Diagnosis of the healthcare sector

Richard Zall and Gary Creem, partners with Proskauer, explain why healthcare has become one of the major areas of focus for private debt investors.

This article is sponsored by Proskauer.

The healthcare sector is one of the most popular areas of private debt investment – why do you think this is?

Gary Creem: Private equity funds and finance sources have to be able to understand the regulations to evaluate risk; the area is constantly evolving and general investors may shy away if they don’t have a firm grasp of what is happening in the industry. It’s also non-cyclical and non-discretionary: whether there’s a recession or economic times are good, people still need healthcare.

Gary Creem

There is also a lot of change going on in the industry: new services and delivery modes are entering the market. That creates opportunity for investors, for M&A and financing. Much like the shift from mainframes to the cloud that has happened in the technology industry, there’s a similar shift taking place in healthcare. Hospitals had traditionally been the site of healthcare delivery. That distribution now has moved to outpatient care, to urgent care and surgery centres; there’s an ongoing shift to a more distribution-focused model. There’s also a lot of innovation taking place. That creates opportunities to invest. This requires capital and that creates opportunities for our clients.

Is there a pattern in the type of financing that healthcare companies need? For example, the need for expansion capital, industry consolidation or distressed opportunities?

GC: There is a lot of industry consolidation taking place: insurance companies are buying doctor groups, insurance companies are getting into pharmacy services; there’s lots of vertical integration. There is also growth-stage demand, given the innovation and disruption that leads to financing needs. Technology is increasingly driving the development of new services and that creates enormous opportunities for private equity funds and the sources of capital that help support them. The other driver is demographics. For instance, the US population is aging. An ageing population means greater healthcare needs, leading to expansion of services and growth opportunities for private equity and investors.

Do you typically find investors in the healthcare area have specialisation? How important is this to be able to invest in the sector?

GC: This industry has heavy regulation and lots of specialisation. Clients that engage in this area tend to have specialised knowledge in the space. They need to be able to evaluate risks like reimbursement rates and appreciate the ever-evolving nature of the industry, which does create more risk. While our clients may not be a speciality firm, they will have that speciality at the firm. We have seen a growth in speciality finance sources but I think we’ve also seen growth in team depth: if firms are interested in doing deals in healthcare they add depth to their healthcare team.

Are there particular regions where healthcare deals are focused?

Richard Zall: The US and Europe are two parts of the world in which there’s a lot of activity, but we have also seen deals in places like South America and Asia. There hasn’t been a pronounced difference in concentration by location. Healthcare is a global need and deals are taking place globally.

Richard Zall

What macroeconomic factors have supported the development of the healthcare market? Has increased privatisation or deregulation of the healthcare sector driven more dealflow?

RZ: The government sector has over the past half a dozen years increased in its regulatory activity; there’s more coverage being funded by the government. The health of the country is also a factor. Primarily though, market development is being driven by the constant innovation in the market, whether that’s the use of AI in drug development, fundamental rethinking of service delivery, or the rise of wearables with a healthcare focus; there’s a lot happening.

In those countries where there is more government involvement in the healthcare sector, can reliance on state contracts create additional political risk for investors?

RZ: Government involvement has by and large created positive investment considerations in our experience, as it protects incumbents to a high degree and there tend not to be major shifts in government programmes and priorities. It is important that investors understand the regulatory trends as those can lead to differences in the ability to generate revenues and earnings, but if you’re in the game it provides a level of protection. There’s always the extreme case of someone violating the law and losing their licence, and some don’t like anything where there’s a government role as it alters market forces, but for those who become expert in the sector it provides some insulation too.

Are there other regulatory hurdles when investing in this sector?

RZ: In just about every jurisdiction inside and outside the US, physicians and clinicians are credentialed to provide service to the public. So, businesses can’t just go out there on a whim and employ the doctors. It does require some creative structures. From a lending perspective, the collateral and the ability to have remedies can be limited by that factor.

Your report highlights a notable fall in mezzanine deals in recent years. Why?

GC: We did not see a dramatic rise in interest rates in 2017 and so floating rate loans were still more attractive to borrowers. I also think that for a lot of our clients, as we get towards the end of a cycle, they may be shying away from junior debt and looking to go up the capital stack to senior debt and so I think that may just reflect a choice of investors to shy away from riskier assets. We are continuing to see more opportunities in senior debt. But we are also seeing some clients go out on the risk curve for really attractive assets that have strong cashflows. So, for those types of deals, they may look at recurring revenue deals; they may look at preferred stock opportunities – for strong companies in the technology and healthcare space.