Brief Intro on what Private Equity is
Bottom line: Private Equity ("PE") is a type of capital investment.
Private equity firms are financial companies that raise money from private sources to buy ownership stakes in companies of interest that fit their funds’ investment thesis.
Firms raise money (AKA, capital) from various sources including wealthy individuals, endowments, other private equity firms, and other sources in order to make direct, control-level investments into private companies.
The firms get the money, allocate it to a fund, then invest that fund into a portfolio of assets based on strategic objectives outlined in the fund’s investment prospectus. I’ll get into examples of healthcare portfolio companies in just a second.
These private stakeholders choose to invest in the PE fundraise based on an initial investment prospectus. The prospectus outlines fund goals, time horizon (typically 5-7 years), and expected rate of return.
Why give private equity your money? Individuals and institutions invest in PE firms to generate higher investment returns than the stock market or other publicly available investment options. At the same time, because of the illiquid & concentrated nature of the investment (usually into one industry like healthcare), the strategy tends to be riskier.
PE activity has been increasingly prevalent in the historically low-interest rate environment as debt financing can often be used to fuel M&A activity and growth.
Availability of Capital - Dry Powder and Low interest rates
Private equity activity in healthcare is still relatively new in the grand scheme of things.
Along with policy changes, the macro economy held interest rates at an unprecedentedly low level after the global financial crisis, which allowed PE to borrow debt at exorbitantly low interest rates over the past decade.
Easy money policies drove up the money supply and level of capital, which caused private equity and other players to seek investment returns outside of their traditional industries and increase speculation. Preqin and others estimate that the level of ‘dry powder’ - that is, the amount of money sitting in funds and not invested - is around $1.9 trillion.
Along with easy money monetary policy, the ACA implemented major changes and fueled consolidation.
As a result, private equity moved into healthcare in a big way.
Healthcare is highly fragmented - the PE Roll-up Playbook
The PE playbook in general works something like this:
Raise funds → use those funds to create a platform in a healthcare sub-industry → make a splashy first acquisition of a large player in that space → finance tuck-in acquisitions (AKA, buy smaller firms to add to the platform) at lower multiples via debt → implement performance improvement plans to enhance profitability of operations → sell the platform business to another PE sponsor or strategic player after 5-7 years at a higher multiple → send investment returns to stakeholders. Rinse, repeat.
So what makes this playbook such a perfect fit in healthcare?
The healthcare services industry is fragmented - meaning that historically, provider organizations are small businesses. Mom and pop shops, if you will. One or two physician groups. One home health agency. One or two hospice locations. You get the idea!
As an example, Kindred Healthcare is one of the, if not the largest players in home health nationwide. As of 2020, Kindred held a 6% national market share if that gives you any idea as to the opportunity for tuck-in acquisitions here.
To add to the perfect storm of PE activity in rolling up healthcare, it’s increasingly difficult to operate a financially viable business as a small business.
For instance, as a small physician practice, layering on EMR and IT costs, facing declining reimbursement from Medicare, and maintaining no negotiating leverage over payors in fee for service land all are major challenges and have been exacerbated by the pandemic.
Factors like these have continued to incentivize consolidation and have been a boon to private equity activity in healthcare.
It’s why we’ve seen a plethora of portfolio companies across all physician practice specialties, physical therapy clinics, home health agencies, hospice agencies, inpatient rehabilitation, hospitals, etc. You name the service - private equity is probably there.
Healthcare’s Inelastic Demand
Private equity players see the writing on the wall for the future of healthcare. With Medicare beneficiaries increasing every day, there will be (and already is) a growing need and expansion in demand utilization for healthcare services across the board. Demand for services is growing for a number of reasons, a few listed below:
Healthcare is a massive part of the economy. As every healthcare aficionado’s favorite statistic, the U.S. spends around 20% of its GDP on healthcare. This total equates to about $4.1 trillion, or $12,531 per person. Since 2000, spending growth has increased 5.8% on average.
Secular growth in Medicare population. An average of 10,000 seniors age into Medicare EVERY DAY. In fact, the total Medicare population is projected to grow to 79 million by 2030, which is double the amount of beneficiaries in 2000.
