The healthcare industry has been the greatest recipient of direct lending dollars from Ares Management for decades, as the credit team has capitalised on the non-cyclical, defensive and non-correlated nature of healthcare assets. But as more private debt investors have gravitated to the sector, the healthcare strategy at Ares has evolved: the investment manager now has a dedicated team and a penchant for more esoteric subsectors in a crowded market.

“Over the last few years, we have formalised our industry specialisation in healthcare after investing in the sector for nearly two decades,” says Kort Schnabel, co-head of US direct lending at Ares. “We believe there is an exceptional opportunity to penetrate the non-sponsored landscape, and that requires a more dedicated healthcare team to be credible and highly knowledgeable in the sector.

“We also see a terrific opportunity to deploy capital into the more specialty areas of healthcare, adding to our strong commitment to healthcare services and expanding into areas that can be harder for other direct lenders to underwrite. Investments in these areas often come with downside protection through existing revenue streams or intellectual property, despite being more complex businesses overall. Having a dedicated healthcare team enables us to provide capital into this less competitive space with a view to generating strong risk-adjusted returns.”

Douglas Dieter, the partner in Ares Credit Group who leads the firm’s direct lending healthcare efforts, points to biopharmaceuticals, medical technologies, tools and diagnostics, healthcare IT and tech-enabled specialty services as key areas of focus.

Schnabel says: “Interestingly, since these subsectors are often less understood by banks or other direct lenders, the alternative source of capital for those companies in most cases is equity. We are able to provide a less dilutive and more efficient source of capital, because we understand how to underwrite those companies from a credit perspective, how to evaluate the downside protection in those assets, and the value those businesses have to strategic buyers and to the healthcare sector overall.”

Ares is not the only lender committing more resource to a sector buoyed by an ageing population and dollars pouring into digitisation. Healthcare emerged – alongside business services and technology – as one of the three sectors most favoured by private debt during the pandemic.

Fundraising has been bullish: in June 2021, GHO Capital raised €2 billion from LPs, the largest ever healthcare-focused private equity fund for a European-headquartered firm and double the €975 million raised in 2019 for the predecessor healthcare vehicle.

Then, in January 2022, Blackstone held a final close on its fourth capital opportunities fund at $8.75 billion, which will focus on technology and healthcare. The firm also raised $4.6 billion in 2020 for its inaugural life sciences fund, the largest life sciences private fund ever raised at the time, focusing on strategic collaborations with established life science companies, late-stage product financings and growth investments in emerging companies.

Growing complexity

Private credit is expanding its reach into more complex parts of the healthcare industry, says Howard Rowe of Hayfin Capital Management. He runs the specialist healthcare team at Hayfin, a credit fund offering traditional private debt to the healthcare space as well as more specialist lending strategies.

“We can look at businesses that are commercial stage, revenue generating, with products approved and appreciable gross margins, that are taking everything below gross margin and reinvesting it elsewhere, whether that is research and development or outsized infrastructure,” Rowe says. “We can support companies with minimal EBITDA, no EBITDA, or really negative EBITDA, and that’s not the model of traditional private debt. There are only a handful of lenders around the globe looking at those deals, but more are moving in.

“The revenue streams are durable and sustainable. We focus on making sure those don’t go backwards by including structural protections like revenue covenants as a way of maintaining value over time. It’s not so much an issue of dollar capital, it’s having the human capital capable of analysing and operating those credits, to source, underwrite, price and asset manage those deals on the back end.”

SLR Capital Partners is another credit firm focused on healthcare. Last year it raised a dedicated investment vehicle with more than $1 billion for directly originated first lien senior secured loans to healthcare businesses, including companies developing innovative drugs, medical devices and technologies.

Julie Reyes, head of healthcare cashflow lending at SLR, says the key to sourcing lies in standing out as a specialist: “We have tried to build a reputation as a lender with specialised healthcare expertise. We believe we offer really flexible solutions across cashflow, life sciences and also healthcare asset-based lending, giving us a unique profile to bring to diligence and underwriting. Our in-depth knowledge and understanding is valued by private equity and VC sponsors that want patient lenders who understand the healthcare sector and understand what might happen. A lot of banks have moved out of healthcare and sponsors prefer to work with a handful of lenders that can take bigger hold sizes.”

