Private Equity Investments in the Healthcare Industry

Introduction: The Fundamentals of Private Equity (Part I of III)

Why is private equity becoming increasingly involved in the business of healthcare? How will their involvement affect the delivery of services? This first installment of a three-part series will describe the fundamentals of the private equity industry, in general, and set forth a common terminology that will be utilized throughout the series. The second and third installments will further discuss the trends in private equity utilization in the healthcare industry. A more detailed version of this article appears in The Value Examiner, January/February 2019 issue. The remaining issues will be published once published by the The Value Examiner.

While private equity investment has declined in the past couple of years due to global economic insecurity, private equity transactions in the healthcare industry have been growing significantly.[1] A growing number of private equity groups are approaching large physician-held groups and other healthcare service enterprises, including hospitals and outpatient enterprises, seeking investment opportunities in the clinical services industry. This influx of private equity investment is not only ameliorating a dearth of financial capital available to healthcare service enterprises, but is also allowing these provider groups to “step up” to the next phase of growth by providing the management capital (e.g., resources, knowledge, skills, and ability) to facilitate the provider’s transition to value-based reimbursement.

This first installment of a three-part series will describe the fundamentals of the private equity industry, in general, and set forth a common terminology that will be utilized throughout the series. The second and third installments will further discuss the trends in private equity utilization in the healthcare industry. A more detailed version of this article appears in The Value Examiner, January/February 2019 issue.

Financial Intermediation

A hallmark of an advanced economy is the development of financial intermediaries, i.e., middlemen that operate between economic actors to facilitate economic transactions.[2] In the investment arena, this role is often fulfilled by financial institutions such as banks, insurance companies, or pension funds, among numerous others.[3] These institutions collect excess financial capital from savers and invest those funds to generate financial returns, wherein a portion is retained by the financial institution as compensation for the services provided and the remainder is distributed to the individual investors.

A simple example is a common savings account with a commercial bank under the fractional reserve banking system.[4] The bank collects deposits from the account holder, and in return, promises to make interest payments to the account holder at an expressed rate of interest. The bank then invests the collected deposits (less the regulated capital reserve requirements) by way of loans, also with an expressed interest rate, which is greater than the interest rate paid on the deposits. In this manner, the bank redirects the excess capital of the savers into productive use by the borrowers, i.e., the bank acts as the middleman between the saver and the borrower. 

Financial intermediation exists to assist market participants in completing economic and financial transactions. Search costs can be a significant expense for both investors and borrowers, an expense that may tend to limit the number of transactions undertaken, as some transactions may have their returns subsumed by these costs. Financial intermediaries can assist in overcoming this hurdle by reducing these search costs for both parties, thereby increasing the potential volume of transactions consummated. 

Imagine a situation where a borrower seeks funds for a startup company in an economy that lacks financial intermediaries, i.e., no banks, no equity markets, no private equity funds. How would this borrower find funding for their project—through attempts to solicit funds from high net worth individuals? By taking an ad out in the paper? These options require the borrower to expend both time and financial capital to fund in pursuit of an uncertain outcome. Should those expenses exceed the expected returns from the project (or diminish them below the borrower’s hurdle rate[5]) the project will not be funded, despite the fact that there may exist willing investors with excess capital in search of investment opportunities. Financial intermediaries exist to help investors and borrowers overcome these obstacles.

What is Private Equity?

Multiple institutional categories exist in the financial intermediation industry, all providing a similar, yet distinct, function within the marketplace. These financial intermediaries can be defined by the specific market participants to which they provide their intermediation services. Among these categories, private equity funds serve the unique market comprised of investors seeking returns on their invested capital from privately held companies, i.e., companies whose equity is not traded on a formal public securities exchange.[6] Typically, these borrowers have limited access to capital, restricted to personally guaranteed loans from commercial banks and loans from the firm’s owners and their friends and family. Private equity, therefore, services a more uncertain set of potential investments and consequently demands returns commensurate with those assumed risks. Accordingly, in the spectrum of financial intermediaries, private equity tends to exist toward the high-risk-high-reward end, thereby providing investors with a greater tolerance to risk to access these private company investments.[7]

The traditional concept of private equity is likely that of the venture capital firm. These types of private equity funds seek out investments in early to mid-stage startup companies (often pre-revenue).[8] The private equity firm will commit capital to a portfolio of potential firms with the knowledge that often these companies will never achieve profitability, but a potentially small number of the investments may generate returns sufficient to offset the losses from the non-performing investments. This is a strategy that has been applied repeatedly throughout the technology startup boom in Silicon Valley. 

In addition to classifying private equity funds by their investment strategy, it is also possible to consider the industry (or industries) within which the private equity fund invests its capital. Private equity funds tend to fall into one of two types of investors: 1) generalists investing in a broad array of firms across multiple industries and 2) industry-specific investments restricting the fund to a specific industry in which the firm has a comparative advantage in knowledge and experience. Private equity firms employing a venture capital, distressed company, or buyout strategy, which require significant management input by the private equity firm to be successful, will often specialize within an industry in which their principals have experience. However, as with the strategies above, a fund may also specialize in multiple companies across industries, particularly those which may offer opportunities for synergies that can further enhance their return prospects across their portfolio of investments.

