Healthcare under the microscope

There are many approaches to healthcare debt, ranging from investing in companies with negative cashflow up to profitable mid-market businesses. We lift the lid on four ways to engage with the sector

firms list healthcare as one strategy among several. Others specialise in the heavily regulated market and invest across the sector, while some pick only small-pocket strategies.

The healthcare market is a behemoth. A report by Deloitte this year found more than $7.72 trillion was spent on healthcare globally in 2017, and that the figure is projected to grow to more than $10 trillion by 2022.

Within the industry, there are many different avenues for investors to go down, each of which offers pros and cons. Investors can focus on strategies that have higher risks, such as investing in pre-commercial-stage companies that are testing new drugs or treatments. Alternatively, they could lend to less risky, more established healthcare practices and offices to help those companies fill routine funding gaps.

Private credit firms loaned more than $60 billion for private equity and venture capital healthcare buyouts in 2018 alone, according to data provided by PitchBook. And those numbers do not include revolving credit lines and growth capital products.

Investors say that supply in the healthcare market is consistently high and that there are frequent opportunities. However, the space comes with its own set of risks and regulations and heavier due diligence requirements than some other industries, especially when working with cash-negative companies and start-ups.

We place four firms with different strategies under the microscope to reveal the nuances that specialised markets have to offer.

The big-ticket writer

CRG has a strategy that might keep mid-market lenders up at night. The Boulder, Colorado-based credit firm commits big loans, sometimes of up to $300 million, to companies that are cashflow- and EBITDA-negative.

It invests in commercial-stage devices, diagnostic tools and healthcare services. The companies it invests in are high-growth and usually have negative profit margins. And according Luke Düster, a partner at the firm, almost all of them are “burning money”.

“The barriers to entry are high because you don’t have the available data, like positive cashflow and the like, to make credit decisions,” he says. “You have to take a much more private equity look [to perform operational due diligence]. You have to do deep interviews with management teams. You have to do your own market research. You have to spend much more time and money on due diligence for a company just launching a product than on a company that is producing profits.”

CRG’s strategy is to loan $20 million -$300 million to commercial-stage companies seeking to scale up. “What we saw was a gap for commercial-stage companies that needed two basic things: more money and more time.” In January it provided a $60 million facility to EyePoint Pharmaceutical to support the launch of its implant treatment, YUTIQ. Last October, it provided a $100 million term loan to NanoString Technologies to help with the biotech company’s latest product launch.

Despite the additional risks, Düster feels there are many great companies in this area of the market. He says that, when looking at potential investments, CRG will ask what the proposition is for the product, whether it will help cut costs for consumers, and whether it will provide a better outcome for patients.

Düster says an example that would hit all three criteria would be a device to reduce the chances of a stroke in people at a higher risk of suffering one. Strokes are relatively common and costly to both patients and society. The company would not look particularly savoury on a balance sheet but could still be a solid investment. “Most companies continue to burn capital for some time,” says CRG’s managing director Scott Li. “The amount of time that these healthcare companies require to fuel and ramp-up growth is a little different [from others in the sector]. It is a decision all our companies go through.”

Li adds that there remains “no shortage” of demand. Düster says CRG will continue to expand its core business and look to bulk up its involvement in healthcare services: “We will continue to grow our base business, identifying and investing in growth companies. The real exciting opportunity is what we have been building with Scott with healthcare services.”

The asset-based niche

MidCap Financial is a Bethesda, Maryland-based firm, backed by Apollo, that focuses on healthcare services and asset-based lending. Garrett Fletcher, its head of ABL, has worked in this type of lending for more than 20 years and says that although it requires a learning curve, it can be lucrative when it comes to healthcare.

MidCap’s strategy consists of lending mainly revolving credit facilities to companies, such as nursing homes and acute care providers, that are looking for capital to finance growth, acquisitions or restructuring.

The firm lends to companies with between $50 million and $500 million of annual revenues. Its loans range from less than $5 million to more than $500 million and typically last three to five years. Fletcher says it tends to form lasting relationships with companies that borrow from it frequently.

“Asset-based lending within healthcare is a niche,” he says. “There are risks in the space, both with regard to credit and collateral, that are specific to healthcare. The lack of understanding of these risks keep some generalist competitors from lending into the space.”

Fletcher says there are factors that may deter investors from the strategy, especially regarding due diligence surrounding the valuations of these types of companies. Valuations are tricky to pinpoint due to being based on billing amounts that have gaps between what is charged and what is covered by private insurance and by Medicare and Medicaid (the US government systems of providing basic healthcare for, respectively, the elderly and people on low incomes).

“If you were to go to a hospital and get surgery, you would see a bill for the surgery – take $10,000 as an example,” Fletcher says. “In fact, your insurance company has contracted with the hospital to pay significantly less than the $10,000 gross charge for the surgery.

“So, if I’m lending to the hospital on the basis of its accounts receivable, how do I ensure that I’m not lending on the $10,000 bill, but rather what the hospital has contracted to receive for the service?”