This secular growth is a major force shaping the industry. As a result, investments in senior-specific services have skyrocketed from the coming Medicare surge.
Growth in chronic conditions. Hand in hand with the aging U.S. population, growth in chronic conditions like diabetes creates a long-term trend to spur continued investment.
As a result of the above factors and plenty more, PE and others involved in healthcare are investing heavily in physician specialties and senior care.
It’s a simple equation when you think about it from a profitability standpoint. Physician ancillaries are highly lucrative, and a number of specialties stand to gain from continued demand:
Ophthalmology investment thesis → tons of seniors will need eye care → cataract lens replacements are profitable in the ASC setting → roll up ophthalmology groups
Gastroenterology investment thesis → current guidelines recommend colonoscopies at age 45 → lots of procedures can be completed in a day → roll up GI groups as we enter the “golden age of older rectums” (sorry, I just had to).
Orthopedics investment thesis → MSK conditions are rampant, seniors will need knee and hip replacements → these are increasingly being performed in outpatient settings (Total Joint) → roll up orthopedic groups
With any specialty platform private equity pursues, the money exists in the ancillary services. After creating a platform and rolling up physicians, PE invests in and develops other revenue streams for the company in adjacent services like anesthesia or pathology / lab.
PE is heavily involved in the post-acute industry as well. We’re all aware of the struggles at nursing homes & SNFs, but they’re also invested in inpatient rehabilitation facilities, rolling up physical therapy groups, home health agencies, hospice, developing MA clinics and risk-based plays, behavioral health hospitals and clinics, and PACE programs.
The Opacity of Healthcare Pricing
A distinct issue in U.S. healthcare: patients don’t know prices, and reimbursement is a closely held trade secret (for now). This is a classic problem in healthcare and why there’s so much talk around the need for increased consumerization and ability to shop services.
As far as healthcare services are concerned, consumers have been historically insulated from knowing the costs associated of going to high-cost providers. They don’t care or are even aware of the cost as long as insurance covers it.
So as you can probably imagine, this dynamic helps out larger services firms who can extract higher prices from insurers by maintaining negotiating leverage in the fee-for-service game.
As PE adds more and more physicians or agencies to their platform companies, they benefit from an immediate revenue synergy in the form of higher reimbursement for the same services. The tactic is essentially pricing arbitrage, and don’t be fooled - it’s not just PE that engages in this strategy.
Anyway, I wanted to bring up this final topic to disclose one final reason why consolidation and scale is the name of the game in healthcare for the time being as another reason why PE rollups have been and continue to be so successful.
Conclusion and Brief Commentary
So hopefully this high level dive into the world of private equity helps you guys understand their motivations for investing in healthcare!
On a final aside, I do want to mention that I’ve worked in the past with both ‘bad’ PE players and ‘good’ PE players. I want to drive the point home that private equity is an investment vehicle, and isn’t good or bad itself - it’s gray.
You can be profit-motivated and be a good partner, provide quality patient care, listen to your staff, increase accessibility, help physicians and other entities with capital investments, etc.
You can also be profit-motivated and screw over physicians, mislead them on their equity stakes, refuse to invest in culture, push insane productivity metrics on them, cut staffing at nursing homes, hospitals, or practices, scalp insurers for out of network ER coverage, and neglect patients in hospice care.
I’m not defending patient exploitation whatsoever and want to acknowledge the fact that private equity’s business model in healthcare, along with how our healthcare system is set up, lends itself to easy exploitation. I get it.
I know I’ll get some pushback on the above points in a number of directions, but please don’t forget: U.S. healthcare is a for-profit business whether you like it or not. Stakeholders invest in healthcare because they seek returns, and that isn’t limited to private equity. I'm just here to keep it real while being cognizant of the fact that major change is continually needed in our broken system if we're going to pursue this weird pseudo-capitalism model for healthcare.
I’m sure there are plenty of points that I’ve missed on both sides, so please feel free to reach out with your comments and thoughts on this highly contentious topic in healthcare.
Thanks so much for reading, and again, please hit me with your (respectful) thoughts.
Resources on Private Equity Investment in Healthcare
