Axial’s virtual roundtable series is back by popular demand, this time, with a focus on the post-Covid M&A environment. Earlier this week, we gathered a group of healthcare-focused investors and investment bankers to sit down with Axial CEO, Peter Lehrman, to discuss the challenges and opportunities facing healthcare businesses in today’s recovering economy. Topics of conversation included transaction considerations coming out of the pandemic, the digitization of the healthcare industry, evolving tax considerations, and the current M&A boom.
Thank you to the following Axial members who participated in the discussion:
- Arjun Bhimavarapu, Vice President, Regal Healthcare Capital Partners
- William Britton, Managing Director, Cross Keys Capital
- Matt Cole, Managing Director, SBJ Capital
- Neil Johnson, Managing Partner, Lawrence Evans & Co.
- Eric Mattson, Principal, Excellere Partners
Introductions 00:00 – 6:46
Underwriting businesses in a post-COVID world – 6:46
- Do the same challenges that arose due to COVID (uncertainty about the performance of businesses, low visibility for the future, etc.) remain, or has the dust settled?
- Bill Britton, Cross Keys: There is almost no impact when it comes to a high-quality business that is looking to transact right now; high quality buyers and sellers are equipped to navigate the market at this point; you don’t even need to entertain the buyers who are looking to low-ball you anymore.
- Eric Mattson, Excellere: There is so much capital that has remained in the market, buyers are open to chasing all of the deals that are out there; it is no longer the same binary market it was 12 months ago where there were certain deals that you just wouldn’t even look at.
- Additionally, sellers are especially motivated right now because of uncertainty and/or fear around what’s going to happen with capital gains taxes, so there is actually good alignment in a lot of cases.
- The government is dictating what’s happening in entirely new ways, so that will be interesting to see how things shake out.
- Neil Johnson, Lawrence Evans & Co.: Bankers try to sell forward/sell the 2021 numbers, so some buyers question if the performance of a company is looking good because it’s a backlog of 2020 business that’s just now coming in this year.
- Bill Britton, Cross Keys: it’s actually easier to deal with the businesses that had a tough 2020 more so than the businesses that skyrocketed, because not only do buyers have sustainability concerns around the latter, but a lot of business owners have a hard time acknowledging that numbers won’t remain so high, so managing valuation expectations can be difficult.
- Matt Cole, SBJ: It’s really a case-by-case, sector-by-sector, geography-by-geography environment right now. It’s a hot market and you need to self-select out of the sectors that you’re not going to be competitive in.
Managing Seller Expectations – 15:18
- Eric Mattson, Excellere: Are bankers trying to set expectations when it comes to sustainability and buyer appetite, or letting the market speak for itself?
- Bill Britton, Cross Keys: Deal activity is so strong right now that Cross Keys is in the position where the firm needs to turn down deals that would have been good fits for them a year ago, but they are too busy.
- When you’re able to cherry pick the projects you’re working on, it’s easier to be extremely upfront with the seller and tell them: this is how buyers will view this deal, this is how it compares in the market, and your valuations need to be in X range. The seller can take it or leave it, because there are plenty of other good deals to work on.
Buyer Expectations & Timelines – 16:58
- In hearing that advisors are able to be picky about deals that they work on and that they’re choosing high-quality deals to work on because of a surplus, how do buyers think about these deals when they come across their desks?
- Neil Johnson, Lawrence Evans: One important thing to recognize is that when a seller signs with a banker today, there is a backlog of work from advisory service providers, and it’s going to take much longer to get numbers & materials together, so the deal may not be coming across the buyers’ desk as quickly as it normally would.
- Bill Britton, Cross Keys: One thing that Cross Keys is telling its clients is that it will need to be deep into the process with buyers by September, because their deal sheets will be so long at that point, that they won’t need to look at any new deals.
- Eric Mattson, Excellere: Excellere is already approaching the point this year where they feel like they need to have a transaction underway if they want to close it by EOY.