Pointing to risks on the cashflow side, Reyes says her team is focused on potential changes to reimbursement, while integration risk is also an issue for many buy-and-build strategies.

Watch out for regulators

There is also regulatory risk. “It’s very important to know that you have a sponsor who has proper experience and is going to ensure that they put in the appropriate controls to handle risk and compliance, because there will be unforeseen challenges that arise during the investment period,” says Reyes.

Isaac Soleimani is the chairman and chief executive of White Oak Healthcare Finance, a full-service mid-market healthcare lending platform. He says: “It’s a regulated industry, the reimbursement is complicated and, unlike every other industry where transactions are bilateral, healthcare is tri-party: you have a patient, a healthcare provider, and then the payer for those services is more than 95 percent of the time a third party, whether that’s government or an insurance provider.

“That creates a lot of interesting complications, as well as opportunities and challenges. To be a good lender you need a high degree of specialisation and experience to understand the risks, what to stay away from, and how to mitigate those risks and structure transactions to make sure you are protecting yourself.”

Soleimani says that after an initial 90 to 180-day freeze period, covid drove new interest in healthcare and an increased focus from lenders already active. Lockdowns hit some healthcare services providers hard, as patients were forced to stay home.

“In the first 90 to 180 days of covid, we really focused on assisting our portfolio companies to make sure they could get through,” Soleimani recalls. “They did, the lockdown eased, and those providers came back and have already paid back the additional loans we provided. Some of our competitors lost money because they hadn’t structured their transactions with the same safeguards. Since then, there are a lot of new M&A transactions taking place and we are participating as a lender in many of them.”

More lending is going to that sector. At HarbourVest, managing director Karen Simeone co-leads the private credit group, investing directly into credit across industries. Citing Q4 2021 figures from Refinitiv, she says healthcare was the largest sector for mid-market lending in both 2020 and 2021, accounting for more than 15 percent of private credit deals last year. The same data shows only a moderate uptick in leverage in the sector since 2013 but loan-to-value declining dramatically, as enterprise value multiples expand much faster than leverage multiples. “In healthcare, leverage has expanded a bit less than in other key sectors such as technology,” Simeone says. “The resulting strong loan-to-value metrics is something that continues to make people feel comfortable about lending into the industry.”

She points to four subsectors as particularly attractive: pharma and pharma-related assets, as large pharmaceutical businesses focus on outsourcing and create opportunities for mid-market providers; healthcare services, bringing efficiencies and cost savings to the industry; multi-site healthcare providers, where there is a consolidation play, particularly in the US; and healthcare manufacturing, again targeting efficiencies or technological innovation.

The HarbourVest approach to specialisation focuses on working with the right GPs, Simeone says: “Healthcare is a space characterised by many different subsectors with different characteristics, so it’s important to work with a specialist. We very much look to the PE sponsors alongside whom we’re investing for their specific healthcare expertise.”

What were the hiccups?

Senior partner Faraaz Kamran, who leads the healthcare team at mid-market lender Twin Brook Capital Partners, says: “Sector-specific experience is a must in healthcare because the speciality expertise in private equity is growing. Those sponsors want to know what other deals their lenders have done in the space, what hiccups there were, and how those issues were dealt with. We – as lenders – are seeing more deals than individual sponsors are, so they want that level of feedback from us.”

At Tikehau Capital, head of private debt Cécile Lévi says the firm has been investing in healthcare for years and the trend accelerated with covid. Tikehau provided debt financing for French pharmaceutical company Provepharm Life Solutions at the end of 2021. Lévi says Provepharm’s focus on consolidating its position as an independent pharma laboratory through acquisitions is the kind of strategy Tikehau likes. “There is a bit more competition in the healthcare lending space right now because everyone is looking to move in,” she says. “There are also a greater number of transactions because it has been identified as a resilient space and more private equity firms are expanding and gaining traction in the sector.

“There are high valuations in the space, and high leverage, so you need to be extremely careful that you have taken a position synonymous with the risk. The space can be more fragile than many people think.”

The key to success is deep sector knowledge and working with sponsors that bring specialisation to the table.