May 15, 2020

The Future of Healthcare Services M&A Amid the COVID-19 Pandemic

Point by Point

This episode of Point By Point was produced prior to the combination of Waller and Holland & Knight.

Healthcare M&A was off to a healthy start early in 2020 but that activity ground to a halt in March and April with the onset of the coronavirus crisis. Waller partner David Marks and Brentwood Capital Advisors’ L.A. Galyon and Porter Meadors take a sector-by-sector look at the current state of healthcare M&A and what the future may hold for the remainder of 2020 and beyond. They also offer advice for healthcare providers that may be exploring options to sustain or grow their businesses.


Morgan Ribeiro: Over the last five years or so, we have witnessed a lot of consolidation in the healthcare services space. The healthcare industry now, however, is facing extreme financial pressures due to COVID-19 that will have lasting effects on the healthcare merger and acquisition market. I have asked David Marks, L.A. Galyon and Porter Meadors to join me today to have a discussion around mergers and acquisitions in the healthcare services space.

David is a partner in Waller's corporate practice who provides counsel to physician practices and healthcare private equity firms on M&A transactions, and L.A. and Porter are with Brentwood Capital Advisors, a boutique investment banking firm working with middle-market healthcare companies. Porter and L.A., Brentwood Capital recently released its Q1 2020 healthcare services M&A report in which you all highlighted the impact of the ongoing pandemic on the M&A market and what you predict to occur in the coming months. L.A., to kick us off, I'd like to hear from your perspective, at a macro level, what are you seeing happening in the economy right now, and how is that ultimately impacting what we're seeing on the merger and acquisition front?

L.A. Galyon: From a macro perspective, deal volume was slightly down in '19, compared to '18. There were several large deals done in '18, but I think most expected 2020 to be a little down from '19. We had a long economic recovery, really high prices and leverage across the board, and certainly COVID-19 threw cold water on an overheated market. I think the other piece is very few sectors of healthcare have not been disrupted. So providers have seen pretty big disruptions to surgeries, visits clinics being closed. But in the same breath software providers or folks who provide services and software to the healthcare system have seen pipelines and things like that either evaporate or be delayed at best. So it's really hit every type of company across the healthcare marketplace.

Morgan: Are the transactions that were underway, prior to the pandemic, generally still on target to close or have those also been delayed?

L.A.: I think it depends on the type of transaction. You know, if you were buying a company, I mean, clearly second quarter M&A volume is going to be a 90% reduction from where it was last year so I think if stuff was on the goal line, and you're ready to close and the business hadn't fallen apart, we've seen it close but I would tell you that 90% plus, of the stuff we were working on or stuff we hear was in the market has been delayed or really kicked down the road.

Morgan: David, is that similar to what you're seeing in your practice right now?

David Marks: It is, especially for the larger private equity-backed exits. Those are definitely on a delay. I think for a lot of those sellers, they're not that interested in creative processes until debt markets recover, but they want to get a return of capital. And to do that, I think they want to maximize their opportunity. The flip side is we're seeing although pretty much in Q2, the smaller add ons all went on pause. I think we're going to see a surge and a return of that kind of smaller add on activity precisely because a lot of these private equity future sellers want to maximize their upside and grow EBITDA as much as possible when the economy does fully recover when the debt market can support a larger acquisition of an entire platform.

Morgan: So let's talk about the dynamic between sellers and buyers. Over the last several years, it has been said that it is a seller's market. But given what's happening right now in the economy, and ultimately in the M&A market, will there be a shift will it become more of a buyer's market than a seller's market, meaning there'll be more sellers than buyers? L.A., I'll start with you.

L.A.: Sure. Yeah, I think it'll take some time for the market to settle. And for the economy reopen. In healthcare, a lot of these businesses are simply closed right now, so there is no market. And I think it's almost impossible to do a transaction in that type of environment. But I do think sellers, as we get into the second part of Q2 and Q3, will have to adjust the new normal. And so it'll take time for that reality to set in. And then I think, as you mentioned, seller's market. It has been like that for a while. But I think it's going to take time to kind of bridge the delta between buyer and seller, it doesn't really matter what asset class that is. And so I think two steps. One, what's the new normal? How long does it take to determine what that is? And two, really managing expectations of the sellers in that environment. Because it's going to be dramatically different

Morgan: Porter, what are you seeing?

