deerpath Capital sees the same trend: mergers and business sales are slow. He’s waiting to see if the two additional interest rate cuts that are expected this year will set more deals in motion.

Reed finds that companies are performing well and have stabilized since the effects of the COVID pandemic. And the local businesses that Deerpath focuses on, such as medical offices, are not terribly affected by world events like supply chain problems or fluctuating oil prices.

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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 try to bring together thought leaders and deal makers at the intersection of healthcare and private equity. Today, I'm thrilled to be joined with my longtime friend, Reed Van Gorden, managing director at Deerpath Capital. Reed, maybe give a little introduction of yourself and Deerpath and then we can jump into some questions.

Yeah, no, Geoff, thanks for having me on, and appreciate the opportunity here. I think we started working together, I don't know, 12 years ago back when I was at Gallup Capital, Reed Van Gorden, managing director and Lead Origination for Deerpath Capital is a middle market lender focused on the enterprise value segment of 50 to 250 million focused exclusively on sponsor-backed deals, meaning we only work really with private equity firms. Healthcare is one of our biggest niches at 15-ish percent of the book. As we all know, it's probably 20% of the economy, so not surprising I think for any lender to have it be pretty material.

So Reed is, we're headed here into Q4, the M&A market has been choppy for quite a while. What does the landscape look like from where you sit as far as deal activity? And we can get into where you're seeing that activity, but to start us off with how you're seeing any uptick in activity or not.

Yeah. So maybe just quickly stepping back on the year. I think first quarter was relatively slow for the overall market. I think that is normal. First quarter tends to be your slowest quarter of the year. Us as well as the market, saw a nice pick-up in second quarter and third quarter with not return to 2021 levels, but probably return to 2022 levels after 2023, that was down a little bit. And then in the fall so far, fourth quarter, there seemed to be deals out there, but there really haven't been a whole bunch of deals transacting yet. And I don't have a great answer of, is it people aren't in a hurry? Are people just trying to buy time with election? Even though I'm not sure the election moves the needle for most companies, it's hard to tell.

The top of the funnel, meaning the total number of opportunities right now is as good as it's ever been. It's just a question of as works through the funnel, how many you like and then how many move forward. I would say one trend we've seen this year, a lot of is a lot more broken deals. And I think when you talk to players out there, there have just been a lot more broken deals, whether because of diligence, because of valuation, impasse or whatever, but that seems to be a real trend over the last 12, 18 months.

Yeah. I've found that seller anxiety around the potential of a busted process is really influencing how they go about these processes. I've got several sell sides running right now and a few of them more than I would've naturally expected have been reluctant to go out into a wider market process, and have instead chosen to do a narrower specifically targeted buyer process. Are you seeing similar dynamics or anxiety around busted deals?

Yeah, absolutely. I think your point's exactly right, and I've heard it from some sponsors that they don't know the actual right way to sell their company because to your point, if you run the small process or let a group or two run ahead and try to really go fast, the cost of not having that secondary bidder is really high. But then similar, if you run the big full-blown process, people are probably going to retrade or adjust because they had to bid high to get the deal under LOI. And I just think people are in a no-win situation of which way is the best.

I'm also seeing a number of quasi sale transactions, whether that is selling to a continuation vehicle or an all equity deal where you've got two decent sized platforms that are going to consolidate and the equity is not being cashed out. The senior debt on one side is usually going to be refinanced, but it's not a true sale. Are you seeing those dynamics as well?

We've seen a couple of those recently. The mergers, I would call them, between two similar sized platforms with the logic to one, they're bigger now, so they should get the valuation uptick as well as there should be some synergies. So we've seen that. I don't know. I haven't seen as many continuation funds this year as I probably expected. Last year we saw a whole bunch. I don't know if it's just a data anomaly. I feel like I hear about them every other day, but we haven't really seen a whole bunch impact our portfolio this year.

How has the recent reduction in interest rates impacted both availability of credit and deal activity?

So I think availability of credit the last six months, five months, I'm not sure what the right period is perfectly. There was some data I recently saw from LSEG or used to be Refinitiv that basically showed the big downtick in spread was between first quarter and second quarter, and then has been pretty stable since then at relatively tight spreads for the last 10-year historical period. And I think we continue to see that today. I think in the upper market, all the negatives you hear about from a documentation, from a covenant, from a multi lender club continue to be very present and really aid the private equity community on getting deals done.

