Not as dire as some would tell you, but a ton more scrutiny just about everywhere
If you’re a keen observer of where the smart money is going in healthcare, you might be a bit perplexed lately. Last year saw a record number of deals, but velocity dropped off sharply at the end of the year, and valuations are down from their peaks. So what are we to make of these developments? After a pandemic and a huge amount of cash poured into the healthcare ecosystem, trends are starting to look ominous.
To help us make sense of it, a couple of weeks ago I hosted a panel of investment experts at the Healthcare Summit at Jackson Hole, an annual event convening pioneers, innovators, and investors from across the industry. Our experts all came with different vantage points in the finance world—venture capital, investment banks, private equity, and even a not-for-profit health system. The panel comprised Andy Colbert, Senior Managing Director at Ziegler; Steve Rodgers, Managing Director at Morgan Stanley Capital Partners; George Sauter, Chief Strategy Officer at John Muir Health; and Brad Sloan, Managing Partner at Questa Capital. So what did we learn? I’ll start with some observations about what’s actually happening in the current market, and then follow up with four conclusions about how investment activity is likely to trend across the next 12 months.
What’s been happening lately?
Observation #1: Deal value is down, but deal volume has been way up, in historical terms.
Relative deal value for healthcare services investment was down in 2022, but the year generated a record volume nonetheless. It should be noted that most of that volume came in the first half of the year; deal velocity slowed markedly in 2022 and has stayed rather sluggish in 2023. That’s usually a sign of two interrelated things: smaller players in various niche markets are consolidating, and larger players are snapping up smaller competitors at higher rates and lower valuations. But also remember, valuations are only low relative to the blowout year of 2021. Relative to recent trends, valuations simply look a bit more historically normal.
Observation #2: We’re seeing drops in deal value across the board, but medical groups have had outsized impact on total deal volume.
Medical groups, post-acute care, and diagnostics drove the spike in total deal volume, with medical groups by far the leader. But note that deal value was down nearly everywhere. Those few areas that saw deal price hikes were driven by a few major acquisitions. This tells us that the era of physician consolidation continues apace. And more important, the industry is settling on three major owner-archetypes for physician practices: health systems, health plans (or their related companies), and major independent groups that enjoy new leverage across the board. The emerging dynamics between these three types of medical group owners are likely to drive healthcare strategy for the next decade.
Observation #3: Venture funding is down, but it’s still up by historical standards.
In the innovation-investment space, venture funding is down—way down from the eye-watering peak of 2021. And that’s probably dropping further in 2023, according to our experts. But if you look at the numbers, venture funding in 2022 was still well above even 2020 levels, and over twice that of pre-pandemic highs. Cash for innovative companies still abounds, but the ease of accessing it does not (more on that in a moment). And that’s true even when you look at venture funding by subsector:
So what to make of all of this? During our panel discussion, my colleagues answered questions on how capital is being deployed differently in the current environment, changes in investor and lender demands, and shifts in the relative power of “haves” and “have-nots.” Here are few takeaways from that conversation.
Four conclusions about how healthcare investment trends are likely to develop across the next year
Conclusion #1: Capital abounds, but it’s far more selective, and its priorities have markedly shifted.
It’s undoubtedly true that investment and overall deal velocity have slowed dramatically. Margin pressures—especially in the provider space—have depressed returns, and interest rate hikes have materially raised the cost of capital. At the beginning of the pandemic, a ton of liquidity flooded the healthcare space, driving a big leap forward in investment in innovation, new capabilities, and novelty. And a good deal of that capital remains to be deployed. But as downward pressure on returns mounts, investors and lenders are becoming more selective, in what my guests often called a return to fundamentals. This means a return to historical norms in terms of deal size. In 2020-21, companies looking for an exit could often demand a 10X multiple on revenue; going forward that’s likely to remain a more reasonable (and historically typical) 3X to 5X multiple. And while two years ago it was commonplace for firms to seek an exit within two to three years, investors are increasingly looking for a three-to-seven year window, with demonstrated positive margins and ample free cash flow.
Conclusion #2: “Enablement” is beating “transformation” as the main investment priority.
At the start of the pandemic, experts and futurists debated how the global response to Covid would change the ways patients access health care, fueling a great deal of investment and speculation in what are often termed “transformation” companies, those that promise new ways to access care, new therapeutics, new financing mechanisms, and new forms of automation. Interest in such innovations hasn’t exactly subsided, but investors increasingly are looking for companies promising “enablement”—services and technologies that help companies achieve their strategic aims more efficiently and effectively. Examples include technologies that facilitate positive returns on value-based care (especially Medicare Advantage), increased automation of administrative and clinical tasks, and outsourced services that expand operating margins. In the not-for-profit investment world, providers increasingly are looking at investments that can generate a positive return with two to three years, which militates in favor of technology and services, rather than grand infrastructure or replacement projects.
Conclusion #3: Big buyers are setting the rules, and are likely to dominate the investment world in the near term.
Rising interest rates, tightened lending requirements, and changes in investment priorities almost always favor bigger, more established players. And the current investment environment is certainly encouraging greater consolidation, with larger companies buying up smaller companies—within the bounds of antitrust actions, of course. While that definitely signals a widening gap between the haves and have-nots, there is some good news in this observation. In 2008-09, the aftermath of the Global Financial Crisis saw a glut of so-called “zombie companies”—in which there simply was not enough capital in the market to enable exits of smaller firms and startups. That’s not the case in 2023. Capital is available, but it's increasingly concentrated, and expectations are decidedly more earthbound than in the past few years.
Conclusion #4: Key healthcare sectors with outsized growth will continue to attract strong investment.
Automation, value-based care enablement, women’s health, outsourced hospital services, pharma services, and primary care enhancements are all receiving a great deal of attention in the investment world today. We’ll be spending more time discussing these topics across 2023 as part of our State of Healthcare research. If you’d like to gain access to that work as it’s released across the year, click here to learn more about Union’s research agenda.