Porter Meadors: You know, I think L.A. is right. I think what I'd add is, we feel there are always going to be buyers, they're always going to be capital providers, for good companies, regardless of the environment. I think we feel that's gonna be true here as well, and frankly, this environment may really distinguish great companies from mediocre ones. I think two things that sellers have going for them now, even in this tough environment, we've seen with the CARES Act stimulus program, massive, massive economic stimulation in excess of $2 trillion. So I think that's going to help soften the blow that some of these companies have had over the last two months and compensate for some of the loss of revenue, particularly those that have had to shut down completely. I think in addition to that, and I think back to the start of this year at JP Morgan, there is an ocean of capital out there waiting to be deployed. Part of this unfolding, it seemed like everybody had a new fund, had a bigger fund, many of those in excess of a billion dollars. So I think those are dollars that are looking for places to be deployed. And I think while we expect sponsors to be patient, to be thoughtful, to be strategic about how and where they deploy, that it's nonetheless a lot of dollars that are going to be looking for a relatively scarce number of really good assets.

David: Totally agree with Porter. The best targets are still really good targets. And if they can perform and demonstrate patient demand is returned or is still there, then buyers are going to be scrambling for it. There are some strategic buyers, some of the big ones out there that are highly leveraged and don't really have room to do deals. But I'll tell you, the fear of missing out is very strong. So with a lot of these really good practices, the ones that can demonstrate, Hey, I keep open on an extra Saturday, and I still have a lot of patients out the door. There's a strong expectation and ability to demonstrate to people that the EBITDA will come back and full, and those from a number of our clients are seen as not only potential opportunistic plays because the field of buyers is smaller, but also particularly important and attractive for funds that need to be able to show a return.

Morgan: Right, that makes sense. You know, as the world is fighting the pandemic right now, M&A activity in many sectors has slowed down, yet many industry advisors you've all mentioned private equity, in particular, we've seen that PE firms have an opportunity to consider select healthcare segments accelerated growth drivers, and that they should deploy their dry powder into sectors, which may see unprecedented demand during this crisis. Do you all agree with that? Porter, I'll start with you on that.

Porter: Sure. So I think going back to the beginning of this year, the economy was humming along. It was doing great. And I think looking at our report, these are numbers that we recently published, PE funds invested $92 billion in 591 distinct transactions in the first quarter. And that's an 8.5% increase year over year from 2019. So we came into the year strong I think, as this COVID situation has taken root, it's not the thematic areas that are going to shut, I mean everybody I'm sure is interested in telehealth and you see that in the public telehealth companies, but I think it's going to be more of a prioritization of tuck-in, add-on acquisitions, deals that can be done with little or no debt. I think you're going to see some structure in terms of using seller notes, lieu of senior debt, higher shareholder rollover, in some cases from sellers. And I think, in all honesty, we expect deal volume is probably going to remain pretty low, certainly through the second quarter and third quarter of this year. You know, capital markets just don't do great with uncertainty. And I think what we're looking at now is a time of just unprecedented uncertainty. So I think the world will open up, we'll get back normal, but it remains to be seen kind of what that volume looks like. But I think you're gonna see near term a lot more kind of tuck-in, add-on smaller acquisitions in place of a big platform acquisition.

Morgan: David, is that similar to what you're hearing from Waller's, healthcare private equity clients?

David: It is maybe I'm a little bit more hopeful that we'll see some return of M&A activity, but you know, much of it is driven by these macro factors, but also really simple issues like PPE. If you've got some of these practices that, in order to drive the volume, they need to support the valuation or multiples that they were getting pre-COVID, the reality is they can't run those procedures that same kind of volume until they get access to PPE on comparable prices. And being able to figure out when that price will return, is it November or is it December? When is it exactly? It's a tough one. So the reality is that the overall volume will decrease. But again, I do think that good practices are good practices, and buyers don't want to miss out on the opportunity. I think what you are going to see is some buyers that are just too leveraged and they're just not in the play anymore. And the question for a lot of sellers is going to be, are you willing to do some of these creative structures that Porter and L.A. are referring to? Are you willing to do with Gastro One did, for example? What they did is made some creative options on it I don't know PE sellers will do it. But founders, I think it makes a lot of sense. It makes a lot of sense to talk to bankers and others who are really thinking creatively about how can they make sure they have an exit soon, and also have future opportunity and upside but get the deal done.

Morgan: L.A., anything you'd add to that?

