As health care continues to be on the forefront of everyone’s mind, M&A activity is picking up. Mergers & Acquisitions convened a special roundtable to discuss the role health care is playing in today’s economy and how investors are getting in on the action. Madison Capital Funding and Katten Muchin Rosenman LLP sponsored the event and the excerpted discussion that follows provides a range of perspectives on what middle market dealmakers can expect from these companies going forward. Participants included private equity investors, a lender and an investment banker.

Mary Kathleen Flynn, Mergers & Acquisitions (moderator): Where are the biggest opportunities in health care today?

Doug Schillinger, DW Healthcare: DW Healthcare is very opportunistic. We do not sit around the table on an annual or semi-annual basis and say: "These are the three or four sectors that we are going to focus all of our attention on." We will pursue companies that can excel in traditionally poor regulatory environments or unhealthy regulatory environments if we believe we found the best of breed in that particular sector. For example, we partnered with Madison Capital on a deal, which is an outsource rehab therapy company in skilled nursing facilities. The business is growing 30 percent year over year. We believe we found a team and a business that simply does it better and can operate in a very difficult regulatory environment, which actually becomes a bit of a competitive advantage because the other competitors can't navigate as fast as they can, allowing them to pick up market share.

Brian Miller, Linden Capital Partners: Linden's approach is very focused. We don't do it on a yearly basis-more like on a two- to four-year basis-but we will pick about four sectors where we go deep. We devote a team with the same partner, post-MBA and pre-MBA, and recruit an operating partner or two, which sometimes becomes the company's future CEO, to work together in that sector.

We currently have live teams in diagnostics and dental. The dental team has executed on three deals and many relationships. The sectors we like have a few things in common. Generally, they are a little less reimbursement heavy. You can't eliminate reimbursement risk from health care investing, but we have attempted to minimize it. With that said, one of our recent successes was in the behavioral space where a good chunk of the revenue came from Medicaid, which can be a very tough payer to have. So we take our shots and try to diversify across the portfolio.

Brian Morfitt, Frazier Healthcare: We're a little bit of a hybrid of what we just heard. We definitely have themes. They don't tend to be three- to four-year themes; maybe a little bit shorter themes. We pick spots where we think there is opportunity and we do so in concert with an operating partner, but we also are opportunistic in what we do. Just broadly, areas that we're looking at are cost-reducing businesses and higher quality-so better, faster and cheaper.

Somebody who's going to get a better outcome at a lower cost is going to win, or at least have a better chance to win.

M. Fazle Husain, Metalmark Capital: About once a year we pick a couple of sectors that we want to get deep into and we develop relationships. I'd say this year and perhaps next year, companies, whether they're diagnostic companies or service companies that are focused on taking some cost out of the system, will be the right place to invest. Outsourcing falls within that.

Flynn: DW invests in companies that are founder-owned. So what happens after you buy: Do you put in new management or an operating partner?

Schillinger: We often do; however this strategy works much better when that discussion is had during the transaction process or during the discussion about the deal as opposed to dropping the hammer post-transaction. It's an acute problem for us because we are partnering with owner/operators who oftentimes do want to continue running the business. Some are very well-positioned to do that, others are not. Some are honest about their capacity, others are not. It's a delicate thing to navigate, but it is the primary reason why we lose deals or walk away from deals.

Husain: We had one instance where we essentially installed the soon-to-be CEO three months before we bought the company. It was just one of those long regulatory finalizations to get to close. We went in and we were essentially making decisions before we actually bought the company. That's very unique. But if you could do it, it makes writing that check much more comfortable.

Flynn: How does the Affordable Care Act (ACA) affect deal making?

Husain: The Affordable Healthcare Act is only Phase 1, and it's insurance reform. Next year people will be insured, but it really just scratches the surface. This is now beginning a regulatory process that may last a decade.

The ACA is an interesting law, but it doesn't do that much. At the end of the day, the physicians will still practice health care. That said, we're going to start seeing a lot more regulations. You want to stay away from areas where there is unpredictability around what will happen with those changes, but that's the nature of our business onwards.

Flynn: Are there any particular subsectors that are benefiting from ACA or where there is more investment opportunity?

Miller: You've got this group of people uninsured coming into the system, where are they going to go? Primary care doctors, maybe the emergency room, triage, urgent care. What's going to happen; we already have a shortage of general practitioners? On average they make $120,000 to $150,000 annually while specialty doctors make $200,000 to $250,000. If the general practitioner can't handle the influx, maybe the nurses can step in or the physician's assistants or even a pharmacist can have a larger scope of the work because a pharmacist sees you on a monthly basis when he fills your script. All of these newly insured people are going to present opportunity for investment.

Faraaz Kamran, Madison Capital (sponsor):Urgent care wasn't around over a decade ago. Now, there are actually stand-alone urgent care clinics that can do a lot more, similar to that of an emergency room. So, minus surgery, urgent care clinics can treat you for a lot of ailments. This is going to be an important piece of the equation as more people have to go through a primary health care physician to go forward with treatment. And that's why you will see more concierge medicine.