- There are a lot of inconsistencies in the market right now (having to move so fast, the expectation of high valuations, tax changes, other deal terms), that we’ll likely need to look to 2022 for things to better align.
Causes of the Boom in Deal Activity – 19:56
- There are many potential causes of the uptick in deal activity — backlogged deals, tax policies, change in administration — what does the group most heavily attribute to this boom?
- Bill Britton, Cross Keys: It’s a mix. Business owners who thought they were unbreakable before tha pandemic now see that it is extremely valuable to have a capital partner standing beside them that can help their company weather future storms.
- It’s the perfect storm right now between
SPACs and their Downstream Implications – 21:08
- Arjun Bhimavarapu, Regal Healthcare: It seems like in addition to all of the dry powder, some of the high valuations that are being driven by SPACs upstream are also having effects on the expectations of business owners in the lower middle market.
- Eric Mattson, Excellere – While SPAC as a term is new, “reverse mergers” have been around for quite a while; they’re not a new animal in the market. Once a (lower middle market) seller has dug in and done his research, he can ultimately see that a SPAC wouldn’t make sense.
- Matt Cole, SBJ: In practice, this theory hasn’t impacted SBJ, but they’ve definitely spoken with business owners (who again, are realistically not a match for a SPAC), that have read things and heard things that lead them to believe they can shoot high.
- Neil Johnson, Lawrence Evans: Aside from the fact that companies in the lower middle market are not actually a fit for these types of deals (and that’s a conversation that needs to be had with sellers from the start), there are challenges in the market that are causing a slow in SPAC deals right now, so it’s a discussion that’s easy to overcome.
Changes in Carried Interest Tax Rates – 25:05
- Carried interest tax changes are especially interesting to financial buyers; how would this impact how a deal is structured? What are the underwriting implications, does it change buyers’ holding periods?
- Eric Mattson, Excellere: It comes back to the old adage, “Don’t let the tax tail wag the deal dog”. Most of Excellere’s investors don’t pay taxes so that is not a concern, so it really only becomes a secondary concern for Excellere. They’d rather continue to focus on getting the right deals done.
- Matt Cole, SBJ: On the personal side, you definitely think about it, but that doesn’t impact the way you do deals. Your job as a PE investor is to think about exits in order to maximize enterprise value, so you can’t start restructuring deals and cannot let something like this keep you from making the right decision.
The Digital Transformation – 28:00
- Are healthcare investors looking a bit deeper into the technology that is behind a lot of the new digitized healthcare? How much has this changed over the past couple of years?
- Eric Mattson, Excellere: The two are completely intertwined today.
- Bill Britton, Cross Keys: There are specific cases where a business will trade at extraordinary multiples, not necessarily because of what they have today, but what their technology can provide going forward. So it’s really important for a banker to understand that technology to adequately place a value on a business.
- Neil Johnson, Lawrence Evans: Almost all businesses today are technology-enabled, and as the world moves to a more data-driven approach, you need to have the right systems in place.
- How do you compete on price if you’re still doing all of your records on paper? That gives a buyer the opportunity to come in at a lower valuation because you don’t have the proper infrastructure in place.
- Cyber has really been exploding this year because when you have all of your data online, you need to protect it.
- You need to be able to gather the data, bill out with the data, and protect the data.
- Eric Mattson, Excellere: Since COVID, Excellere had to increase the sophistication of their thesis on healthcare; while it previously was something along the lines of: there are more and more people getting older who are going to need healthcare and services, it’s gotten a lot more intricate in the past year.
- The easier we make healthcare to consume, more people will use those services, the more health issues will come to light, and more services will be needed.
- There is still a disconnect with laws and healthcare regulations, so it’s going to be an evolution versus an immediate change (for example, even with telehealth and virtual appointments, providers are limited by certain geographies).
- Matt Cole, SBJ: When you look at the consumerization of healthcare, tech is 100% behind that.
- Peter Lehrman, Axial: A lot of the time, a healthcare business has purchased the technology that they’re using — it’s not their own intellectual property. As tech enables more and more of the operations of a business, how does that impact how investors think about the actual healthcare component of the company versus the tech?