L.A.: Yeah, I would tell you, I would echo what Porter and David have both said, I think when you hire an advisor, be it a lawyer or a banker or someone to help you through this, the challenging part of today's market is it's tough to define what the market is what is fair? What is the bell curve? What should this look like? Because I think if you talk to 10 different buyers about a potential opportunity, you're allowed to get 10 wildly different answers. So that's the hardest part is the consistency, the things the capital markets typically want don't exist. So I think by default, we're having to move to these other structures that may not be as transparent and as straightforward, but it's really all you can do right now. So we may return to kind of normal, but I definitely think the market will be different than it was pre-COVID.

Morgan: Right? So I want to hear some of your thoughts on specific sectors within healthcare services. I'll start with behavioral health. Both of our firms do a lot of work in this space and have for many years, and our two firms most recently represented Psychiatric Medical Care, and its investment by Consonance Capital. At times there have been specific areas of behavioral that have heated up. And right now, for instance, there's a lot of conversation around investor interest in autism, eating disorders, addiction treatment, just to name a few. What trends are you seeing in this area? And what do you think will come in the post-pandemic market? L.A., I'll start with you.

L.A.: Sure. Mental health, in general, is something that's been impacted by this whole crisis. We have a client out West, and it's outpatient mental health business, and I think his suicide hotline was at 400% year over year from patients calling in, and so job losses, all these things compound isolation, the things that mental health providers are set up to provide. So it's one of the few sectors when we talk to clients today, hey can our business do something. Mental health, as Porter mentioned telehealth, is one of the few segments of healthcare services still kind of open for business. And unfortunately, it's a pretty big demand for the services. There was some activity in key one, I think the things you can do from a telehealth standpoint, outpatient standpoint and mental health will be attractive for a long time.

Morgan: David, I know that's an area that you're tracking closely and working with clients in the behavioral health space. Anything you'd add to that?

David: I think it is an exciting area, and we've been lucky to work on one of the larger mental health counseling platforms out there, pre-COVID. The concept of it to me is proven by COVID. The fact that there's such an interest in demand for telecounseling, to me, at least what I hope to see is an expansion of some of the rules that otherwise limit the ability for prescriptions, for example, so if there is a more flexibility or creative legal structures that would allow some of these counseling platforms to tie in with psychiatry platforms, it's an enormous growth opportunity. Unclear to me at this point whether or not COVID is going to be enough to spark that. But clearly the trend towards telemedicine in the context of mental health treatment from everything from autism and eating disorders, which is has had and has continued to have a massive amount of growth and interest, is a real opportunity and one that we're closely tracking.

Morgan: Yeah, and I think home health and hospice, switching to another sector of healthcare services, has received a lot of attention in recent years. L.A., anything that you would mention about the home health and hospice space, and particularly how it's been impacted by COVID-19?

L.A.: Sure, the trend was already there. Home care and hospice companies already saw people who were more comfortable being in a home than a facility-based setting. This has accelerated that trend. I think someone mentioned earlier the biggest issue with them getting equipment when they go into nursing home or someone's home. That's an issue for all providers. But think if you ask the average American, hey, where can you receive your care, they would choose their home, they wouldn't choose to go to a facility. And so the businesses we've talked to in-home care and hospice are doing fine. They're treading water in this environment and are declining. They're not growing by leaps and bounds. But if you look at the public companies, they trade for about two and a half x, the multiple other providers do, so they have done really well in this. We closed a deal in Q1 in the hospice space. We have other clients in this space. So it's again, I think if you look at hospice to the other piece, I'd note their reimbursement is already per diem value-based, so they're already ahead of the curve as far as not doing fee for service. I think a lot of the healthcare industry can probably learn from this sector.

Morgan: Absolutely. Porter, looking at a market in which there's been a lot of consolidation over the last few years, looking at the outpatient services, dermatology dental vision, what did you all see in Q1 and what do you expect to come over the next few months?

Porter: Historically, these have been incredibly attractive sub-sectors and they have a lot of things in common. They operate in large markets, there's substantial fragmentation, there's really strong in market demand, typically driven by demographic trends and an aging population that has income to spend on mostly elective procedures. And from an investment thesis it's pretty simple, at least in theory, it can be hard to execute, you buy assets, you integrate them, you put infrastructure in place, and then you can sell that or recapitalize that at a premium. I think the challenge in the first quarter with all of these sub-sectors is that they're dependent on patient volumes which haven't been there. And they're dependent upon patients getting these elective procedures which have been down dramatically if not down to zero. In dental, it's the veneers, the bridges, the crowns, those things just haven't happened, at least in the latter part of the first quarter. And so those businesses are going to be adversely affected. I think the expectation is we talked about this earlier, the care stimulus should soften some of that blow. There's going to be a rebound. You know, these are these are groups where you're only going to put off an elective procedure for so long, you may not get it the first day that you're able to. But once each of these sectors opens up, I think the trends are going to start to at least the trends in volume and having these procedures performed, I think they're going to pick up dramatically. They may not be exactly where they were in January. But I think we're going to see those start to tick up over the course of this year. So it's been a tough quarter., but I think we're optimistic that it'll improve.