Flynn: What role does private equity play in developing these companies?

Schillinger: We recently invested in a business that manufactures hemostatic agents. It's a gauze-based product. It's capped with or embedded an inner mineral called Kaolin. Kaolin is a clay used in laboratory settings as a coagulant. We found the business via a trade show with a set of physicians we were working with who, and as funny as it might sound, kept raiding the free sample booth at the trade show of this particular manufacturer. When we asked the physicians about it, they raved, so we tried to find out who owned it and initiated a set of discussions with them. It took a long time, but two years later we made an investment.

The primary reason why they elected to partner with a group like us is because they needed help accessing U.S. domestic health care channels. If you think about the application for this product, the most obvious is first responders; right? This is a product that stops bleeding, traumatic bleeding very quickly on external wounds. Most of the business, when we discovered the company, was still in military channels. Accessing first responder channels in U.S. domestic health care markets is really tough because it's highly fragmented. It's very difficult to figure out who the buyers are. The founders weren't health care guys and they weren't particularly adept at figuring out how to address those markets. We partnered with an executive who has had a number of roles in innovative medical device companies. The owner was as excited about him running the business as they were about taking our money.

Flynn: What types of companies are emblematic of the trends we're seeing in the marketplace now?

Miller: We own a diagnostic business called Hycor. The business had been under-managed and under-resourced. When we took the business over there was significant work we had to undertake, and we bought it with an executive who had been CEO of LabCorp, which was Hycor's No. 1 customer for its allergy business. This allowed us to understand the customer. Nobody had asked the customer questions before, so it was a nice initial kickoff, and then we brought in a whole new set of managers and replaced the sales reps in the field with significantly higher quality, higher salaried reps. We made progress against the competition in a way they never had before.

Morfitt: We put together Trident USA. It's an outsourced diagnostic provider to the post-acute-care space. Post-acute spaces are a cheaper place to care for patients. The industry was a mom-and-pop type industry and very local, which means a lot of variation by geography and not a lot of managerial talent and higher-level partner type thinking. In four and a half years we have built the company up from just being relevant in Southern California to a national company. What you can do now is provide customers a higher level of touch than just the service itself. We can standardize the interface, help patients in a lower cost setting and get data and learn about what's happening in a very different type of a patient care setting.

Schillinger: With that platform, you are well positioned to provide other ancillary services.

Morfitt: When you get to a size where you can start providing more services, it's better for the patient and better for the system because a very de-consolidated mom-and-pop industry, which a lot of health care is, makes it very tough to get to the standards of quality and the higher level of managerial talent that is needed.

Husain: We bought a company in the wound care space about four and a half years ago called National Healing and is now known as Healogics. It was about $10 million in Ebitda and we grew that company organically to $20 million and doubled the number of clinics. We had 75 clinics when we bought the company. Now there are 150 clinics. We were able to merge it with the largest company in the industry about a year and a half ago. That company had about 300 clinics, so we put the companies together. Now we have a company that's a leader in the market. It's got 550 clinics and the best management in the industry. The No. 2 competitor is only a tenth our size. So we've taken a small platform company and over the years added new information systems, management and performance to it. Now we have a company that can do some pretty exciting things.

Flynn: What value does private equity bring to the health care sector?

Kamran: Private equity brings a menu of options. They have access to advisers, attorneys and lenders who can get you a very efficient capital structure. They bring advice and have contacts in Washington. I know private equity firms that will spend a week to 10 days at the company per month during the first year after buying it to really gel the management team. It's the idea that they are focused on growing the company and making it something bigger and better. And for most of my clients, there's more benefit than just making money. I mean you're literally saving lives. We have talked about not only the cost savings, but providing better care for a patient. There's a public good that's being done by these companies.

Flynn: How important are operating partners?

Miller: They expand your knowledge and relationships and that's ultimately what our business boils down to. Operational partners offer a different set of eyes, different views on businesses and a more operational viewpoint. We now do due diligence so we'll end up with our 180-day or 12-month plan before we close. Ten years ago due diligence was done to basically validate the purchase price, get the loan set up, do the legal, deal with the sellers and get the valuation done. We would do that and then get a strategy plan put together. Years ago that's how we did things. The strategy plan has been pulled forward in the process and you will have a consistent person on your team besides the private equity professional on the board to bring in. We were doing due diligence on one of our companies last year and we actually had the gentleman who was going to be CEO on the site at the company for three weeks straight talking to all the employees and getting the water cooler vibe. This really helps.

Flynn: What kind of year do you expect the health care sector to have in 2013?

Kamran: Across the board, management teams are speaking to their advisers trying to figure what their actual income is with the new 2.3 percent medical device tax. No one knows how that's going to play out under the Generally Accepted Accounting Principles (GAAP) because they haven't decided how to treat it on a case-by-case basis. The lender, sponsor and management team will have to figure out how to actually treat this new tax and how to cope with it. In middle market, we are driven by income, so at the end of the day, whether it's health care or not, there will be activity.