Fletcher says Midcap makes sure it lends on the valuation based on actual payments. He adds that lending on the company’s collateral also helps remove some of that risk for investors. Despite the potential discrepancies, Fletcher finds it to be a safe form of investing.

“We can be both smart about it and take risks that others might not be willing to take because that regulatory risk exists,” he says. “Certainly, we do see other competitors raising capital around the healthcare investing thesis. I think there is ample appetite for it.”

The connection point

Armentum Partners, a financial services firm based in Menlo Park, California, advises healthcare start-ups. It also operates sustainability and technology venture debt advising strategies.

When it was founded 10 years ago, it looked at every potential deal. However, managing partner Brian Demmert says it has since narrowed its focus to 75 percent commercial-stage deals and 25 percent other strategies.

Most of its loan mandates are healthcare deals and it advised on 34 in 2018. It connects start-ups to the best types of funding from private venture debt lenders, venture debt banks, or even royalty financing.

“Most of our companies are still burning cash,” Demmert says. “The risk appetite for pre-commercial, earlier stage, private, venture capital-backed companies is not as high as it was.”

Within commercial-stage companies Armentum looks at deals including biotech, medical devices and healthcare services. Recently, it has advised on a $200 million senior loan to San Francisco-based pharmaceutical company Tricida and a $60 million senior loan to Massachusetts-based biotech company Aldeyra Therapeutics.

“For commercial-stage companies, [venture debt] is an amazing product relative to the cost of equity,” Demmert says. “Companies that are still burning cash, particularly public companies, can fund most of what their expected burn is going to be through debt.”

Armentum looks for companies working on multiple products, which lowers the risk for investors because it can take years to get a product to market, even if it is approved by the Food and Drug Administration. He says the deals with lots of “harsh” covenants give him pause because most of the companies he works with are at a stage in their development where they could easily break covenant guidelines by accident.

Demmert says competition in the healthcare venture debt market continues to grow and that medtech and biotech remain popular strategies for lending. “I talked to a biotech company a few weeks ago and they already had 15 people lined up. They weren’t even looking for debt. If a biotech company announces positive data, venture debt folks are banging down their door.”

Armentum also advises on royalty debt financing deals. Managing partner  John Sailer says they can be a great way for inventors, universities and places of academic research to reduce financial risk before getting deep into the testing and clinical stages of development.

“If you are a university, and you have something that makes it into phase two or phase three [of development], you can de-risk yourself institutionally by taking capital up front and avoiding taking the deeper risk,” Sailer says. He has noticed growth in the royalty healthcare market, with deal opportunities increasing each year: “The benefit [of royalties] is that you can realise the value up-front. That it is a pretty robust market to be an issuer in.”

The PE-focused generalist

There are also firms whose activities extend into the healthcare space. One of these is Twin Brook Capital Partners, a generalist mid-market lender with a dedicated healthcare team whose members have decades of collective experience in the field.

Faraaz Kamran, senior partner and head of healthcare leverage finance, says the strategy accounts for around 30 percent of its business. The Chicago-based GP deployed more than $1 billion to healthcare companies in 2018. “We continue to be extremely active,” he says. “We are definitely one of the market leaders.”

Twin Brook focuses on lending to private equity-backed mid-market healthcare businesses with between $4 million and around $25 million of EBITDA. It takes a generalist look at healthcare and invests across a variety of sub-sectors. Kamran says the firm sources all its healthcare deals through its private equity clients. Some of these are healthcare-specific lenders, while others are generalists. “We are a little bit reactive,” he says. “We aren’t seeking out a specific sector. We are responding to what our clients see.”

Kamran says it does a lot of business around healthcare services that have multiple locations, such as physical therapy or dental practices. It has also helped to fund pharmaceuticals, medical devices and other verticals.

Twin Brook completed a deal for a $95 million loan to support the merger in February of on-demand medical providers Emergency Care Partners and Progressive Emergency Physicians. The following month it partnered with Riverside Partners to provide a loan for an undisclosed amount to Allied Dental, a chain of dental surgeries.

Kamran says that although Twin Brook will consider any sub-sector within healthcare, its primary focus is on companies that will be able to morph and adjust to regulatory changes and businesses that would still be in high demand during an economic slowdown. “There are a lot of different winds blowing east and west and you have to be able to look at how my portfolio companies will be affected. How long do they have to adjust to industry changes?”

While Twin Brook has established strategies across financial services, industrial and other sectors, Kamran says the healthcare strategy is a good fit for the firm. He says deals in the sector have perhaps five associated risks and that and one or two might be specific to healthcare. However, he adds that, for the most part, these deals follow the same structure as those in other fields. Because Twin Brook has a team of healthcare experts, it claims to offer expertise that generalist firms without the necessary specialisation or experience cannot.

“There is a pathway for portfolio companies to grow,” Kamran previously told Private Debt Investor about the sector. “You can be in the mid-market and be the third- or fourth-biggest provider. You don’t have to be a billion-dollar company.”