But that being said, we haven't really seen this giant rush or wave of deals. I keep waiting. The one thing we track in our portfolio is number of companies preparing to sell, and that for the last probably six months has been at a pretty elevated level compared to the last couple of years. That being said, we're still not really seeing the companies go to market. They're just prepped and ready. So it'll be interesting. Now, to your point, with the rate reduction and basically the Fed saying they expect two more this year, does that cause the logjam to loosen up? I guess time will tell.

Yeah. It would seem that from a buyer perspective, particular rate cuts wouldn't impact your model too much resetting interest rates every, let's call it six months anyway. So your bigger model impact is your longer term expectations rather than any particular rate event. But it does impact thinking on macroeconomic questions. And to that point, how much of your underwriting thesis has an eye towards macro level events, whether that's an election, whether that is unrest in the Middle East and impact on oil pricing, how much do you keep track of and add to your model, those macro events?

So I think we think about those macro events with where we play, and by that I mean we focus on being top of the capital structure, first lien, senior secured and private equity backed businesses such that when there is a unforeseen shock, we have a private equity firm both with the capital as well as the desire to support the company, as well as operationally to help manage the company and improve it. I think we go about that more in terms of where we play and how we build our strategy than saying, "We're now going to be more risk on, because jobs came out positive." I would say in our portfolio over the last 2 years, 18 months performance has been pretty good. Margins are down a little, but that's probably from your peak coming out of COVID. But companies overwhelmingly have continued to perform well and maybe that's ultimately what we factor in is this vertical has been doing well, this business type has been doing well, continue to want to do more of them.

The other thing I would add is given the segment we play in of that 50 to 250 million of enterprise value, most of our companies tend to be service-based, local-based businesses. Whether it be a urology business or a dermatology business on the practice management side or on the more whether products or technology, our revenue cycle management play, a clinical site business, something that really has local demand such that supply chain isn't going to disrupt it, oil prices won't really disrupted besides a general economic impact. And in some sense that's the nice thing about where we play is you're much more driven by local and the US general GDP growth than any other factors.

And whether it's operational challenges or balance sheet challenges that are occasioned by higher interest rates, nobody wants to have platforms in distress, but distress is part of the exercise. How do you think of your role as a lender when companies in varying degrees of distress?

Yeah. So I think the nice thing about being a private lender and having access to sufficient capital is if someone else isn't going to do it, I can do it. And we've done that in a fair number of circumstances where for some reason or another, the owners will not support the company. We've stepped in and provided the capital to, one, continue going along, continue running the operating business as well as to invest for growth. We have a dedicated team that focuses on that. Healthcare has been one of the sectors and specifically more practice management that's been under pressure due to a combination of labor, wage increases, labor shortage, and just difficulty operating. What's interesting is it was never a demand issue. I think people tend to be more always concerned about some demand issue, when you think about a business. It really hasn't been demand, it's been the input side and being able to service the demand profitably.

Do you have any advice for sponsors or platforms that are anticipating or experiencing distress?

I think it's always to everyone's benefit to be transparent with the lender because the worst surprise is something that they don't know about. I don't know, I've heard people say this before and there's probably some truth in it, is the lender doesn't like going back to their investment committee anymore than the private equity firm does with bad news. So I think we're all aligned there that it's just about keeping the lines of communication open, being transparent, because most likely they've seen this in three other portfolio companies. Most people don't have a single deal in the space or they've been talking to their colleagues at other firms and been talking about where the problems are.

I don't think you're going to freak out the lender, or if the lender didn't expect it or know what was happening, they weren't doing their job. I think most lenders are on top of it. That being said, I think we're, I don't know. I would hope we're through most of it. It feels like most businesses at this point have stabilized. Maybe some are less profitable, maybe some are still passing through price increases. But it seems like most things, at least on the practice management side aren't getting worse. But I guess only time will tell.

Yeah. I'm still having conversations with PPM businesses that are having varying degrees of distress. And your point I think is well taken. And that's usually the advice I give. Sometimes there's questions as to whether or not going early to a lender is giving a potentially hostile party, more room to navigate. I generally don't go in that direction. And I think that transparency, there's going to come a day when you are going to need some engagement and maybe concessions from a lender. And going to them early with both a problem and a solution is the most successful pathway to getting everyone's buy into that solution. So I totally agree that transparency is the way to go.

