With higher interest rates causing anxiety throughout much of the first quarter of 2023, McGuireWoods' Geoff Cockrell invites David Baker, Managing Director at FTI Consulting Group, to share his view of the market and how it’s impacting sellers in the M&A space. 

Healthcare as an industry is more resilient in a down economy, David explains, as demand is less likely to be impacted by economic factors. This resilience attracts investors looking to avoid the challenges present in other sectors. 

“I think what attracts a lot of investors to the segment is how steady it is,” says David. “Healthcare hasn't had the highs and lows that many other sectors have gotten over the years.” 

The healthcare economy needs efficiency to close the current gap between demand and supply, and investors who find these solutions will emerge as winners. With interest rates on the rise, David provides insights into how this is impacting overall pricing and deal structures, along with what buyers and sellers need to be considering.

Featured Guest

Name: David Baker

What he does: David is a member of FTI Capital Advisors, FTI Consulting’s investment banking subsidiary. He has over 30 years of experience in international M&A, capital formation, partnership agreements, and corporate strategic development.

Organization: FTI Consulting

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 where we bring together dealmakers in healthcare investing by private equity investors to discuss some of the current trends, we dive into particular market sectors, just to have a general interesting discussion. I'm your host, Geoff Cockrell, partner at McGuireWoods. I head the private equity industry group here. I'm glad you could all join us. I'm thrilled to be joined by my good friend, David Baker, from FTI, one of my favorite investment bankers in the healthcare space. David, maybe give a quick introduction of yourself and then we'll jump into some topics.

Sure. Thanks, Geoff. I'm recently with FTI Capital Advisors, which is the investment banking arm for FTI Consulting. I've been doing M&A transactions my entire career, my first job out of school, and got into healthcare with GE Healthcare. I was on the buy side with GE, bought 25 different companies with GE, I went into an operating role with them in Europe. But coming back from that assignment, I went back to the banking side, exclusively on healthcare. I've been doing that ever since for 30 years now, all healthcare, all the time. So it's been fun. It's a great segment. We're doing services, medtech, equipment deals, and some healthcare IT as well. So it's good to join you this morning.

Thanks, David. We chatted out at JP Morgan Conference a few weeks ago, and I had a number of discussions with investment bankers, and there was a fair amount of doom and gloom as to what the pipeline in Q1 looks like. And from where I sit, one of the drivers in that is availability of credit that senior lenders were both over-extended in investing but also feeling a fair amount of rate instability with the interest rates continuing to move, coupled with the private credit market can only go so far before they run out of dry powder themselves, but all of that leading to a little bit of doom and gloom in Q1. But I want to ask you a specific question, that the higher rates have implication in pricing, the models for buyers to achieve their return have to incorporate higher rates, which has a natural implication on valuation multiples. One of the discussions I was having with folks out there is whether or not sellers are ready to acquiesce to some of those pricing implications.

From where you sit in your conversations with sellers and potential sellers, how do sellers view valuation implications of higher rates?

We still do. We track all of the variables that effect the transaction market, which certainly include rates, availability of credit, but also just the economy generally, segment growth, other things that are happening within the economy overall. And for the last several years, a pandemic aside, it was all markers were green, everything was pointing up, everything was green, and we said you can't get a better deal market. And we knew at some point things would change, and here we are. And certainly rates are impacting the transactions and the pricing. We've heard that from a strategic looking at one of our clients right now, and we had just closed a deal with them last year and they said, "Look, clearly for us, and right now just because of rates, the multiple is down a turn or two from where they're going to be." But more importantly, for that particular asset, for them, it was a little bit more about the opportunity on that particular transaction.

So I think that tends to drive the decision making even more. So for them, it was a bit more about that segment, that geography, that particular fit, although rates certainly have an impact. And as you know, a lot of the middle market deals, they're not highly leveraged. They do deploy leverage and they're using that effectively to help the equity returns, but the middle market is not impacted as much as maybe the much larger transactions. So it has somewhat of an effect, but it's not the overall driver. It's still about quality companies that have growth prospects are still going to get attention in the market and likely have a premium price to them as well.

As far as the buyers, I guess the second part of the question, the buyer's view and are they willing to move? They certainly don't go into a deal thinking, "Well, it's going to be suboptimal," like any, I'm sorry, a sellers, any seller certainly is looking at having the optimal outcome, but they're also willing to accept what the market feedback is. When you get this very consistent message coming back from the marketplace, they are willing to accept that that is the view of the market, you have some pretty smart money looking at these opportunities, and you tend to see a pretty consistent response, which the consistency of that response I think is what allows for sellers to be comfortable with what the opportunity is.

Setting aside pricing, just from an execution perspective, there's a certain amount of anxiety around just availability credit. And I appreciate that middle market and a lot of healthcare, as middle markets, are generally going to be less levered, but it still plays a part in it. Does anxiety around the availability of credit to finance a transaction, whether you're talking senior lenders, private credit funds, or even limited availability on delayed draw term loans for existing strategic buyers, does that impact any of your thinking on timing of bringing an asset to market, or is anytime good if you have a good asset?