Morgan: David, I know you spend a large majority of your time working with clients in the outpatient services sector, in particular vision and dermatology and other related areas. What impact do you think COVID-19 will have on current deal activity and what are you seeing otherwise with your clients in this area?

David: Well, what I've seen is a surprising unevenness, in terms of the impact. So for one, there had been this trend of poopooing on the more retail-oriented practices. So, in the optometry world, the folks who sell contact lenses is a significant part of their revenue, somewhat surprisingly, to me, and maybe just me, some reports came out showing that contact lens purchases actually increased initially during much of the self-quarantine, and part of that is you can buy them online. So while it had been popular to poopoo those practices on the premise that they can't compete with Warby Parker, it actually offered a lifeline for a lot of practices in those fields. I think that may be short term, but it's something that I think is allowing them to sustain numbers that will help them in terms of acquisitions. You know, in the ophthalmology space, I totally agree that those folks that really focus on elective procedures, LASIK, for example, have been struggling with the cash flow problem. I think there's a lot of question marks around will patients come back for that, or are they going to wait until their jobs are fully going and they build up their savings again, before committing thousands of dollars to procedures? You know, one thing I will mention is that I have a unique vantage point of three dogs who bark a lot plus, one of our clients is one of the larger pet products manufacturers out there. And what I've heard from both on a personal level and actually talking to them is the demand and interest, both for vet services and pet products has really sustained itself throughout this time period. People spend so much time with their dogs now they actually noticed that they need attention from the vet, and it's one of those unusual or unexpected results. Yes, it's still hard for the same reasons with all healthcare practices. You've got to find a number of patients you could treat in a day, but for those that are staying open longer, they're really seeing continued results and I expect those to see continued M&A activity.

Morgan: Great. So in the Brentwood report, you all mention many segments of healthcare continuum like anesthesia and ER management have consistently been outsourced by hospitals. Just last week, Waller closed a transaction for our client, North American Partners and Anesthesia in its acquisition of American Anesthesiology from MedMax, which created one of the most comprehensive anesthesia and pain management companies in the U.S. So provider outsourcing groups like Napa are providing efficiencies and high-quality services for their hospital and clinical clients. But I'm curious, given what's going on with COVID-19 you know, post COVID-19, post-pandemic, what will deal activity look like in the outsourced services sector? L.A.?

L.A.: Yeah, I think the biggest question that maybe none of us can answer today is how long it takes the volumes to return to health systems for surgeries. A lot of these things have been put on the back burner. So as you mentioned with the volumes declining, M&A will be very challenging. I think we noted there was one deal one smaller deal done in the first quarter like surgeries will need to ramp back up. I think people will need to feel comfortable going to the ER again, with their volumes down. And talking to health systems, I thought this was an interesting data point: In 2008, it took about three years to recover their volumes back to normal. So that was not a healthcare pandemic scare, that was a financial crisis. So how long does it take this time? I think most would tell you probably longer.

Morgan: Porter, I know a large portion of your practice as in working with healthcare IT companies. How is COVID-19 impacting M&A in that space?

Porter: Yeah, I think generally healthcare IT companies can in a lot of cases have recurring revenue business models that at least in the short term will insulate them from a lot of the impact that has come with COVID. They've had to deal with converting to remote work environments. They've had to ensure that data is sufficiently protected and those sorts of things, but it's not like they're shutting down like a dental office might have to. I think where they're going to be challenged and where M&A activity is going to be affected is the in markets that they're going after have been pretty severely impacted, whether it's hospitals, whether it's surgery centers, whether it's labs, these are all in markets, where COVID has had a pretty dramatic impact, negative impact, on how they're performing. And I think what you're going to see is, we still have a number of healthcare IT deals underway. But I think what you're going to see is a pretty strong bifurcation or distinction between companies that have a real hard-dollar ROI that have to have solutions versus nice to have where the return on investment is less clear. So I think these are areas where we still have ongoing in M&A activity. We have processes underway, that are advancing. It remains to be seen what the long term impact is just due to the impact on the in markets that they're going after.