I think one point you said that I think is really important is come with a solution. Don't just lay the problem at, because invariably, they may just throw it back at you of like, "Why are you making this my problem? You need to give me some type of path forward or solution." I think the other thing that people often forget is while it is a negotiation and while it is technically like there are different sides of the spectrum, that one could either get more flexibility, get more what they want, get less, et cetera.

I think the nice thing about this ecosystem is so much of it is multi-year, multi-deal relationships that these aren't single zero-sum games. These are multi-part, multi-year interactions, relationships, and ultimately negotiations. And these aren't a closed-loop system. If someone misbehaves, whichever side, it will be talked about in the community. And that ultimately, I think does sometimes enforce a decorum and relatively narrow solution set.

In the healthcare arena thought more broadly than just services. So picking up life science, picking up pharma services, payer services, a lot of different areas that are related to healthcare, which of those areas are captivating your thesis looking forward? I ask this question to a lot of people and I get some consistent answers and then some not. So what sectors within broader healthcare do you find most appealing?

So I think revenue cycle management continues to be a very active and healthy sector. I think there's a lot of different flavors of that, whether it be early out deductible, whether it be complex claims, whether it be full outsourcing, whatever it may be. But there continue to be a lot of strong businesses with healthy growth there, given the return on investment to the customers is really high. Another sector we like broadly as a firm, and we don't see a ton of it in healthcare, but there's now been a couple ones done is some of these IT managed service businesses. Sometimes you can loop in some of these digital transformation businesses in that mix. There's Metasys sold earlier this year, and there's a couple other plays in that business that can be really nice, both equity deals as well as credits due to the strong recurring revenue or reoccurring revenue, strong customer trends. So that continues to be a place where we see good activity. That being said, I would like a few more.

And then maybe the two other segments to mention is one broadly KPAs or groups playing to address the needs of self-insured employers. I'm always astounded by how many employers are self-insured and then ultimately choosing to manage the healthcare costs themselves as well. So not just as simple as, "We'll do the insurance portion, but we're still going to have Aetna, UnitedHealth manage it, but actually doing the management themselves. And there's been a whole bunch of different plays in that market of whether TPAs, whether utilization review, whether case management, different to reduce healthcare costs.

And then the fourth maybe area broadly is pharma outsourcing and biotech outsourcing, and is it ultimately a clinical site business, which is where they actually do the trials? Is it the CRO that's managing it? Is it the manufacturing or the development TBD? I think all of them can be good businesses. I think the hard thing there often is there tends to be a lot of customer concentration. When you look at the volatility of revenue, sometimes it doesn't show what you really want due to that customer concentration.

Maybe separating those two. So you mentioned businesses that are connected to large self-insured, or to a certain degree self-insured employers. That would also seem to connect well with a number of thesis around value-based contracting. So rather than the risk-bearing employer, if it's a risk bearing through contract, how involved in value-based contracting businesses have you been? And obviously as a lender, risk-based contracting means taking risk, and how do you think about your thesis as it surrounds value-based care?

Yeah. So we have historically done a whole bunch in that sector. Interestingly enough, today we really don't have a lot of exposure in it. I think a mix of companies grew so well that they grew out of our market segment as well as the financing got so aggressive that we just chose not to partake. We really don't have a lot of exposure in that market anymore. I know there continues to be a lot of different regulatory changes, whether direct contracting. Now, there was what? The big Quemana star rating thing last week, but historically we found it a very good place to lend. I think the key being what you raised is really making sure you understand the risk.

The ones we have done have not really been full risk bearing. They've been more the Medicare advantage managing the patient population, but then have very strong stop loss. So the, I don't know, MLR ratio that they're exposed to is relatively narrow. I know ophthalmology, some of our ophthalmology plays have a component, but that's almost more like a... It's not really prepaid, but it's not a very big suite of services that you're exposed to. But historically, we found them very good businesses to lend to. It's just I can't really speak to now given we just don't have a lot of exposure.

Reed, I think we could talk for quite a bit, but maybe we'll end it there. You're right. We've worked together in one form or another for a long, long time. I'm glad to finally have you on the series here. Thanks for joining. It's been a ton of fun.

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.