Well, I think generally, if you have a good asset, anytime is a good time. Good assets in strong markets or softer markets are still going to get, and probably even more so in the softer market, will get more of the attention because buyers don't want to take on something needs to be fixed or troubled as much in a softer market, it's harder. So I think a good asset, even in a softer market, will get equal or probably even more attention. Availability of credit, certainly we have to understand that and we have a responsibility to make sure we can get to the close with that structure, with that buyer. And so we'll certainly dig in along with the buyer to understand what the availability is for that debt structure.

But we have not run into any problems with any re-trades or availability with respect to of the credit side of the transactions. So far everything has been working. Who knows what happens here in the coming months, but so far, everything's been pretty much business as usual, apart from obviously what we've talked about before. Rates have gone up a bit, has some marginal effect on the overall pricing and the deal structure or the deal pricing, but it hasn't impacted it in a large way, at this time anyway.

Given some of the macro-level headwinds in the economy, both real and anticipated, one of the benefits of healthcare investing is that healthcare as an industry is a little bit more resilient against a down economy, in that demand for healthcare services is not directly correlated to economic growth more at a macro level. Do you see a lot of investors moving towards healthcare in the midst of maybe challenges in other sectors that they might invest? And does that have an impact on pricing as well?

It does. It helps support, I think, the valuations in many of the healthcare segments, because as you said, it is shielded. We just closed on an equipment services transaction, and that company was providing services to labs principally, and the labs obviously, they're going to be processing their samples and doing their diagnostics regardless of economy. So a lot of pathology and derm and histology and those things, those tests are going to be done regardless. Therefore, the equipment needs to be up and running and that's what our client was doing was servicing that, the equipment. So it's pretty steady. And that's what I think a lot of what attracts a lot of investors to the segment is how steady it is. Healthcare, it hasn't gotten the highs and lows that many other sectors have gotten over year.

We've been through these segments in the past, and the only time that really I saw a very significant slowdown, and even pause, in the healthcare segment was when Obamacare was going to the Supreme Court. The few months when right before that decision was made, and I don't know if you probably saw the same thing, but a lot of people just sat on their hands just leading up to that just because it was such a binary decision, waiting for the Supreme Court decision on how it was going to be treated. But apart from that event, I think even through the pandemic, even though certain segments got shut down in the pandemic, but others, we closed deals in the middle of that. In the financial crisis, same thing. It was deals were still getting done, and it was still fairly steady within many of the healthcare segments.

You mentioned healthcare support services, so not provider services. We are seeing a ton of interest in activities surrounding healthcare non-provider services, so those support services, maybe pharma services, pharmacy services, payer services. The confluence from where I sit is that you have some non-healthcare primary investors wanting to move into healthcare investing, both on account of it being a sixth of the economy and also on some of those dynamics we're talking about where it's a little bit more resilient to a more challenging macroeconomy, but also investors that have done a lot of provider services looking to diversify. That feels like a white-hot area right now. Is that consistent with what you're seeing?

Yeah, I think so. And I think that tends to be fairly consistent, but it also certainly gets the support services, non-provider keeps the investors that don't like to have the direct reimbursement risk, so it keeps them a step removed from the direct reimbursement risk. Maybe they don't want to invest in a business that is accepting Medicare, Medicaid. A lot of reasons for investors that may shy away from provider, the non-provider is going to be critical for those services to continue to be able to leverage all the providers because our healthcare economy, it cannot deliver what is going to be demanded of it without creating more efficiencies for the providers. The providers need to be just over time, you have a gap between many provider segments in terms of the demand and supply. And the only solution really to solve that, apart from magically creating more experts, which isn't going to happen quickly within any field, the only solution is to better leverage their capabilities through a lot of these support services.

And that's where I think a lot of these activities is coming to play. And if somebody has a solution that can provide and help better outcomes at lower cost, it's going to be a winner and it's going to continue to attract a lot of attention for that reason.

Maybe diving a little further into provider services, a few questions. It's been a pretty extended run of consolidation in the provider services arena, as you look at, sector by sector, investor attention has migrated their way through the provider services arena. First question is, do you see any end in sight to that trend from an availability perspective? Dental is a massive industry, a lot of other provider sectors are a lot smaller, do you see any end in availability of things to consolidate?

Well, certainly there is a theoretical end to it, but I mean, your dental example, dental is still largely fragmented. Even despite the 100 plus platforms that private equity has invested in and created over the years, there's still a huge amount, I don't know what the number is now, maybe it's 20% of the market or so, I mean, it was, I think, 12, 15%, is climbing up and so certainly it's getting consolidated, but what's the point of saturation? There's certainly providers, dental or other segments that want to stay independent and will, so you'll never get to the 100% max certainly. And there's other reasons probably that would push against that trend. Just being able to, once you have further consolidation, there's going to be other models that will come into play that are able to find a solution or find a home that might be more efficient. I think those things certainly could happen. But it's harder for new providers coming out of school in any segment, just go out and start a business and hang a shingle. It goes back to the availability of credit that you mention.

