Investing in the Medical Device and Life Sciences industry?
Key issues and trends to understand
INSIGHT ARTICLE |
The health care and life sciences industries are in a period of dramatic change. Despite this change, successful private equity funds and strategic buyers can still execute deals. McGuireWoods and RSM host an annual conference to explore ways to successfully close transactions and achieve capital growth by implementing the right strategies in the right markets. This summary represents one of the panel discussions at the 2018 event.
Buy-side competition is fierce among established life sciences and medical device companies, particularly for PE firms in this challenging seller’s market. “It’s a frothy market out there,” noted Phil Smith, managing director at Duff & Phelps, “and valuations and multiples are high. Where we see tension is buyers are having to stretch from a valuation standpoint, and as a result there’s almost a sense of deals being priced for perfection.”
The bet on early-stage Life Sciences
Today’s sellers are inundated with options, with more buyers than there are attractive or sizable opportunities. Consequently, bigger funds are coming downmarket and are extraordinarily aggressive in their appetite. “We are talking about funds not just doing one or two add-ons over the life of the investment, but doing one or two add-ons over a quarter,” said Dave Harvey, president of Harvey and Company LLC, a principal investment and acquisition advisory firm. Naturally this has led to inflated purchase prices. However, the panel agreed that there is an opportunity to create significant value by building add-on businesses. “We do a lot of these kind of smaller buy-and-build strategies,” said Harvey. “The valuations are kind of driving people down to sometimes pursuing smaller transactions.”
Investors in early-stage life sciences are looking for opportunity obviously, but what makes a business more attractive to a PE or a strategic is debatable. While innovation is vital, so is the sustainability of that innovation. What does the pipeline look like? What is the culture that has created that innovation? These are among the important questions when one is considering a deal.
“It's clearly not as easy to raise medical device venture capital as it was, call it five or certainly ten years ago,” said Smith. “It’s much more challenging. And the availability of capital is reduced.” Part of the challenge, he said, comes from the unpredictability of FDA approval and the difficult path medical devices must follow to gain it.
The panel agreed that more rigorous regulatory screening may slow the acquisition of younger companies. Smith observed, “there’s a trend where the strategics are less likely to buy earlier-stage companies. They’d rather wait and pay more for a more mature company that’s product is already approved and is generating revenues.”
However, Mark Nicholson, vice president, corporate development, at Hill-Rom, saw beyond a safe bet and painted a brighter picture. “I am optimistic,” he said. “I think we’ll continue to evolve and learn from different pressures that are impacting earlier-stage innovation. In healthcare, particularly on the med-device side, it gets trickier to be a successful early-stage company, because the capital pressures, the regulatory timelines and external forces, become more and more challenging. That’s where a strategic buyer can be a good partner.”
Strategic buyer vs. private equity firm
It’s a widely held notion that, in general, strategics pay more than private equity. But according to Smith, this may no longer be the case. “You still see some of that,” he said, “but in today’s market there are just far more buyers than sellers, in addition to a frothy market. I’ve seen situations where private equity firms have outbid strategics. So that sort of thesis doesn’t hold water.”
The panel noted that, with the market so abundant in buyers, today’s sellers can take advantage of the appeal of their non-cash assets as well, including their long-term plan and their success in maintaining employees and facilities. It all comes down to who can pay, the panel agreed.
From the strategic perspective, Smith continued, “a big selling point is that we can credibly state that we’re not really focused on a period between buying and selling. We can articulate a long-range plan, a cultural fit, and the importance of correctly matched management teams.”
Getting the full picture of a company—is essential to a deal. “It’s certainly a market where you have to look at the numbers and understand what’s really driving the incremental performance of this company versus other companies that you’re looking at,” said Greg Naviloff, director at RSM US LLP. He noted that a quality-of-earnings report helps a buyer predict whether a company’s growth is sustainable.
In fact, across the panel, a quality-of-earnings report was considered a common best practice for prospective buyers and today even sellers are increasingly likely to perform such an analysis before they go into the sales process. According to Phil Smith, “A big part of what’s driving the use of QOE reports by sellers are the higher valuations and the potential debate around adjustments to earnings.” With prices so high, he said, sellers are becoming proactive, trying to control the narrative around their valuations ahead of the buy-side quality-of-earnings report still to come.
Higher multiples, soft skills and the bidding process
Greg Naviloff spoke of the uncertainty in revenue stream resulting from today’s higher multiples and how that impacts new deals. However, he doesn’t think this is necessarily a detriment. Added Nicholson of Hill-Rom: “From the strategic buyer perspective, the multiple shift creates additional opportunities to leverage more creative structuring and think about different ways to get deals.” Therefore, he suggested, it’s more important than ever that a buyer understand the best strategic fit.
For these reasons, investors are seeing value beyond the numbers in soft skills that can also influence the bidding process. “We do a lot of partnering with operating executives—talented, successful, industry-relevant executives—with our searches,” said Dave Harvey. “They help tremendously in terms of just building credibility with the sellers.”
Supporting Harvey’s comments, Smith adds, “When we’re running a sell-side process, often many bids may come in. There may be some difference in dollars, but it’s not that dramatic, and very often a seller may not choose the highest-dollar bid; they may choose the second or third, where they feel like they have a good cultural fit.”
“When we go into the sale process,” noted Phil Smith, “I tell my clients that when you’re in management meetings, you’re being evaluated by buyers, but you’re also evaluating them." He added that good buyers spend time selling the sellers as well and talking about how they would work comfortably together.
Smith commented, “I’ve seen some private equity firms say, ‘You know what? You want my references? Here’s every company we’ve ever invested in, and here’s a list of every CEO and all their phone numbers. Call whoever you want.’”
“That’s a good sign and a tone of transparency that is appreciated on all sides of a deal,” he added.
In closing, the panel discussed additional items to consider during a deal. Mark Nicholson noted that it’s important to always remember that this is a “people industry.” Healthcare is, by nature, a patient-centric business that deeply impacts families and caregivers. “Keeping patients in mind when assessing opportunities for growth and strategy, and understanding that there could be opportunity in funding these areas, is the right direction to travel,” he said.
To learn more about the McGuireWoods and RSM US Annual Healthcare and Life Sciences Private Equity and Finance Conference, please visit the conference website.
For more health care and life sciences industry insights, read RSM’s quarterly industry spotlights developed in partnership with Pitchbook.