Some investors focus on health care subsectors amid traditional deal decline

Deal volume in the first quarter was the lowest since the second quarter of 2020, according to PitchBook data, consistent with overall declines in U.S. private equity transactions.

The headwinds depressing health care services deal volume include macroeconomic challenges—primarily higher interest rates—and industry pressures around reimbursement, labor costs and regulatory scrutiny.

Yields on health care debt, which is critical to financing private equity deals, have increased in cost and will remain elevated for the near term. The five-year tenor on the Health Care BBB Composite Corporate Debt Index, which serves as a proxy for movement in health care private debt costs, increased to 5.05% through March 31 from 4.75% at the end of the last year. This is significantly higher than the 2.45% recorded at the end of 2019. Debt instruments of all duration are more expensive than prior to 2022.

As of this writing, the Federal Reserve is expected to cut rates later in 2024. However, such cuts are not expected to return markets to pre-pandemic interest rate levels. Higher interest rates and the resulting higher costs of capital will continue to pressure dealmaking.

Furthermore, reimbursement increases from both government and commercial payers generally lag increases in labor costs. Providers can now expect to pay annual wage increases of 3% to 6% for 2024 and beyond, consistent with 2023, in our estimation. While this represents a decline from the significant increases many providers paid in 2021 and 2022, such increases will continue to pressure margins, as reimbursements from payers are expected to increase only 2% to 4%.

Additionally, government is increasing scrutiny of health care transactions. Currently 12 states have passed laws that require notification of a health care transaction. A few of the state laws specifically mention physician practices in the notice requirements and some specifically call out private equity transactions. California, Connecticut and Minnesota are also proposing legislation that would require covered health care transactions to be approved by the state. Minnesota’s proposed law would essentially ban private equity firms and real estate investment trusts from owning any kind of health care provider.

The health care ‘lite’ investment pivot

Despite margin and regulatory challenges facing the health care industry, investors still want exposure to the $5 trillion health care ecosystem. Many are pivoting to health care subsectors such as practice management technology, suppliers and other health-care-adjacent or “lite” businesses. In fact, the last two quarters saw over 75% of health care private capital investment and 30% of total deal volume go into health care lite subsectors rather than actual health care services, proportions last seen in the first quarter of 2021.

Conversations with clients and other market participants suggest continued emphasis on these ancillary health care businesses as a way for investors to access the economics of the health care ecosystem while avoiding the risks associated with traditional service providers. Bloomberg data demonstrates investor fervor: As of April 18, 2024, Private equity firms have raised $78 billion in new health care buyout funds, and closed buyout funds retained $123 billion in dry powder. Furthermore, Bloomberg expects that at least 10 health care buyout funds of at least $1 billion will begin fundraising in 2024, with many smaller funds expected to do so as well. We expect a growing portion of this dry powder will be deployed into health care, but outside of traditional health care service acquisition strategies.

The takeaway

The winter of 2023 to 2024 was slow for health care dealmaking. However, investors retain interest in the sector, and we expect dealmaking will recover, albeit likely with more focus outside of traditional health care services organizations.