- Neil Johnson, Lawrence Evans: Right now it just seems like there is the price compression, where those that don’t have the technology are getting squeezed on the valuations.
- Matt Cole, SBJ: Even the ability to successfully deploy and integrate a set of IT systems is a differentiator at this point in time. That could change over time, but just the use of technology is a huge benefit right now.
- Eric Mattson, Excellere: There is so much technology being introduced into the healthcare market right now that it can be overwhelming. A lot of providers are being bombarded with all of these new tech platforms, and it can be paralyzing for operators to try to make the right decision on what to use and how to move forward.
- It’s made even scarier for these operators, because making the wrong choice can cause crippling revenue implications.
- One of the most important things is that management of these businesses has the systems/services in place to help make the right decision, because the speed with which new technology is so aggressive.
- Three of Excellere’s healthcare businesses built their own technology, so there definitely are thoughtful homegrown applications out there.
- Bill Britton, Cross Keys: It comes down to: how well was it built? A lot of small businesses don’t have the resources to do a great job, especially when it’s not the company’s main focus, so outsourcing is oftentimes a better idea for lower middle market healthcare businesses. It’s not that you can’t build it internally, but more so that it’s not the core competency.
Labor Shortage Across the Industry – 45:10
- Neil Johnson, Lawrence Evans: Despite a shift to technology, healthcare is still driven by the people & providers. Everyone is looking for good skilled labor; where can you find it?
- Eric Mattson, Excellere: Not only are nurses burning out due to things like COVID, but there are now a lot more immigration implications that don’t allow businesses to source people from places like the Philippines, so this is going to be one of the most significant hurdles going forward.
- Matt Cole, SBJ: When you’re looking at CIMs, every single one of them has something in there about the shortage of providers.
- This has been something that has been coming for years, it’s not a completely new dynamic that is fully attributable to COVID.
- Eric Mattson, Excellere: That said, COVID did have a huge impact on this issue. Not only was the pandemic physically taxing on doctors and nurses who were working around the clock, but there were new emotional taxes: they didn’t know if they’d survive, they were seeing so many more people than normal pass away, etc.
- Burnout has always been an issue in the nursing profession, so COVID really exacerbated this problem.
- Malpractice insurance, the administrative burnout, regulatory hassle, etc. are all major considerations for doctors nowadays; An oncologist employs half their staff strictly to do paperwork that they’re not being reimbursed for.
- Many people are coming out of school and choosing to do different things.
- Matt Cole, SBJ: If someone is compensation-motivated, there are a lot of alternatives to being a medical provider that pay better in this day and age.
- Eric Mattson, Excellere: We have to have technology in place to help solve this.
“Tales from the Crypt”: Sectors, Pricing, Structure, Etc. – 52:00
- Neil Johnson, Lawrence Evans: Some of the hot sectors: revenue cycle management, primary care, Medicare advantage, home health/hospice, behavioral health
- There are so many buyers in the lower middle market looking for behavioral health transactions, and not enough deals
- Having a lot of conversations now with sellers that they need to “get on your horse now” otherwise it may be too late. It’s not going to work to ask for more money just because a seller’s taxes will be different.
- Eric Mattson, Excellere: Excellere is looking for interesting entrepreneurs versus focusing only on certain sectors.
- ESG is becoming a much more important part of due diligence for investors; they’ve worked questions around diversity, carbon footprints, etc. into their diligence questions
- That said, if a deal wasn’t doing a top-notch job with some of those things but it was otherwise a fairway fit, the deal would probably get done. That may not be the case in 2-3 years.
- Bill Britton, Cross Keys: Prior to COVID, earnouts were a lot harder to get done; now they’re very doable
- Eric Mattson, Excellere: Rather than trailing 12 months or last year, Excellere is getting comfortable looking at the run rate
- Neil Johnson, Lawrence Evans: Buyers wouldn’t do a working capital adjustment
- Could be a sign of frothiness in the market