Physicians used to go to their local bank and get a credit line and open a office, and off they go. And now you can still do that, but it's a little different game than it used to be in terms of the security for the lender. So I think that has become harder as well. The segments I think that have not had as much attention, I think, on the provider side are starting to. I mean, we've seen transactions in many segments that historically have not had the same type of attention, even podiatry. Cardiology, we did a cardiology deal a couple years ago just when reimbursement changes were coming into play and most of those cardiologists, vast majority, are employed by hospitals as a historical fact of, it goes back to, again, back to Obamacare and I think some of the change in the incentives for the hospitals to pull in those cardiologists in an employment basis. And now it's shifting back. So these shifts in reimbursements, the capital coming in, other efficiencies available to support the physicians.

They all come into play in different segments and in different ways. But I think what happens is, or what is happening is it is driving the consolidation and it will continue. And it's also, I think, a fact of those physicians that have built up a large practice as a partnership, and they're trying to understand their exit opportunities relative to newly minted physicians coming out of school and looking whether they're going to be employment model or a partner model. And more and more are happy to choose the employment model versus the partnership. So I think a lot of these factors come into play, which will continue to have consolidation in segments as a result. So it's both the financial as well as the personal as well as the strategic, all are part of the mix of the decision making.

Maybe flipping the analysis to the other end of the spectrum. From a consolidation perspective, you got smaller consolidators that sell to larger consolidators, usually a private equity fund, a private equity fund transaction, and then to a larger fund to a larger fund. Ultimately, it would seem that for the model to continue and succeed, those backend buyers need to have success. What does success look like for a very large buyer? Does everyone end up selling to Optum or becoming public? What are some of the backend scenarios that will be successful for those buyers? Because if those buyers don't find success, that will ripple down through the entire consolidation apparatus. Are you bullish on what that looks like?

Well, certainly there continues to be a demand amongst large strategics for physician practice in a variety of segments. I mean, Optum, while they might have, as an example, might have interest in a certain segment, they're at the point even where they're going to get some attention in certain markets relative to antitrust. So their density in certain markets is probably nearing a point where they're not going to be able to do too much getting drawing attention, although there's a lot of the market still left for them to cover. And then you also have the example with the announcement with CVS and Oak Street just yesterday. So you certainly have a number of different strategics that are still looking to pick up and build out the provider services in a bigger way.

So I think there still remain exit opportunities, the public markets that this was a path that is another alternative maybe for a larger platform. While this was done 30 years ago, as you recall, the wave of Fi-Core and the others that were many publicly-traded physician practices, but those really didn't last, I think because of the way they were structured and the alignment of incentives. And I think the way the deals are getting structured today better align the new investors with the physician providers and the incentives. And so everybody's driving towards the same growth model. I think there remains an opportunity, I mean, for even the larger platforms to find an exit. But that's the natural it has to happen is, to your point, how else does somebody come in, and everybody's coming in who's making that investment already has a view on the exit. So without those two things, you can't even get to the close.

And I'm of the view that you get to a certain size and scale, and some of the return expectations can shift, that, I mean, a private equity fund is modeling out to leverage, and other means, a return, whether IRR or in cash-on-cash, maybe 2, 3, 4 times cash-on-cash return for an investment. You get to a certain size, either of direct major institutional investors, where I think they view investing in this arena a little bit more like they view the return expectations in public markets, that they can get exposure to large assets. And if you have a diversified portfolio, it will behave maybe a little better, but like direct public market investment. So the return expectations can level off on that higher end, which I think can be a definition of success that will continue to support the model.

So I'm still bullish that A, there's the supply, like we talked about before, and B, you don't run out of room for growth as you land on major platforms that ultimately will behave and grow at a more measured pace, more like a publicly-traded company would, and that will be okay. So I'm still bullish as well.

Yeah, and you have, also adding to that, in terms of the larger platforms, the larger also have the ability to add other services and even be more relevant to their patients. And again, if we're thinking about on the provider side, and taking the cardiology for example, once you start getting to a certain scale and you have a cath lab and you can have your own imaging 'cause you have the volumes to support that and it's more efficient, and the imaging's is in the cath lab, it's next door to it. The cardiology deal we did, they had a sleep lab, which obviously has a big tie in to cardiology. And then the home telemonitoring. So there's a lot of different services that you can more efficiently bring to the table versus when you're a little bit smaller and you're more focused on a specific therapy or specific segments.

And that also adds to the growth, the stickiness of those revenue streams, which speaks to your point on the stability and how investors look at it more like a public market because there you have a bit more stability. Maybe it's less of the up and downs or maybe the risk profile is more modest, and therefore you're willing to accept a slightly lower return because the risk profile has changed. And so therefore that leads to the same conclusion, which is, yes, there should be exit opportunity even for the much larger platforms because that capital can generate a return over time.

David, I think we could talk all day, but let's leave it there. It's been great to explore some of these macro-level trends with you, and we'd love to have you back on The Corner Series sometime.

Yeah, well, thanks. Always happy to talk about the healthcare deal market. So thanks, Geoff. Thanks very much.

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@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.