Specialty finance: Perceptive Advisors on healthcare returns

Investing in healthcare companies using structured debt can provide broader downside protection than royalty financing, posits Sam Chawla, portfolio manager of the Perceptive Credit Opportunities strategy at Perceptive Advisors.

As institutional capital continues to pour money into the private debt asset class, it seems few places are immune from the competitive forces that most private credit managers are facing. Relatively niche areas may be one of the last refuges where an attractive return profile still exists.

Sam Chawla of Perceptive Advisors explains what makes healthcare direct lending a promising sector strategy and how the industry has developed over time.

What’s the typical profile of a healthcare speciality finance firm?

Sam Chawla

Sam Chawla: In general, there are a number of different types of firms that are focused on providing alternative capital, such as structured debt, to companies in the healthcare sector. Over time, focused healthcare funds have formed to provide growth companies with alternative forms of debt capital as a complement to traditional equity capital. Structured debt capital is attractive to management teams and boards of healthcare companies due to it being minimally-dilutive capital, relative to equity.

The two predominant sources of structured debt capital are dedicated healthcare funds and traditional business development companies. The funds often employ a private equity-style structure and will have some internal expertise in healthcare markets. There are also some generalist direct lending funds that focus on a variety of different sectors with healthcare sometimes being one of those verticals. Finally, there are some smaller commercial banks and BDCs that focus on healthcare, among many other industry sectors.

Many funds and BDCs have successfully produced strong investment returns by indiscriminately providing structured debt to companies through a formulaic underwriting approach with a secondary emphasis on the fundamentals of the underlying company at hand. Perceptive’s roots are in equity investing as a fundamental healthcare investor, and over time we organically realised that there is a significant opportunity set for us, but just in another part of the capital structure, and that’s structured debt.

How has the healthcare speciality finance industry developed?
SC: The direct lending segment of healthcare has really evolved over the past 10 years. Historically, growth companies in healthcare, or more specifically, the life sciences sector, had been capitalised with 100 percent equity or with a complement of convertible equity. In the early 2000s, or maybe even a little earlier than that, some firms emerged to start providing royalty-based financing to healthcare companies, which turned out to be a creative means of financing. For many funds, the royalty-based product has matured and morphed into providing structured debt to companies as an alternative or a complement to equity.

When the financial crisis hit in the late 2007 timeframe, the scarcity of equity capital in the market helped solidify structured debt as a complement in the capital structures of growth companies in healthcare. Exiting the credit crisis, many [healthcare] companies realised that structured debt capital can be an interesting way to optimise the cost of capital when used “properly”.

“Properly” means with some degree of conservatism around sizing of the structured debt. As an extreme example, one cannot entirely finance a growth company that’s not cash flow-positive with an all-debt capital structure. There needs to be a high-quality base of equity investors beneath the debt.

“Investment sourcing is a highly manual effort and there are a significant number of public and private companies in our target segment”

Today, we sit in a market full of attractive investment opportunities that is continuing to grow. We rarely meet a CFO that does not have experience with structured debt on the balance sheet. In the life sciences space, these structured debt transactions are often bilateral in nature and not broadly syndicated. However, occasionally you’ll see a couple of players in a deal. The structures are highly bespoke and customised to the company at hand. Many limited partners like the return profile of these investment structures and the lack of broad fundamental competition in our niche.

If an investment portfolio is properly managed, a well-run fund could achieve double-digit-type returns through structured debt on an unlevered basis.

What are the selling points to investors on a healthcare direct lending strategy when compared with other private credit strategies?
SC: What’s unique about the healthcare space is that outside of healthcare services, the technology, science, regulatory path and clinical utility underlying a product or product candidate all need to be carefully analysed and considered. There is a complexity to understanding all of these components, among others, that requires a high degree of sector specialisation to get it right.

Understanding the science and related implications requires unique insight, academic training and investment experience. For instance, what does the underlying science and technology translate into in terms of prospects for FDA approval and what does it mean commercially from a reimbursement and uptake perspective? It is exactly this level of complexity and required expertise that has insulated the healthcare segment and enabled durable returns for the healthcare sector. Given the clinical aspects and reimbursement distortions of the healthcare sector, it’s often challenging to apply general industrial thought to analysing healthcare companies, and one needs unique knowledge and insight to assess appropriately.

Consequently, most generalist private debt firms tend to avoid segments of the healthcare sector, and to a larger degree, life sciences specifically. Additionally, some dedicated healthcare funds don’t have deep and broad resident sector knowledge, and instead outsource to external firms or consultants.

What types of securities do healthcare direct lenders invest in?
SC: There is a wide range of structured investments; the ‘art of the possible’ spans from senior secured loans to structured equity.

What does it take to execute a deal from start to finish, from sourcing and diligence to closing?
SC: The deal process is complex from start to finish. Investment sourcing is a highly manual effort and there are a significant number of public and private companies in our target segment. All facets of fundamental diligence are important and typically it is a multi-week process. We go through the underwriting and diligence simultaneously and arrive at an investment decision. The whole process will vary, but on average is an eight-week process and requires significant documentation in conjunction with closing.

From a fundamental standpoint, there are many factors that are critical to executing a transaction: deep understanding of the science and the assets that underpin the company, the competitive environment, the quality of the management team, equity investors and the financial profile of the company. It’s a multi-variate equation of elements that converge together to arrive at the investment decision and ultimately the sizing and deal structure.

What’s the return profile for these investments?
SC: We are targeting double-digit net annual returns. The return is predominantly comprised of the coupon on the debt and warrants which could appreciate over time.

What is the difference between healthcare specialty finance and royalty
SC: From our perspective, being able to underwrite an entire company’s basket of assets versus just one product – which is an element of a royalty strategy – is a broader way to protect ourselves in a downside scenario. This debt strategy is a unique way for investors to have a broader basket of collateral and participate in the upside of the equity in the whole company.
Moreover, the royalty side is a fairly competitive space and mature. Smaller-sized royalty investments are harder to uncover and there is a lot of competition, which has compressed unlevered returns in the market. Moreover, some firms are taking more risk around royalty monetisations, including investing in future royalties of products that are still in development. We see tremendous opportunities in the structured debt market from a risk reward perspective relative to royalties.

This article is sponsored by Perceptive Advisors