Schillinger: At the end of 2012 everybody was frantically trying to get their August/September deals done by year end and there was absolutely a low in January and February. It has picked up substantially just in the last three to four weeks so I think there will be a return of normalcy.

Those who were worried about some of the tax law changes and figuring out how it's going to shake out have greater clarity now and so they're more comfortable going to market. Those who missed the bus on getting their deals done before the capital gains tax change don't really have a reason to wait, so I think activity will pick up and be back to normal.

Miller: It may take a little bit of time. The fourth quarter of 2012 was the second-most-active period in the last decade after the fourth quarter of 2010. I do think capital gains made people act. People were also trying to figure out what was going to happen with the Affordable Care Act. There was a lot going on in the fourth quarter. In health care specifically, we benefit from some state of normalcy.

Morfitt: Folks are getting a little bit more comfortable with uncertainty. It's probably a necessity to get capital to work. I think you might see more deals being driven by larger strategics that still have lots of cash on their balance sheet and want to continue to get bigger. They want to have a broader slice of the continuum so if they get squeezed on one part of the balloon, they have another part they can go through.

Husain: Two thousand eleven had been a strong year; things typically slow down in an election year. So the fact that we had the activity that we had last year was pretty impressive. I think this year will be equal, if not better, than last year. I think what's partly driving that is that there is a lot of equity capital sitting out there that will expire either at the end of this year or next year. And, frankly, that does change the dynamics. I know there are funds between $1 billion and $10 billion raised in 2007 and 2008. Many of them got an extension, but the money is running out in the next 12 to 15 months, so that money has to be deployed.

Flynn: What is driving demand for health care companies?

Husain: Some of the public companies are now trading at record multiples. Companies like Team Health, Medal and IBC are trading at multiples that we haven't seen in years. Hospital multiples have come up in the last six months and are up 30 percent. There is less uncertainty now than there was back in October.

Kamran: Lack of volume also impacts pricing. A lot more people will be chasing deals that they usually wouldn't just because there's not a lot of good ones out there. So you'll bid a half a turn, one turn, more than you normally may because the opportunity is in front of you and there is pressure to put capital to work.

Flynn: What's the fundraising climate like?

Morfitt: The fundraising market has been slower because limited partners are taking their time to determine how and where to allocate capital. It's a much different fundraising market now even though there's probably as much equity in the LP market as there was in 2008.

Schillinger: We raised our third fund, which was a substantial step up from our second fund. We raised $265 million of capital. It took us a little more than a year; we started at the beginning of 2012 and we closed at the end of January 2013. We had a lot exposure in our second fund to European funds that had struggled in this environment. So their access to capital and their capacity to continue to deploy it and support existing general partner relationships was not what it used to be so we had to look for some new capital for the third fund.

Flynn: How are developments in technology changing the companies that you invest in and creating opportunities?

Miller: Intravenous feeding tubes are historically placed blindly. The nurse will come up to the unconscious patient and snake it up the nose and hope it goes into the stomach instead of the lung then generally take an x-ray to make sure it's placed correctly. Sadly, occasionally things happen and the tube goes into the lung, which can be fatal. One of our portfolio companies came up with a product that is a bedside monitor that gives a three-dimensional visual of where the tube is being placed so you make sure you're going in the stomach.

This method is more expensive. You have to buy into a device, but generally the snaking can be done in one try instead of poking around, which leads to less likelihood of pneumothorax, a condition that causes collapsed lungs. This technology can improve patient care and reduce potential long-term expenses and make the nurses happier and the patient happier in a holistic way.

Morfitt: Data collection is big. You need to have the data to know what's happening. And that's been very tough. How do you have the data and the view of what is happening to the patient from soup to nuts? How do you analyze that and how do you optimize it? Data on the patient and the patient care has never been more valuable to optimize.

Kamran: Since the American Recovery Reinvestment Act in 2009, I read $9 billion has been spent across 174,000 professionals, 3,400 hospitals. So the hospitals that are better off financially can spend more on enterprise systems, but there are a tremendous amount of hospitals that barely break even and can't afford this.

Husian: People would argue that the adoption of information technology in health care is still disappointingly low.

When you go to the doctor's office, there are still paper-based records. When you go to the hospital, outpatient clinics don't speak to your doctor electronically. It's kind of a mess out there and there's a lot of redundancy in the system. We invested in Allscripts 15 years ago. It's now one of the leading electronic medical records companies. But the adoption by the industry as a whole is very low. There's more that has to be done here. In the next decade health care will become better, with a lot of IT improvement. It's happening, but slowly.



Roundtable Participants

Mary Kathleen Flynn, Mergers & Acquisitions (moderator)

M. Fazle Husain, Metalmark Capital

Faraaz Kamran, Madison Capital (sponsor)

Brian Miller, Linden Capital Partners

Brian Morfitt, Frazier Healthcare

Doug Schillinger, DW Healthcare Partners

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