Access to capital for operations and growth is a critical to every organization. Though healthcare has been attractive to investors and relatively safe for lenders in years past, in the days ahead, things are likely to change.
Healthcare is an industry that attracts investors and lenders because it’s big, global and virtually recession proof. In the U.S., it’s 17% of our GDP accounting for more than $10,000 in annual spending per capita. In 60 other countries of the world, it’s a maturing or developing industry, accounting for 4-12% of their national economies. And in many of the other 111, it’s an emergent industry as governments invest in public health programs and facilities.
While the rest of the U.S. economy went into a free-fall losing 8 million jobs (2007-2010), healthcare added 1 million. While our GDP shrank to zilch in that period, healthcare spending increased 4% per year. And as our economy recovered, annual healthcare spending growth exceeded our overall GDP improvement. Case in point, for 2016, our GDP will close up 1.6% while total health spending will be up 5.8%.
The reality is that in the U.S., healthcare does well when the rest of the economy doesn’t, and it does even better when the rest of the economy is doing well. That’s why we’ve been a safe bet for lenders and investors for decades. Demand for our “stuff” is easy to calculate: 10,000 new Baby Boomers age into Medicare daily until 2029 and we have precise measures of use for every band aid we need. We know how many of our providers are retiring and how many are in the training pipeline. We know how many drugs are in the FDA’s review cycle (though their approvals are increasingly complicated) and the therapeutic classes where there are gaps. We know how many beds we have and the number we need going forward, and we have a pretty good sense of the clinical innovations that will define how we diagnose and treat for future generations. Thanks to regulations and public expectations, we’re a predictable, change-resistant industry, so capital has been accessible to healthcare dependably. But that’s changing.
In the past four years, drug manufacturers have had a great run, raising prices bi-annually to score double digit profit gains. Now the new administration is declaring war against drug prices. Insurers had a great run after passage of the Affordable Care Act, but prospects for Medicaid expansion and marketplace enrollments are uncertain. Hospitals in states that expanded their Medicaid programs did better but bad debt is escalating again and operating margins are evaporating. In fact, in the S&P 500, healthcare will close the year down in the negative range while energy, utilities, consumer discretionary and financial sectors post solid gains of at least 20% or more. That’s why initial public offerings for promising healthcare companies fell by two thirds to an eight year low of 33 this year.
Add uncertainty about the replacement the Affordable Care Act and increased borrowing costs as the Fed raises rates, healthcare lending or investing is less attractive. That’s why the capital markets are taking a fresh look at their strategies. That’s why capital flows to healthcare in the future might not be as strong as in the past.
The Predispositions of Lenders and Investors about Healthcare
As is true for every industry, there are three major sources of capital for companies and organizations needing funds for growth or acquisitions: 1-debt via bank loans and other credit instruments, 2-strategic investments from outside companies that stand to gain by aligning their financial interests with another organization, and 3-financial investments by hedge funds, private equity and others who seek optimal return on investment through deals in multiple industries. What’s happening now?
In every sector of healthcare, debt is becoming tougher to get and more expensive. The Fed raised rates .25 earlier this month and will raise rates three times in 2017, so capital will carry higher interest costs. And lenders will be more cautious: the uncertainty about the ACA’s replacement, possible trade policy shifts impacting the technologies, drugs and devices we import and export, and anticipated changes in tax policy signaled by the new GOP leadership mean bankers will be more cautious. So the debt market for non-credit worthy organizations will be tougher, and costs of capital for debt will cut into margins and free cash flow for everyone.
For strategic investors, these events are good. Increased M&A activity is likely as consolidation activity in most sectors accelerates. The biggest players i.e. the large cap companies, will have a wide-open field for deal-making, especially if the new administration’s pro-business agenda is actualized and Department of Justice constraints on consolidation shrink. For strategic investors, deal making will increase and terms of conditions will favor buyers over sellers. For many companies and organizations, go big or get out will be a C suite imperatives.
