Private equity: changing attitudes to European healthcare

Kunal Kadiwar

The private equity community’s interest in healthcare has been moulded by its perception of it being an evergreen industry that is resistant to economic cycles and driven by underlying fundamentals and undeniable long-term trends.

The fact is, as we are living longer with an ageing population, there is an increasing prevalence of chronic diseases due to lifestyle changes and pollution; and populations are getting wealthier and wanting to use their disposable incomes to get access to the best treatments.

As long as our bodies continue to endure sickness and fail, there will always be a need to continue innovating to find better solutions. Regardless of economic and regulatory pressures, there is an opportunity for the industry to continue furthering revenues through the discovery of new treatments or devices that physicians and patients find valuable. Encouraged by this logic and coupled with the low interest rates and buoyant fundraising environment, private equity funds have been drawn to healthcare.

Particularly in periods of economic disparity, investors have turned to healthcare somewhat in the same way that they have turned to precious metals or defensive industries. If one looks at the performing funds in the ten-year period following the financial crisis of 2008, the best performing specialist funds were those that exclusively invested in the biotech and healthcare sector. Since 1994, the MSCI World Pharma, Biotech and Life Science fund has returned an annualised return of 10.8% when compared to the wider MSCI World Index delivering 7.5%. However, one cannot overlook the inherently high volatility that these stocks bring, as they are highly sensitive to drug development attrition rates, pricing pressures, and regulatory hurdles.

From an M&A perspective the last five years has witnessed incredible activity. Healthcare deal value surged in 2017 reaching US$332 billion, nearing the record levels seen a few years earlier. Private equity M&A healthcare activity is a similar story; we observed record highs in 2017 with 265 deals announced at US$43 billion, a year-on-year increase of 17% and 29%, respectively. Even with valuations reaching an all time high, some believe that we will continue at this level of M&A activity, at least in the short-term.

“The best performing specialist funds (in the ten-year period following the financial crisis) were those that exclusively invested in the biotech and healthcare sector.”

One of the reasons for the high valuation is that competition has become crowded. Healthcare private equity buyout funds now face competition not just from strategic buyers but also new categories of players that have entered the space; these include generalist private equity investors, pension funds, sovereign wealth funds and family offices. A recent study by the Boston Consulting Group showed that healthcare makes up 13% of sovereign wealth fund portfolios with 54 deals in 2017 – that’s a five-fold increase from 2012.

Despite this general trend, McKinsey believe that there is still scope for further private equity to penetrate the healthcare market, particularly in Europe where healthcare has lagged behind some other sector groups. European private equity’s healthcare investment is on average only 8% of assets under management, which is comparably lower than other industries of a similar size such as consumer and business services which are at 18% and 14%, respectively. They have cited several reasons for this subdued participation.

“Private equity is increasingly proving that it does have the sector understanding and confidence to outbid strategic players.”

Many of the leading mid-market healthcare companies are privately owned and have favoured growing in their local and specialised markets, and therefore can be susceptible to slipping under the radar. Sometimes this lack of access can be highlighted by absence of dedicated healthcare teams that have the local and sub sector expertise. The healthcare representation amongst the private equity community certainly evolved over the past decades when there were only a handful of dedicated teams. However, healthcare is a complex ecosystem that is constantly changing, and you need people who are comfortable that they understand the dynamics and underlying science to be able to invest. The scarcity of accessible and attractively priced assets has meant that when they do become available, the competition has generally been with other private equity firms. Despite the broader competition, two-thirds of the private equity assets acquired above €200 million have been sourced from other private equity investors. Where strategic investors are involved in the process they have shown a willingness to overpay to complete their offering, differentiate their value proposition or solidify customer relationships. In an industry where the underlying fundamentals are based on intellectual property, building something yourself is not always an option.

CG Results Healthcare has seen in its latest research that mid-market private equity funds have increasing interest in the sector, as they believe it will fare well throughout Brexit and offers ample opportunities for quickly building value. In deals over the past five years, private equity firms have paid an average of 11.9x EBITDA for healthcare companies and assets, compared to the European average of 9.5x across all sectors.

The dynamics are changing, and we are finding that private equity is increasingly proving that it does have the sector understanding and confidence to outbid strategic players. Funds are taking a greater risk appetite to find broader ways of deploying capital, including assets which come with high exposure to reimbursement risk. For example, in 2017 we witnessed funds take new positions in branded and generic pharmaceuticals, investing directly in research and development; areas traditionally seen as unchartered territory by regional buyout funds.

First published in Global Banking & Finance Review.

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