As a result, a particular private equity fund (which may be one of many individual funds managed by a private equity group) can be classified by their investment strategy and their industry, e.g., Acme fund is a healthcare services buyout fund or Acme fund is a gas and power distressed company fund.

The Structure of a Private Equity Fund

Private equity funds are typically organized as partnerships, with the external investors in the fund being referred to as limited partners and the private equity firm as the general partner. The limited partners are typically comprised of investors with access to large amounts of capital, such as pension funds, endowments, or high net worth individuals, among others. The general partner is the private equity firm(s) that performs the management functions for the fund.

Returns generated by the fund are divided between the general partner and the limited partners as per the partnership agreement. The general partner is typically compensated through management fees based on a percentage of assets under management, as well as, a performance fee (often referred to as carried interest), which is based upon a share of the profitability of the fund and often subject to a hurdle rate, i.e., the performance fee is a share of the profits after a specified minimum return.

Conclusion

Private equity is a form of financial intermediation that seeks to connect investors seeking returns with potential investments in operations that do not currently have access to formal equity markets. Private equity funds allow investors to participate in the ownership of these privately held companies, while diversifying their risk across numerous investment opportunities. Private equity funds can come in several “flavors,” which are typically defined by their investment strategy and specialization (or lack of) in a specific industry. These funds are generally organized as partnerships between a private equity firm, which provides the management services to the private equity fund, and investors, which provide the capital. 

The aggressive search for returns and the flexibility of the private equity model have resulted in the private equity industry being a hot bed for investment in innovative products and services, as evidenced in the private equity investments throughout the technology industry. It would only seem natural that the healthcare industry, which is undergoing rapid changes in technology and regulation, would be ripe for an infusion of capital from the private equity industry.

The second and third installments of this three-part series will review trends in the use of private equity in general and within the healthcare industry.

This article was published in The Value Examiner, January/February 2019 issue, and is re-published here with permission.

 

[1]       “Global Healthcare Private Equity and Corporate M&A Report 2017” By Kara Murphy et al., Bain and Company, April 19, 2017, http://www.bain.com/publications/articles/global-healthcare-pe-and-corporate-ma-report-2017.aspx (Accessed 11/10/17).

[2]      “Financial Intermediary” Investopedia, https://www.investopedia.com/terms/f/financialintermediary.asp (Accessed 12/18/18).

[3]          “Chapter 2: Financial Intermediaries and Financial Innovation” in “Foundations of Financial Markets and Institutions” By Frank J. Fabozzi, et al., Prentice-Hall: Upper Saddle River, NJ, 2002, p. 15.

[4]          “Chapter 4: Depository Institutions: Activities and Characteristics” in “Foundations of Financial Markets and Institutions” By Frank J. Fabozzi, et al., Prentice-Hall: Upper Saddle River, NJ, 2002, p. 43–64.

[5]          Defined as “the minimum rate of return on a project or investment required by a manager or investor. “Hurdle Rate” Investopedia, May 17, 2018, https://www.investopedia.com/terms/h/hurdlerate.asp (Accessed 12/18/18).

[6]          “Chapter 19: Issuing Securities to the Public” in “Modern Financial Management” By Stephen A. Ross, McGraw-Hill/Irwin: New York, NY, 2008, p. 570–573.

[7]    “Part 1: What is Private Equity? Private Equity Education Series” UBS Alternative Investments, December 13, 2010, https://www.activeallocator.com/static/pdf/UBS%20Compendium%20Alternative%20Investments%20Education%20Series.pdf (Accessed 12/18/18).

[8]      “Unpacking Private Equity, Characteristics and Implications by Asset Class” McCombie Group, http://www.mccombiegroup.com/wp-content/uploads/2013/03/20130222-Unpacking-Private-Equity.pdf (Accessed 12/18/18).

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Todd A. Zigrang, MBA, MHA, CVA, ASA, FACHE, is president of Health Capital Consultants, where he focuses on the areas of valuation and financial analysis for hospitals and other healthcare enterprises. Mr. Zigrang has significant physician-integration and financial analysis experience and has participated in the development of a physician-owned, multispecialty management service organizations, and networks involving a wide range of specialties, physician owned hospitals, as well as several limited liability companies for acquiring acute care and specialty hospitals, ASCs, and other ancillary facilities.

Mr. Zigrang can be contacted at (800) 394-8258 or by e-mail to tzigrang@healthcapital.com.

Jessica Bailey-Wheaton, Esq., is Vice President and General Counsel for Heath Capital Consultants where she conducts project management and consulting services related to the impact of both federal and state regulations on healthcare exempt organization transactions, and provides research services necessary to support certified opinions of value related to the Fair Market Value and Commercial Reasonableness of transactions related to healthcare enterprises, assets, and services.

Ms. Bailey-Wheaton can be contacted at (800) 394-8258 or by e-mail to jbailey@healthcapital.com.