Morgan: So we've covered quite a few sectors that are impacted by this and healthcare. So for our listeners, particularly those that are healthcare practices or services companies, but we also probably have some listeners that are investors or other advisors in this area, I would love to provide some practical tips for them. So L.A. I'll start with you. Any pointers you have for our listeners that may be looking to potentially sell their practice?

L.A.: I think the first thing they all should think about is, get your business, your employees and your customers, maybe patients, kind of settled and stabilized. I think it'd be impossible to evaluate a transaction while there are so many variables up in the air and volumes will come back over time, but I think it's a really good time to evaluate your long term strategy of the business. The healthcare sector is going to consolidate significantly. I think the top four payers have 80% market share. Is your business strong enough to grow in this new normal? Or do you need to evaluate alternatives that exist? Like we're discussing today a sale, a growth raise or recapitalization. You know, make sure you have a good board/advisors around the table, to help you navigate not only the next few months or a year but the next five years, I think this is a really good time for introspection and to really look at your business.

Porter: I'd echo what L.A. said about organization and that is kind of the number one tenant that we recommend clients follow when they're thinking about this, and that's just run the business. Run your business like it's not for sale. Continue to focus on your strategic priorities, continue to keep everything running, set budgets, challenging quotas that are that are achievable, and hire good investment banks so the disruption of your business is minimal.

David: I agree with all that. But don't forget, buyers want deals. They want good deals. And so if it's a practice that's different, a practice that can actually demonstrate that its patient revenue is not declined or is surging back, people are waiting at the door long line to make appointments, that they can demonstrate that the revenue and predict choosing, for example, premium lens for contact. If you are a different type of practice from the rest of the industry, you can play into the fear that people have about the industry generally by saying I'm the one practice that doesn't have those problematic tailwinds. I've got good backup and infrastructure behind. On the other hand, if you are like the rest of the industry and suffering the same way, then this is a great opportunity to look inward. To think about incentive structures. We're getting a lot of inbounds from folks that I think are rightfully thinking about, alright, let's look at our incentive compensation for some of our younger management team, some of our associates. How can we get them motivated to take maybe a little less cash right now with more long term opportunity so that we all are oriented towards a better upside scenario in a sale, even if it's not right now, maybe it's a year from now, but it's a better opportunity. So it is a really good time to be honestly self-assessing, I think was what L.A. was getting at. And it's an opportunity that really shouldn't be missed.

Morgan: I'd like to end on a positive note. I know that there's a lot of fear out there right now, a lot of unknowns and uncertainty about when will this all end and when we do back to normal, but surely there are some positives that can come out of this and we're already seeing a lot of innovation in the healthcare space. But L.A. I'll start with you, just to get your perspective on maybe some positives that could come out of this pandemic and the economic uncertainty right now.

L.A.: Sure. I think the biggest positive I see if we draw a parallel to 2008 is the strongest companies, operators will get through this, evolve and thrive. If you look at the banks that were well set up, that were well governed, that were well capitalized in 2008, they ended up gobbling up market share and buying other weaker institutions. And now they're much stronger today than that industry was 12 years ago. So today in healthcare, whether it's buying smaller companies in the sectors, adding new service lines to diversify their platforms, there are lots of ways they can evolve and grow. I think this has been a historic business interruption that no one predicted and the U.S. hasn't seen before. So I'm optimistic that the best operators and companies will use this to their advantage to become more efficient.

Porter: I would think that this would create just a greater appreciation for frontline healthcare workers. They've kind of been in the trenches with this for the last handful of months. I think, like L.A. said, I think it's going to be a situation that really forces everybody to focus on results as you get out of this, whether it's minimizing COVID incidence and improving patient safety, streamlining operations. Certainly financial results are always a part of that, but I think it's just, you're going to see the good companies continue to perform and get better as we come out of this.

David: I'm hopeful that the best companies will get loyalty, really, from the folks that they maintained and were able to bring back if they were furloughed. I think this is exactly what L.A. and Porter are getting at is the good companies will rise to the top, and sometimes being stressed in this kind of macroeconomic environment where there are big problems does yield stronger companies for those that rise to the top and identify leadership and efficiencies in how they run their operations. The kinds of things they might have overlooked before when it was easier. So you know, I hope that we see that, but to echo Porter's point, I think it will be fantastic across the world to see this greater appreciation for healthcare.

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