And for financial investors, deals in healthcare will continue but terms and conditions will be tougher. While healthcare companies might expect to benefit from anticipated tax reforms, financial investors want to put their money at work in industries where scale and growth are predictable advantages. And the complexities of healthcare at home and abroad lend to financial investor opportunism and scrutiny.
Who can get Capital?
Lenders and investors look first at the fundamentals within a sector to gauge the headwinds or tailwinds they’re need to navigate. Then, they look at the organization itself: its operations, governance, products and services, and perhaps most important, its management. If comfortable, negotiations begin.
Many lenders and investors favor certain sectors over others, or specialize in certain types of transactions. Some specialize in bio-pharma, aggregating scientists and bioinfomaticists as principals on their teams. Some specialized in a sector of the delivery system, like acute care hospitals or skilled nursing facilities. And there’s a growing cadre of venture funds that invest exclusively in digital health and other technologies that are likely to be integrated into emerging systems of health. Finding and keeping the right bankers and investors is an ongoing challenge for CFOs and CEOs.
So, looking at 2017, what are the bankers and investors looking for? Here’s a simplistic breakdown of their investment theses and areas of highest interest:
Several themes figure for lenders and investors looking at healthcare going forward…
Do it cheaper! Organizations that offer a demonstrably cheaper way to do things will be able to acquire. They are interested in technologies that streamline functions, pills that are cheaper than an incumbent brand, operating models that gets more done faster or cheaper. Lenders and investors in healthcare value solid management. And management teams that apply novel technologies and proprietary analytics to operating cost reduction are golden.
Do it bigger! Domestically, healthcare delivery in the U.S. is a cottage industry: 4900 hospitals, 850,000 physicians and so on. By contrast, our drug, device, insurance and information technology sectors are dominated by large cap companies with healthy balance sheets and global operations Consolidation among suppliers and insurers is accelerating. By contrast, consolidation to achieve scale among providers is lagging. Affiliations between hospitals, employment of physicians, and expansion of services into population health have not produced measurable advantages in scale, especially when contrasted to the scale advantages among the big players in other sectors. Going big without achieving scale is zero sum game because margin pressures will hit every sector in coming months. The capital markets see consolidation to achieve significant improvements in scale and purchasing leverage as viable options where their money can be put to work.
Do it smarter! Healthcare has institutionalized its ways of doing business. We have calcified core processes, like scheduling, testing, diagnosing, purchasing, paying and so much more. Capital will flow to companies that bring new processes to routine tasks. Better ways or doing the same jobs thru automation or alternative engineering. Virtual clinical trials, immunotherapies, telehealth and self-diagnostics are new solutions to routine problems. Capital loves disruptive process companies.
Do it quicker! Gaining access to new users of a medication, or solution, is the channel to organizational growth. Old ways or educating providers, conducting translational research, getting diagnostic tests done and managing chronic conditions are subject to disruption by organizations that do these faster. Capital will be readily accessible to these.
So, what’s ahead?
No one knows for sure how the ACA might be replaced and when nor how the fallout from Brexit and global trade will play out. For U.S. health industry watchers, the duo of Paul Ryan, current Speaker of the House and former Chairman of the House Ways and Means Committee, and Tom Price, the incoming Secretary of Health and Human Services and former Chairman of the House Budget Committee, bring clear preferences for a market-driven, pro-business approach to healthcare which means lender and investor opportunities will increase. No one knows for sure how the 20,000,000 who gained coverage through the ACA’s exchanges and Medicaid expansion will be dispatched. No one knows how President Trump will make good on promises to bring down drug prices, allow those with pre-existing conditions to get coverage, leave Medicare alone and improve Veterans Health.
No one knows for sure about the future of the U.S. health system nor how healthcare will evolve in the 191 countries of the world. What we know for sure is that access to capital will determine who survives and thrives, and who doesn’t. That’s why it’s important to understand how bankers and investors are thinking these days.
Next week’s Keckley Report will focus on the 8 most important stories in U.S. healthcare in 2017!
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