Healthcare M&A: PE firms see brighter days ahead

By the fourth quarter of 2022, activity was down 15% compared with the same quarter a year earlier,¹ and that slide continued into 2023. In the third quarter of 2023, healthcare M&A volume fell by 16% compared with the previous quarter and 19% versus the same quarter of 2022, according to data from LevinPro HC.²

Despite the downbeat figures, there’s cause for hope looking forward: The macroeconomic picture is improving, with inflation cooling and supply chain bottlenecks and labor shortages easing. Most important, the American Bankers Association’s Economic Advisory Committee has stated that the Federal Reserve is finished raising interest rates and may even look to cut them in 2024.³ So, how are private equity (PE) firms navigating the current doldrums and preparing for a potential break in the clouds?

At the most recent Cain Brothers Private Company Healthcare Conference, Andy Goldberg, managing director at Cain Brothers, talked with several PE partners about how they’re approaching portfolio, capital, and platform capital allocation in the current environment. Joining Goldberg on the panel were Matt Altman, managing partner at Arlington Capital Partners; Michael Langer, managing director at Lightyear Capital; and Syliva Qiu, managing director at CVC Capital Partners.

The panel kicked off with a look at how the market dislocation of the past year has affected their investment decisions.

PE strategies run the gamut

After deploying record equity in healthcare throughout 2021 and into 2022, CVC Capital Partners’ Qiu noted that the downturn had allowed her and her partners to focus on their portfolios and digest some of those investments, while remaining open to new opportunities. But, she added, not all firms have followed that patient and prudent approach.

“I have friends at different peer firms who, when the Fed first started raising rates in early 2022, just said, ‘We’re risk-off, goodbye.’ Others have been investing like it’s 2021,” said Qiu. “There’s been a greater dispersion of activity, but the high-quality assets that show real organic growth still have a lot of demand.”

Arlington Capital Partners’ Altman agreed that attractive assets that come to market are getting a lot of attention, but that otherwise he has seen volume drop precipitously.

“The biggest challenge in getting a deal across the finish line has been just getting them to the starting line,” Altman said. “The leading indicators haven’t been as relevant. People keep saying pitch volume is up and 2024 is going to be a great year, and there’s a lot of pent-up demand — but we just need to see it happen.”

Lightyear Capital’s Langer said the sticking point is a disconnect between seller expectations and buyers’ willingness to lean in. The sharp rise in interest rates since March 2022 and the M&A feeding frenzy that preceded it have made comps from that period irrelevant.

“Cost of capital of senior debt is trading at a 12% return and, during the peak of the frenzy, sponsors were solving returns to the mid-teens. That’s just not enough risk premium for us,” Langer said. “So, multiples will come down, but no one knows where they’ll settle and that’s really the source of uncertainty.”

While M&A activity and value are still depressed, there are signs that some stability and predictability have returned to the business environment.

Portfolio companies breathing a sigh of relief

While some new risks have emerged, like a brewing crisis in commercial real estate and the anticipated cooling of consumer spending, many of the headwinds that have plagued the economy over the past couple of years have either subsided or plateaued. Most notably, inflation is less than half what it was a year ago and the Fed has declined to raise the federal funds rate since July 2023.

“A lot of our companies have gone through at least three cycles of instability since the (COVID-19) vaccine came out in early 2021 — from Omicron to the great resignation, to inflation, and so on,” said Qiu. “The main thing I hear from my portfolio companies is that they’re excited to be operating in this new normal and to see fewer dislocations, even though it is a different environment now than it was in 2019.”

With this relative stability comes an opportunity for portfolio companies to pivot from putting out fires to focusing on further developing their capabilities and growing their businesses. One of the big components in this evolution is the increased adoption of artificial intelligence (AI).

AI will propel future M&A, but gradually

Cain Brothers’ Goldberg noted that AI was one of the big business stories of 2023, thanks to the release a year ago of ChatGPT. An application based on generative AI, ChatGPT can carry on humanlike conversations, an innovation that has enthralled the general public and business leaders alike. Langer, for one, said the hype is justified.

“I’m a huge believer that this is going to have a massive impact on healthcare, where there’s a lot of inefficiencies,” Langer said. “Pharma companies are already using it in complex models around large-molecule drugs. And on the provider side, you could see a world where you’re taking a lot of administrative tasks away from the physician.”

However, Langer added, before companies can start leveraging AI to its full potential, they first need to get their data houses in order.

“The data needs to be consistent and clean or the results these models produce based on that data will be useless,” Langer said. “We’re notorious in healthcare for having antiquated tech stacks and disparate systems, so there needs to be material investment made in healthcare to really get effectiveness out of these models.”

Rather than an overnight change, Langer said the impact will be more gradual. “But it is a topic of conversation in every investment committee and board of directors meeting we have, because there’s a lot of uncertainty of how it’s going to impact businesses.”

Have we seen the end of the turmoil?

The past few years have been tumultuous for healthcare M&A, and while activity has yet to pick up, there are signs that the worst of the volatility and uncertainty could be over.

“The job of PE is to forecast the future. When there’s uncertainty, it becomes harder to do that,” Qiu said. “So, I think we are really just hoping for the end of all this turmoil. Hopefully, that will help draw out some of the M&A activity we’ve been missing.”

Altman agreed that stability is the tonic for what’s ailing the market: “There is a lot of capital — and there are a lot of companies that will come to market if there is some level of relative normalcy.”